How Deep Should Investors Swim?

by | February 15, 2021

A rising tide lifts all boats. When the tide goes out, you can see who’s been swimming without trunks. 

Two cliches, both apt for investors.

The first depicts how most stock, bond, real estate and commodity prices rise when markets are awash in liquidity and underpinned by improving fundamentals. The second, attributed to famed value investor Warren Buffet, warns how quick reversals in monetary policy, or the fundamentals, can leave exposed swimmers high and dry.

After nine months of spectacular market gains and heavy consensus positioning in risk assets, investors are now right to question which way the tide is headed.

For reasons we outline below, it is still hard to argue against the rising tide thesis. But the higher the tide rises, the more it is worth asking, what could precipitate a sudden reversal that could leave investors marooned?

The first reason to believe that equities, commodities and credits will remain supported is US politics. With an acquittal in former president Trump’s impeachment trial a foregone conclusion last week, Democrats in Washington opted for a quick conclusion to the Senate trial. Their motivation was to ‘clear the legislative decks’ for President Biden’s Covid-19 relief package, which totals some $1.9 trillion in new spending. That legislation will be introduced as a reconciliation bill, requiring only a simple majority in the Senate, which the Democrats will be able to deliver.

Accordingly, the US and world economy will very likely receive a further large dose of fiscal stimulus in the first half of 2021. Meanwhile, recent comments from Fed Chairman Jerome Powell suggest that he and the Federal Open Market Committee (FOMC) are satisfied with the US inflation outlook. The Fed surely took comfort from the latest benign consumer price inflation data. Similarly, the Lagarde-led ECB also shows no signs of deviating from its expansionary monetary policy.

Global reflation, therefore, will remain the dominant macroeconomic factor influencing investor decision-making. Although stretched equity and credit fixed income valuations pose a higher threshold for positive earnings surprises, it nevertheless will be difficult for investors to abandon their pro-cyclical stances. At the asset allocation level, there is simply no compelling alternative.

The only genuine choices facing investors today regard which equity factors, regions and sectors to overweight. An improving global outlook favors more cyclical sectors and regions, such as financials, industrials, basic materials and emerging markets. Those growth stocks that increasingly dominate cyclical sectors, such as consumer retail or advertising, are also likely to do well. Defensive sectors, such as utilities or consumer staples, will probably lag.

Still, some real challenges still remain for investors to discern.

First, where does endogenous risk reside? What wheels are being set in motion that could ultimately derail the current happy state of affairs in markets? 

Second, what exogenous risks could suddenly arise that would shatter market optimism?

Third, how should portfolios be diversified in order to improve return per unit of risk?

Accelerating inflation is the key endogenous risk. Motivated by campaign pledges, the Biden Administration is ignoring warnings by some fellow Democrats that its Covid-19 relief package may be too large. According to most forecasts, inflation will bottom by the second quarter of this year. 

It is important to remember that the pandemic is not a mere demand shock. Combined with disruptive trade wars, the pandemic has impaired supply – along extended global trading routes, as well as in labor markets. Excess aggregate demand may not be as far away as backward-looking output gap estimates suggest. Oil, food and other commodity prices have recently surged. Companies may not absorb rising costs in profit margins.

The pandemic and geo-politics remain the key exogenous risk factors. Viral mutations or unanticipated conflicts in various ‘hot zones’ could dramatically change current optimistic investor expectations for global growth.

Finally, investors face a daunting task of finding assets with uncorrelated and lower volatility returns, given portfolios gorged with equities and credits. Private equity and private credit are often touted as such diversifiers based on historic return premiums for manager skill, but the craze of funds flowing into special purpose acquisition companies (SPACs) – seeking to play in the same space as PE – is worrisome. After all, over-investment typically results in under-performance. Finally, the other ‘alternative’ in hedge funds may not be the answer. On average, their returns have lagged market indices badly for more than a decade.

For those concerned about inflation, crypto currencies might be appealing, but their volatility is not for the faint of heart. Inflation-linked bonds may be a sounder instrument. Yet after a steady rise in market-based expectations of inflation, ‘linkers’ are no longer cheap.

In short, the tide continues to rise, yet there are few diversification ‘life-vests’ available for investors bobbing along the waters of market euphoria. 

Swimming against a tide pushed forward by massive policy stimulus seems likely to leave contrarian investors with little to show for their efforts, except depleted resources. For now, the best option may very well be to suit up…but not to go in over your head.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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