What is asset allocation and what are the roles of asset allocators?

The fund management companies overall investment strategy (often referred to as the house view) is generally periodically reviewed by senior investment directors in the light of current macro economic and market data and investment views shared across desks within this firm. The role of asset allocators is to decide on the proportions of client’s funds between equalities, bonds, property and cash.


In addition, asset allocation is also carried out within each broad market (i.e. between regions of the world for equities and across currency blocs and between government and corporate bonds for fixed interest). There is obviously a huge amount of information available to asset management houses, not the smallest source of which comes from brokerages falling over each other to flood the asset management doorstep with paper each morning. In general, however, the types of factors asset alligators are looking at include overall prospects for economic growth, interest rates, cost factors, inflation prospectus and business cycles.

Since the US minimized the foremost global economic power and huge importer of goods from many markets around the world, US economic indicators suggests interest rates have significant implications for the rest of the world economy. The relative strength of the US dollar is connected, but slightly different, factor. Since US dollars are used so extensively, any increase in the value of the dollar will have an adverse effect on other currencies. Many emerging market economies are highly dependent upon the US for loans and other economic support, and will be highly sensitive to bad economy news.

Political changes affect asset allocation in terms of prospective governments expected policies on government spending, interest rates, balance of payment strategy and economic management generally.

Economic Data of Interest:

As mentioned the asset allocation process is driven by an array of economic data. These data influence the following four major factors. Economic growth, Inflation, Interest rates and Currency level(however, it is important to note that this high level factors are interdependent, for e.g. currency level are dependent upon interest rates and economic growth prospectus). In general, forecasted changes regarding these four major factors will have the following implications for asset allocators.

Scenario
Forecasted Changes
Possible impacts on markets
Economic growth Increased Pace - Strong equity growth in Short term
- Increased inflation risk- longer bonds depressed.
Inflation Increase

- Inflation proofing ofEquities attractive, however, equality earning value eroded in longer term

- Bonds generally down due to lower real case flow values, especially at a long end

- Index linked bonds more attractive.

Interest rates Increase - Equities down through effect on earnings NPV's.

- Bonds down through cash follow NPV reduction.

- Cash / short bonds allocation attractive since higher rates available.

Currency Level Increase - All asset classes increase in value for not domiciled holders.

- Equity earning affected by

- Fall in demand abroad since goods more expensive.

- Cheaper import competition. Bond markets strengthen due to anticipated increase.

Other factors include government fiscal policy, such as money supply changes which can lead to expectations of inflation increases, which may in turn lead to interest rate rises to damp down inflationary pressures. In addition, there is a degree of inter dependence between markets, e.g. a general rise in bond yields will tend to increase the currency of denominations, as well as reducing the amount of funding sourced from bond issuance in favor of equity.

Market Specific Asset Allocation Considerations:

Equities: The following is a high level summary of the factors affecting general allocation to equities.

Cost Factors Impacting Earnings: Interest rate prospects are of concern, especially with recent government standard interest rate increase responses to inflationary pressures. Companies will suffer higher funding costs accompanied by higher wage claims. Additionally, as mentioned, domestic interest rate rises also increase the domestic currency’s strength, reducing export demand. The factor is becoming increasingly important with the growing internationalization of companies.

Other significant factors that affect different industrial sectors in different ways include the oil price, wage inflation, productivity and threats to certain markets through the instigation ore removal of trade barriers.

Inter-relationship with corporate bond market:
Most corporate are borrowers as well as issuers of equity, and are seeking to gain a greater return on new projects in their industry that that paid in terms of borrowing costs. There are a few exceptions, the so-called cash rich corporate, historical examples being GEC and BT, who are less interest rate sensitive since they can finance projects out of their own funds. However, in general expected interest rate raises are bad news for equities.


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