CIO views: turning volatility's downside up

Fixed income: a tactical route through volatile terrain

In contrast to recent years, market shifts in 2022 may not manifest as signposted turns or sudden shocks.

New waves of Covid-19 infections are unlikely to be as disruptive for markets as the initial outbreak and spread of Delta: with each new variant, the market’s reaction becomes more muted. Persistent inflation and US monetary tightening are near-term certainties, but the most pragmatic response can be to act on central banks’ interpretation of that data rather than the information itself – and even to play the market’s reaction to key statements instead of what’s actually said.

Our exposure to the carry trade means we need to monitor risk, and geopolitics in China and Latin America clearly warrant attention. But we believe that emerging markets feature relatively attractive real yields¹, sovereigns with supportive lending programmes and corporates with solid fundamentals. Limited supply benefits hard-currency bonds, too.

US and European credit markets are generally robust, in our view, with defaults scarce and high cash levels among companies. As central-bank support is withdrawn, however, identifying issuers with strong fundamentals will become more important – so will an active, bottom-up strategy rather than one relying on beta, in our view.

These inflections could add up to an overall level of volatility warranting a tactical approach that complements long-term allocations. We may feel reasonably confident about the final destination, but there will be many twists and turns along the way. By reacting effectively to these nuances, we believe active managers can make a difference.

Expecting higher volatility in 2022, we are focused on tactical positioning across sovereign and credit markets to exploit pockets of value.

Source 

[1] Yields are subject to change. Past performance is not an indicator of future results.

Asia fixed income: hedging US yields, capturing credit spreads

As 2022 progresses, we expect US Treasury yields to remain elevated amid structurally stronger growth and persistent inflation, compelling the Federal Reserve (Fed) to accelerate monetary-policy tightening. By mid-year, yields could peak as markets focus on one or a combination of three factors:

• The US midterm election, in which Democrats could lose control of the House or Senate, or both, leading to policymaking gridlock and potentially lower Treasury yields.
• Cooling inflation
• A US fiscal cliff, impacting federal aid spending as the pandemic continues

Therefore, we will continue to hedge portfolio duration tactically in H1 in order to reduce the impact of rising yields. But we stand ready to extend duration by removing hedges when we judge that Treasury yields are peaking. At this point, yields will be attractive, in our opinion.

Hard-currency opportunities

Asia credit markets experienced unprecedented volatility in 2021 due to reasons unrelated to Fed policy and inflation dynamics. Instead, China’s tightening of funding conditions in the property sector greatly affected the regional high-yield (HY) market in the first instance, while investment-grade (IG) bonds recovered losses only after the bailout of state-owned asset manager Huarong². Following this turbulence, our view of key risks and opportunities in Asia credit are:

• Asia IG is attractive for two reasons: first, spreads are appealing given rising US Treasury yields and should provide enough of a buffer to compensate for further yield increases; and second, the asset class overall has a structurally lower duration relative to global and US credit, making spreads appealing – especially on a duration-adjusted basis.
• Asia HY is recovering from the extreme left-tail event of 2021 when property-sector troubles saw USD 50 billion in bonds default. We anticipate a period of stabilisation and price appreciation among higher quality names. Outside China, attractive opportunities exist in other markets, like India renewables.

Source

[2] Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.

Multi asset: navigating turbulence and the bearish rotation

Signals of greater dispersion and a rotation to value stocks in December 2021 presaged a fast-paced, bearish rotation that gripped markets in the early weeks of January 2022. Unfunded growth stocks, which had outperformed in 2021, fell sharply amid a rotation to value stocks.

Rising real rates were key to this bearish rotation as inflation indicators rose, US Federal Reserve communication turned increasingly hawkish and excess savings incurred during the pandemic were drained by price rises.

We expect 2022 to see a continuation of the rise in real rates and, therefore, a continuation in the rotation, but at a more sustainable pace. Investors seeking diversified exposure should remain exposed to equities but with a preference for well-funded and quality growth names.

Investors should also prepare themselves to navigate more turbulent waters. This can be done in several ways using tailored, derivative-based solutions, such as long volatility strategies that offer interesting defensive characteristics, both in equities and bonds.  Continuous risk monitoring and risk-driven portfolio rebalancing also offer potential robustness against a rise in volatility.

Heading into what is expected to be a volatile year, we keep diversification and flexible positioning at the centre of our ethos for multi-asset investors.

Discover more in our feature viewpoint here.

Convertible bonds: embedded advantages in volatile markets

We expect global equities to remain volatile in 2022. Markets have become increasingly dependent on monetary policies being tailored for crisis management, geopolitical risk is rising and the emergence of further highly contagious Covid-19 variants cannot be overlooked. As many central banks enter tightening cycles and with real rates still negative, investors are searching for viable hedges against the risk of an equity-market correction.

In this environment, convertible bonds offer the dual advantage of an element of protection against market volatility given their bond component, and low direct exposure to interest rates due to their embedded equity option.

The asset class is technically inexpensive in the current volatile market environment and displays a high level of asymmetry to equity-market moves. We expect a significant level of dispersion in individual share-price returns in 2022, and convertibles investors should benefit from this by participating in equity upside but with downside protection due to the fixed-income attributes of the instruments.

Flows into the asset class in 2020-2021 have been steady, and risk-taking among investors and market-makers disciplined amid ample liquidity. If there is a risk that the macro picture is less rosy than what the consensus view currently indicates, an asset class which has more exposure to Europe than the US – given the former’s better valuations, lower exposure to high-growth names and stronger sustainability characteristics – should benefit investors. This, combined with our defensive bias in convertibles, should serve clients well this year, in our view.

We believe that some simple strategies will help us navigate the year ahead;

• Maintaining selected exposure to China
• Reducing exposure to, or exiting, names with no equity upside and no compelling yield attributes
• Avoiding low-conviction credits
• Reducing exposure to holdings with high equity sensitivity as markets rise
• Buying back favoured names more cheaply after they have sold off due to style rotations

Above all, we believe that maintaining our defensive discipline, and investing in profitable growth companies whose valuations have corrected, will be the key to generating attractive risk-adjusted performance in 2022.

Alternatives: volatility is an opportunity

Investors have been used to the Goldilocks economy, with a constant decrease in the cost of capital. As it approached zero, there was almost no price too high for solid growth, and this was the recipe for high returns in recent years. Moving away from this paradigm naturally creates fear as volatility and sector rotation start to pick up.

However, these can be good conditions for alternatives. Obviously, it is never easy to generate returns in periods of market panic, but company differentiations lead to more stock-picking opportunities.

This can be an especially supportive environment for alternatives at Lombard Odier, where we typically keep a very small net exposure to traditional markets. We look to build strategies that benefit from mispricings and volatility and that tend to carry a bearish bias. For instance, we carry an outright exposure to dispersion strategies, where we buy volatility of the constituents of an index and we sell volatility of the index itself. This has already been very profitable this year. The S&P is only down 6%, but some stocks are down considerably, while others are holding well. Again, the more differentiation there is, the better it is for a dispersion strategy. 

The Lombard Odier alternative range has been designed specifically with increased volatility in mind. With inflation looking to be more structural, with resulting increases in interest rates and the cost of capital, with geopolitical uncertainties and rising inequalities, volatility is set to stay. We view this as an opportunity. 

Sustainability: the energy transition’s long-term, stabilising role

Any transition necessarily involves an element of change and – by extension – volatility. That is true, perhaps more than ever, for the transition to a net-zero economy as well. Coming out of COP26, a flurry of new policy targets and commitments are already resetting investor and market expectations for sectors most exposed to the transition, with both upside and downside potential.

In recent months, uncertainty in European energy prices has been a further contributor to volatility. While US energy prices have remained comparatively insulated, the crisis has shifted Transatlantic competitiveness and reverberated through markets. While some identified the energy transition as a possible cause, geographic and political factors, including low gas storage stocks, high demand from Asia and reduced supply from Russia were the more direct drivers. The energy transition – by gradually shifting reliance away from gas and fossil fuels – could in fact be expected to play a stabilising role over time, and reduce the long-term cost of energy (or electricity, more specifically).

Interestingly, we find that while uncertainty over climate-related policy direction may contribute to volatility, during recent market turmoil, sustainability factors have actually played a stabilising role. We find that companies scoring among the worst third on material ESG factors lost approximately twice the amount of market value, compared to the upper two thirds. But solution providers – companies providing climate-relevant products, technologies, and solutions – were insulated from this effect somewhat, being more homogenously exposed to market drops. This suggests companies’ own environmental, social and governance (ESG) performance is given less weight when it comes to such climate-relevant players.