The Investment Committee (IC) met on Monday 23 January and reflected on the downstream impact of the dramatic escalation in geopolitical risks, due to the Russian invasion of Ukraine, now almost 12 months ago, and the associated commodity price shocks.
The macro environment is radically different to the optimistic one prevailing at the start of last year. Global growth has slowed much more than anticipated, whilst the expected ‘temporary’ spike in inflation, rather than easing, further increased and has become embedded. As core measures of inflation remained far above central bank targets and headline rates reached double digits in most economies, this prompted global central banks to embark on the most rapid pace of policy tightening in 40 years.
The current macro perspective can perhaps be best described as a fiscal and monetary ‘hangover’. The previous 10-year plus regime, where a 2% inflation target was made possible due to secular disinflationary forces, is not normal by historical standards. The supply chain problems that emerged in 2021, following the initial economic recovery from Covid, extended into 2022 as labour shortage issues and the ensuing commodity price shock embedded a higher level of inflation and lowered growth expectations.
Now the elephant in the room is high inflation, requiring rising global interest rates and a reduction in the bloated balance sheets of the central banks. This implies steeper yield curves, more quantitative tightening and ongoing high budget deficits. Alongside extended levels of bond market leverage (mainly due to widespread use within LDI strategies) and persistently high inflation, the risk of a liquidity driven global government debt crisis and ongoing bond volatility increases.
The impact of both the energy supply shock and the rapid tightening in monetary policy will slow global real growth, but also risks some economies flirting with moderate or intermittent recession in 2023. This is particularly pertinent to the UK economy, forecasted by the IMF to be the only G7 country to contract this year. It continues to grapple with supply chain issues following the Covid bounce back and has a higher dependence on expensive liquid natural gas, which has been driving up the cost of living even further. This is alongside rising taxes, labour shortages, widespread public sector worker unrest and the persistent lack of productivity growth in the economy.
However, whilst there are significant short-term headwinds in the UK, markets always look forward and signs of inflation easing will help slow the pace and quantum of further rate rises. The IC discussed the latest proposed Capital Markets Assumptions (CMA’s) to be applied in Dynamic Planner. The impact of the sharp rise in bond yields across the board over the previous quarter and the observed uptick in their volatility, has been reflected in the calibration process when setting the CMA’s this quarter.
Given the considerable economic headwinds, the key unknowns are how close we are to reaching the peak in the interest rate cycle this year and the extent of potential corporate defaults, which are still running at low levels by historical standards. For equities, the focus is now on the extent of earnings downgrades and how much of the recession risk is already priced into current valuations.
Dynamic Planner’s asset and risk model provides volatility, covariance, correlation and expected return assumptions, which are updated each quarter. They cover a wide range of bond maturities, equity market capitalisations and alternative assets, thereby equipping users with the flexibility to tilt portfolios relative to the risk-adjusted benchmarks as they see fit. Since the CMA’s are updated each quarter, these remain sensitive to long-term secular trends and reflect the average expected outcomes for investors buying and selling at different times over the cycle.
You can read the full Investment Committee update here
In light of elevated economic and market volatility unfolding globally, and the UK government’s recently announced major tax cuts and increases in government borrowing, the rapid plummet in the value of the Pound and UK gilts has been truly eye-watering. Below, is insight from the Dynamic Planner Investment Committee, to add a more practical perspective on currency swings, away from market noise and speculation.
Exposure to foreign exchange movements goes with the territory – if you want to benefit from a diversified portfolio offering access to UK and global equities, bonds, or alternative assets.
Swings in currencies can however significantly impact portfolio returns, positively as well as negatively, when translated back into British Pound terms.
They are very difficult to predict, particularly over shorter time periods, as we have recently witnessed when market confidence can move rapidly based on changing economic fundamentals. Over the longer term though, the effects of currency movements often tend to even themselves out.
Several asset managers do consider currency movements to be an important part of their tactical asset allocation and currency hedging decisions. Others however avoid trying to second guess the vagaries of foreign exchange markets and instead take a more strategic perspective, relying on a broad mix of currency exposures in their portfolios to even out fluctuations longer-term.
The full implications of shifts in currencies can be hard to fully understand…
- We tend to focus on the face value of a currency, not taking into account its real worth. This can be even more challenging for a ‘home’ currency that we are familiar with and emotionally attached to, as we perceive movements to be more extreme. This has a greater effect on how we feel.
- At an overall portfolio level, by investing in a selection of larger UK-based companies with significant business overseas, well over 70% of the revenue generated is earned in foreign currency, if viewed across the average of the FTSE-100 index. The opposite to this would be investing in medium or smaller sized companies, which are typically mostly exposed to the domestic economy and currency.
At Dynamic Planner, each benchmark asset allocation is carefully constructed to balance return expectations in line with investor risk tolerance.
- For the LOWER RISK benchmark allocations, there is greater emphasis on assets such as UK government bonds and UK equities, plus the added diversification of money market deposits. The overall currency exposure is therefore mainly attributed to the British Pound, thereby reducing the level of foreign exchange related portfolio volatility.
- For the MEDIUM AND HIGHER RISK benchmark allocations, a more global perspective is adopted and as a result, the greater opportunity to benefit from currency diversification. The higher the risk, the greater the exposure to non-UK assets and currencies.
Since 2017, the strategic direction of travel, of the asset allocation decisions taken by the Investment Committee, has been to gradually increase exposure to non-£ assets, both equities and bonds, while prudently adding to money market deposits for added diversification.
The 2022/23 asset allocation review has continued with this strategy.
Join Chief Investment Strategist, Abhimanyu Chatterjee on 20 October for his quarterly update, where he will discuss these allocation changes
By Sam Liddle, Sales Director, Church House Investment Management
For a long time, the 60/40 approach to portfolio management was perfectly effective. Offering a combination of equity-like returns and stable income, it allowed investors to participate in any market upside, while at the same time offering protection during periods of volatility. Simple. However, the approach has faced snowballing criticism over recent years in the face of unprecedented market performance.
Well, over time, as the value of each asset in a portfolio shifts in line with its performance, its size within the total portfolio in percentage terms will naturally also change. To keep the 60/40 split between equities and bonds in check, then, it becomes necessary to sell overperforming assets and add to underperforming ones periodically.
In and of itself, this is not a problem. In fact, rebalancing in such a way is good practice –working to reduce concentration risk and prevent emotion-driven decisions like panic buying and euphoric selling. And in an ideal world, the underperforming assets into which the investor re-invests would see an uptick in performance, enhancing total portfolio returns and smoothing out volatility.
The issue, however, is that this hasn’t been the case at all in recent years. We have seen unprecedented global central bank support since the global financial crisis in the form of interest rates and other initiatives designed to aid economic recovery.
On the one hand, this has consistently suppressed bond yields, leaving them stuck at just a fraction of the level at which they have typically sat historically. On the other, it has enabled equity prices to soar to new records, with valuations stretching to levels consistently highlighted as unsustainable by commentators.
As you’d imagine, maintaining the 60/40 split against this backdrop has consistently required investors to sell off overperforming equities and invest in underperforming bonds. And in the eyes of many, this has been akin to throwing good money after bad, effectively wiping away returns time and time again for no good reason.
So, while the 60/40 approach may not have generated the best returns in recent years, is it fair to classify it as ‘dead’? No, we don’t think so. And the reason why is that things are now changing seismically in the market.
The tremendous injection of liquidity by central banks throughout, and in the wake of, the pandemic has pushed inflation to unsustainable, multi-decade highs worldwide. As a result, those same central banks are now being forced to increase rates in earnest to steer clear of hyperinflation.
Likewise, we are now seeing institutions like the Bank of England and the Federal Reserve move away from their roles as the de facto buyers of corporate debt. In some cases, they have even begun to unwind their recent purchases back into the market.
There’s an argument to be made, of course, that the ongoing conflict in Ukraine is slowing this tightening of monetary policy. But this will only be temporary – higher rates and tougher stances are an inevitability over the long term.
And for many investors, the move away from the seemingly endless ‘growth’ phase that has favoured equities and hurt bonds for so long and into the ‘slowdown’, ‘recession’ and ‘recovery’ phases is going to come as quite a shock.
Indeed, there’s a good chance that we will see heavily stretched equity valuations come into question as rising rates continue to elevate bond yields. And if this takes place, then something closer to the 60/40 approach – with its emphasis on income alongside growth, may suddenly become much more effective.
Yes, there have been significant losses for some bond investors so far this year but by proactively protecting holdings, either through curve positioning (the duration), credit quality or more explicit interest rate hedges via floating rate bonds, is crucial to getting the fixed income element of portfolios right.
Government benchmark yields have risen sharply and holders of too much duration have certainly paid the price. But bear in mind though the opportunities that this readjustment has created through a combination of the increase in the ten-year gilt yield (discounting a move to 1.5% in UK interest rates) and the widening of the credit spread above that.
Only a few months ago, the short end of the gilt curve was almost negative, now we have two-year gilts offering a mighty 1.3%. Not that attractive in itself, but when you add a credit spread on top, you can access a fair yield on a total return basis. There are now a number of quality bonds, issued last year when yields were low, that are trading well below par.
The 60/40 approach to portfolio construction was unquestionably of limited effectiveness throughout the enormous post-millennium equity bull market. However, to describe it as ‘dead’, as many commentators have, is so definitive. After all, it promotes a responsible approach to asset allocation that accounts for both growth and volatility. And in a world where many indicators suggest we are moving towards a more depressed stage of the market cycle, this is becoming increasingly invaluable.
Find out more about Church House investment solutions.
First published on Trustnet. The above article has been prepared for investment professionals. Any other readers should note this content does not constitute advice or a solicitation to buy, sell, or hold any investment. We strongly recommend speaking to an investment adviser before taking any action based on the information contained in this article. Please also note the value of investments and the income you get from them may fall as well as rise, and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future performance.
By Brooks Macdonald
Several major global events – including most recently the coronavirus pandemic and the Russia/Ukraine situation – have prompted investors to flee financial markets, but history shows this could have been a mistake. In this article, we discuss the importance of remaining invested and how missing the best performing days could have led to a portfolio’s significant underperformance over the long-term.
What potentially seems a distant memory, the stay at home orders and dystopian feel to everyday life sent shockwaves through financials markets at the start of 2020, as a result of COVID-19. More recently, Russia’s invasion of Ukraine has rocked markets. In such conditions, it may be tempting to consider exiting the financial markets or switching to cash, with the intention of reducing further expected losses.
Trying to time the market can seriously damage your investment returns
Amidst heightened volatility, it is understandable that many are concerned about the impact on the value of their investments. But, while sharp declines in markets can naturally be disconcerting, if you want to give your investments the best chance of earning a long-term return, then it’s a good idea to practice the art of patience.
When markets fall and fear dominates, it can be difficult to resist the temptation to sell out of the financial markets and switch to cash, with the idea of reinvesting in the future when feeling more positive about market prospects – trying to ‘time the market’. But this is a strategy that carries with it the risk of missing out on some of the best days of market performance. And this could have a devastating impact on long-term returns.
Remaining invested may be an emotional rollercoaster during times of market stress, but research shows time and again that this is the best investment approach over the long term. For example, one study of US equity mutual fund investors showed that their tendency to try and time the market was a key driver of their underperformance (Dalbar, 2019)1. In the current environment, it is understandable that many people are concerned about geopolitical risks, and how this is being reflected in the value of their investments. To give some context, the speed at which the market entered into ‘bear’ territory (typically a 20% decline) in response to the coronavirus pandemic was the fastest in history. The current sell off does not qualify as a bear market but has dropped 10% since recent highs as shown in the chart below.
1 Dalbar (2019). ‘Quantitative Analysis of Investor Behaviour
Despite temptations to switch into cash, data shows that missing out on just the 10 best market performing days can have a big impact on long-term returns.
Staying ‘fully invested’ during the ups and downs has resulted in an initial £100,000 portfolio, for example, having an ending value of £445,000, compared to £250,000 for those that missed the 10 best days in previous 20 years. This effect also highlights the powerful effect of ‘compounding returns’ over time. If, for example, the 50 best days are missed, the long-term returns are indeed negative.
A different way of delivering the same message, where staying invested over the 20-year period generates annualised returns of 7.9%, compared to 0.8% annualised returns if one misses the 30 best days:
One of the most common reasons investors lose money is when they try to time the market, trying to avoid the worst days of the stock market by cashing out and then re-investing when they think the market is going to pick up. However, as the chart shows, the best and worst days of the stock market cluster. Try to miss the lows and you’ll probably miss the highs too.
Missing the best days during the downturn and subsequent upturn can again have a large impact on the returns generated over the subsequent period.
With the benefit of hindsight, we are now fully aware of the global impact of COVID-19, and the rapidity in which it has hit equity markets. While markets rivalled the speed of the virus in trying to price-in the near-term damage, we expected they could also be swift to act when a tipping-point was seen to be close- at-hand. World equity markets returned to highs around 120 days following 2020 lows.
By keeping to an established and proven investment framework, we can look to take advantage of short-term volatility as we continue to seek out longer-term investment opportunities. We look to avoid behavioural biases that may result in decisions that negatively impact long-term return potential. Yes, the journey may not be smooth, but generally it is important to look through the noise, and remain invested during times of market stress.
Investors should be aware that the price of investments and the income from them can go down as well as up and that neither is guaranteed. Past performance is not a reliable indicator of future results. Investors may not get back the amount invested. Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Investors should be aware of the additional risks associated with funds investing in emerging or developing markets. The information in this document does not constitute advice or a recommendation and you should not make any investment decisions on the basis of it. This document is for the information of the recipient only and should not be reproduced, copied or made available to others. The MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)
Brooks Macdonald is a trading name of Brooks Macdonald Group plc used by various companies in the Brooks Macdonald group of companies. Brooks Macdonald Group plc is registered in England No 4402058. Registered office: 21 Lombard Street, London, EC3V 9AH. Brooks Macdonald Asset Management Limited is regulated by the Financial Conduct Authority. Registered in England No 3417519. Registered office: 21 Lombard Street, London, EC3V 9AH.
More information about the Brooks Macdonald Group can be found at: www.brooksmacdonald.com
Like all of us, we are deeply disturbed by what is happening in Ukraine. While it may not be equal to that, we fully understand your clients will have concerns right now.
We want to provide you with reassurance and information below regarding our model and processes, which you can share when speaking with your clients about their investments. If you have further questions or concerns, please do not hesitate to contact the Dynamic Planner Client Success team in the usual way.
Capital Market Assumptions and benchmark asset allocations
Dynamic Planner provides forward-looking, ex-Ante assumptions for real returns, volatility, correlations and covariances, and associated calculations such as 95% VaR. They are calculated objectively through proven, statistical models using many decades of data – and rigidly reviewed, monitored and governed to ensure discipline and objectivity.
In Dynamic Planner, you can accurately risk profile any combination of assets. So, however you choose to position yourself tactically, over or underweight to our benchmark, you can understand the risk and expected return.
At times like this, there will no doubt be assets, countries and companies that will do better or worse. This could also change quite quickly. Ultimately, in the medium to long-term, this will mean a change to the constituents and weighting or ranking of the indices that define the assets within our Capital Market Assumptions.
If you want your firm’s or your clients’ investments to react to these changes, then you would need to rely upon a professional fund manager to do that effectively on your behalf. We would therefore, as we always do, encourage the use of the appropriate Risk Target Managed [RTM], Risk Managed Decumulation [RMD] and Risk Profiled solutions in Dynamic Planner.
Risk characteristics within Risk Profiled solutions
Dynamic Planner is unique in the way that it calculates the risk profile of solutions, especially RTM and RMD. We insist that asset managers provide us with the underlying holdings and their weights throughout the review period, including specific stock and derivatives. We calculate the solution’s risk profile using the correlations and covariances of all those underlying instruments.
We hold a database of more than 40,000 instruments and continually review their risk characteristics relative to 72 asset class indices, considering a wide range of potential factors, depending on the nature of the instrument. Dynamic Planner’s Asset Risk team have been considering these risk factors and how they may change the risk factors of certain instruments in light of the crisis in Ukraine, sanctions and market closures.
The Solutions Risk team are using these live risk factors of the underlying instruments within any solution to calculate its risk profile, as well as engaging with asset managers as to whether and how they may be reacting within their mandate to meet a solution’s objectives.
MSCI ESG ratings
We have always known that this is an emotive, complex and evolving issue that we do not have the in-house expertise or resource to fully understand or monitor at an investment instrument level. We rely upon ESG research from MSCI, respected pioneers in this space. Currently, we only make the MSCI ESG fund reports available to Dynamic Planner users, but we do have the full MSCI stock holdings level data available to us.
We have engaged with MSCI and they have said that, owing to the unprecedented nature of the current crisis, and the severe economic pressures facing Russian listed companies, they have implemented a series of ESG ratings downgrades with immediate effect. MSCI will continue to assess these companies’ ratings on an ongoing basis.
They have applied an ESG ratings ceiling of ‘B’ for all Russian companies within their coverage. Companies that were already ‘B’ or ‘CCC’, retain that rating, but all others have been downgraded to this ‘Laggard’ status.
Within MSCI’s corporate governance methodology, Russian companies will see the application of a ‘Very severe’ assessment on the ‘Other high impact governance events’ key metric. Additionally, Russian state-owned enterprises will see the application of a ‘Severe’ flag on the ‘Financing difficulties’ key metric, owing to their additional risk and exposure to sanctions, export restrictions, and removal of access to international financing channels.
MSCI have also downgraded the ESG government rating for Russia from BBB to B (equivalent to ‘Laggard’ status).
At a multi-asset fund solution level, which are very diversified by nature, it is unlikely that such actions of Russian companies or state will have turned the dial on their overall MSCI ratings yet. However, for those relying upon Dynamic Planner and MSCI data, recent actions are being proactively picked up within the assessment of their ESG risks.
If you have any further concerns about market conditions and your customers, please get in touch with the Client Success team.
It’s been difficult to catch up on the news lately without seeing headlines of inflation hitting 30-year highs. But are we heading back to the 1990s? What can be done? And does inflation even matter in financial planning, asks Steph Willcox, Head of Actuarial Implementation at Dynamic Planner?
What is inflation?
Inflation is the decline of purchasing power of a given currency over time. As is tradition when discussing inflation, this can be demonstrated by the price of Freddos. When I was small, I could buy 10 Freddos for £1. Now I can only buy four. Therefore, my purchasing power has been eroded by Freddoflation.
An estimate of inflation can be reflected in the increase of an average price of a basket of selected goods and services in an economy over a period of time.
The rise in the general level of prices, often expressed as a percentage, is the thing that we state as inflation.
It is of course important to remember that the price of goods can be affected by lots of things, all of which will be captured as ‘inflation’, but could be driven by currency fluctuations, supply issues, increases in business expenditure or any number of different reasons.
Equally, it’s important to recognise that different goods increase in price at different rates, and ‘inflation’, as it is calculated, is only an estimate of the average change in purchasing power.
Freddos have traditionally increased much quicker than inflation, so if your entire basket of goods was made up of Freddos, (please note, this is not a recommendation), your personally experienced inflation level would be much higher than the average inflation level quoted.
What is high inflation?
The Bank of England’s Monetary Policy Committee is responsible for maintaining a target inflation rate, currently set at 2%, although their expectations are that inflation will remain around 5% until April 2022 when it will peak at 6% before gradually returning to the targeted rate.
This level of high inflation is being influenced by emerging from the pandemic, rising consumer energy prices, disruption to supply chains and good shortages.
Of course, the inflation level can’t be allowed to drift forever and the MPC will take measures to reduce inflation through a change in monetary policy. It’s important to note that monetary policy cannot solve supply-side issues, but it can still be used to alter inflation levels in the medium term.
The Committee can choose to change policy in the form of an increase to interest rates, or a reduction in the current quantitative easing programme.
As interest rates rise, borrowing through loans and mortgages becomes more expensive and savings become more profitable. This shifts consumer habits away from spending, reducing demand, and therefore reducing inflation. We’ve already seen one increase in interest rates, making England the first developed nation to increase interest rates following the global pandemic, and more rate rises are expected.
Quantitative easing, which was first introduced in 2009, is where the Bank of England buys back bonds from the private sector, financed by the creation of central bank reserves.
The aim is to increase the price of bonds, by stimulating demand, which will reduce bond yields. As bond yields reduce, so does the interest rates on savings and loans. Therefore, stopping quantitative easing would be expected to reduce the demand of bonds, reducing the price, and increasing the yields. Increasing bond yields will increase interest rates on savings and loans, and thereby lower inflation.
Changes in monetary policies can take up to two years to see their effects fully felt within the economy, so any change in policy will not be a quick fix.
Should I be worried about inflation in financial planning?
With inflation playing such a major role in an individual’s purchasing power, it’s of course vitally important that this is reflected in the advice process, and it is even more necessary when creating a long-term cash flow plan for your clients.
As we see, inflation is not a static number and therefore shouldn’t be modelled as such.
Dynamic Planner forecasts real returns – therefore net of inflation – across its system, in the risk-reward trade-off shown for risk profiling, in investment portfolio reviews and in cash flow planning.
The forecast is generated by a Monte Carlo scenario engine that generates thousands of possible real returns over 49 asset classes. As the returns are real to begin with, the various possibilities for inflation at different times are already factored in. It is therefore inappropriate to guess and factor in other numbers for inflation and apply them to the forecast.
As both the returns and the forecasts are real, you don’t need to worry about inflation – it’s already all accounted for. You can be confident that you are seeing the expected purchasing power of a client’s assets at each point in time, even through these times of increased volatility.
Further to this, the Asset Risk Model and the Dynamic Planner risk profile asset allocations are stress tested to ensure that you can have confidence in our growth assumptions and plan confidently with your client. The stress testing performed in late 2020 focussed purely on inflation and the emergence from the global pandemic.
So, perhaps now is the time to reassure your clients that inflation fluctuations are expected and covered in our modelling, and that their retirement plans will remain on track – as long as they’re planning on purchasing something that isn’t a Freddo.
Read more about Dynamic Planner Cash Flow
Dynamic Planner Proposition Director CHRIS JONES analyses key considerations when creating a Centralised Retirement Proposition for clients at your firm, reflecting on mistakes made during the 2008 financial crisis and concluding by pinpointing three ways to manage sequencing risk.
In retirement planning, there is a moment when the client’s needs and objectives change and you are most likely to recommend a pension switch or transfer – the point of retirement itself when everything pivots.
On one level, you are no longer planning for the future, you are planning for now. A client is no longer putting money in, they are taking it out. A client’s typical day changes and so does their expenditure. And we don’t have to mention pension regulation changes.
You could view PROD and imagine your target market is relatively narrow, defined. You don’t need a myriad of different solutions. And yet it is utterly implausible that you could use the same Centralised Investment Proposition [CIP] before and after retirement, and so the Centralised Retirement Proposition [CRP] was born.
Different factors to consider in a Centralised Retirement Proposition
#1 The pattern and frequency of withdrawals
Does the target client want a fixed monthly income like a salary? Would they withdraw a lump sum each year and spend it sensibly? Can they afford to delay withdrawals? Could they tolerate a variable income?
#2 Sequence of returns risk
If you take a fixed withdrawal of capital each month, then you introduce an additional risk into the portfolio. You may until now have effectively managed the risks in your CIP, but this is extra. Until retirement, the value mattered at annual review. Now, it matters every month when units are sold. This means that the volatility of unit price needs to be managed on a monthly not an annual basis. It isn’t as simple as reducing overall annual risk.
#3 Early loss risk
When we look for past retirement risk, the examples of people’s income halving between retiring in 2007 and 2008 is powerful. However, that was due to a combination of a sudden fall in capital value alongside a fall in annuity rates. There is some important context.
Firstly, the fall hurt people in the run up to retirement as much as those who had retired using pension fund withdrawal, so that is an issue for both a firm’s CIP and CRP.
Second, the compulsion or tendency to buy an annuity in 2008 forced people to lock in the loss. People confused this one early loss with sequence of returns risk, but it is different. The impact for clients who remained invested, particularly if they reacted by adjusting the level of withdrawals taken, was much less. The important factor ultimately to consider is whether the client will buy an annuity in the future when the time is right or whether they will continue to withdraw capital until it is gone, or they die.
Like a CIP, as well as the needs of a target market, the level of work an adviser has to do to maintain it and how the costs of that can be reasonably passed on to the client should also be considered. With a CRP needing to further manage monthly withdrawals and risk, a firm can expect a higher level of maintenance work.
How can you manage sequence of returns risk in a Centralised Retirement Proposition?
#1 Do not take fixed regular withdrawals from a portfolio
From a non-individual, centralised perspective, this means only distributing the interest, rent or dividends to the investor, also known as natural income and leaving units untouched. This can work for clients who can afford to live off a small percentage of their capital that varies.
Important considerations when selecting a Centralised Retirement Proposition for this target cohort are: level of ‘income’, its consistency, risk to remaining capital and total return. This approach works by not spending capital but does nothing to manage out sequence of returns risk. Dynamic Planner offers specialist Income Focused Fund Research that addresses this.
#2 Withdraw from the stable part of a client’s portfolio, typically cash
This works if you have effective and efficient portfolio construction software that helps you provide both initial and ongoing suitability assessments and disclosure. The approach becomes personalised and hands-on, so there are challenges with scale and also greater inflation risk due to the amount held in non-real assets.
#3 Invest in solutions which manage risk on a monthly rather than annual basis
This could be through an asset allocation that is negatively correlated in shorter time frames; it could be through highly active management; or it could be the provider using its own capital to smooth the unit price. In whichever case, due to the mathematic nature of sequence of returns risk, it is a matter of analysing and risk profiling with a monthly rather than annual perspective to identify solutions’ risk profile even when fixed regular withdrawals are taken. In Dynamic Planner, these are Risk Managed Decumulation funds.
While these approaches can deal with any target market in retirement, there is one final difference to the pre-retirement accumulation market. Most accumulating clients, in short, require as much capital as possible, while retiring decumulation clients have personal and varied income requirements, time frames and patterns.
As a result, a good Central Retirement Proposition is seamlessly aligned with – and underpinned by – a powerful cash flow planning tool, which is easy to use from somebody you trust.
“Dynamic Planner Cash flow is based on the volatility of the client’s funds or benchmark asset allocation for their risk profile. That is a superb improvement over assuming a flat growth rate, which takes no account of sequencing risk.”
Read how one advice firm uses Dynamic Planner Cash flow
Abhimanyu Chatterjee, Dynamic Planner’s Chief Investment Strategist, discusses the hot topic of inflation amid increasing concerns it could soon rapidly rise. How has it been viewed over time? What are arguments both for and against?
Abhimanyu then analyses what could happen next before outlining four extreme inflation scenarios Dynamic Planner has run to robustly stress test its Asset Risk Model. Finally, he considers cash flow planning and inflation’s potentially acute impact here now for financial planners
Everyone worries about rising prices, especially savers. This general increase (or decrease) in prices of goods and services in an economy is referred to as inflation (or deflation). Margaret Thatcher referred to it as ‘the robber of those who have saved’, while the high priest of the ‘Free Market Economy’, Milton Freidman, called it ‘taxation without legislation’.
The general rise in the price level in an economy results in a sustained drop in the purchasing power of money, as each unit of currency buys fewer goods and services. It reflects a loss in the real value of the medium of exchange.
The opposite scenario, deflation, is characterized by a sustained decrease in prices in the economy.
Market participants are firmly of the opinion that low, positive and stable inflation is generally good for the economy as inflation causes reconfiguration of labour markets through increasing wages and lower unemployment. Excessive inflation or deflation is generally the cause for concern, often caused by step changes in monetary policy.
Inflation: Arguments for and against
It is said that if there are 10 economists in a room, there are 11 opinions. A debate on the causes of inflation results in 20 opinions in the same room.
One often cited reason for inflation is an increase in money supply – both steady or sudden as we have observed during the continuing Covid crisis or during the financial crisis of 2008.
Central banks in the developed world this year have expanded their balance sheets to previously unseen levels to stimulate their economies. Governments have moved beyond monetary policy to fiscal measures, given diminishing marginal returns of monetary policies. In addition, central banks are prepared to move away from their mandates of inflation stability for a period of time to jump-start economies.
As can be seen in Figure 1 above, while CPI inflation has dropped significantly due to the slowdown in demand, the expectations of inflation has picked up from previous levels. On the other hand, the case for disinflation is gaining traction.
At Dynamic Planner, we feel that, rather than being a financial crisis, as seen in the past, this is a social crisis – a crisis in which consumers are voluntarily choosing to socially distance themselves and postpone consumption, due to uncertainties surrounding health and employment. In addition, there is a sizeable output gap across the global economy, indicating spare capacity.
In China, the current output gap is around 7.5%, an historical high, as it is in the US (8%), which stands at the same levels of the Great Depression. In addition, there is a school of thought that the link between money supply and inflation has broken down – a case in point being the large stimulus measures implemented during the Financial Crisis 2008 did not result in runaway inflation as was expected then.
Further, given the nature of the current pandemic, it is obvious there will be sectors which will be worse off than others and hamstrung in their efforts to grow. Previous bouts of quantitative easing and other fiscal measures failed to increase inflation materially, with divergence being even more stark and asset prices rising and the bulk of the economy facing disinflationary forces.
Inflation scenarios: Stress testing the Dynamic Planner asset allocations
In stress testing our allocations, we consider four specific scenarios:
- Reflation: In this first scenario, monetary and fiscal policy proves to be successful and stimulus brings the economy closer to its pre-Covid long-term trend growth. Nominal rates remain relatively stable, inflation picks up to levels slightly above 2% and the US dollar strengthens. This is good news for equity markets in general. With real rates and risk premia decreasing further, they could gain around 16%.
- Deflation: A grimmer scenario where dis-inflationary trends get the upper hand despite central banks across developed markets keeping yields of all maturities close to zero. With economic growth impaired and increased uncertainty, this is bad news for equity markets, which could lose around 23% in this scenario, with growth stocks underperforming the market.
- Inflation overheating: In this scenario, inflation picks up slightly more than planned, which leads to disrupted economic growth and increases in nominal rates as the US Fed reacts to rising inflation. Equities benefit moderately from decreasing real rates with growth stocks benefiting more from declining real rates.
- Stagflation: This final test is a more extreme version of the previous one, with inflation going up even more. However, this scenario assumes developed market economies are impacted more severely than other regions, as a result of more aggressive fiscal and monetary stimulus. Although real rates decline, growth disruption and uncertainty take the upper hand, pushing equities into slightly negative territory and resulting in a positive bond-equity correlation.
In assessing these scenarios, we have set out the major risk factors to perform in Figure 2 below:
Based on the above scenarios above, we calculate the performance of the allocations for the different Dynamic Planner Risk Profiles.
As can be seen from the graphs in Figure 3 below, the deflationary scenario is the worst one for our allocations, which is understandable, as in this scenario all growth assets underperform immensely.
On the other hand, modest inflation increases or a re-emergence of the economy from the stress and uncertainty of the pandemic would be extremely beneficial for the allocations. In the stagflationary scenario, allocations for the more conservative risk profiles would be safe while the more aggressive allocations with higher equity allocations would suffer mild negative performances.
As fiscal and monetary policies expand to allow governments to deal with the fall out of the pandemic, market participants have started engaging in conversations regarding the possibilities of inflation. This analysis is meant to add structure around conversations for our clients, who use our allocations as a guide to making allocation decisions.
Cash flow planning with confidence
To navigate scenarios as mentioned, our clients, at the coalface of financial planning, need to create a long-term cash flow plan for their clients.
If the plan uses inflation and growth assumptions which are reasonable and based on objective data, a financial planner can engage more effectively with their client and create a quality and understandable plan.
Dynamic Planner forecasts real returns – i.e. net of inflation – across its system, in the risk-reward trade-off shown for risk profiling, in investment portfolio reviews and in cash flow planning.
The forecast is generated by a Monte Carlo scenario engine that generates thousands of possible real returns. As the returns are real to begin with, the various possibilities for inflation at different times are already factored in. It is therefore inappropriate to guess and factor in other numbers for inflation and apply them to the forecast.
With current events set to make inflation more confusing and volatile, clients will need your advice and explanation even more. It is therefore even more important that growth assumptions used are risk-based, real, reasonable and based on objective data. We conduct extreme stress testing like this, so that you can have confidence in ours and plan confidently with your client.
Read about new Dynamic Planner Cash flow planning
Unprecedented. Extreme. Sobering. It has been hard to keep pace with what’s happened in markets this year. Here, Dynamic Planner’s Head of Investment Services Jim Henning takes a step back from the headlines and highlights the immediate and longer-term trends and shifts witnessed in 2020.
How does this year’s volatility compare in the context of the last 20 years? Which asset classes have been the biggest winners and losers in the first half of 2020? And how have the benchmark asset allocations, representing Dynamic Planner’s 1-10 risk profiles, stood up to all this?
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Individual asset classes
None of us escaped the headlines earlier this year detailing dramatic drops of more than 20% in major financial markets, which of course has been a concern for advice firms and for their clients. Looking beyond that, clients’ investment portfolios by and large are well diversified. So how have individual asset classes performed this year against such a volatile backdrop?
Considering this through first the lens of an equity investor and then a bond investor can perhaps put this into greater perspective.
The graph below shows what is called the ‘fear index’, implied market volatility historically over the last 20 years. In this context, it is sobering to see the scale of what we’ve experienced this year as a result of the pandemic. That is what equity markets have had to address, while the story has been similarly brutal for bonds.
We can see below bond yields this year and where we have circled March, when we witnessed the most dramatic market downturns due to Covid-19. First, they plummeted. Then, they jumped back up. Then, they have fallen again. And these are huge shifts.
Things thankfully have settled down somewhat since, but we can see an inexorable trend of UK 10-year gilt yields falling to just 0.1%, which is unprecedented in scale and is driven by the massive financial stimulus we’ve seen globally here and from other central banks in response to the pandemic.
Here in the UK, it is forecast that the Bank of England – in terms of issuance and showcasing the scale of QE, quantitative easing – will own approximately one-third of the UK gilt market and around £2 trillion of debt in issuance. Quite sobering. We have never seen anything like this.
It’s interesting if we look at how all that has manifested itself, in terms of core asset class performance in H1 2020, as we see below.
On the left-hand side, we can see a dichotomy in that UK index linked gilts were the best performing asset class followed by UK gilts or government bonds. Meanwhile on the opposite, right-hand side of the graph, we can see the travails of equities markets and the UK, in particular, which has very much been the pariah here this year, given the gloomy outlook for the UK economy and dare we mention it, Brexit uncertainty which continues as I write. Ditto here, UK property, which too has had a torrid time.
How have the Dynamic Planner asset allocations fared?
Moving away from that, how have the 1-10 Dynamic Planner benchmark asset allocations performed and stood up to these pressures in H1 2020?
We can see below in the claret bars the returns and losses experienced in Q1 this year before, in the gold bars, the strong recovery we enjoyed in Q2. In short, most losses had been recouped, which is comforting to see.
Another way we can consider this is by looking in greater detail at the returns you would expect from a diversified portfolio. For example, below left shows the performance of the benchmark asset allocation for a Dynamic Planner Risk Profile 5 over 18 months from January 2019 to July 2020, with the blue line trajectory showing expected returns we forecasted over this period back in January 2019. We can see the returns, as of July 2020, actually exceeded expectations.
Above right we can see our Value at Risk measure in H1 2020, showing what we would expect with a 95% confidence. Given the torrid time markets have had, it’s been encouraging to see our Asset Risk Model perform largely in line with expectations.
To put this further into context, below left we can see actual observed volatility across our 1-10 benchmark asset allocations in red, since launch in 2005 and in gold, since 2015 in the last five years, where we can happily see that symmetry and relationship between risk and reward, which has again been largely consistent over these periods.
Above to the right, what we see is more challenging. Of course, as we have repeated, we have been in unprecedented times, with untold helicopter money pouring into risk assets and that has undoubtedly impacted at the lower end of our 1-10 risk scale.
There is a flattening towards the centre of the scale of performance of the benchmark asset allocations over the last 12 months, which perhaps is not what we would have expected, but given that environment, hopefully it is still apparent that there is a long-term trend of being rewarded for taking extra risk. Of course, that is clearly becoming more challenging and that is across the board for multi asset investment portfolios today.
Find out more about how you can research funds for your clients in Dynamic Planner.
The Investment Committee reviewed the performance of the benchmark asset allocations and noted their great resilience in weathering the extreme market turmoil post the Covid outbreak, with all staying within, or very close to, their expected annual Value at Risk (VAR) limits.
The benefits of portfolio diversification provided by Dynamic Planner’s Asset Risk Model can be illustrated by the level of annual drawdown the benchmarks have experienced over these unprecedented times.
The one-year returns are compared to their respective expected VAR, within a 95% confidence limit, as represented by the horizontal line in the charts below. The benchmarks are calculated by MSCI [Morgan Stanley Capital International] and include quarterly rebalancing.
Navigating cross currents
- Uncertainty over the extent of lockdown measures and the nature of the eventual economic recovery prevails. In the absence of a vaccine, bolstering consumer confidence remains the priority for the post-lockdown world, but rising fears of the growing second wave of infections is beginning to see the re-imposition of stricter social distancing measures.With sentiment so fragile, any prolonged economic weakness could lead to increasing defaults from over-indebted corporates and the vicious cycle of increasing unemployment. However, there is an important distinction between the ‘run on the banks’ witnessed in 2008, to the ‘run to the banks’ to borrow this time round, as banks have significantly shored up their balance sheets.All eyes will be focused on how and when furlough measures will be adapted and tapered, as they must eventually have to be, given the eyewatering levels of debt / GDP that many economies are now having to grapple with.
- Interest rates are at rock bottom and if they remain ‘lower for longer’ or even ‘lower forever’ is an open question.Whether this macro demand-led shock leads to a long-term macro ‘regime change’, with the possibility of negative interest rates and deflation across developed economies, cannot be ruled out at this stage. However, low interest rates and excessive monetary stimulus must normalize at some point.In the case of the UK, the ballooning debt overhang, coupled with potential supply side inflation as a result of a no-deal Brexit and further weakening of the pound, could plausibly result in interest rate increases becoming necessary.
- From a valuation perspective, global bonds appear extremely overvalued after the extent of central bank intervention, with around 20% of issuance now in negative yield territory in nominal terms.Given the recent strong market bounce, global equity valuations also appear stretched and considerable uncertainty prevails around economic forecasts and corporate profitability. Existing business models are coming under increased scrutiny, with the market already signalling the potential winners (e.g. the tech and healthcare sectors) and the losers (such as retail, transport and energy).
- Given this unprecedented backdrop, ‘volatility of volatility’ will be an ongoing major concern for investors and can be expected to manifest itself in periods of heightened spikes.
Dynamic Planner Annual Asset Allocation Review – Key themes
During the annual review process, the Investment Committee agreed that the long-term strategic themes of building out further global diversification and a reduction from bonds into equities should gradually continue. The revised allocations – that went live in Dynamic Planner on 24 September 2020 – include:
- Further reduction in UK equities and an increase to US equities
- Reduced allocation into Sterling Corporate Bonds being exchanged for an increase in Global Investment Grade Bonds
- Recentralisation within expected risk boundaries being required. This involved marginal changes for the equity exposures being applied to the higher risk benchmark allocations
What’s the latest market and economic analysis? Read ‘Depression to euphoria’, by Abhi Chatterjee, Dynamic Planner Chief Investment Strategist