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:
- 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.
- 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 (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
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
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
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.
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