FIIG - The Fixed Income Experts

News and Education

Higher savings inconsistent with rotation to equity

by Dr Stephen Nash | Mar 06, 2013

Increased savings tell us that the consumer and investor are conservative, so expecting a rotation from bonds to equities is fundamentally inconsistent with this new conservatism and with global best practice. Expression of this new conservatism is failing to translate to investor’s investment portfolios for two main reasons:

  1. The search for conservative cash flows is being channelled into the equity market by the tax system; the wrong place to look for conservative returns. While the preferential treatment for the taxation of equities exists, it is now luring investors to a market well known for volatile returns; something the preferential tax was never designed to do.
  2. A second constraint to expressing this new conservatism is a misnomer about asset allocation, where large allocation to equities is seen as “balanced”. This misnomer is making investors feel much too comfortable with large allocations to equities; a dangerous complacency, in our view.

Underlying driver: increased saving indicates a structural decrease in risk appetite

Since the global financial crisis, a structural change has occurred in the degree to which Australian consumers are prepared to assume financial risk. Experiences from other developed markets have led consumers to be much more conservative and we can measure the relative disposition of consumers to take on financial risk by looking at the savings ratio, which is the ratio of savings to household disposable income (see Figure 1). 

Figure 1: Household Income and Consumption
Figure 1 (Source: Graph 3.2, Statement of Monetary Policy, February 2013, p. 32)

This decrease in risk appetite has meant that consumers are paying down debt and not borrowing. The RBA expects the savings rate will remain largely unchanged and will constrain growth in the non-mining sector. Greater conservatism in financial risk taking, should translate through to investing, in the absence of the two main constraints.

Global best practice (OECD)

In translating the newfound conservatism of the consumer into asset allocation, we refer to a global best practice comparison, as shown in Figure 2.

Figure 2 - Pension fund asset allocation
Figure 2

As Figure 2 indicates, Australian investors are already overweight equities, relative to global peers, so the idea of rotating out of bonds, into equities, is problematic, as the above graph indicates that Australian investors do not, typically, have enough bond exposure, relative to other global economies. Instead of decreasing financial risk-taking, and aligning with global best practice, the “great rotation” from bonds to equities implies that Australian investors will turn their backs on the quest for lower financial risk-taking, as expressed by the increase in the savings ratio. We think this is unlikely and further rotation to equities, therefore, places financial planners at additional risk of future complaints from disgruntled clients, in the event of the eventual return to equity market volatility. Global benchmarking is a tool to reduce the risk of client dissatisfaction; it is not your enemy but your friend.

Constraint 1 - Investors look for “bonds” in all the wrong places

Investors have tried to find stable cash flows from any asset class. Yet, some asset classes remain essentially the wrong ones to express financial conservatism and the consequent substantial moderation in financial risk-taking. However, unequal taxation policies, of equity relative to debt, are now confusing investors; making the choices available more difficult than they need to be. Specifically, preferential tax of equity, has forced investors to try and find low volatility investments in the equity market that pay a “bond-like” cash flow. Such a bias is evident in Figure 3, which shows the recent rise of the All Ordinaries Accumulation Index, and the total performance of a major bank against that index. See how much the bank have outperformed the market, as investors pile into the supposed “stable cash flows” of banks.

While the All Ordinaries has returned around 14% from September 2012, up to 15 February 2013, the major bank under consideration has, partly as a result of this misguided search for “bond-like” cash flows, beaten that return by 5-6%, as shown in Figure 3.

Figure 3 - All ordinaries v major bank performance
Figure 3

The problem with equities is the volatility of prices. Whatever cash flow is derived in a bull market for equities can be lost almost overnight, if the pricing of equity risk changes. “Issues” have a habit of cropping up, like the recent sequester in the United States, which can cut growth expectations dramatically. A decline in growth expectations comes with a decline in equity prices; and the adjustment is typically abrupt and painful for those holding equities. Equities may pay stable dividends but volatile pricing can impact returns and lead to losses. The ability of Australian banks to pay these “bond-like” dividend cash flows, in future will be constrained in terms of the pay-out ratio (value of dividend payout compared to net profit after tax).

Constraint 2 - Misnomer about 75% equities allocation being a “balanced” allocation

The misnomer that a 75% allocation to equities constitutes a “balanced” portfolio clouds asset allocation. Over the longer term, from October 1989 to January 2013, the annual risk from equities is around 16% with an annual return of around 10%, while the annual risk from bonds is roughly 6.10% with an annual return of 8.80%. Now, if investors try to implement a strategy with the typical allocation to equities, of 75% with 25% fixed rate bonds, they can reduce risk to around 10.50%, with a return of around 10%. However, a much better asset allocation is one that dampens risk much more than the typical allocation, without much of a fall in return. Specifically, the 75% bond portfolio, 25% equity portfolio, cuts annual risk right down to 4.50% with an 8.75% annual return.

We would submit that the 75% bond portfolio, with a much improved risk characteristic, is much more in tune with the need to reduce financial risk, as implied by the elevation in the savings rate, when compared to the typical “balanced” fund of 75% equities and 25% bonds. Figure 4 bears this observation out, as even in the global financial crisis, the dampening impact of bonds on volatility greatly impacted risk at that difficult time. If we have further volatility in equities, and that is to be expected, then investors with financial planners will want to know why the portfolio allocation remains high to the highest risk asset class.

Figure 4 - Portfolio annual return
Figure 4

Conclusion

Sometimes statistics can be misleading, and sometimes they can be highly illuminating. In this case, the statistical observation, that the savings ratio has become and is forecast to remain high, provides a very important insight into the current mood of the Australian consumer. In the aftermath of the global financial crisis, consumers have changed their ways; they no longer borrow to consume. Rather, they save to consume; consumers reject financial risk-taking and accept a much more conservative approach to debt and financial leverage, where borrowing is lower than it has been for the last few decades. This mood is slowly being translated into asset allocation, yet some constraints exist.

The idea of switching from bonds to equities really depends on your starting point of asset allocation, and OECD data suggests that Australians hold too many equities compared to global best practice and that is inconsistent with the elevated savings rate. If Australians are underweight bonds, then they have to change that; they need to overcome the two constraints identified, by creating a portfolio that aligns with the newfound conservatism.

Disclaimer
The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced, distributed or to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

FIIG Securities Limited (‘FIIG’) provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not make a market in the securities or products that may be referred to in this document.

The credit analyst certifies that all of the views expressed in this document accurately reflects their views about the companies and securities referred to in this document and that their remuneration is not directly or indirectly related to the views of the credit analyst. FIIG, its directors, representatives, employees or related parties may have an interest in any companies and entitles, and may earn revenue from the sale or purchase of any financial product, referred to in this document or any advice. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG.