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William R. Benz
This article originally appeared in the online edition of Pensions & Investments on 5 August 2013.
For much of 2013, until mid-May, it felt a lot like we were back in 2006 – with most developed equity markets hitting record highs, bond yields plumbing along the bottom of secular lows (see Figure 1), credit spreads near historically tight levels and volatility measures again near lows.
If you just looked at the markets and nothing else, the world was a very good and very stable place.
Yet, if you examined the underlying economic fundamentals, you would see, as shown in Figure 2, significant structural imbalances. Back in 2006, the issues were mostly in the private sector – housing bubbles in the U.S. and UK, surging private sector debt and consumption growth at the expense of savings. Today, the imbalances lie more in the public sector where large government deficits and debts are choking most developed economies and creating structural impediments to growth.
We referred to this state in 2006 and 2007 as being one of stable disequilibrium, and felt a strong sense that we were morphing into a similar state earlier this year. As in 2006, markets and valuations implied stability, while fundamentals signaled disequilibrium. However, stable disequilibriums, by definition, don’t last: Either fundamentals rise to meet valuations, or valuations fall to synch up with fundamentals. It’s not a matter of if, but simply when.
The calm was broken – in a big way – with U.S. Federal Reserve (Fed) Chairman Ben Bernanke’s “tapering” speech on 19 June at a press conference in Washington, D.C., which fueled investor anxiety regarding the future course of Fed monetary policy and the continued willingness (and effectiveness) of global central banks in supporting asset prices. Bond markets sold off, Treasury yields rose to year-ago levels, and credit spreads widened, particularly in emerging markets. Volatility jumped. And most equity markets fell.
Over the past weeks, however, Mr. Bernanke and other developed central banks have toned down their comments, which in turn have helped settle global markets. Still, almost five years since Lehman’s bankruptcy in 2008 ushered in the global financial crisis, memories remain fresh and reflexes strong.
Is this the start of something more ominous?
We don’t think so. Global economies are structurally too weak and inflation pressures, for the most part, nonexistent for a potential rise in interest rates to signal the start of a secular bear market in bonds and other financial assets. This does not mean volatility won’t continue to be high, nor does it mean rates won’t notch higher before settling down. It does suggest global markets now expect a full Fed reversal rather than just tapering, such that there is a lot of bad news already built into the markets. As U.S. mortgage rates have risen back above 4%, there is an added drag on the economy that could affect current growth dynamics and keep inflation further retrenched.
So what does this mean for investors?
Regardless of whether we’re in a stable or an unstable disequilibrium, we face a world full of “S-curves”, with continued volatility punctuated by the occasional surprise, and potential “T-junctions”, where economies and markets are forced into more binary, left or right turn outcomes, in the coming months, quarters and perhaps years ahead. In such an uncertain environment, investors need to keep the following in mind.
First, they need to be flexible, retaining both the resilience to stay on the road when hitting S-curves and the agility to turn left or right when coming into T-junctions. This means having real diversification, being able to play both offence and defence, maintaining liquidity and dry powder, considering tail risk hedges and employing strong and proactive governance structures to be able to move quickly and forcefully when necessary.
Second, investors may want think about pivoting to “alpha” (with a focus on generating excess returns) as the days of easy “beta” (simply earning high market-based returns) are behind us. This includes building smarter betas, adopting better benchmarks and adding discretion in core portfolios. And, for those with specific absolute return, income or hedging needs, it means moving to more outcome-oriented solutions.
Third, we believe investors should stay active. This is more than a good health tip. It means maximising investment flexibility by not locking in passive allocations, beta exposures, portfolio structures and hedges. There are times when passive strategies can offer value, but likely not in the current environment.
Fourth, they need to be forward-thinking. Move away from asset-class-based to risk-factor-based asset allocations; from historical to forward-looking return methodology; from market value to GDP-weighted benchmarks; and from alpha-generating strategies that worked in the past to those better suited for today’s investment landscape. History provides important perspective, which we ignore at our own peril, but we have to look forward to stay on the road.
Finally, investors need to be patient. We’re still in a state of disequilibrium. Now is not the time to go all in or be all out.
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