The New Normal

The New Normal
Do You Have a 2007 Approach for a 2009 Market?

By Ed Devlin, PIMCO Executive Vice President and Head of Canadian Portfolio Management

Investors are confronting several new realities—and the starkest one is the reality of a severe worldwide recession. For the first time in the post–World War II period, U.S. consumers likely won’t be the spenders of last resort due to plummeting property values and decimated equity wealth. A key factor of this economic reality is the paradox of thrift, which sees a global trend toward increased savings during a recession decrease aggregate demand, consumption, production and income, further weakening the economy.

Another reality is the financial reality, which encompasses the paradox of deleveraging: asset prices are declining dramatically, spurred by the unwinding of highly leveraged positions throughout the financial system. If everybody attempts to delever by selling assets or equity stakes and paying down debt, while risk appetites are dampened and few investors are buying, prices fall.

We must also fact a political reality: neither politicians nor the public have the will to support the fiscal intervention needed to overcome the paradoxes of thrift and deleveraging, put a bottom under asset prices (especially housing), and encourage growth and risk-taking. Governments need to err on the side of doing too much, rather than not doing enough, but socializing the losses of the banking system after their years of privatized gains is tough for many to swallow.

These realities have investors facing a new “normal” which is still unclear, and they must discard old approaches.

New Investment Management Skills for New Realities
In this complicated environment, the skills necessary for investment management are changing. Understanding government policies and their potential effects is a critical skill. And given the variety of good, bad and even toxic assets in the marketplace, intensive and highly detailed credit analysis is crucial. Risk management skills are essential as always, especially when risks are harder to pin down.

Good Government: Regulator and Participant
Governments are responding to the financial crisis with several policy actions. The paradox of thrift calls for increased government spending, while some are turning a massive expansion of the government balance sheet and unprecedented intervention in the private sector to help counter the paradox of deleveraging.

Such direct government participation in the markets may change the hierarchy of capital structures and introduce other uncertainties as the public and private sectors interact in new and unpredictable ways. These uncertainties rattle the markets. Uncertainty is not the same thing as risk: risk can be analyzed and managed; uncertainty has unknown parameters and can discourage and disengage market participants, leading to illiquidity, further asset price deflation and lower real economic activity.

The “60/40” Mix: Getting the Most From the 40%
During this crisis, the 60/40 asset allocation mix has been tested and often found wanting. Portfolios that rely on asset class diversification performed poorly in 2008 as typically uncorrelated sectors sank together. Relying on equities as the return engine and fixed income as the anchor simply may not be optimal. Gauging by index returns over the past two years, long-term fixed income investments – the traditional 40% allocation – outperformed equities.

Don’t Be an Accidental Investor – Buy the Risk You Want
Investment managers should make an appropriate balance between risk and return their key goal. They should be equipped to use all tools available to manage multiple risk factors and tailor investment portfolios according to tolerances and guidelines.

Despite all the risks, opportunities abound even in a difficult market environment: spreads are at very high levels, many high-quality assets are attractively priced and government programs are expected to bolster certain spread markets such as provincials, high-quality U.S. agency mortgage pass-throughs and asset-backed securities.