With the steep rise in bond yields in recent months, investors might be able to take some risk off the table, Morgan Stanley’s Alexandre Ventelon says
Morgan Stanley Wealth Management has recently finished a review of its capital market assumptions over the next seven years, which will form the basis for any asset allocation changes in the firm’s model portfolios.
Alexandre Ventelon, Head of Research and Investment Strategy for Morgan Stanley Wealth Management Australia, is now in the process of translating these assumptions to the Australian market and adjusting the asset allocation for its domestic clients.
Although this process is still under way, Ventelon says it will be no secret that the forecasts have changed in regards to fixed income assets, compared to last year’s assumptions.
“Without front-running the conclusion of our work, what we can say is that the return expectations for the fixed income asset class, as well as for cash, have gone up quite tremendously, whereas it’s been the opposite for risk assets, especially equities,” he says.
“We know that over the medium to long-term valuations drive most of the returns, and right now valuations are more attractive for cash and fixed income, whereas the high PEs (price/earnings ratios) in equities mean that clearly equity markets face some major headwinds,” he says.
Bond yields, on the other hand, have risen so much that in some cases they tend to be on par with Morgan Stanley’s equity return assumptions.
In our forecast, we have broad bond indices returning between four to five per cent, which is more or less [the same as] what we have for international equities
“In our forecast, we have broad bond indices returning between four to five per cent, which is more or less [the same as] what we have for international equities,” Ventelon says.
“So one of the key conclusions from this work is that, although this might not boost the returns at the portfolio level, to get the same level of return you might be in a situation where you have to take less risk,” he says.
This conclusion is in stark contrast to the measures taken in asset allocation reviews the firm has conducted in the recent past.
“The conclusion of our last SAA review back in 2021 – when bond yields and cash rates were extremely depressed, while equity forecasts were not necessarily extremely strong either – was that clients would have to take quite a lot of risk to generate returns over and above inflation,” he says.
Despite the muted expectation for near-term investment returns, Ventelon says Morgan Stanley actually believes that the world is in the midst of a structural bull market for equities on the back of a number of significant economic and technological changes.
“Our view is that we are in a tactical bear market, within a secular bull market. So we still think that over the medium to long term, a number of things are going to propel the equity markets forwards,” he says.
“Clearly, there’s a global transformation of the economic and geopolitical backdrop that will lead to an enormous amount of capital spending in the next decade, whether you’re talking about the repatriation of key supply chains, or green energy, energy infrastructure, infrastructure in general, or whether you’re talking about security. We think all these are going to foster a wealth of opportunities into the next cycle,” he says.
“Unfortunately, right now we are late cycle in terms of the low unemployment rate, high inflation and growth that has been moderating and that will continue to moderate into next year.
“So with that in mind, we are making the implicit assumption that we should see a recession in the next seven year cycle. Once we have passed this next recession, however, we would be of the view that this next cycle should be a pretty strong one for equities,” he says.
But Ventelon says a recession is not the firm’s base case for the near future. He believes the economy in both the United States and Australia is heading for a soft landing. He also believes that this means any recovery period will be a slow grind.
“In the same way that the fall will not be steep, the recovery will also be relatively sluggish,” he says.
“Coming out of COVID, we called a V-shaped recovery and we got it right. This time around, we call it more of an L-shaped recovery, which means that there are still some decent odds of a recession. We can’t rule it out, maybe [the probability] is around 30 per cent.”
“But even though we are not forecasting a recession, we think growth is going to moderate. We’re not expecting capital markets to shoot the lights out in the next 18 months, so we tend to focus on alternatives and finding more opportunities to generate income in range trading markets,” he says.
Hedge Funds Are Back
Although the performance of alternative assets has been a mixed bag in the post-global financial crisis to COVID cycle, Ventelon says the situation has changed now that rates are likely to stay higher and volatility to remain greater than it has been for a long time.
These two ingredients provide the right situation for alternative strategies, especially certain types of hedge funds, to perform well.
“Alternatives has been our favourite asset class in the last two years. We have been overweight alternatives, and then within alternatives we have shifted our preference last year away from private assets into hedge funds,” he says.
“Within hedge funds, what we wanted to focus on was funds that had the ability to benefit from volatile markets, so strategies with the possibility to go long and short, including long/short, market neutral and relative value strategies. We have not invested in strategies like global macro or trend following,” he says.
Ventelon says the firm has also reduced its exposure to direct private equity in favour of opportunities in secondaries markets.
Competing with Super Funds for Capacity
For long, superannuation funds were the main choice for top performing asset managers, as they were seen as a source of patient, long-term capital. It was especially hard for wealth management firms to gain access to sophisticated, top tier hedge funds.
But as funds have become bigger, capacity has become a problem and many asset managers simply can’t accept the big ticket mandates from the larger funds. Mandates today are often north of $1 billion, or sometimes several billion, while only a few years ago $500 million was the norm.
Ventelon says this has meant asset managers have shifted their focus to the wealth management sector in recent years, looking not just for a new source of funds, but also for long-term partnership opportunities.
“When joining the wealth management sector, it seemed that the very crème de la crème, as we say in French, managers were maxed out by pension funds,” Ventelon says.
Within hedge funds, what we wanted to focus on was funds that had the ability to benefit from volatile markets, so strategies with the possibility to go long and short, including long/short, market neutral and relative value strategies. We have not invested in strategies like global macro or trend following
“They would seek this money from pension funds and in the most illiquid asset classes, such as small and micro caps, this money would force them to soft or hard close. And so it was quite difficult for people in wealth management to secure allocations to these tier one managers.
“This has clearly changed with the environment and now managers themselves seek out wealth management firms and are interested in partnerships with wealth management clients,” he says.
In addition to liquidity and transition management considerations, the increasing fee sensitivity, more recently bolstered by the Your Future, Your Super legislation has only added to asset managers willingness to diversify away from the superannuation industry.
Looking forward, Ventelon expects that geopolitics will have a significant influence on economic activity and subsequently investment portfolios.
The shifts set in motion by the global coronavirus pandemic, including the repatriation of supply chains and ‘friendshoring’, will continue to unfold, while climate change and technological progress will further push changes in the makeup of the global economy.
Geopolitics is, therefore, an important part of the firms underlying assumptions over the next seven years, but Ventelon is careful to point out that investors shouldn’t make any wholesale changes based on a shifting political landscape alone.
“What matters the most from the client standpoint are the long-term implications of structural shifts in the geopolitical landscape,” he says. “A good example of that is the work that the firm has done on what we call the new ‘multipolar world’, which is based on the fact that we think we have past peak collaboration and peak globalisation.
“The post-COVID environment is accelerating this transition out of full, global cooperation and supply chain integration and towards a form of collaboration within allied blocks and the repatriation of key supply chains within those allied blocks.
“Of course this is tied to sub-thematics, such as energy independence, the defence industry, cyber security, as well as, robotics and artificial intelligence,” he says.
Although it is clear that these themes will continue to play out in the near future, it is not necessarily clear how exactly they will affect markets and companies. Investors would therefore do well to act conservatively on new information, he says.
“What pays off in the long run is to not be overreacting and be careful of not moving the portfolio too aggressively whilst having limited information and insights as to what’s going to happen next,” he says.
“You’ve got to be humble; I think that is really the key. Humble by saying that you might not know where this is going.
“But then when the hard facts are coming in, you have to think about not only the first-order effects, but also the second-order ones. In the short-term, the impact is very often about risk aversion,” he says.
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