Emeritus professor of economic history; emeritus master and honorary fellow of Trinity Hall, University of Cambridge (United Kingdom)
Unanswered questions & answers
Failures in economic governance and implications for investors
How will the major investments/loans by China to various emerging markets such as Sri Lanka be viewed by history? (Joanna Davison, FEAL)
There is the famous remark of one Chinese leader when asked about the French Revolution – too early to tell. But the serious answer is that it might be seen as a form of neocolonialism akin to British informal empire ie. not direct rule but economic dominance. There might be resistance in the countries receiving loans if debt rises etc, which then means that the Chinese might have to respond in a flexible way – or might take a harsher line. How history views the matter will depend on what happens in the next decade or so, whether it is about postcode development or economic loss of sovereignty
A great analysis of economic history and policy and lots of good ideas. Do fiduciary investors have a duty not merely to consider the risks, but to consider the mitigants, and play a part in driving solutions (Mark Mansley, Brunel)
Very much so. I talked to one participant who made that point. It is both altruistic and self interested, for if problems are not mitigated there might be a serious threat which will be more damaging. My historical analogy would be to the British ruling elite i. The early 19th century who realised that reform was a way of preventing revolution.
Do you think people in developed countries are too well-off, relative to the 30s, for populism in a very radical way to take hold? (Success of Thatcher property owning society) (Kate Barker, British Coal Pension Schemes)
Not sure that the issue is the absolute level of income or relative change. The graph I showed indicates that developed middle class is still richer than in emerging markets, but a sense of. Ot advancing on the previous generation, of problems in buying a house or securing a good pension leads to a feeling of frustration.
Is it possible that governments have actually lost the ability to control international trade as it goes increasingly digital and has fluidity that trade in physical goods does not? If so, is it possible that governments may not be able to regulate international trade effectively? (Wylie Tollette, Franklin Templeton)
Yes, that is the big challenge. I suppose it is one reason for problems with the WTO and the failure of the Doha round on services, intellectual property. But the issue is also domestic, in how to deal with intangible capital which is now larger than tangible capital. We need to think about how to va,je and tax.
Entering a more dangerous time
Co-chief investment officer, Bridgewater Associates (United States)
Do you believe that the interest rates will go up in the next 5 years? (Marcin Borratynski, CERN)
We really don’t know, and as much as possible we try to avoid making such long-term predictions. There are competing considerations – on the one hand, the possibility that deflationary forces prevail and we enter a prolonged depressionary period such as what Japan has experienced can’t be ruled out, which would imply that interest rates stay low and even decline further from where they are now. On the other hand, the possibility that we see higher than expected inflation, for example because of populist policies in reaction to the next downturn (given the traditional monetary policy tools are near their limits) has to be considered, which would imply higher interest rates. The most important thing from our perspective would be to ensure that your portfolio can survive either outcome, and not to bet too much on either one.
Negatively correlated returns are a holy grail of diversification. Where do these return streams exist in large enough size to be meaningful and how can we be confident that negative correlation will hold in a severe market drawdown? (Tanya Branwhite, Tcorp)
As far as negatively correlated return streams, I was referring to alpha – unfortunately, we don’t think it’s possible to find negatively correlated betas, as all betas share exposure to risk premiums and discount rates. (Though as mentioned in my next answer there are lowly correlated betas that we think investors should be taking greater advantage of.) And alpha is almost by definition hard to find, as it requires unique insight not priced into markets, and even uncorrelated alpha is rare. So I’m not saying this is easy by any means. But the point I would make is to seriously consider the relationship of your alpha to your beta, and to recognize that how diversifying an alpha is can be as important as how good it is. You can apply this line of thinking to the managers you already have, in assessing whether you’ve appropriately sized those allocations, as well as to internal alpha decisions (for example, tilts) you’re considering. And we’d take a fundamental approach to understanding diversification, as opposed to relaying on measures like historical correlation. As an example, alphas that are short assets you already hold in your beta portfolio are structurally diversifying and reliably negatively correlated over time. As we apply this approach, we look at all of the alpha views that we have at a point in time and select the ones that are structurally most diversifying to the beta we hold (e.g., alphas that are short the assets we hold in our beta). Of course, you have to be right in your active views, and any alpha will lose money at points in time. But alphas that are structurally diversifying give you at least a fighting chance to make money in environments when all betas underperform, and we think that’s about the best that you can do in terms of portfolio design.
What would be the one thing to change in a 60/40 portfolio in order to get some more balance (Niina Bergring, Veritas)
When we look at a typical 60/40 portfolio, what stands out to us is that the portfolio is biased to do poorly when growth is weaker than expected, or inflation higher than expected, or both. And from a strategic perspective we’d think it’s equally likely that growth and inflation surprise to the upside vs. the downside, as it’s all relative to what markets are already discounting. So the most impactful changes to make to that portfolio are ones that bring it into better balance with respect to growth and inflation. Inflation-linked bonds can be a valuable addition as they do well in weaker growth and higher inflation – they have the opposite biases to a 60/40 portfolio. But there are other ways to get better balance – real assets like commodities and gold can help on the inflation side, and nominal bonds can help on the growth side. We’d also stress the importance of getting better geographical balance (not overly concentrating in any one economy or region), which has been made much easier with the opening up of Chinese markets. Of course, no matter what assets you hold you are always exposed to shifts in investors’ preference for cash vs. assets: in environments of rising risk premiums and discount rates even a well-diversified portfolio of assets can underperform. The only way we know of to deal with this source of risk is with alpha, in particular alpha that doesn’t have embedded beta.
How is environmental balance assessed? (Eric Zwickel, HSBC)
As alluded to in the previous answer, while particular assets are driven by all sorts of things, at the broad asset class level growth and inflation are the dominant drivers – that is, whether growth and inflation come in higher or lower than markets were discounting, and how future discounting of growth and inflation changes. So we assess environmental balance primarily by looking at how a portfolio and is exposed to these two drivers (growth and inflation). The environmental sensitives or biases of an asset are just a function of the nature of its cash flows and the discount rate used to value those cash flows, and you can understand these logically (as opposed to statistically). E.g., stocks give you a claim on future earnings, so they discount a future path of earnings growth and are worth more when earnings and the economy are stronger than expected; bonds give you a fixed stream of payments and discount a forward path of interest rates for valuing those payments, so do well when interest rates unexpectedly fall due to unforeseen economic weakness. You can apply this same approach to any asset – even private assets – to understand its biases. Despite the many differences in institutional portfolios, at the end of the day when we apply this lens, most portfolios we see are significantly biased to do poorly when growth is weaker than expected and/or inflation higher than expected.
How do you think the huge amount of global debt will be reduced to a more balanced level and over what timeframe? (Gerard Parlevliet, Prime Super)
The most fundamental economic challenge most economies have is that the claims on purchasing power are greater than the abilities to meet them. When you add up all of the debt and other IOUs across the developed world, there are too many promises relative to future goods and services. One the one hand, savers and retirees believe they are holding assets that will produce enough income to fund their future spending without having to work. On the other hand, workers expect to get spending power that is equal in power to what they are giving. However this gets worked out, someone is going to be disappointed. We call this the “big squeeze.” We don’t see this as an immediate crisis but rather expect it to play out over time as the reality of lower asset returns and lower growth sets in. And while it’s far from clear how it will be resolved, barring a productivity miracle ultimately the IOUs will have to be reduced either via debt restructurings or monetized. The more likely path as we see it is the latter — bigger fiscal deficits, and monetizing the government debts arising from them, because it’s the least obvious way of redistributing wealth. But with the current degree of political fragmentation and populism which is only likely to get worse as these issues intensify, there’s a wide range of possible policy responses and outcomes, and this will be a critical dynamic to monitor.
If you have any further questions, please feel free to contact Greg at [email protected].
Building a culture of innovation
Global head of investment content, Willis Towers Watson (United Kingdom)
Does the panel think that the governance in managing assets create a greater challenge to innovation on the way we are able to manage and invest? Innovation often implies risk. (Tanya Branwhite, Tcorp)
Exactly so. Investment is always a balancing act between applying risk (in ‘right’ amounts and types) in pursuit of value. So innovation as the pursuit of new ideas and ways of doing things offers a particular type of ‘risk’ and opportunity for value. In practice, the governance issue is there. The conservatism of asset owners leads them to favour continuing with strategies and methods that have been effective so far. This produces some tension with this ideal state where the future is not so likely to be an extrapolation of the past. Governance circumstances produce this fear of under-performance from an innovation relative to the counterfactual of staying put. This often produces an argument against innovation.
The logical case for thinking creatively about new ideas and ways of doing things is strong given fast-changing landscape conditions and organisational circumstances. Stronger governance will support innovation by being prepared to take some calculated risks which over time can create greater value over time; weaker governance will be innovation-averse and in the long run funds will be the poorer for this. I continue to think that innovation to address the highest order issues: getting to break-even returns in nearer-term headwind conditions; building resilience and sustainability into processes and strategies; evolving a more purposeful version of capitalism that creates more value for more people. These are not just ripe for innovation, they are essential. These innovations are not risky to do, they are risky not to do.
Is building real diversified teams an important component to achieving innovation? (Gerard Parlevliet, Prime Super)
Some great innovations come from individuals, some from teams. Certainly diversity in teams improves the chances of producing innovative thinking if those teams have good processes for settling their differences and exploiting their diversity. Probably the best single model of innovation is where an individual has a great idea that those in the team around that person improve by constructive challenge.
To innovate you need to be able to be prepared to fail. How can you innovate when looking after other people’s money is involved if part of the process could be initial failure? (Gerard Parlevliet, Prime Super)
This question is similar to Tanya’s. We might draw a distinction between innovation in the investment portfolio itself where the concepts of ‘experimentation’, ‘learning from mistakes’ and ‘test and learn’ seem inappropriate for other people’s money because any under-performance will be badly received; but innovation in the operating model of asset owners where the benefits or otherwise of innovation will emerge without a performance ‘shadow’ has a clearer business case.
Do you have an example of a powerful lesson learned through failed innovation? (Peter Hosier, Conexus Financial)
Innovation is a cousin of transformational change. In any change process success or failure are dictated by strength of vision and depth of leadership commitment. The most powerful examples of failed innovation tend to be associated with omissions in one of these areas. In vision issues, I would cite 130-30 funds as not producing enough of a need, and so that innovation failed. I would cite robo models as often failing so far because the vision is not properly embracing the human element needed to reach investors. In leadership commitment, if too much of the innovation comes from one individual then failure usually follows. I would cite a number of mergers in asset management as reflective of this problem.
Geopolitics – Brexit and Europe
Professor of public policy, University of Cambridge (United Kingdom)
Do you think Brexit will take place whatsoever with or without a deal? Will UK have to leave EU on the deadline in June as the latest if EU does not agree to further extension? If 60% of British now believe should remain in EU, why are these public opinion changes not reflected in the paramount? (Xingdong Chen, Peking University; BNP Paribas)
The likelihood is still that the UK will still leave the EU, but if a second Referendum is held, and Remain is one of the options, it is still possible that it may not. A long extension to the Article 50 decision process makes the possibility of a further Referendum more likely. At the same time, both main parties are currently trying to come to an agreement which would make it possible to pass the Withdrawal Agreement that would enable Brexit to happen.
You mentioned that Brexit has a much higher saliency than party loyalty among citizenry (and presumably local party activists). Should we focus on the leaders’ desire for party cohesion as the lens for understanding policy instead of economic rationality? (John St-Hill, NEST)
The challenges of party management are a very important dynamic within the current crisis over Brexit. Both leaders face significant opposition within the parliamentary parties and this makes the prospects of keeping their parties together over this issue extremely hard. More generally one of the challenges of an issue like Brexit – which touches on fundamental issues about self-government and national identity – is that for many people, the idea of restoring sovereignty to your own parliament trumps calculations informed by economic rationality. That is something that the ‘Remain’ side did not really factor in to its calculations during the Referendum campaign.
Suppose Brexit takes place by April 12 without deal, what will you do? Is it really that different with or without a deal as the trouble has been for so long? Do you have plan for that? Doing nothing or making major change into your investment portfolio? (Xingdong Chen, Peking University; BNP Paribas)
A ‘No Deal’ scenario is very different to leaving with an agreement in place, because of the nature of the disruption it would bring to supply chains, to the movement of goods, and also to consumers. More generally, there is the risk of a severe market shock, and the possibility of other European economies being damaged in the short term. But at the moment this prospect looks fairly unlikely if the EU 27 are willing to offer the UK an extension to Article 50. My sense is that most investors are delaying decisions as they wait to see what kind of exit the UK has from the EU.
China: opportunities and threats
Director and chief strategist, China Wealth Management 50 Forum (China)
Do you agree with Professor Kotkin’s analysis of communist party fragility? (Kate Barker, British Coal Pension Scheme)
No. I’d agree with Xindong on my panel that President Xi and the communist party are very pragmatic to make changes that are helpful for the majority of Chinese people.
Could you add any context to the performance figures for alpha she gave for the Social Security Fund? (Roger Urwin, Willis Towers Watson)
From the founding member of Mr. LI Keping, during his years (2003-2010) as CIO of SSF, they achieved annualized alpha of 15% in the equity portfolio. It’s a combination of both security selection and timing.
What are the prospects for meaningful corporate governance reform in China that encourages board independence and shareholder engagement with foreign investors? (Mariela Vargova, Rockefeller Family Office)
Chinese investors and regulators welcome foreign investors to bring best practice on corporate governance to Chinese companies. A healthy market with good companies would be beneficial to all participants.
The challenges and opportunities of an ageing population
Chief executive, Octopus Healthcare (United Kingdom)
Do you believe AI or AI Robots will help to resolve or to alleviate the demographic problems? (Xingdong Chen, Peking University; BNP Pariba)
There are some areas where this will certainly help, for instance:
- Sensors constantly monitoring environments and people’s vital stats, with an AI engine to interpret this and detect or preempt problems / treatments in real time. This will help people to be able to stay safer and longer in their homes.
- Driverless cars will enable elderly people to remains more independent, for longer.
- Robots in care environments to perform certain tasks, such as personal care
With the clear and long trend in life expectancy why has the pension system and governments not recognised this in the years we can and should be expected to work? (Tanya Branwhite, TCorp)
This is one of those problems that people have been aware of for a long time, but not enough has been done. There have been some changes in the UK. For instance it used to be possible for an employer to force someone to retire at 65 – which was scrapped in 2011. Also, the pension age has been increased in the UK from 65 to 66, and will increase further to 67 by 2028. One of the challenges is that political cycles are quite short, and the changes needed to really address the ageing population would be deeply unpopular… so no government is really making the big decisions needed – for instance increasing taxation, creating new compulsory insurance products, creating incentives to save for care funds, etc.
How would the aging demographics impact the retirement expectations? Wouldn’t it foster willingness to work longer and even to seek new careers later in life? If so, are we equipped to meet this challenge at a policy, societal and investment level (Mariela Vargova, Rockefeller Family Office)
Absolutely – and this should be applauded. Many people want to continue working – but more flexibly (both in location and days per week), and workplaces need to accommodate this. This is a similar challenge faced with the workplace needing to be more flexible around highly qualified female workers who have children, then want to work part-time in their careers.