CIO views: the power of selection

Asia fixed income: credit selection pivotal amid trend upheaval

Asia and emerging market (EM) credit has never demanded more pronounced name selection than in the aftermath of the Covid-19 pandemic: the large fiscal packages of 2020 have significantly stretched sovereign balance sheets and corporate fundamentals have evolved at different paces. 

The investment rationale for some names has changed radically compared to before the pandemic. For instance, before the pandemic we did not favour EM sovereigns, such as Oman, due to their high reliance on commodity revenues and lack of tax reforms. Now, however, structurally higher oil prices have spurred these to become improving credits. Asian high-yield bonds from renewable-energy companies, which were very cheap relative to their long-term fundamentals at around 6% yield¹ pre-Covid, have now become expensive in the 3-4% yield range as demand exceeds supply. Chinese credits, which previously enjoyed virtually no downgrade risk from investment grade to high yield, and where default risk among high-yield property names was almost nil, are witnessing higher downgrade and default risks owing to the tightening of macro policy by the authorities.

Overall, many long-established trends in countries, sectors and single names pre-Covid have been turned upside down or tested. India high-yield debt used to trade at 6-8%¹ yield compared to China high-yield at 4-6% on average, barring stressed names. That has now flipped to India high yield trading more tightly for the most part, excluding names like Vedanta², at 3.5-4.5%. After the recent fallout of Evergrande², China high yield trades at around 5-6%¹ for BBs and at high-single-digit levels for B-rated bonds. 

We now believe the underperformance of China high yield is worth looking into, as investors are being well compensated for risk. 

Summer rethink

“A Man for All Markets” by Edward O. Thorp

Two-thirds autobiography, one-third investment advice, this book tells the story of Thorp’s remarkable career. Rising to become a mathematics professor at MIT, he then vanquished Las Vegas blackjack tables after inventing card counting before pioneering quantitative strategies as a head-fund heavyweight on Wall Street. After co-creating the world’s first wearable computer, Thorp returned to casinos to systematically beat the roulette wheel. It’s no surprise his life story and perspectives now make him a best-selling author, too.

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Equities: secular growth calls for strong convictions

We believe that equity markets have transitioned from a phase of hope, built on expectations of recovery, to one of secular growth that favours specific themes and stock-selection skill.

This shift is one of four stages that we have identified as characteristics of equity-market cycles, and each is marked by certain investor preferences. These phases are wall of worries, hope, secular growth and exuberance.

Currently, we believe the market has entered a phase of secular growth. In this phase, the market’s cyclical recovery, and associated surging returns, end as policymakers indicate that accommodative measures will be scaled back. Earnings catch up with valuations, multiples begin to contract and the market climbs at a slower pace. This phase lasts 38 months on average and markets can rise by 30%, potentially delivering 9% in annualised returns – before dividend yields are accounted for. Earnings releases are scrutinised as investors seek evidence of the hoped-for growth that is still embedded in their outlooks, and their focus on cyclical recovery morphs into a search for sustained, secular growth.

In our view, weighing exposures to factors such as growth or value become less important in this environment as thematic exposures and stock selection comes to the fore. There are still opportunities to catch some ‘laggers’ – stocks which have yet to catch up with their valuations – while maintaining a focus on quality.

It also presents an opportunity to access attractively priced structural-growth themes largely overlooked during the hope phase, when investors focused mainly on cyclicality. We see such themes as sustainability, the ‘silver economy’ driven by retiring baby boomers, powerful global consumer brands, digitalisation throughout industries and the rise of north Asia. High-conviction stock-picking aligned with these themes can be a particularly powerful driver of returns in a time of secular growth.

Summer rethink

In September, LOIM is hosting a webinar on healthy ageing with the World Health Organisation – subscribers to our insights should look out for an invitation in the coming weeks. In the meantime, we encourage you to consider including the following books on your summer reading list:

“The Great Demographic Reversal”, by Charles Goodhart and Manoj Pradhan, addresses ageing societies, waning inequality and the revival of inflation.

“The 100-year Life” by Andrew Scott and Lynda Gratton focuses on living and working in an age of greatly increased longevity.

Convertible bonds: preferences grounded in differentiators and thematics

We continue to believe that the economic environment remains supportive, but headwinds are undoubtedly getting stronger. Growth is peaking and the emergence of new Covid-19 variants could compromise a full reopening of the global economy. Equities have performed well in 2021 so far but the current market calm hides a high level of performance dispersion between, and even within, sectors  and strengthens the spotlight on selection.

This is reflected in our portfolio positioning. We prefer domestic airlines to long-haul operators, as the proliferation of variants continues to restrict intercontinental travel. We have maintained our exposure to companies whose profitability is being boosted by the work-from-home theme, since many employees are not yet back in the office and have no definite timeline for a prolonged return. In the technology sector, we own issuers who are more likely to benefit from earnings-growth momentum and we have observed that the well-known, dominant names in the sector have outperformed so far in 2021.

Several features of convertible bonds are well suited to current conditions, in our view. They are:

• The convertible bond market offers differentiated exposure compared to traditional global equity and credit indices in terms of sector, investment style and issuer type.
• The asset class also offers different drivers of performance, providing alternative market exposure opportunities for all types of investor. For fixed income investors, convertibles offer upside participation with the equity market while providing a measure of downside protection¹. For equity investors, the asset class offers a lower volatility exposure to equities.
• After months of cheapening, the asset class now offers a compelling hedge against a market correction, in our view, as the result of its positive correlation with market volatility.

• Convertible bonds also offer natural exposure to a broad mix of themes. Backed by Lombard Odier’s deep credit and equity research expertise, investors are able to gain exposure to specific growth names in sectors ranging from biotech, diagnostics, semiconductors and software with the protection of solid bond floors. The asset class also offers significant upside participation to the reopening of economies, and our focus on best-in-class names should mitigate the volatility of those issuers whose share-price performance will be most affected by the emergence of new variants.

Summer rethink

“Bad Blood – Secrets and Lies in a Silicon Valley Startup” by John Carreyrou

This book was released in 2018 and covers the rise and fall of Theranos, the multi-billion-dollar biotech startup headed by Elizabeth Holmes. It began as a series of investigative articles in the Wall Street Journal, which questioned the company’s claim to be able to run a wide range of tests using only a tiny blood sample from a pinprick.

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Multi asset: remaining nimble when conditions change

Much uncertainty remains about the trajectory of the pandemic recovery, making flexibility and agility key. We approach multi-asset investment from this perspective, highlighting the need for adaptability and diversification among markets, regions and implementation techniques to ensure we remain nimble in the face of changing macroeconomic and market conditions.

As investors, we believe that a systematic framework can provide a robust solution by sticking to clear rules: these are tightly monitored and challenged through continuous research. While history and experience guide us, we must beware of our behavioural biases and remain alert to surprises: overconfidence could be a worst enemy, while humility could be a best friend.

We also use portfolio insurance techniques to face new challenges, while highlighting that these remain a strategic choice (not a tactical or timing feature) because the constant search for yield and return should not jeopardise the need for capital preservation¹.

How does our multi-asset strategy employ a variety of tools to face unforeseen challenges ahead? To read the feature viewpoint in this issue of CIO views, please click here.

Summer rethink

”Noise: A Flaw in Human Judgment” by Daniel Kahneman, Olivier Sibony and Cass Sunstein

The authors argue that noise – volatility in judgements based on the same information –produces errors in many fields and can be found wherever people are making decisions. The idea of reducing noise resonates highly with our investment philosophy: we constantly strive to find ways to reduce noise in our processes, while maintaining diverse measurement techniques.

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Alternatives: a wise option as the tide turns

Like the rise and fall of ocean tides, our equity colleagues have identified four phases in equity markets: wall of worries, hope, secular growth and then exuberance. We continue the discussion in the same vein. We too believe the market is transitioning from a phase of hope to one of secular growth – yet we already notice pockets of exuberance, too.

In the hope phase, risky assets tend to go up in unison. Expectations of an improving economy stimulate multiple expansion across the board, with little differentiation, or low dispersion, among stocks. There is usually low volatility. This period is relatively complex for active managers. It is even harder for long/short managers when beta performance is strong, but short books tend to detract from performance and relative value plays deliver marginal returns.

As market participants move on to the secular growth phase, they tend to focus more on individual earnings results and the ability of companies to deliver on their promises. Beta returns diminish, dispersion increases, volatility picks up and there is more room for active managers to manoeuvre. At this time of the cycle, alpha generation should improve and could outperform beta.

With equity and bond markets at all-time highs, the case for using alternatives to improve diversification in a portfolio strengthens. Against this backdrop, moving away from momentum-oriented strategies into more contrarian strategies can make sense.

We believe investors should be careful not to blindly allocate to the managers who performed best over the last 8-10 months as the market enters a new phase against a transitioning environment. Our active managers have noticed much complacency in markets and consequently identified attractive dislocations in valuations, notably in equities, credit and volatility.

We are currently implementing contrarian positions in our equity long/short and relative value franchises. The latter embeds strong asymmetry and tail-risk hedging capabilities at what we believe to be a limited cost. While such positioning can prove frustrating as dislocations persist, we believe it adds tremendous value to a balanced portfolio in the long run. As markets keep trending higher and risky assets perform well, this positioning should prove helpful when markets inevitably reprice and risky assets underperform.

Summer rethink

“Flashboys: Cracking the Money Code” and “Boomerang: Travels in the New Third World” by Michael Lewis

We choose two books from an author we believe is one of the best chroniclers of our age – Michael Lewis, the financial journalist who made his name in 1989 with Liar’s Poker, an insider’s account of Salomon Brothers’ mortgage-backed bond business. Boomerang sets out the macroeconomic consequences of the cheap financing available during the 2000s, while Flashboys investigates high-frequency trading and exposes how it might not be what you would think it is.