Rethink investment objective and risk tolerance, urges Mercer chief investment strategist

TODAY’S macroeconomic environment marks a distinct departure from the investment backdrop of the past 10 to 15 years, and investors would do well to revisit their objectives and risk tolerance, says Rich Nuzum, Mercer’s executive director (investments) and global chief investment strategist.

There are more than a couple of departures from what investors have been accustomed to in the past decade or two: One, the traditional 60/40 portfolio comprising 60 per cent bonds and 40 per cent equities has failed to provide diversification benefits. Two, it remains uncertain where fixed income yields would settle, as the Federal Reserve is not done in its battle to quell inflation.

Buying on dips, which has worked in past downturns, has also proved disastrous this year.

Nuzum is confident, however, that exposure to China could provide diversification benefits despite the current unease over the ongoing tensions between the US and China over Taiwan.

“The jury is still out; we don’t know yet the secular trend or about fixed income as an asset class. This market downturn differs from March 2020’s Covid downturn, and from the 2008 financial crisis in two ways. One, we’re not getting a quick bounce… And, this is not a liquidity crisis.

“This time there is plenty of cash in the world; individuals and corporations are sitting on cash. We have clients coming to us asking – is it time to buy? They’re conditioned to think a market correction or bear market is a good time to buy. But we don’t have screaming-buy opportunities.”

He said over the past two decades, investment professionals have been advising clients on the shortcomings of a 60/40 portfolio and the need for private market assets for diversification. Private market assets however are still beyond the reach of retail investors, except for some markets like Australia where over a third of superannuation accounts can be invested in illiquid alternative investments. “In some of our key Asian markets, the private sector and regulators are working to make that access happen, but it’s not there yet.”

Bond yields have risen amid aggressive tightening measures by the Federal Reserve. But real yields remain negative given high inflation rates. “If inflation drops to the Fed’s 2 per cent target and yields stay at 3.5 per cent, then we’ll have a positive real yield of 1.5 per cent. That is horrible against long-term history, but it’s better than negative.

“But if you can stomach the volatility of the stock market, why would you invest in bonds at 1.5 per cent real yield, instead of stocks, which would offer a higher dividend yield and growth potential?”

He is optimistic that the simmering tensions between the US and China over Taiwan would not be allowed to escalate into war, unlike the Ukraine invasion. “The bull case is that the chances of China taking military action – whether it’s over Taiwan or any disputed islands – has gone down. Because the Chinese government would have looked at the Ukraine war and said – that doesn’t work.” Russia’s does not wield the upper hand in its war with Ukraine, which has turned out to be protracted, and support for Nato (North Atlantic Treaty Organization) has actually strengthened.

In terms of the investment case, China is the world’s second-largest economy, but its weight in global indices is just a fraction of its real economic heft. China has a 3.3 per cent weight in the MSCI All Country World Index. “Every investor has to take a specific decision on China… I’m bullish on the situation because I think the Chinese government is a lot smarter… They’ve had the lesson of Russia’s disastrous invasion. China will participate in setting the rules of the world, as opposed to the rest of the world telling China how to participate.”

In a paper, Mercer has advised clients to make a strategic allocation of 5 to 10 per cent of equity portfolios into China-A shares, “due to (China’s) under-representation in global benchmarks, significant portfolio diversification benefits and potential for outsized alpha”. The five largest companies in the MSCI World Index are all US companies – Apple, Microsoft, Amazon, Tesla and Alphabet – which have a combined weight of around 12 per cent. US equities’ weight in the index is about 62 per cent. “If investors are comfortable with this level of absolute exposure in a few individual companies all listed in one market, it seems reasonable to consider at least similar overall exposure to the world’s second-largest stock market, which is composed of thousands of companies.”

On ESG (environmental, social and governance), he says it’s important for investors and regulators to understand that ESG investing is not a one-size-fit-all approach. There are advocates for the “screen for green” approach, where funds and asset managers are castigated for exposure to fossil fuel companies. There are also advocates for the “brown to green” approach, which sees traditional energy companies as part of the transition towards clean energy.

“We have to create technologies that are cheaper than traditional energy… My most sophisticated clients tell me all the time – if we can’t make it cheap enough for India and China to do it, then we won’t solve this. So, it’s not that asset owners or investment managers who invest in traditional energy companies are ignoring climate change. In many cases they’re doing it because if you want to migrate a city from coal to natural gas to renewables, where will you find 60 engineers for that? You’ll find them in traditional energy companies, not in a startup.

“Our most sophisticated clients are throwing money into disruptive technology investments to try to get the cost of (renewable energy) down, so that it becomes economically viable and attractive to go for lower carbon.”