CIO views: what about an outlier scenario?

Alternatives: searching for cheap optionality

There are typically three opportunities to invest in strategies that offer an outlier scenario (usually bad, but potentially good as well).

The first is when mispricing in the market enables you to structure trades so that you are a strong beneficiary while the cost of getting it wrong is negligible. These are equivalent to “free options”. We focus heavily on this within the alternatives division, continuously scanning the universe for very cheap optionality. A clear example is decompression in credit, where we would benefit from risky credits doing proportionally worse than safer credits.

The second opportunity arises when the cost of putting on a hedge is still cheap enough when you factor in how current possible scenarios could impact the portfolio. With volatility in the US currently around 30 on the VIX index, being long volatility is not cheap on an historical basis. That said, this trade appears sufficiently attractive given the suite of events: inflation (driven by energy and bottlenecks, and thus hard to compress), geopolitical uncertainties, the paradigm shift in the cost of capital and resulting asset repricing, and more importantly, the possibility of a deep recession combined with persistent inflation. We continue to be long pure tails and volatility overall.

The final opportunity comes when you anticipate a specific outlier scenario and look to benefit from it or hedge your portfolio. That is much more akin to a short-term macro view, which we do not tend to implement, nor do we think the outlier scenario is the most likely. Overall, we as such favour a barbell approach, combining the purchase of assets that have been oversold with continuing to run an outsized tail portfolio that remains attractively priced.

Explore our feature viewpoint about preparing for extreme events.

Convertible bonds: designed for unpredictability

In past periods when interest rates have risen or stocks have fallen, convertible bonds have been an effective all-weather vehicle because they structurally position investors for a volatile environment. When equities sell off, volatility tends to rise and convertibles can act as a hedge. Unlike a direct stock investment, convertibles benefit from rising volatility – the embedded equity option becomes more valuable and the bond floor limits losses on the downside. The greater the magnitude of a market move, the more convertible bonds typically protect investors from downside risk and participate incrementally with the upside as equities recover.

While in theory convertible bonds are well suited for an extreme scenario, valuations can also be adversely affected by moves in rates and credit. During past crises, rates generally fell because of central bank action or a flight to quality by investors. This pattern has now completely reversed due to the resurgence of global inflation. Weaker credits are particularly vulnerable in such a scenario, especially if rates remain higher for longer. Investors derive the full benefit of convertible bonds only if the bond floor remains solid. This is why we select convertibles from companies with a sound credit rating, no immediate refinancing needs and lower duration.

Many convertibles today are trading on their bond floor with what is technically a free equity option – holders are paid to wait for equity markets to recover. The coupon income and pull-to-par coupled with the potential return of convexity can be valuable. This dislocation creates the opportunity to generate equity-type returns from a fixed-income investment.

Fixed income: active and flexible strategies to mitigate drawdowns 

The drawdown experienced in fixed income markets this year has been unprecedented in the modern era, so is an outlier in itself. As a long only fixed income investor, a continuation or escalation in this trend would clearly generate ongoing headwinds. However, tools and strategies do exist to flexible and innovative fixed-income investors that can help to mitigate drawdowns in such tail events and preserve capital.

First and foremost, for any chance of outperformance in tail risk scenarios, active management is vital. Highly volatile environments can be alarming, but such conditions always present ample relative value opportunities. The alpha-beta separation within our portfolio construction allows for active PMs to allocate accordingly and swiftly as openings arise, while maintaining a core portfolio reflecting the target market exposure.

Additionally, implementing overlays allows us to manage risk within the portfolio for targeted adjustments to overall credit and rate exposure notably via derivatives such as credit default swaps (CDS) and interest rate futures. Alternatively, options provide the opportunity for convex exposure to negative shocks. When macro moves dominate the narrative, this can provide a source of substantial outperformance versus benchmarks. However, such insurance can be expensive and requires either prudent timing or a smart systematic approach to mitigate the potential cost.

All in all, flexibility in portfolio management is key in such scenarios to be able to access all tools available and, ultimately, preserve capital. In doing so, it maintains a base to deploy risk as the tail risk event passes. This is particularly important in fixed income as an early business cycle outperformer versus other asset classes, as the pull to par feature dominates in recovery periods.

Asia fixed income: hedging duration as hawkishness peaks 

With the US and European government bond markets down 13% and 19% respectively at the time of writing, 2022 is proving to be one of the toughest years for global fixed income since the 1980s. Meanwhile, the US investment-grade market, upon which Asia credit is priced, is down 19%. 

This comes after a whopping 300 basis points of Federal Reserve (Fed) rate hikes in the last six months, bringing the benchmark rate to 3.25%. But Fed hawkishness is likely peaking, with its forward guidance suggesting a terminal rate of 4.5-4.75%. Markets expect this outcome in early 2023 given 10-year Treasuries are yielding 4%, which we see as fair value given the yield-curve inversion, economic slowdown and rate cuts that will follow.

Extreme scenario and current positioning

There is market talk of rates peaking above 5%, which we believe to be an extreme scenario that would probably force a US hard landing, increase the risk of policy accidents akin to what has happened in the UK, and compel the Fed to cut rates.

To navigate the current volatility, we are lowering rates duration through hedges while favouring longer maturity points, which will likely benefit from US yield-curve inversion. That said, all-in yields for Asia BBB and BB-rated credit are now at 6-7% and 10-12% in USD terms respectively¹, offering strong multi-year returns driven by carry and yield compression as US rates peak, stabilise and then decline as the easing cycle progresses into late 2023 and 2024.

Sources

[1] Yields are subject to change and can vary over time. Past performance is not a reliable indicator of future returns.

Equities: seek quality for strength throughout cycles  

Throughout 2022 so far – and into the future – our conviction in quality stocks underpins the resilience of our long-only portfolios.

In early Q1, the flattening US yield curve warned of a likely transition from economic expansion to slowdown and, potentially, a recession. For equity markets, such a change typically signals a shift in preference from growth companies – especially those reliant on capital-market funding – towards quality companies with strong financials. Such firms demonstrate high capital efficiency, strong free cash flow, low dependence on external financing and solid economic moats.

Investing in quality is at the core of our equity investment process. This focus strengthened during the growth-to-value rotation and a defining feature of all our portfolios is an overweight to quality companies with an ability to capture secular growth with limited sensitivity to economic cycles.

The valuation question

In our view, the potential for a recession is already factored into equity valuations. And with spot real rates still negative and price-to-earnings multiples normalising rapidly towards historical averages, valuations remain attractive, in our view. We believe the key risk is an upward turn by real rates into positive territory, which would drive a deterioration in valuations. 

Sustainability: climate change is a hidden source of inflation 

The full assessment of how climate change affects inflation has only just begun. Until now, economic models merely measured the cost of climate-related disasters. This is now changing. Extreme weather is an unacknowledged source of inflation. Floods can disrupt crops, pushing up food prices. Hurricanes can damage power plants and cause energy shortages.

An example is the recent microchip inflation. Computer-chip makers need water for the production process. Taiwan is a major supplier of chips, and a severe drought there contributed to a shortage that hobbled the auto industry.

A few statistics also paint the picture. In 2021, climate-related weather disasters cost the US economy USD 145 billion (up 50% on 2020). According to the National Climate Assessment, the annual cost of such events will surge to USD 500 bn by 2090. Although none of the CPI components is directly linked to climate, it is a hidden cause of inflation. The impact of climate change is lifting prices for goods including food, clothing and electronics. Fossil fuels are subject to abrupt changes in supply that cause shocks in energy markets and fuel inflation worldwide.

Investing in renewable energy is a direct way to shield consumers from energy price inflation. In addressing the current energy crisis, it is important to remember that the transition to cleaner sources takes time. The less time you have, the higher the risks of economic disruption. Countries need to act early and decisively for an orderly transformation without price spikes. While climate is a major inflationary force, it cannot be tackled simply by central bankers adjusting interest rates. The current environment should motivate policy makers and markets to accelerate the decarbonisation shift and invest in provisions to counter climate change’s increasing disruption.