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Survey Report

Five-Year Capital Market Outlook — 2019 Asia


By David Hoile | February 26, 2019

Surviving and thriving in a late cycle environment

We expect that 2019 will bring a trilogy of challenges to Asia. In particular:

  • We anticipate a material slowdown in growth in most of the major economies in 2019, with downside risks rising as we move into 2020. We believe that this will put pressure on the operating environment of many corporate sponsors.
  • Relative to our medium-term outlook, we think valuations for growth-related assets are still high and expect low returns on average over five years, putting pressure on savers’ wider financial positions.
  • Achieving fixed “inflation plus” targets - and hence meeting savers’ expectations – is going to be difficult in this environment in our view, even over longer time periods.

Here is an overview of our Outlook. Download the report to read more.

Key actions from a macro viewpoint also make sense through other portfolio construction lenses

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At Willis Towers Watson, we believe no single approach to portfolio construction can yield “the answer.” Therefore, we consider the problem through multiple "lenses," four of which are displayed below — our delegated/"outsource-CIO" portfolios capture more but we simplify for illustration. Doing so shows that ideas make sense based on our macro views will tend to make sense anyway.

Five portfolio priorities for a surprise-free 2019

We think the chances of nasty surprises has gn. How can we deliver needed returns, whilst reducing the risk of unexpected events?

1. Diversify

Why? Diversification is always a good idea and is an especially good idea now. Relative to equity-heavy peer groups, it is not always painless, but we remain firmly of the view it will prove correct.

How? It doesn’t (always) have to be. Ideas that are consistent with our macro outlook are discussed below.

Many investors could still benefit from diversifying equity risk. Simple ways of doing so include investing in:

  • Alternative credit: Many institutions have added credit to their return-seeking portfolio through relatively vanilla loans, high-yield or multi-strategy alternative credit mandates. We strongly believe success in alternative credit is driven by a consistent and persistent focus on manager and strategy selection. Over the past few years, new and better strategies are available in niche, undercapitalized areas of the market. Private debt (bridge financing) and parts of securitized markets are key examples.
  • Alternative beta: Some hedge fund strategies are just expensive, but novel, forms of beta. Over the years we have sought to strip away the complexity and fees and provide these betas to investors cheaply. These strategies include reinsurance and momentum, which have the benefit of being much less macro sensitive than equities. Selectivity, innovation and scale – if it doesn’t exist, create it – are required.
  • Low beta hedge funds: (See priority #4, Alpha).
  • For investors with strong domestic or regional focus in their portfolios, we recommend continuing to diversify equity and bond exposure internationally.
  • We advocate a ‘whole-portfolio’ approach to the additional FX exposure this creates, which itself can add important diversity. The USD deserves special consideration given its downside hedging characteristics (see priority #3, Dynamism).

2. Reduce unrewarded risks

Why? Because risk should only be taken if it is required and rewarded.

How? An implication of our longer-term outlook is that the same forces pushing long-run expected returns lower are also pushing the returns required to meet savers’ objectives lower. Might you be targeting a level of return and risk that is high relative to what members actually need? We suggest assessing overall risk employed in the portfolio to assess if required return targets are appropriate.

We also encourage investors to integrate scenario analysis into risk management. This has two dimensions:

  • Macro scenarios: We believe we are approaching an inflection point in the business cycle and have passed it in the capital cycle. This creates additional uncertainty that traditional risk management approaches will struggle with. Considering the impact of, for example, a Japan-style deflationary equilibrium emerging in the developed world will provide an intuitive understanding of macro risks.
  • Climate change scenarios: Climate change is, in our view, an important form of systemic uncertainty that long-term investors face. Grappling with its impact on a portfolio is daunting, but we strongly believe scenario analysis is the answer. Even an approximate understanding of portfolio exposures to climate risk factors can help indicate the easy wins to reducing financial exposures and, for those inclined, to improving the nonfinancial impacts that are likely to become more important.

Finally, all these and other risk metrics can be combined to form a Portfolio Quality Scorecard. This embeds beliefs about expected returns and risk under different scenarios, dynamism, diversity requirements, illiquidity, fee tolerance, peer risk and sustainability factors (among others) and quantifies the current portfolio’s standing relative to them. The result is a holistic view of risk and portfolio resilience that can be used to assess future portfolio changes.

3. Macro and dynamism

Why? Understanding the range of outcomes is an important way to reduce uncertainty. That understanding can be used to dynamically manage risk or to create value. The latter is hard and should only be undertaken by those with the governance budgets and beliefs required. But using dynamism to manage risk is more widely accessible.

How? In most cases, effective dynamic risk management means focusing on downside risk and introducing intelligent protection. Diversity is the first answer here, but there are others:

  • Increase exposure to high-quality bonds: Return-seeking assets tend to do well when GDP growth does well. The flipside is they don’t, when growth expectations deteriorate. Adding exposure to US, or possibly Chinese, bonds is typically diversifying in ‘normal’ times, and returns are especially good in the downside economic outcomes we expect. Our preferred approach is levered exposure through interest rate futures but a less capital-efficient version of this would be to dynamically underweight the credit portion of global aggregate portfolios in favour of treasuries.
  • Controlled unhedged FX exposure: For investors with pro-cyclical base currencies, unhedged exposure to currencies like the US dollar and Japanese yen can add downside protection in significant market sell-offs.
  • Ideas to dynamically create value, which we consider for the portfolios we manage, include:
    • Reduce macro risk temporarily: Our outlook suggests taking less risk now in order to take more later. The difficulty of this decision is not to be underestimated, but underweighting equities in favour of less macro sensitive assets ( e.g., alternative credit, alternative beta, low beta hedge funds) or derisking through options should be considered.
    • Reduce exposure to tighter liquidity: Some emerging countries are vulnerable to tighter US liquidity; lower risk corporate debt is another area of concern. For example, in our view, vanilla leveraged loans face a set of medium-term fundamental pressures.
    • Reduce exposure to ‘great expectations’: At the time of writing, earnings growth expectations in the US remain excessive. Consequently, forward-looking returns for US equities in particular are weak. We remain underweight versus the rest of the world.
    • Look to the next cycle: Risk premia will not remain unattractive forever, creating an opportunity to redeploy capital when they are reasonable. While the near-term pathway for some emerging nations is risky, medium-and long-term prospects are strong. Understanding and managing the macro, in particular FX exposure, is critical though.
    • Selectivity in illiquid allocations: While illiquid assets are a powerful diversifier, our outlook suggests being very selective when deploying fresh capital at this stage in the cycle.

4. Innovate through alpha

Why? The reality investors face is, in our view, one of generally low returns – due to low cash rates and low starting risk premia – and elevated volatility as the business and capital cycles move through their late phases. In this environment, the value of genuinely skilled active management is outsized.

How? Finding skilled managers is not easy and requires a relentless focus on achieving truly ‘best in class’ skill. However, with best-in-class alpha in your toolkit you can consider the following:

  • Reduce beta risk by replacing foregone return with alpha.
  • Better, more concentrated equity portfolios: Diversifying exposure to specific risk premia or the economic cycle is one thing, but stock diversification is another and often goes too far within active equity portfolios. Provided you can find a number of truly skilled equity investors with complementary styles to run your portfolio, concentrating your holdings in their 10 to 20 best ideas and combining those portfolios together captures their alpha, controls costs and delivers superior equity returns in most environments.
  • Differentiated, low beta hedge funds: In general, hedge fund performance disappointed over the global financial crisis. However, we remain committed to our approach to hedge fund investment, which prioritises differentiation, low beta and value for money as well as all-out skill. In our view, many portfolios would benefit from exposure to these managers.
  • Skilled fixed-income managers can help you navigate the late stages of the business and debt cycles in bond markets, within alternative credit strategies or within sovereign debt (including FX) mandates.

Finally, we are acutely aware of the tension between alpha and fees. Our focus as advisors may be value for money, but inevitably investors will face increased scrutiny and pressure on outright fee levels. This means prioritising the fee spend to focus on maximising alpha per unit of fee and capital invested. The ideas in the section are presented in the priority order we would suggest.

5. Innovate to find diversity: China

Why? The world economy can increasingly be simplified to three centers of gravity:

  1. The US: a $20 trillion economy, ging at c.4% nominal
  2. The Eurozone: a $14 trillion economy, ging at c.3% nominal
  3. China: a $14 trillion economy, ging at c.8 — 9% nominal

These centers of gravity operate in economic terms (quantified above), political terms and, more recently, investment terms. Until now, locally listed Chinese assets have been hard for foreign investors to access. But China’s gradual financial liberalization means this is no longer true. This third opportunity set is now open to foreign institutional investors and, in our view, cannot be ignored.

How? From an opportunity set perspective, it makes sense to access this large and ging set of cash flows. But, the attraction of China’s markets is not about stellar returns but stellar diversity. Because its economy and capital markets are still relatively closed, its economy and its assets will operate on a different (albeit not entirely decoupled) cycle to the rest of the developed world economies and capital markets. Assets that behave differently mean diversity and it is that which makes China’s local capital markets attractive. Admittedly the economic exposure to China that the Asian region enjoys through trade and capital flow linkages mitigates this somewhat for many Asian investors relative to global peers, it does not negate it.

However, capturing that diversity is not that straightforward:

  • China’s economy will continue to liberalize and manage its reliance on debt growth, which creates a manageable but challenging economic outlook.
  • That, and the wish to capture economic diversity and a broad range of asset risk premiums, means we want to own exposure to both positive Chinese economic outcomes and negative ones.
  • Moreover, there are a variety of issues with existing equity and fixed-income benchmarks – concentration, patchy accounting disclosure, volatile prices – which means being highly selective when investing passively.

Therefore, we want exposure to both risky assets, (e.g., equities and private markets) and bonds. In some cases these assets will need to be actively managed or have some form of cost-effective smart beta overlay, so the governance demands are not inconsiderable. But, the diversity on offer from local Chinese assets is high..

The contents of this article are for general interest. No action should be taken on the basis of this article without seeking specific advice.


Senior Director, Investments

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