Submited by Yves Lamoureux of Macquarie Private Wealth
Liability-Driven Investing & Equity Duration: Implications and Considerations for Investors
Asset classes behave as expected - at least for some of us. Scenarios of both deflation and hyperinflation appear priced in. Do not expect to get rewarded on confirming events.
Our recent performance underscores the benefit of thinking in terms of liability-driven investing.
Analyzing pension liability risks is the first step in determining future market influences and direction. A major error of judgment by portfolio managers at the end of the 90’s was allowing equities to continue to dictate asset allocation. The equity premium has not materialized in the last 10 years.
You know where we stand: bonds will outperform stocks.
The massive exodus of retail investors from stocks will eventually end. I am ready to suggest buying any cheap stocks the market offers but I am not holding my breath.
We have already suggested looking at grains and soft commodities on top of long treasuries to be adequately immunized. I did by the way recently warn that it was too crowded a place. With the recent correction in Treasuries, it does give us a further entry point and, yes I am still in the bull camp.
I have also been a strong hard asset follower for quite some time. I am now worried that this trade has become too crowded. Let me explain.
Let’s take, for example, an inflatable life raft. If maximum capacity is 12 people and 36 poor souls looking for escape and survival climb aboard, the life raft will sink and will defeat its purpose. This is perhaps the tragedy in the making now in gold and corporate bonds. High uncertainty surrounding markets supports behaviour pricing big risk premiums in anticipation of events.
One key catalyst for hyperinflation that is not found is wage pressures, as wages must be forced up. You also do not find a loss of productive capacity but rather you find more capacity underutilized. I certainly can tell you that you do not see hot money moving in and out of the USA as it only wants to get out.
In studying behaviour we have this huge lacuna where complacency is the order of the day. Really? When was the last time you heard news of a run on a bank ? It is one of the traits of lost of confidence in a system. This is one that has always amazed me. If you knew your bank was going under, wouldn’t you rush to get as much out as you could? In this case, it would seem not. This is an essential trademark of hyperinflation to sustain itself. If not, it only flares up and is over quickly.
I am always delighted to show the equity duration graph. Here is the most recent version courtesy of Aye Soe at Standard and Poor’s. You will notice that equity duration has become shorter and stands at 21 years. It is important for pension funds to understand this concept as a way to match their assets with their longer duration liabilities. In practice, this will drive most pension funds toward long duration bonds and longevity products.
Using an empirical approach, they estimate the duration to be 9.63 years as of mid-2010. You will notice the difficulty in matching liabilities with shorter duration equities. A point I have always referred to as a mismatch.
Here is a novel strategic idea for regular folks in these uncertain times: CASH
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