CIO views: investing as war in Ukraine, inflation shape the outlook

Fixed income: back to active basics as clarity clouds 

In recent years, investors enjoyed an environment offering remarkable clarity. The notable exception was the Covid-19 shock in 2020, where the impact was unclear for several months. Otherwise, geopolitical and external shocks were rare, leaving investors to focus on macroeconomic conditions and risks limited to specific assets. Central banks stepped in when needed, easing monetary policy to curtail any downside.

We are now leaving this comfort zone: financial conditions are set to tighten, the inflation narrative has moved from temporary to persistent, and the growth trajectory is being challenged. Long-term trends in areas such as demographics are reversing. Geopolitical shocks are taking centre stage.

Where next? In our view, there are two unavoidable outcomes.

1. Volatility will remain high for the foreseeable future. We believe investors need to prepare, and there won’t be a one-size-fits-all solution. With increasing uncertainties and market dislocations, active portfolio managers are well-suited to find attractive opportunities. Being long the market through passive vehicles will not be the best tactic, in our opinion.

It is time to return to the basics of active fixed income investing: making qualified choices based on thorough analysis and proprietary research. Markets shaped by government and central bank intervention failed to separate winners from losers. Going forward, every detail will matter when picking investments, especially during volatility spikes. It will be vital to remain humble in the face of change, question analyses, and recognise the risks. We believe in being ready should a perfect storm hit by hedging tail risk, being flexible and diversifying.

2. Global warming will continue to threaten human prosperity. In Europe, opposition to Russia should accelerate the transition to renewable energy to reduce dependence on imported oil and gas. Portfolio managers need to step up efforts to support sustainable investments aimed at slowing the rise in the Earth’s temperature. At Lombard Odier, we believe that selecting companies making the transition to a net-zero economy happen will help generate returns.

Asia fixed income: balancing opportunities and hedges

The world is emerging from over a decade of low yields and low inflation that began after the global financial crisis. In the post-Covid era, fixed income investors are navigating an environment of high inflation, recovering growth and rising yields with added geopolitical uncertainty driven by the battle for Ukraine. Inflation is likely to remain elevated given structurally higher commodity prices, tight labour markets (particularly in the US) and enduring supply chain issues. In this environment, we see opportunities to outperform but also the need to hedge duration.

Geopolitics 

We believe Russia’s invasion of Ukraine marks the end of the post-Cold War era. This has implications at the sovereign and corporate levels, including: higher national defence spending, energy security concerns and the need to strengthen supply chains. All of these will reinforce existing inflationary pressures. 

These developments, in the context of forthcoming US interest-rate hikes and quantitative tightening, mean we continue to hedge portfolio duration tactically in order to reduce the impact of rising Treasury yields. We will aim to extend duration and take profit on these hedges when yields peak and become attractive for investors. 

Outlook for EM debt 

The region’s credit markets should emerge stronger from the high volatility beginning in 2021, in our view. China’s crackdown on the real estate sector resulted in a record default rate, which is expected to decline and reduce systemic capital risk.

In the emerging-market (EM) debt universe, Asia will likely benefit from portfolio and capital reallocations in the medium-term as geopolitical risk or Western sanctions impact countries in the Commonwealth of Independent States, which were formed after the dissolution of the Soviet Union, over the medium-term.

We see opportunities in attractive and sustainability-oriented parts of the wider asset class, including India investment grade (IG) and high yield, Indonesia investment grade and select credit issuers in Gulf Cooperation Council nations. We are also positive on select IG subordinated bonds issued by banks.

Convertible bonds: volatility suits convertibles

Volatility has become more pronounced as inflation concerns spur many of the main global central banks to enter a tightening cycle. Geopolitical tensions from the war in the Ukraine have exacerbated sharp market moves. Such uncertainty creates conducive conditions for the asymmetric return profile of convertible bonds – one might say volatility actually suits convertibles.

The prospect of higher funding costs has prompted a growth-to-value rotation in the stock market – the third since early 2021. The exposure of the asset class to shares most sensitive to the rotation has decreased markedly since February 2021. As their underlying equities have fallen, the convertible bonds issued by high-growth companies have moved closer to their bond floors, providing some defence in periods of heightened volatility. We favour quality companies less susceptible to rotation and seek to generate style-agnostic alpha in both growth and value names.

Convertible bonds enjoy the dual advantage of providing an element of protection¹ against volatility and of lower direct exposure to interest rates, due to the embedded equity option. A lower underlying share price means that some convertibles are now pure credit plays. They offer fixed income investors the possibility of owning an instrument with less exposure to interest rates and the option to participate in equity upside, should the share price rise sufficiently to restore some optionality. For certain issuers, convertibles are their only tradeable debt, offering additional potential for bond investors.

Importantly, the asset class is technically inexpensive in the current volatile environment and displays a high level of asymmetry to equity-market moves. Many convertible bonds are now trading below what is deemed to be their fair value.

We believe the defensive characteristics of convertibles, together with a quality-driven approach to selection, could help investors weather the volatile environment and generate appealing risk-adjusted performance.

Sources

1. Capital protection is a portfolio construction goal that cannot be guaranteed.

Multi asset: embracing uncertainty in portfolio construction

As Monty Williams, the American basketball coach, said: “it’s a skill to navigate uncertainty”. Risk, the ultimate expression of uncertainty, is hard to manage because emotions often get in the way. At LOIM, we believe in a disciplined, process-driven asset allocation to mitigate behavioural biases and efficiently manage risk. A central part of this process is to regard volatility not as a foe, but as a friend. Incorporating volatility to size portfolio positions – enlarging them when volatility is low, diminishing them when it is high – is key to our goal of delivering better risk-adjusted returns¹, in our view.

We embrace uncertainty in our portfolio construction and we will always seek to include scenarios that may appear unlikely to occur in tandem, such as a renewed rise in inflation and a monetary-policy mistake. In order to address the former, we believe commodities and inflation-linked instruments should remain part of a core asset allocation at all times. As regards the latter, which would likely lead to a recessionary shock, nominal sovereign debt would be well positioned to protect² portfolios to an extent. However, we recognise that the future will never be a perfect repeat of the past and hence new solutions must be continuously sought.

Thus, we continue to see scope for “diversifying the diversifiers”, for instance through convex strategies such as long-volatility trades (another way to exploit volatility to our advantage rather than submit to it), trend-following strategies, or just the philosophical open-mindedness to embrace cash as a fairly simple shock absorber in case of heightened uncertainty such as that spurred by the unfolding Ukraine crisis.

Sources

(1) Target performance/risk represents a portfolio construction goal. It does not represent past performance/risk and may not be representative of actual future performance/risk.

(2) Capital protection is portfolio construction goal that cannot be guaranteed.

Alternatives: relative-value strategies to capture price dislocations from volatility

The start of 2022 is proving to be highly volatile, marked by conflict in Ukraine and substantial dispersion and sector rotation in the stock market. Importantly, sticky inflation and central-bank policy tightening are set to raise the cost of capital, while economic scenarios ranging from a significant rate increase to stagflation are all possible.

Typically, alternative strategies rely on discrimination, dispersion and volatility to perform. Today, as markets move towards a new normal fueled by the higher cost of capital, we believe the environment is becoming extremely favourable for relative-value strategies focused on alpha generation, such as dispersion trades or credit-spread plays.

Flows in the derivatives markets are dominated by non-specialists looking to enter directional trades, often to hedge existing positions. These large flows create price dislocations in certain options that specialists can take advantage of by screening for expensive and cheap optionality and building relative-value trades with an asymmetric return profile. The greater the uncertainty, the greater the hedging needs – and the more interesting the opportunity set, in our view. High levels of realised volatility typically enable our managers to quickly monetise positions. As a result, heightened market uncertainty and stress tend to provide a very attractive environment.

Dispersion trades that involve going long the volatility of constituents of an index and shorting the volatility of the index itself, in order to benefit from the large sector rotation, are examples of the opportunities currently available. They play on the fact that while an index might only move marginally at the overall level, within the index some stocks could experience pronounced shifts. Given current market conditions, we see this opportunity set remaining attractive.

Previously, an indiscriminate compression of risk premia led both risky and less-risky spreads to yield similar returns. Our credit-exposed strategies are positioned to be long safer credits and short riskier credits in order to benefit when the markets reprice, given that spreads on riskier credits typically widen more quickly. While the early 2022 selloff has not yet impacted credit, we believe such relative-value plays could provide interesting returns in periods of real stress.