Convergence: asset allocation in wartime


Although the drums of war have somewhat died down over Ukraine and the Taiwan Strait, a fundamental problem facing all asset managers is how to allocate funds strategically in the face of higher geopolitical risks. , climate change, inflation and technology.

According to the World Economic Forum’s Global Risks Report 2022, 89% of respondents perceive the short-term outlook as volatile, fragmented or increasingly catastrophic, while 84% expressed negative feelings about the future, being “concerned” or “worried”. This is not surprising, given the exhausting worries about pandemic shutdowns, health or jobs, as well as an Omicron wave that has raised huge uncertainties about economic growth and recovery in 2022.

The biggest worry seems to be pandemic fatigue, as people have just had enough of worrying, which is why so many people are partying or traveling locally and even overseas.

Despite the hype about war-related concerns, the Global Risks Report ranks geo-economic confrontation as the 10th most serious risk, with the top five being failure of climate action, extreme weather, biodiversity loss, erosion of social cohesion (inequality) and livelihood crises. Surprisingly, sovereign debt, which had increased by 13 percentage points to 97% of GDP in 2020, ranked the debt crisis 9th in terms of perceived severity.

Additionally, as stock markets hit record highs in the United States late last year, veteran GMO asset manager Jeremy Grantham signaled that the long bull market since 2009, when banks central banks embarked on quantitative easing for the first time, may have “finally matured into an epic bubble in their own right”. He noted that “today the market price-earnings ratio is in the upper few percent of the historical range and the economy is in the worst percent.” Of course, no one knows when this bubble will burst, but last month fears that the US Federal Reserve would begin to scale back its asset purchases as inflation figures rose prompted a correction in the global market.

Triggers for stock market adjustments are very difficult to predict, but events such as unexpected interest rate hikes, financial bankruptcies, war, and supply chain or commodity shocks could suddenly trigger a contagion effect on the markets. Few people have forgotten how the bankruptcy of Lehman Brothers triggered the global financial crisis of 2008. Lehman believed it was too big to fail, and the US Congress believed that no institution should be too big to fail. When not rescued, the chain reaction of selling off all the other highly leveraged financial institutions caused the market to collapse.

We need to consider war risks in our investment decisions because war is unpredictable in its onset, scale, scope and rate of contagion. The classic story is the assassination of Austrian Archduke Franz Ferdinand on June 28, 1914 in Serbia. Austria wanted to punish Serbia with a short war, but this led to Russian mobilization and by August 4, the United Kingdom, Germany, Russia, France and Belgium had declared war on each other. History has shown that no European leader wanted a war, but a series of accidents and blunders caused a devastating global conflict within weeks.

During World War I, US stock markets were highly dependent on foreign funding, so when war was declared (although the US did not enter the war there until 1917), the dollar-pound rate first devalued when European investors sold their dollar holdings and bought gold.

During World War II, the United States again benefited from gold imports, as European and other warring nations sold gold to purchase imports of food and industrial products, including armaments. The United States benefited from influxes of flight capital, particularly in gold holdings, which rose from just under 4,000 tons in 1922 to over 20,000 tons by the end of 1950. Since then , the US dollar has become the currency of choice for capital flight whenever geopolitical tensions mount.

The standard asset allocation is always a mix of stocks, bonds and cash equivalents. In the 1980s, portfolio managers turned to commodities, real estate and financial derivatives, collectively known as alternative assets. Diversification away from conventional assets has occurred not only with traditional asset managers, but also with central banks, sovereign wealth funds and, more recently, family offices. For example, from 1990 to 2020, the price of gold has increased by approximately 360%, while over the same period the Dow Jones Industrial Average has gained 991% ( Gold has historically performed well in times of high inflation or geopolitical tensions.

Since 2000, family offices that professionally manage the affairs of high net worth individuals (HNWIs) have grown rapidly as they began to seek better returns. One of the largest sovereign wealth funds in the world (Norway’s Government Pension Fund Global) had an asset allocation of 72% in equities, 25.4% in fixed income, 2.5% in unlisted real estate and 0, 1% in unlisted infrastructure. Its return since 1996 was 6.6%, with an excellent return of 14.5% in 2021.

In contrast, the Goldman Sachs Family Office Report 2021 noted that its average asset allocation to alternative assets (private equity, hedge funds, real estate and private credit) reached 45%. This implied that family offices are not risk averse. Although few are into cryptocurrencies, almost half of the offices plan to allocate money in this direction.

Cryptocurrencies offer a new asset class that can be a safe haven from geopolitical risks. Since Bitcoin was invented by the anonymous Satoshi Nakamoto in 2009, the market value of registered cryptocurrencies has peaked at US$3 trillion, with several reasonably liquid trading platforms making it a credible asset class.

Central bankers and mainstream commentators have described cryptocurrencies as having “no revenue, utility, or relationship to economic fundamentals,” bordering on Ponzi scams. But once Facebook began exploring the issue of its own digital currency, there were signs that the use of cryptocurrencies was rapidly becoming mainstream, as Tesla and other high-profile retail brands reported that they would accept certain cryptocurrencies for payment.

In 2021, Bitcoin returned 59.8%, Ethereum (smart exchange platform) 399.2% and Binance Coin (an exchange token) 1,268.9%. So many young investors who have experimented with buying or trading cryptocurrencies seem to have done well, as many have piled into these new tokens.

The main appeal of digital currencies is that they offer the anonymity of official surveillance for tax, money laundering, regulatory or national security purposes. The second attraction is that the cost and convenience of transactions is faster and cheaper than using conventional banks. It is estimated that currency transactions of small amounts through retail banks and exchange offices can cost up to 7% of the amount transferred. Thus, a young internet user can buy and sell non-fungible tokens (NFTs) for digital artwork very quickly and easily. Buyers and sellers should exercise sufficient due diligence to ensure that their transactions are secure and free from scams or theft, including loss of encryption codes.

Although central banks are now increasingly keen to regulate cybercurrencies on the premise that if they behave like a currency, have uses as a currency, and look like a currency, then they should be regulated at the same level as fiat currencies. Note that since China banned the mining of private cyber-currencies, mining activity has shifted to the United States and turnover has increased.

My own assessment is that cryptocurrencies, like the coronavirus, are here to stay, although many may fail. A few would be very successful and eventually become the benchmark for other cyber currencies.

Are cybercurrencies useful stores of value in times of volatility and conflict? Frankly, I guess if the internet can’t be destroyed by global hacking or virus attacks, then cryptocurrencies will survive. But we can never be sure that in a futuristic cyberwar the internet can be destroyed, causing investors to lose access to their cybercurrency holdings.

Remember that in the event of an all-out nuclear war, there are no perfect assets or safe harbors. International financial centers where current stocks, bonds and securities, including gold, are held in custody may be destroyed. If you live in a peaceful zone without the threat of nuclear or terrorist wars, then conventional banking and assets under management should be relatively safe.

There are assets like art or wine that can suffer badly in times of conflict, but can come out spectacularly in times of peace. Each asset has its own unique characteristics in terms of liquidity, return, risk and convenience. Basically, understand what you are actually buying because you may not be able to sell it easily during volatile times. As usual, caveat emptor, or buyer beware, applies to all investments.

Tan Sri Andrew Sheng writes about global issues affecting investors


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