Should we resist the temptation to carry?

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we analyse the choice investors currently face between volatile asset prices and tempting carry strategies. 

The prospect for carry strategies

First, we had the UK Liability Driven Investment (LDI) crisis, then there was the shakeup of the banking sector. The ’soft landing’ scenario that our central banks are trying to orchestrate is getting put to the test, and portfolios are falling victim to that. As inflation remains elevated, the need for higher rates is now blatant. With it, markets are likely to remain quite volatile: a lack of trend with large ups-and-downs is definitely not the friend of long-only investors.

The risk/return profile of many investments has deteriorated as of late – what we refer to as the Sharpe ratio – and this is likely to prompt asset allocators to rethink how they deploy their capital. When asset prices turn volatile, but expected returns do not progress, the temptation to add to illiquids or to income-styled investment opportunities grows stronger. Putting illiquids to one side for now, what are the prospects of carry strategies today? Boon or bane to volatility-adverse investors?

Realised volatility is higher

We do not start any client or prospect meeting these days without the chart presented in Figure 1. That chart shows percentiled volatility measured across risk premia, based on our proprietary risk measures. These risk measures do deliver a striking message. When one tries to identify where the volatility of each asset lies within the context of its own history, our conclusion is: whatever the risk premium, the situation is the same. Risk has increased on all fronts, and all risk premiums now suffer higher-than-average volatility.

Even worse, the asset class whose risk deviates most from its historical levels is government bonds, the ultimate portfolio diversifier of the last 10 years. If the volatility of government bonds in December 2021 was still around its 50th percentile (its median), it now stands around its 95th percentile. For comparison, developed-market stocks have a volatility fluctuating around their 65th percentile, and credit around its 70th percentile.

Commodities come second in this race for risk, with volatility reaching the 90th percentile. This is of course no coincidence: part of the bond risk reflects the risk of energy inflation and the associated geopolitical risk. In turn, unstable rates can naturally lead to instability across all risky assets, as valuation uncertainty may grow out of discounting mechanisms. For asset allocators, this environment makes it very challenging to identify preferences and set a hierarchy of expected returns across assets.

From an investment point of view, there are two key observations. The fight against inflation has generated a significant wave of volatility, and this volatility is affecting diversification assets in particular: bonds as the recession-diversifier and commodities as the inflation-diversifier.

As the outlook for returns on standard asset classes does not necessarily seem to be improving - between banking risk, geopolitical risk and unexpectedly sticky inflation - it is probably time to ask: is it worth scratching our heads about medium-term asset allocation and return forecasting, while diversification opportunities disappear? If we are convinced of the opposite, what are the alternatives today to build our exposure to liquid markets?

FIG 1. Percentiled volatility measure per risk premia

Source: Bloomberg, LOIM

The call of the wild carry

As our readers know, the choices are limited. On the one hand, investors can decide to stop bearing the risk of daily liquidity and turn to illiquid investments (private equity, private debt, real estate, infrastructure). On the other hand, they can turn to income-generating strategies - the ‘value’ equivalent of alternative risk premia that do not necessarily rely on equity markets.

The first solution has been widely used since the 2008 crisis through the ’endowment model’ and may be somewhat under pressure now with rising rates as well as a crisis of trust on the financing side. The second option has fallen out of favour due to several factors, ranging from the evisceration of forex carry strategies in 2007, the disappointment linked to alternative risk premia since 2018, and finally the drying up of the credit carry premium since 2019.

Today, however, these carry strategies have a certain appeal again: firstly, they seemingly allow investors to avoid having to care too much about market directionality, and secondly, with the rise in rates, it seems legitimate to imagine that the income linked to carry strategies will increase in all asset classes and get closer to investors’ required rate of return.

The right part of Figure 2 shows the annualised performance of different carry strategies as a function of the level of US 10-year rates. The intuition about a positive link between expected return and interest rates level seems to be confirmed by the data, calculated over 2006-2023: higher interest rates can indeed be a call to substitute market risk with carry.

Nevertheless, the left part of Figure 2 calls for caution: while our estimates seem to show a link between carry and the level of rates, there is also a link between carry and rate changes. And not all carry strategies benefit in the same way when rates rise or fall significantly (in other words, when there is more rates volatility). Strongly rising rates naturally weigh on the performance of bond carry strategies. On the contrary, credit and forex carry strategies suffer more when rates fall substantially (here we may assume rates fall more during market stress events).

Picking carry strategies has its advantages without being an ‘all-weather’ solution. It supposes a lasting commitment and a low sensitivity to the path taken by the strategy: the investment horizon or the investor's patience appears to be a key variable. The question might be even more relevant given today’s debate around ‘hold-to-maturity’ assets!

FIG 2. Carry strategies’ performances as a function of interest rates level (right) and variations (left), based on a non-parametric regression (2006-2023)

Source: Bloomberg, LOIM

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. 

Our nowcasting indicators currently point to:

• Our growth indicator rose last week, essentially as the Chinese growth data showed an uptick, confirming the ongoing recovery of the country
• Inflation surprises are stabilising to low levels this week, essentially as the Chinese data again paves the way to a higher inflation there
• Our monetary policy indicator has crossed the 45% threshold and remains below this level for now. The better Chinese data has pushed our indicator marginally higher
   

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicators gather economic indicators in a point-in-time manner to measure the likelihood of three macro risks – growth, inflation surprises and monetary policy surprises. The nowcasters vary between zero (low growth, low inflation surprises and dovish monetary policy) and 100% (high growth, high inflation surprises and hawkish monetary policy).

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