Best avoid landmines

The first 3 months of 2016 were characterised by heightened volatility across asset markets with sharp falls in risk asset prices in January and early February reversed in late February and March. Likewise, bond yields declined sharply as risk assets fell before stabilising / rising in conjunction with the recovery in risk assets. 

The behaviour of markets during the March quarter is broadly symptomatic of a bigger problem – namely that no one’s really sure as to where to next – for either the global economy or for markets. In part this has been fuelled by the news flow which has had something for everyone. The economic “bears” have been able to promote the de-synchronization of the major global economic blocks, tepid US consumption and jittery central banks. The more “bullish” (note it is hard to find outright bulls), have ample support from a continued solid US labour market and aggressive policy stimulus from the ECB, BOJ and China.

While uncomfortable, we probably sit in the middle. We’d characterise global growth as reasonable – importantly we see the imminent risk of recession as low. In terms of markets, we remain cautious, but not as cautious as we could be. This is because economic uncertainty and associated market volatility has improved valuations in a number of assets classes – credit in particular, but also in a number of the mainstream equity markets like Japan and the UK. We added high yield credit during the quarter in preference to equities and this has performed well over a relatively short period as spreads have narrowed materially. This increase in high yield debt was cash funded, causing our cash exposure to fall to around 25%. We have also added some downside protection via at-the-money S&P put options and with the AUD having rebounded against a weaker USD on a dovish Fed, we have also added some AUD/USD puts as well.

Looking forward, the prevailing and overwhelming consensus is that we are in a “low return” world. After all, with negative bond yields prevailing in many parts of the globe and extended structural valuations evident in key equity markets – like the US – it is empirically difficult to see how many markets could deliver decent size, positive returns.

This seemingly universal agreement around the inevitability of enduring low returns is problematic in my view.

It is absolutely true that for many assets current valuations make the achievement of high returns difficult. This is particularly the case for fixed income assets, where low to negative policy rates, low/ negligible/negative bond yields effectively guarantee poor returns over the medium term – certainly to the extent that these assets are held to maturity. Likewise there have been lots of assets priced off these low/negligible/negative yields – like property trusts, infrastructure and direct property that should also find the going tough – particularly if we do see higher yields at some point.

What’s less certain though is how long low returns will prevail. In other words, it is far from true to say that we are in an enduring low return environment. History shows that market risk premium can reprice quickly and aggressively. Many of the statements that can be made about market valuations today could have been equally well made in 2007 (with the exception of sovereign bond yields), but it took less than 12 months (2008) to rapidly reprice risk and turn some of the most extended assets (particularly both credit and equities) into some of the cheapest in history.

What was clearly true was that starting from the valuations that prevailed at the end of 2007, medium term returns were low for an extended period as this impact washed through, but if you could avoid the damage and invested just a year later the medium term outlook has been significantly different.

A more recent example has been in credit – especially high yield. 18 months ago high yield credit spreads were traversing post GFC lows. Prospective 3 year returns on our numbers were barely positive. By mid-February this year, the impact of the energy sector and a broader repricing of credit risk on high yield bond spreads had been significant, pushing prospective returns on our numbers back above 8% p.a. The point here is that as investors we need to be alert to the fact that environments can and do change rapidly. It is possible that we could move from a low to a high return world very quickly.

In part as a consequence of the prevailing concerns around the low return environment, there is growing pressure on investors to lift returns and part of the solution is to fill the gap with alternatives. This is not new. We’ve seen it before with hedge funds (who by and large have overpromised and under-delivered – particularly after fees). We saw it in the lead up to the GFC with structured credit (and we know how that ended). The latest machination, dressed up in concepts such as “idiosyncratic alpha” or “alternative risk premium” are primarily focused on the implementation of strategies that have a low correlation to either equity or bond beta. While conceptually it is logical in a world where returns from equities and bonds (the predominant market betas) are likely to be constrained, stepping down this path is unlikely to solve the low return problem faced by investors.

Firstly, these strategies typically involve the identification and capture of factors that are relatively easy to identify in theory (such as volatility risk premium) but much harder to capture in practice, often requiring relatively complex financial engineering.

Secondly, they are difficult to scale. These strategies often exist because of this and any attempt to arbitrage away what is effectively a market anomaly means it may likely disappear quickly.

Thirdly, they require demonstrable skill to consistently identify and exploit. Identifying who has this skill and who doesn’t will be a key variable on successful implementation.

Finally, and particularly with respect to the concept of “idiosyncratic” or non-directional alpha strategies, investors should be aware that these are for the most part relative value trades, requiring leverage, potentially bring additional risk.

In making these observations I am not denying that these approaches can help augment a broader more beta focussed approach. What I am saying though is that at best they should only form a small part of a broader solution. Effective beta management is really the most important driver as to whether investor objectives will be achieved. This is particularly the case in a “low return” world where avoidance of landmines is likely to be more important than identifying where returns will come from. After all, as I have argued above, low returns may prove to be a shorter term phenomena than investors currently assume. While achieving our return objectives over the next 3 years is unlikely to be easy - “starting from here” - we are still confident. Significant shifts in market pricing and thereby expected returns in recent months support this.

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