On Asset Allocation in a Volatile World, and the Power of Turmeric!

From: aditya rana
Date: Sat, Jun 15, 2013 at 2:24 PM
Subject: On Asset Allocation in a Volatile World, and the Power of Turmeric!

Hi!,

It is extremely helpful, from time to time, to step back from the daily business of managing capital and look at the bigger picture in terms of broad asset allocation and expected portfolio returns over the medium term (3 to 5 years). There are few people who do this better than Saumil Parikh, a member of PIMCO’s Investment Committee, and his recent note titled "A Secular View of Assets: Surfing the Wedge" http://www.pimco.com.hk/EN/Insights/Pages/Secular-View-of-Assets-2013.aspx provides a useful framework to help construct a suitable portfolio asset allocation (this note follows his excellent note "Forecasting Equity Returns in the New Normal" from November, 2012 which helps dispel widespread misunderstandings regarding the constituents of equity returns). To summarise:

-To elaborate on Warren Buffet’s famous 2008 statement "price is what you pay, value is what you get", value represents the income plus growth return on any investment as determined by future economic fundamentals, while price is the current market expectation of future economic fundamentals, influenced significantly by "animal spirits".

-Future economic fundamentals are driven by views on the levels of growth and inflation, the volatility of these two key variables, and their distribution between the various factors of production (capital , labour, commodities etc).

-Firstly, global growth is expected to slow over the next 3 to 5 years, driven by slower growth in emerging markets, stagnation in Europe, and slow but steady growth in the U.S.. In addition, expect more competition for growth amongst countries which is likely to reflected in increased trade and currency frictions.

-Secondly, inflation is expected to remain low over the next 3 to 5 years, as aggregate global demand growth continues to lag steady growth in aggregate global supply. In addition, the commodity cycle is expected to turn from an investment to a production phase.

-Thirdly, global economic volatility is expected to rise as the global economy falls into a recession every six years or so, with increased frequency in an environment where debt is high and decreasing as opposed to when debt is low and rising. Given that the last global recession ended four years ago, and debt levels are even higher today than four years ago (and therefore likely to decrease over time ), there is a greater than 60% probability that the global economy will experience a recession in the coming 3 to 5 years.

-Lastly, the distribution of global growth is expected to shift over the next 3 to 5 years, with commodities receiving a declining share as growth in demand falls behind supply growth, capital retaining its share of global growth as multi-factor productivity remains steady, and with labour gaining share of global growth as declining demographics begins to diminish the supply of productive labour.

-Building on PIMCO’s framework developed to forecast equity and bond returns , and the macroeconomic assumptions discussed above, the current expected real returns for equities and bonds are 2-3% below their respective 100 year averages (see chart below).

-With the implied nominal expected return for equities at about 5%, and for bonds falling between 1% and 2%, the expected risk premium for equities is below the historical average, though above levels in recent years (see chart below).

-The implications of the above for asset allocation decisions are:

-Firstly, given that almost all asset classes are expensive, and with deteriorating economic fundamentals and rising market volatility, it would be prudent to opt for a "reduce risk and wait for return" approach rather than an "increase risk and reach for return" one.

-Secondly, opt for strategies focusing on alpha return (i.e. asset specific) generation and relative value encompassing strategies involving yield curve, volatility, inflation, distressed mortgage and sovereign credit.

-Thirdly, go global to access relatively superior risk premium, particularly from some less liquid developed and emerging markets, which have better economic fundamentals (compared to the U.S.) and more attractive valuations.

-Lastly, keep a balanced risk profile – which currently implies roughly an equal weighting to nominal bonds, global equities and global inflation strategies.

-With U.S. equities and bonds being overvalued, it would make more sense to include high-quality bonds in Australia, New Zealand, Sweden, Mexico and Brazil , and distressed mortgage credits in the U.S. which should benefit from the continued housing recovery.

-For inflation-linked bond strategies, include long maturities in the U.S., Brazil, Italy and Chile, particularly for maturities greater than 10 years which is the time horizon for upside inflation surprises.

-For equities, emerging markets provide superior expected returns after several years of declining valuations and continued high growth in profits . Chinese nonfinancial stocks are particularly attractive, while Spain and Ireland offer an opportunistic play due to deeply discounted valuations and upside from growth surprises going forward. Areas to reduce risk are the U.S., Japan, Germany, Australia and Mexico due to high valuations and relatively low growth.

-As the chart below illustrates, the level of debt, equity and bonds as a percentage of U.S. GNP has never been higher which implies lower expected returns.

-By contrast, emerging market equities offer the most attractive expected returns (albeit with higher volatility) of about 10% (base case) , followed by global equities (7%), and EM local government bonds and US equities (5%).

-Expect the environment over the next 5 years to be particularly challenging across all asset classes, with higher volatility and less stable correlations across assets, as central bank liquidity has kindled the "animal spirits" and inflated almost all asset prices.

Another brilliant note from Saumil Parikh (in the event you have not read his previous note on forecasting equity returns I would strongly urge you to do so), which provides a well constructed and clear framework to help make asset allocation decisions. Underweighting U.S. equities, while increasing allocation to emerging market and peripheral European equities (I would also add Japan, particularly after its recent correction) makes sense given current valuations and the prevailing negative sentiment towards the latter two asset classes. For bonds, EM local currency bonds, U.S. distressed mortgages and select sovereign and corporate credits (peripheral Europe, EM). Finally, with regards to inflation-linked assets, I think commodity stocks (in particular energy) offer more upside to higher than expected inflation down the road than inflation-linked bonds (which are perhaps more suitable for institutional portfolios), despite the slowing of demand growth for commodities in the near term.

The power of Turmeric:

I have been a big fan of turmeric for many years, it being one of the main herbs in Ayurveda. It was therefore with much with interest that I read the following article on the many benefits of turmeric based on modern scientific studies:

(Natural News) March 01, 2013: There is definitely no shortage of scientific evidence these days to show that curcumin, the believed-to-be primary active ingredient in the spice turmeric, holds incredible therapeutic value, and just might be the most advisable medicinal spice of our day.

– A prominent medical oncologist from Johns Hopkins University recently highlighted the incredible ability of curcumin to fight diabetes, inflammation, and even cancer without causing any harmful side effects. Besides quelling inflammatory pain and promoting wound healing, turmeric is a seemingly miraculous anti-cancer nutrient of the highest order. "We have close to 300 publications (that cite turmeric) for its anti-cancer effects," said Dr. Sukumar "Many diseases, such as colon cancer and other types of cancer, are being traced to inflammation."

-The inflammation link to cancer is backed by numerous scientific studies, including a 2011 review published in the journal Proceedings of the National Academy of Sciences which found that up to 25 percent of all cancers are caused by chronic inflammation. According to scientists from Ohio State University’s (OSU) Comprehensive Cancer Center, inflammation triggers an increase in a molecule that causes a reduction in levels of the protein responsible for repairing damaged DNA.

-And what about the other 75 percent of cancers? Research by scientists from the University of Texas MD Anderson Cancer Center (see below) revealed that curcumin actually seeks out malignant cancer cells and alters the regulation of DNA in order to kill them. And unlike synthetic anti-cancer drugs, curcumin leaves healthy cells and DNA alone so as not to cause harmful side effects

Curcumin and cancer: an "old-age" disease with an "age-old" solution.

The University of Texas M.D. Anderson Cancer Center, Houston, TX, USA. Aug, 2008.

-Cancer is primarily a disease of old age, and that life style plays a major role in the development of most cancers is now well recognized. While plant-based formulations have been used to treat cancer for centuries, current treatments usually involve poisonous mustard gas, chemotherapy, radiation, and targeted therapies. While traditional plant-derived medicines are safe, what are the active principles in them and how do they mediate their effects against cancer is perhaps best illustrated by curcumin, a derivative of turmeric used for centuries to treat a wide variety of inflammatory conditions. Curcumin has been shown to interfere with multiple cell signaling pathways. The activity of curcumin reported against leukemia and lymphoma, gastrointestinal cancers, genitourinary cancers, breast cancer, ovarian cancer, head and neck cell carcinoma, lung cancer, melanoma, neurological cancers, and sarcoma reflects its ability to affect multiple targets. Thus an "old-age" disease such as cancer requires an "age-old" treatment.

http://www.ncbi.nlm.nih.gov/pubmed/18462866

-In addition to cancer, turmeric provides a host of other benefits as the research article below states:

Therapeutic roles of curcumin: lessons learned from clinical trials

The University of Texas MD Anderson Cancer Center, Texas. Jan, 2013.

-Extensive research over the past half century has shown that curcumin, can modulate multiple cell signaling pathways. Extensive clinical trials over the past quarter century have addressed the safety, and efficacy of this agent against numerous diseases in humans. Some promising effects have been observed in patients with various pro-inflammatory diseases including cancer, cardiovascular disease, arthritis, Crohn’s disease, ulcerative colitis, irritable bowel disease, tropical pancreatitis, peptic ulcer, gastric ulcer, gastric inflammation, vitiligo, psoriasis, acute coronary syndrome, atherosclerosis, diabetes, lupus nephritis, renal conditions, acquired immunodeficiency syndrome, and chronic bacterial prostatitis. Curcumin has also shown protection against hepatic conditions, chronic arsenic exposure, and alcohol intoxication. Dose-escalating studies have indicated the safety of curcumin at doses as high as 12 g/day over 3 months. Curcumin’s activities emanate from its ability to modulate numerous signaling molecules. In clinical trials, curcumin has been used either alone or in combination with other agents. Various formulations of curcumin, including nanoparticles, liposomal encapsulation, emulsions, capsules, tablets, and powder, have been examined.

http://www.ncbi.nlm.nih.gov/pubmed/23143785

How to have turmeric?:

Heating turmeric powder in milk with a dash of black pepper will give you a healthy tonic that you can use daily to mollify chronic inflammation and help prevent a variety of diseases. This combination mimics traditional Indian cuisine and is necessary to get maximum absorption of turmeric’s curcumin (an option without milk is to have it, adding a pinch of black pepper, with hot water or honey with meals). For more acute issues, high dose curcumin is also available in enteric coated capsules with piperine, the active ingredient of black pepper that enhances nutritional absorption. Enteric coating keeps the capsules from breaking apart and exposing their fragile curcumin to stomach acids. This allows the curcumin to get into the small intestines and into the blood.

Here’s to the age old power of turmeric (i.e. haldi)!

Regards

Aditya

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