Assessing risks and opportunities in an uncertain investment landscape
Global Investment Insights
with Simon Calder, Economic and Investment Consultant, Absolute Strategy Research
Simon is the Economic and Investment Consultant to Absolute Strategy Research (ASR), a leading UK-based independent research house, helping clients navigate their portfolios through the global macro-environment.
In his capacity, Simon’s main areas of focus at the moment are assessing the risks and opportunities stemming from the many sources of uncertainty investors are facing from:
The regional ebb and flow of the global pandemic.
The potential risks to equities from both earnings disappointments and the extreme valuation disparities between equity risk factors.
The re-activation of fiscal policy, the accompanying central bank accommodation of budget deficits and the potential implications for inflation.
The increasingly uncertain role of bonds within portfolios as a diversifier against equity and credit risk.
The escalating US-China strategic rivalry.
The growing number of zombie companies in developed economies and lingering solvency risks, to name but a few.
While a gradual global recovery remains the base case, the distribution curve of potential macro-economic and geo-political outcomes appears wider and flatter than usual. Left tail risks, typically growth disappointments, are now arguably becoming more balanced by right tail risks – the potential for an unexpected rise in inflation and the adverse implications for all long-duration assets. As investors, we want to hedge against both risks, but we also want to be cognisant of the added complication surrounding the usefulness of traditional fixed income in today’s low rate environment. “At the moment we find ourselves taking more active risk at the intra-asset class level than across the major asset classes – multiple sources of active diversification to confront the multiple sources of investing uncertainty”, Simon remarked.
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Left tail risks, typically growth disappointments, are now arguably becoming more balanced by right tail risks – the potential for an unexpected rise in inflation and the adverse implications for all long-duration assets.
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Historically, recessions are often the catalyst for very different investment environments or investment regimes than those of the preceding economic cycle. Although an external ‘shock’, and relatively brief but exceptionally deep, the COVID-19 recession of 2020 will likely be no different. It suggests that investors should be very wary of paying a premium for investment strategies that worked well over the past 10 years, particularly tech, growth, US outperformance and a rising US dollar, defensive yield and other strategies that benefited from monetary policy ‘dominance’ and the accompanying collapse in global bond yields. Rather, investors should be focusing on themes that will benefit from the combination of re-activated fiscal policy, the preparedness of central bankers to accommodate ballooning budget deficits as a means of trying to push inflation higher, and the growing market power of ‘Big Tech’.
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Investors should be wary of paying a premium for investment strategies that worked well over the past 10 years. Rather, investors should be focusing on themes that will benefit from the combination of re-activated fiscal policy, the preparedness of central bankers to accommodate ballooning budget deficits as a means of trying to push inflation higher, and the growing market power of ‘Big Tech’.
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Despite sustained underperformance over the past few years, emerging markets and commodities could be potential beneficiaries as the US dollar weakens. As the world becomes more populist and protectionist, this will play into China’s hand and the Asian nexus countries – (and Africa is included in that given the Belt & Road initiative). Asia will be the largest, fastest growing and youngest of the three major blocs (North America, Eurasia and Asia).
More broadly, if we are in an investment regime change triggered by more active fiscal and monetary policy, then investors will start to look towards commodities (not bonds) as hedges for their equities. Hedging inflation risk will become an increasingly important strategy in this environment. However, the shift towards commodities will need to be balanced against the pressures for increased ESG recognition. Watch out for the emergence of new ‘dirty funds’ where companies offload ‘bad assets’ in the way that banks would offload bad loans to special purpose vehicles.
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If we are in an investment regime change triggered by more active fiscal and monetary policy, then investors will start to look towards commodities (not bonds) as hedges for their equities.
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Expect to see the end of the ‘digital conglomerate’ – after a decade or more of the large Tech companies buying companies to build vertically integrated ‘stacks’ regulators will look to unbundle these businesses.
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Watch out for the emergence of new ‘dirty funds’ where companies offload ‘bad assets’ in the way that banks would offload bad loans to special purpose vehicle.
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One of the biggest challenges at the moment is the issue of costs and investment management fees, the different perspectives of (and accompanying ‘tension’ between) the different stakeholders, and how performance should be assessed. Somewhat understandably, asset owners, governments and regulators maintain a strong focus on reducing fees where practicable, particularly given the very mixed performance among active managers in recent years. Numbers like $30 billion (an estimate of total investment management costs in Australia’s superannuation system) will inevitably attract the interest of politicians. Conversely, however, asset managers argue the proper focus should be on after-fee performance, as investors seek to move away from publicly-traded equity and fixed income markets (where future returns are expected to be much lower than historical long-term average returns), and towards asset classes offering other sources of more idiosyncratic risk premia (e.g. illiquidity premia, complexity premia, etc.)
Against the spectacular rise of passive investing, the big challenge for active managers is the need to avoid ‘benchmark hugging’ and to demonstrate an appetite for true risk-taking. If you do not try to do that you will lose the battle – passive costs are so much lower.
‘Relative value’ investing only works if you apply a lot of leverage… trying to eke out a few basis points here and there is why passive funds are beating ‘active’ funds. More broadly, at some stage the inappropriate capital allocation that QE has delivered will be unwound. If bond yields rise and equity prices fall (given their high starting points) investors will feel that they have been ‘sold a pup’.
Greatest investment opportunities over the coming three years?
Simon’s tips:
Emerging market equities could benefit from a new investment regime of increased inflation volatility and a shift away from the high-valuation, long-duration strategies that worked so well in the previous decade. Asian EM offers GDP and earnings growth, LATAM offers inflation protection through commodities.
Potentially Australian equities could also perform well if commodities become more popular as a hedge against inflation risk.
Value will likely have periodic rallies, but until we reach escape velocity and rates move away from zero, any such rallies may be more ‘trades’ than a fundamental rotation. Is big ‘tech’ overvalued, or has tech ‘over-earned’ in an acquiescent political environment that is now under much greater scrutiny?
Simon left us with some of his key lessons learned throughout his career. He recalled, “after changing roles several times over the course of my career, and following periods of reflection after each move, I have always been surprised at how much more I absorbed in these roles than I thought at the time. A role may be narrowly defined, with specific responsibilities, targets or objectives, but many people will be unaware at the time how much additional knowledge and how many additional skills they are acquiring (sub-consciously).
Some of this human capital may be acquired formally though exposures to the different functions of a particular organisation, or it may be acquired through personal interactions and listening-in to other conversations in an office environment. I think this is especially pertinent now that COVID-19 seems likely to produce more flexible working arrangements in terms of time spent between the office and home. In my mind, so much human capital is developed informally in the workplace, and I would be saddened if such opportunities were denied to new generations of people entering and moving through the workforce.”
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Against the spectacular rise of passive investing, the big challenge for active managers is the need to avoid ‘benchmark hugging’ and to demonstrate an appetite for true risk-taking. If you do not try to do that you will lose the battle – passive costs are so much lower.
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Disclaimer
All information contained within this publication is general advice only, as the knowledge levels and needs of all individual and corporate investors vary greatly this publication should not be used solely as a decision-making tool, further opinions and information should be sought before making an investment decision. It is the recommendation of Global Investment Institute (GII) that you seek the opinions of a fee-for-service, independent investment adviser before making any investment decision.
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