CIO views: a new era of finding alpha

Asian fixed income: credit allocation decisions to source alpha

Less than a year ago, US interest rates were at zero and the Federal Reserve (Fed) was conducting quantitative easing via bond repurchases. Today, the rate is at 4.5% with terminal expectations at just over 5%. The Treasury yield curve is severely inverted, and short-term volatility in credit markets remains elevated.

At the time of writing, USD-denominated investors can choose to buy US six-month bills at 5%, two-year Treasuries at 4.8%, or investment-grade (IG) credit at around 5.5% for US or over 6.5% for Asia/emerging market (EM)¹. Credit IG strategies, which are of longer duration (six-to-seven years), do not offer much more yield than short-dated Treasuries because of the inverted curve. Short-duration US rates provide high reinvestment risk, while longer-duration credit brings high volatility and poorer shorter term total return if inflation and growth do not cool. 

If US inflation and growth cool sufficiently into 2024, credit strategies would provide a strong total return given the greater duration uplift. Furthermore, USD strength will have peaked and Asian and emerging-market spreads would compress more than developed-market (DM) peers – especially since Asia is expected to grow markedly faster than DM this year with China’s reopening. Asia also has relatively lower inflation pressures, more accommodative central banks and better growth drivers given wider credit spreads.

We believe this allocation decision – factoring in rates, longer duration credit or higher spread Asia – will likely be the largest source of alpha for fixed income investors over the next three years or more. We expect Fed and European Central Bank (ECB) monetary policy to remain sufficiently tight to stall those economies, and for lower growth to return after the sugar high of the last two years.

With the US hiking cycle almost over, Asia's growth advantages over DM and attractive Asian spreads, we think active management and a pro-risk stance can be sufficiently rewarded over the next one-to-three years as risk aversion is still quite high in our asset classes.

 

Source

[1] For illustrative purposes. Yields are subject to change and can vary over time.

Equities: a stock-picker’s future

As resilient economies absorb central-bank hikes, is a shift to a regime of higher rates and inflation than previously expected underway?

Perhaps. If last year was characterised by phenomenal tightening, 2023 could see a duration-focused market emerge in which investors reconsider yield curves and anticipate a higher plateau. This would weigh on equity valuations – especially those of unfunded growth companies, which we aim to avoid.

But since equities are a claim on nominal growth (including inflation), the asset class might benefit from investors willing to escape the current financial repression in which nominal rates are lower than realised inflation.

 

Move over, beta

In November, we argued that attractive valuations should compel investors to overcome defensive biases. As the easiest part of the current equity trade – multiple expansion – concludes, investors must search harder for keenly priced pockets of earnings-per-share (EPS) growth, while being wary of the impact of duration on valuations.

But from a bottom-up perspective, EPS growth appears scarce. Europe, Japan and China might be the only markets left with relatively cheap valuations. Stock pickers, take note: idiosyncratic stories involving growth attributes, quality fundamentals and attractive relative valuations signal that the equity trade has shifted from beta capture to alpha generation.

 

Policy drivers

Landmark US policies – the Inflation Reduction Act, Infrastructure Investment and Jobs Act, and CHIPS and Science Act – commit to more than tripling the nation’s average annual spending on climate and clean energy for this decade. They will also create jobs and re-localise strategic industries, like semiconductor and battery manufacturing. The impact of Europe’s response, the Green Deal Industrial Plan, will mainly be to lift regulatory roadblocks, while Japan has developed a green transformation strategy and China’s latest Five-Year Plan strongly supports clean technologies.

As policies lead to capex pathways and economic change, stock-pickers can identify which quality industrial, materials and other enabling companies will benefit.

 

Convertible bonds: high-conviction investing, focused on convexity

The year 2022 was a reality check for many investors who had become comfortable with a decade of low interest rates and several rounds of stimulus spending. During that period, buying market dips and focusing on riskier assets became the dominant investment strategy. Last year’s events put a brutal end to this era, with some strategies – such as 60/40 multi-asset allocations – particularly suffering.

Today’s market paradigm has forced investors to find new investment strategies while also dramatically altering their investment processes. All of our convertible bond strategies rely on deep investment expertise and selection to exploit the benefits of the asset class. We built the foundations of our core investment process to help generate alpha, including features such as:

• A high-conviction approach to navigate stormy market conditions that keeps portfolio managers on course for the long term, despite short-term noise
• A disciplined investment process to generate alpha. This includes a rigorous fundamental approach mixed with a flexible investment strategy where entry and exit points are reassessed on a regular basis – it should prove effective in a macro backdrop that is likely to remain volatile

Convertible bonds as an asset class can also help to achieve that goal. In a scenario where rates remain higher for longer and central banks’ ‘put option’ has been reset at a much lower level, the embedded options in convertible bonds could provide convexity at a time when it is rare.

For the first time since the 2008 financial crisis, convertible bond investors also benefit from positive yields (if held until maturity), while also retaining exposure to the equity market. We expect a buoyant primary market in the asset class that will provide another source of alpha in 2023, provided the right issues are chosen.

 

Multi asset: dynamic allocation, real diversification

Investors are watching keenly as rate-setters try to extinguish inflation amid robust employment, but they are also looking forward, asking: how will the economy land? Irrespective of the macroeconomic outlook, one thing is clear: the key macro driver for markets has changed. If rates were the key macro force last year, growth is in the driving seat in 2023.

We are positioned for a soft landing but hard-landing wary. We use multiple dynamic overlays to change the tactical positioning of our portfolios, including our Macro Risk Premia overlay. This dynamic tool is based on macro data that helps provide diversification from our trend-following and bond and commodity carry strategies. Together, these overlays inform a marginal overweight to equities at the expense of fixed income assets in our dynamic asset allocation. As such, we are tepidly constructive, not bullish, and ready to react if turbulence disrupts the soft-landing narrative.

The rigid capital-allocation practices of many traditional multi-asset strategies, like the 60/40 portfolio, tend to conceal concentration risk and lead to a false sense of diversification. Tomorrow’s diversifier could come from outside the fixed-income world – from say, commodities, or it could manifest as volatility strategies.

Risk-based multi-asset solutions, which seek consistent diversification among risk premia instead of following capital-allocation policies, are built to continuously search for the next diversifier and adapt to the uncertainty that typifies markets. Our All Roads strategy aims to deliver this for investors with diverse risk appetites and portfolio requirements.

How are we positioning our risk-based approach for current markets and higher real rates in the longer term? To read the feature viewpoint from this issue of CIO views, please click here.

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Alternatives: a broad mandate allows diversified opportunities

Before this tightening cycle, zero and negative interest-rate policies forced investors to deploy capital, fuelling an unprecedented rally in risk assets and compressing risk premia across asset classes – irrespective of asset quality. Now, higher rates and less-accommodative policymakers make investors more discerning about where they deploy capital. The differentiation between high- and low-quality assets has returned, and is increasing.

This shift in regime should translate into higher dispersion, resulting in better rewards for intelligent risk-taking. This is good news for active investors.

But with every market shift comes rising uncertainty, resulting in higher levels of volatility. This often pushes asset prices further away from fair value, providing greater trading opportunities – especially for alternatives managers, who tend to be the most active of all investors.

Among hedge funds, the trend of the previous decade favoured managers with a well-defined (and constrained) investment universe. In 2016, we chose the opposite route, favouring managers with broad investment mandates and the ability to invest across capital structures and asset classes to find the best value for money and most appealing opportunities.

Today, it seems that the market is coming around to our way of thinking – notably with the rise of the multi-portfolio manager model, offering exposure to a diversified set of opportunities. We believe this shift has many years to run.