CIO views: what comes next?

Alternatives: fertile grounds for active management

Whilst it is difficult to predict the H2 market direction, given it is heavily reliant on a medical solution, it appears to us that the latter part of this year will continue to see elevated volatility and thus a market favorable to active managers, especially in the Alternatives arena.

Passive investments are ill-prepared for a rapid change in business outcomes, in our view. Some industries will see very volatile earnings revision, particularly within the so-called BEACH (Booking, Entertainment and Events, Airlines, Cruise and Casinos, Hotels and Resorts) sectors. Companies within these sectors have weaker balance sheets that are unlikely to be able to withstand a collapse of revenues, and will have to be bailed out. There will continue to be uncertainty around these outcomes no doubt, building on our belief that an active manager can more swiftly and adequately respond to news flow.

Central banks and governments are typically passive investors by and large, and will look to act as a stablising force. However, they will focus on systemic risk, not idiosyncratic risk. Secondly, companies are not all of equal importance to them and cannot always be saved. Finally, this is a public health crisis with widespread real economy implications, so financial support alone will not be enough.

As a result, an agile active manager that can swiftly adjust to newsflow, anticipate market changes and focus on key drivers of returns for individual securities could potentially offer more interesting returns than a passive index in the post-Covid environment.

Summer rethink

‘Thinking, Fast and Slow’ by Daniel Kahneman
A well-deserved best seller by an Economics Nobel Prize winner, that looks into two modes of thought that is no stranger to behavioural biases we see in the investment world: a fast reflex system versus a more deliberate and calculated approach. 

‘My Climate Journey’ by Jason Jacobs
This inspiring and relatable podcast was started by a software entrepreneur who sought to better understand climate change through the practical and multi-faceted lens of business leaders, journalists, investors, policy makers and thought leaders. We thought it very relevant for our very own sustainability journey.
 

Convertibles: working well from home

These past few months will prove historically important, marked not only by the severity of the recession but also by the impressive range of budgetary and monetary aid deployed to counter it.

The market outlook is very uncertain with serious concerns about the sustainability of the recovery and historically large sovereign debt levels, evidenced by the elevated level of equity volatility. The US is still struggling with the first wave of the pandemic, while Europe fears a resurgence of the virus in the autumn. Thus, central banks will have no choice but to continue providing support to the real economy by various means, including corporate debt purchasing programs.

Convertible bonds have shone compared to most asset classes in 2020, outperforming both equities and corporate credit in H1. Their natural asymmetry give them protection against the worst of the equity market corrections (thanks to the protective effect of their bond floor¹) but also the ability to participate in the recovery (thanks to the equity sensitivity of their optional part). 

The convertible bond asset class continues to offer pockets of technically ‘dislocated’ convertible bonds, and the portfolio has taken advantage of this. Their technical profiles combine strong bond protection, unusually generous yields² and a discounted equity call option. It is important to remember that the optionality of a convertible bond is long term and thus gives longer exposure to a recovery of the underlying shares. 

One of the biggest changes affecting the convertible bond asset class in H1 2020 is undoubtedly the strength of the primary market, and how new issuers are likely to affect the asset class performance and risk profile in the future. Although some of the new issues are best described as “rescue capital” for companies most affected by the COVID-19 pandemic, the asset class continues to see great dynamism from high-growth companies. In particular, there are increasing number of convertible bond issuers in what we call the “working or consuming from home” space, such as software companies, e-commerce players and online consumer services. Investors can therefore gain exposure to the business models that will shape our future through convertible bonds.

Summer rethink

"Guns, Germs & Steel" by Jared Diamond
 First published in 1997, this book which synthesizes history, biology, ecology and linguistics to explain the evolution of man over the past 13,000 years seems particularly relevant today. 

"The Prospect Interview" podcast from The Prospect Magazine. 
Always enlightening, the latest episode introduces an annual list of “top 50 thinkers” (intellectuals, artists, scientists and writers who have come to define our time). In particular we recommend the recent episode entitled "Rebuilding the world after COVID-19" with Oxford historian Margaret McMillan and Harvard economist Dani Rodrick.

Sources.

Fixed income: Navigating a deeply disjointed environment

The easing of financial conditions by global central banks is set to persist through a combination of sovereign and corporate asset purchases. The possibility of the ECB joining the Fed in expanding into high yield corporates (fallen angels – bonds downgraded from investment grade to high yield) is also still very much on the table.

In general, we expect that the asset purchase programs from central banks will continue to support risk assets, particularly the credit markets. However, the global economy remains at the whim of the effects of COVID-19, and expect the vast disparities in economic recoveries across different sectors to persist - and possibly even widen. Sectors such as airlines and hospitality now face the challenge of trying to operate with persistently subdued demand. On the other hand, certain disruptive tech sectors are seeing sharp pickups in demand and market share. 

In the second quarter of 2020, we saw huge inflows into liquid index-tracking ETFs, causing an indiscriminate rally in many asset classes. Therefore, we believe that active management and rigorous bottom-up analysis are crucial to thrive in this deeply disjointed environment. We believe many potential relative value opportunities abound, as the struggles of the hardest hit companies come to the fore in coming earnings releases. We believe our strategies in the crossover segment – bonds rated BBB to BB - are particularly well-positioned, on the back of unprecedented fiscal and monetary stimulus that should remain in place for the coming quarters, as well as structural benefits such as the record level of fallen angels supply.

Summer rethink

"Revisionist History" podcast from Malcolm Gladwell.
Revisionist History takes a fresh look at historical figures, events, or ideas, and challenges pre-conceived notions. It is a fascinating journey into the past, reminding us that  history is subject to interpretation, there are always more questions to be answered and we may need to rethink what we know about history.

Multi-asset: Visibility remains low

From a pure asset allocation perspective the active/passive debate takes different dimensions.

First, higher volatility, performances and valuation dislocations across assets or regions and sectors come with opportunities and risks that challenge passive approaches. In addition, shall we stick passively to a former strategic asset allocation or is there something new that warrants a review? 

Investors may be tempted to seek outperformance through a repositioning consistent with discretionary scenarios. However, the 2020 crisis has grown into a huge disconnect between markets and fundamentals. Macroeconomic indicators obviously failed to anticipate the crisis, but they also plunged when markets rebounded. As markets still react essentially to non-macro news flow (virus breakouts, central banks and governments reactions, trade tensions and other political tensions), we believe visibility remains low and discretionary bets with short horizons will be challenged further.

However, long-term trends keep going, if not at an accelerated pace, which justifies reviewing structural assumptions such as risk models and portfolio construction principles from a strategic perspective. This is also an active decision.

Yields were low and went down further: while government bonds diversified nicely again this year, how much can we expect for the next shock? Shall we get rid of them or review tactical positioning signals? Other assets, across fixed income and equities or commodities, suffered fast, severe coincident losses with price dislocations, reflecting a real challenge to implementing short-term tactical bets efficiently.

We believe these evolutions support several choices. First, we must seek other stress diversifiers such as long volatility positions. Second, bring risk management techniques into the rebalancing process, independently from views. Additionally, profit from short-term shocks by becoming liquidity providers and opportunistically building structural exposures at more favorable prices. There has been interesting entry points in credit markets since March with a buy and hold approach. 

In such conditions, we believe an active mindset can add value over time but we always favor a disciplined, systematic, diversified and risk controlled approach.

Summer rethink

‘The Model Thinker’ by Scott E. Page
This book faces a real challenge as the field of data analysis is also getting broader by the day and can get quite complex. The author manages to cover the topic by remaining approachable and pleasant. It triggers many questions relevant to our daily tasks and research as investment managers, challenging our current thinking and forcing us to think twice about our choices and being careful about working assumptions, which may sometimes become too strong convictions.

Asia fixed income: Asia’s economic recovery

Our outlook for 2H is very simple. A continued economic recovery across Asia, and emerging markets, from trough levels in 2Q 2020; peaking corporate credit leverage trends in 2H 2020;and a subsequent increase in operating cashflow for most firms in 2021 and hence a reduction of leverage in 2021. In line with this view, we think resilient large-cap credits in cyclical industries such as sea-ports, logistics management, petrochemicals and refineries will do well. They should present a good long-term opportunity to enjoy higher-than-average spread carry than defensive sectors such as high quality utilities and technology, whilst providing spread compression opportunities in the next few quarters as the recovery across markets take hold. 

The difficult business environment has caused two interesting trends. Firstly, the demand for fixed income credit seemed to have increased significantly pre-Covid, owing to structurally zero interest rates going forward and large central bank support. Secondly, dispersion in credit markets have significantly increased between risk segments. For example, within our universe BBBs in USD credit trade at 3.2% (0.2% tighter YTD), BBs at 6% (0.4% wider YTD) and Bs at 10.85 (2.5% wider YTD). This dispersion is very high, and represents a flight to quality as well as expectation of higher downgrades and default rates. We think this flight to quality will be maintained, and Asian and EM Investment Grade will likely hold up very well in a low volatility environment on the back of low new net supply of bonds, higher demand, and greater relative value vs US high grade, which is now only at 2% for over 8 year duration. Within High Yield, we expect idiosyncratic risk to be high as default rates crystalize at the highest level in several years, but will drop back down in 2021 as weak names are flushed out of the universe.

It is counterintuitive to think credit market volatility could be low in 2H and that spreads could keep grinding despite prolonged recessionary conditions globally. However, all evidence points to that being the case.

Summer rethink

‘Collapse’ by Jared Diamond
A fascinating collection of historical facts which shows how societies have thrived and failed, and what is necessary to avoid collapse. Through the pages of this book, we can perhaps ponder what will be leading communities, societies and nations of tomorrow, in my opinion. And makes for great investment thought, as nothing is more aligned to investment outcomes than survival and avoidance of failure.