Portfolio managers who adhere to a method of asset allocation that has served them well for more than three decades may be in need of a wake-up call.
The warning comes as a number of prominent economists are arguing that a demographic sea change threatens to foster rising interest rates, reduced inequality, and stronger wage growth around the globe. This could have huge practical implications for people who manage money, potentially upending the long- standing schematic for asset allocation that sees many portfolio managers split their investments between bonds and stocks.
"Most pension funds and endowments around the world have a similar sort of way of sussing out their projected returns from bonds and from equities and then use historical correlations from bond and equities to build efficient frontiers," Toby Nangle, head of multi-asset allocation at Columbia Threadneedle Investments, said in an interview with BloombergTV. "But if that data that that historical correlation matrix is based on is based on this 35-year period of declining real yields and low levels of correlation, with bonds meaningfully outperforming cash, then this is sort of challenged if that starts to go into reverse."
Such a change would upend typical portfolio management, which has seen asset managers look to the past performance of both bonds and stocks as their guide to the future. Managers usually examine historical volatility and returns to construct portfolios that smooth and maximize returns, depending on an investor's risk tolerance.
The key benefit provided by such diversification is a lack of covariance between assets within a portfolio; in other words, there is a tendency for the two holdings to move in opposite directions. In practice, this results in reduced upside during boom periods but more protection during rougher patches in financial markets.
For the past 35 years, holding a mix of stocks and bonds has been a successful strategy in achieving this end, with the low levels of correlation between the two asset classes resulting in more consistent returns than a fully concentrated portfolio.
Nangle, however, sees the potential for the looming scarcity of labor to reshape economic and financial market dynamics in a piece for VoxEU in May. Along with Charles Goodhart, senior economic consultant for Morgan Stanley and a former member of the Bank of England's Monetary Policy Committee, Nangle proffered the thesis that the fall in global real interest rates over the past few decades has been driven by a massive pool of available workers and the ability to access them thanks to globalization.
The increased supply of workers pushed down the cost of labor and encouraged employers to invest in labor-intensive rather than capital-intensive plants. This, in turn, put downward pressure on interest rates in light of the depressed demand for capital equipment.
As an increase in labor bargaining power and a decrease in global savings pushes interest rates, the price of bonds will head in the opposite direction and lose value. Since Nangle expects stocks and bonds to move more in tandem in a rising rate environment, this manner of constructing portfolios to reduce volatility and produce better risk-adjusted returns must be reexamined.
Data shows that over the past few decades, the volatility of an all-bond portfolio could be reduced—and the returns improved—by adding equity exposure, up to a certain point: