Curating Winning Client Portfolios as Investors and Funds Navigate Hyper-Active Markets
A Hubbis Thought Leadership Discussion - Co-Hosted in Association with GAM Investments
Little did we anticipate that a discussion on market uncertainties and ongoing volatility would be held just as Russian missiles and tank shells were to start raining down on Ukraine.
The discussion had been predicated on all the world’s other financial, economic and geopolitical uncertainties, but the onset of this latest crisis only served to underscore just how unpredictable and therefore volatile the world can be.
Hubbis has distilled a selection of the observations from our invited guests, all wealth management experts and leaders in their respective fields, all based in Asia, and with all their comments presented as off-the-record.
And we have summarised and quoted the extensive and very valuable insights from the main GAM Investments speaker, London-based Julian Howard, the Lead Investment Director of Multi-Asset Solutions at GAM Investments.
Howard is responsible for strategic and tactical asset allocation as well as fund selection for funds valued at some USD2 billion. He has long experience in the global markets from which to draw his assumptions - prior to joining GAM some 15 years ago in 2007, he held roles at leading firms such as Henderson Global Investors, Insight Investment, Invesco Perpetual and JP Morgan Investment Management.
In a nutshell, his current view – supported by extensive data - is that whatever other ‘noise’ exists currently or might emerge, nothing has changed long term. He and colleagues will continue to base their strategic portfolio allocations on their view of secular stagnation, low growth, low rates and low inflation. He said the evidence for those factors enduring into the foreseeable future is absolutely overwhelming. And that in turn means investors should look long-term and find pockets of value.
Observations, Insights & Questions from the Guests:
The burning question of the moment – where are rates going, and what will the Fed do next?
A guest pointed to the question that has been most on clients’ minds, namely the direction of interest rates and the policy strategy of the US Federal Reserve. He asked: “Is inflation going to sustain or increase? Will the Fed be raising rates aggressively? What does it all mean for growth fundamentals, profits and valuations? And what does Russian’s attack on Ukraine mean for energy prices?”
Inflation might be considerably more pernicious than many believe, and central banks possibly powerless to fight back
A guest observed that inflation had worried him for some time and that he believes it might be considerably more troublesome rather than transitory. “China's peaking population and the focus on quality over quantity means they will be already exporting inflation rather than deflation,” he explained. “And the really high debt and deficits in many major countries can drive inflation further as governments try to get out of that through negative real interest rates.”
He noted that where the European Central Bank some weeks earlier had positioned itself tougher on inflation after record Eurozone inflation numbers emerged, Greek and Italian bond yields jumped. “That shows me the ECB is stuck – they dare not hike too much, or they risk a Southern Europe debt crisis. The same is true elsewhere. The US deficit is way too high, and we remember what Alan Greenspan warned before COVID, namely that high deficits foreshadow rising inflation, and that was before the pandemic money printing took place.”
But he pointed to the Catch-22, namely that if the central banks could just increase rates to address their problem they would probably already have done so. “Today, you have inflation above 7% by some estimates and rates on bank deposits closer to zero. The central bankers and politicians seem to be praying for people just to hold their currencies and have their cash eroded through inflation. Then they are hoping inflation will not persist, but I fear it will and could even rise.”
But is inflation as rampant across the globe or restricted to the more developed economies?
Another perspective came from a guest who remarked that the key economies that have high or rising inflation are consumer economies or those with real supply chain issues, for example, the US, Canada, Western Europe, the UK, Singapore, and New Zealand. “There’s no inflation anywhere else in the world,” he reported. “The Hong Kong budget anticipates 2.1% inflation this year, and 2% next year, and it could be lower. The Fed and the policymakers have sort of infected everybody's mindset that there's rampant inflation everywhere around the globe, and there really isn't.”
Watching, waiting, and hedging appear to be the best approaches for many in the current environment
An attendee agreed that all these issues are key concerns for the asset management and advisory community but reported that they had not yet been advising clients to significantly alter existing portfolios.
Another expert also agreed, remarking that they had advised clients to somewhat hit the pause button without unloading assets.
“Most of the asset classes we have been promoting were somewhat neutral, so we are more inclined to wait and see, with a lot more focus on hedging, including buying more exposure to gold, and to private assets for longer-term holds that are not really affected by the short-term volatility.
He explained that some clients were de-risking by reducing equity exposures, but the outflows thus far were not significant. He said clients were already expressing heightened anxiety around inflation and rate hikes, and the Ukraine crisis will only serve to exacerbate those concerns.
Another banker concurred, adding that having sufficient cash is important in the current environment. He pointed to the China market, which had suffered a significant drop since early 2021, remarking that he would like to be soon buying back into Chinese equity and event, albeit to a lesser extent, Chinese bonds. “There are opportunities in private equity, venture capital and real estate as we speak,” he reported.
China in the spotlight – could the worst be over for now?
A guest observed that his bank believes the worst is behind us with regards to regulatory crackdowns. He said that in typical Chinese fashion, they do everything at the same time, just get over and done with. Having said that, the real estate sector is still in the mire, at least for the first half of 2022. He noted that the Chinese central bank is probably the only such major institution in the world that still has ammunition to drop rates. All these factors, he said, and given the huge corrections in indices for China and Hong Kong, add up to some weighty tactical bets. “We say to our clients, okay, you might want to dip your toes in the water again at this stage,” he told the assembled experts.
Insights from Julian Howard, Lead Investment Director of Multi-Asset Solutions at GAM
Howard’s Key Insights & Observations in Brief
Julian Howard offered his extensive views on global economies, finance and markets. We have selected and summarised those views in these on-the-record comments from Julian below.
Howard’s Headline – the big picture story of secular stagnation, low inflation and low rates remains intact and will endure for the foreseeable years ahead
“Are we at the point of a meaningful regime change that in turn means portfolios need to be adjusted and does that adjustment take place tactically or strategically?
Well, our view is nothing has changed long term. We base our strategic allocations on our view of secular stagnation, low growth, low rates and low inflation. I think the evidence for that over a long period of time into the future is absolutely overwhelming.
But what we have right now is a blip along that road. The story of secular stagnation is not linear; it is not year on year, it is an observed trend over a longer period of time.
The drivers of secular stagnation are a combination of things, one of which is inequality, and the other probably will be climate change. Another is low productivity. And then we have the demographics. None of those has really changed as a result of the pandemic or other events.
Inequality is worse than for many years
Inequality has deteriorated further during the pandemic. The Piketty Inequality Lab released a report just last year, which suggested that billionaires’ hold on total household wealth accelerated during the pandemic and is now higher than ever. It is absolutely extraordinary that the pandemic drove inequality. Inequality is bad for long term growth because effectively the hyper-rich don't really spend; yes, they make high profile purchases, the boats and planes and so forth, but generally, they don't inject growth into the economy, they save much of their wealth.
Climate change will create a negative 20% global GDP impact by 2050 if we do not act!
The Swiss Re Institute predicted a 20% GDP impact by 2050 if we don't hold temperature changes to the Paris Agreement, which is something that we're probably going to fail at, unless we somehow solve fusion by 2050.
The globe’s demographics are frightening, especially for the developed economies
Population growth rates across the major economies keep worsening. Economic growth is really a function of population multiplied by productivity. And populations simply aren't growing across the developed world. We have demographic stagnation and worsening dependency ratios. Japan, in particular, is actually outright negative in terms of its population growth.
Inequality + Climate Disruption + Declining G7/Developed Demographics = Low Growth, Low Rates and Low Inflation
All in all, the overwhelming case is for a world of low interest rates, low inflation and low growth, which is pretty much where we were in 2019 and the decade before that. And we had strong asset price growth during that period due to the low rate policy response.
With the discount rate persistently low, the net present value of all of the assets out there, from property to tech stocks to bonds, all were boosted.
What has changed this year is there is the threat of higher interest rates because of inflation. But, I think the central banks are wrong. They're chasing an inflation that, in our view, is an exclusive by-product of the pandemic response and now the Ukraine conflict. It's a supply phenomenon rather than a demand phenomenon. So they are using a demand control tool to address a supply issue..
All of this is confusing people into thinking that perhaps secular stagnation has ended, perhaps we are really moving to a new phase, a regime change with higher inflation and higher rates. Perhaps we are going back to the 1990s, the Clinton boom years. And that would mean we need to re-price everything from real estate to bonds to Bitcoin to equities. Hence the volatility seen in markets.
However, in my view, that is wrong. We believe that what is driving these central banks to get so excited and to act as they have been doing is transient. At some point inflation will ease and central banks will reverse course.
A closer look under the hood at the realities and the true underlying causes of inflation
Labour market dislocation is coming to an end
If you look at the causes of this inflation in detail, a major issue has been labour market dislocation.
In the UK, in the US, that's actually being fixed. In the UK – and this is surprising many in Asia, for example – all pandemic restrictions have been lifted, isolation has ended, state control, in general, has come to an end, and that is all very positive in my view. That means people are returning as normal to the labour market, and we will gradually return to normalisation.
In turn, that means wages are not tracking as high as inflation in the UK and US because the labour market is normalising first. It is leading the way.
In the US they never really locked down in the traditional sense; it's not an economic culture that’s optimised for locking down. People are coming back to the labour market as a result. Labour market dislocation that had been driving inflation higher is coming to an end.
Supply chain disruption is gradually lowing over
The other cause of inflation is of course supply chain disruption. In Asia, there is the emphasis on COVID-zero, so entire towns and cities in China are being locked down at will. Factories and facilities that serve the world are affected. Perhaps the zero policies will come to an end as the authorities realise it is not a realistic policy. That is far from a certainty, but there could be a greater realisation that the virus is endemic, that you can't control the ad infinitum, it becomes too expensive. Let’s watch what happens in Hong Kong and China to see how that plays out.
Semiconductor shortages are transitory, and the situation will soon improve
There is a lot of investment going into semiconductors now, for example by TSMC and other major global firms. The semiconductor shortages will be fixed and actually fairly soon. And there is a long history of semiconductors vacillating from feast to famine and back to feat again. I think we're going to shift more towards feast towards late 2022. And that will drag inflation down.
Russian roulette or calculated gamble?
It is hard to know what Putin’s end game is. But I don't think it's in Putin’s interest to cut off gas supplies, because obviously that's a major source of revenue. Accordingly, I think there are limits to how much pain he's willing to inflict on Europe, because they would suffer a lot as well. Yes, this crisis causes uncertainty, as that is always bad for energy prices, but I see more cause for hope for prices than negativity right now.
The agriculture and food markets are not likely to collapse
I think the market mechanisms are very good at bringing more food supply on stream. We have a robust history of innovation, and I think the ability of humanity to produce and challenges to supply will be met with enhanced means of production. I am therefore not so worried about some sort of resource and food nightmare scenario emerging. Climate change is another matter, but in terms of food and water supply, I think those are things that can be resolved through market mechanisms and innovation.
If the Fed is truly data dependent, they will soon react to easing inflation
The Fed says they are data dependent, and we just need to see a couple of inflation prints that are a little bit softer, and their current narrative will change.
Of course, the timing is really difficult. There's a lot of volatility, and it is very tough for clients. But I would suggest that if you're strategically invested, the overwhelming investment theme remains one of secular stagnation, and that is what you should point to.
Rates have been falling for centuries and will stay low, so think strategically and avoid tactical changes
It is I must admit somewhat depressing to be rooting for the wrong side, to be convinced that we remain in a sustained period of low growth and low growth rates. But real rates have actually been falling for centuries. This is not just a decade-long phenomenon. It's actually a multi-century phenomenon whose causes are worth a of a separate discussion (see P. Schmelzing’s 2020 Bank of England paper).
Ultimately, the play for the strategic investor long term is that low rates should support earning streams going into the future, and that particularly points to long-duration investments, whether it's government bonds or technology stocks that have been beaten up in recent weeks. Those are the places you need to be in the long term.
I completely understand why there is pressure to do things tactically. And we've done things tactically too to ‘soften the ride’. But there are limits to how much you can do before you end up with a portfolio that doesn't have any view whatsoever. We will, in my view, snap back to that stagnation scenario, so see the long-term picture, and beware of excessive tactical change leaking into strategic change, and trying to get market timing right, as well all know that is not possible.
Bond market break-even points and inflation
We do look at the long-term implied inflation from the bond market perspective. We look at the break-evens and swap markets. The two-year inflation swap, the implied inflation in the market, is actually going up. But if you look at the five-year / five-years inflation swap, which means 5-year inflation expectations in five years’ time, that's actually coming down a little bit. This means there remains scepticism in the bond market around the persistence of this particular bout of inflation.
The other point that reinforces the view on stagnation is the real yield. If you look at the 10-year US Treasury yield, and if you take away the break-even inflation expectations, you see through to implied growth in the future. And that growth picture has been steadily falling since the late 1990s, as implied by the bond market, and that hasn't changed radically either.
So, from the bond market’s actions and stance, there is really no sense that this post-pandemic world is going to be one of better growth. Build back better is literally just a catchphrase. Lack of growth will detract from inflation, and therefore rates will move down in line.
However, we are in this extremely awkward period in the middle which all of us in the investment industry must help clients navigate. And we all face the challenge of the daily public quotation unless we are in private assets or real estate. In that regard, I am somewhat jealous of property investors, because they only get the quotation on the point of transaction, whereas obviously, we have to deal with the quotation on a daily basis. And that means much more nervousness and also scrutiny from clients. But equally it means that the investment thesis is more robust as a result – it needs to be.
The role of net-zero and questions over the potential for softening of the stated targets
I think we may fail on climate change vis a vis the Paris Agreement. Unless there's some incredible breakthrough, for example we solve fusion, or there is some other major paradigm shift. I think therefore there will be a temperature change of over two and a half degrees, and that's going to be very costly for growth. My instinct is that it won't be inflationary because growth will be low, and demand will be too
However, if governments try to force through complete change transition, that could be inflationary in the medium term. The cost of transition to net zero is high and governments are broke post-pandemic response while investors are starting to separate out the clean energy story from valuations and business models. We’ve seen S&P Clean Energy underperform dirty energy in recent weeks, so many investors are still in an evaluation phase on investing into net zero. But equally doing nothing is getting costly too - the rising price of carbon credits (until recently) is noteworthy.
Nevertheless, my instinct is that longer term this is going to be growth damaging. And ultimately, if there's low growth, that tends to precede lower inflation. So, my sense is that there will be a low inflation era ahead.
In short, climate change will be negative for growth and inflation will remain low as a result.
Investors should think now about timing their return to technology where valuations are largely much lower
There is probably an opportunity for investors coming back into tech sometime this year, having sat on the sidelines, or for those who believe the current phase is temporary. At some point, there is likely to be a snapback, and I was quite encouraged to hear this view from a guest today. These are still great firms, and if you look at ‘standard big tech’, say the NASDAQ 100, this is trading far cheaper than it was back in November-December. If you think inflation will ease off and maybe the pressure on rates will ease off too, there's going to be an enormous snapback in these stocks. And of course it’s a good place to be long term anyway per the stagnation point.
Howard’s Way on China. Don’t overcomplicate things; the secular story will surely play itself out
“There is an entry point on China now and the long term story is a secular one. The simple facts are that China is 5% of the MSCI AC World Index, but 20% of the world economy. China needs capital markets to allocate resources efficiently. It may not feel like it right now with all the talk about Common Prosperity and the associated state intervention, but they need capital markets which can do a better job than many state-owned enterprises, which as we know are not the most efficient.
So, for me, it's as simple as having a structural weighting to China, whether you choose active stock-picking or passively through ETFs, both are valid approaches. The play is a structural weighting.
If you look at the long, long-term history of China, and I'm sure a lot of people will be aware of this, the colonial 200 years from roughly 1750 to around 1950, that's really an aberration. That's a time when China was beaten down and oppressed, and of course it was a much smaller part of the world economy.
But the long-term history is actually of world primacy . And I think we're really seeing a resumption of historical trends there. Consequently, I think the capital markets are one way that investors can play it. However, nothing is linear, and that is also the same with China.
There was and is a feeling that the growth story has been unfair to many Chinese people, hence a lot of working parents are absolutely exhausted with the tutoring and the exams ‘arms race’, for example, and things were out of control. The government saw this and said we need to make things a little bit fairer for everyone. I think companies will adapt to that. Companies in the West are very used to rising regulation and interference, and they adapt to it too. And I don't think it'll be any different in China. And once it's well communicated, and that process of adaptation is complete, there's a fantastic secular trend available at a low price right now. There is a valuation opportunity now for sure. The ‘A’ shares market allows for direct investment in Chinese exchanges and we also like it because it has lower exposures to the more contentious areas of Real Estate and Technology than say the MSCI China index.
Conclusion: Looking wide angle at the world’s markets, investors need to stay diversified, take the long view and focus on long-term value
Whatever your investment resources, figure out what you need in the coming few years and keep that liquid. The reality is there is inflation right now, it will wane, as I said, but it will erode cash in the nearer term. That can’t be avoided easily. But for the bulk of your investible money look into the depths of the markets and take a long-term view, constantly looking at secular trends that will transcend low growth.
In terms of valuation the equity risk premium in the US - the difference between the earnings yield on the S&P 500 and the 10-year Treasury yield – you are getting paid a clear 3% or more for holding equities. Historically, that's resulted in returns on average in returns of around 9% compound over the following five years.
We haven’t ‘cracked the code’ on market timing, but valuations relative to risk-free yields or rates are not a bad prognostic indicator, and I think if there is available capital that you can set aside, and you are not really worried about the near-term volatility, then this not a bad time to get involved. Don’t look at prices daily, and buy in gradually. Take a long view and providing this is money you do not need in the next perhaps ten year period then it’s worth a look. Don’t allocate investments for shorter-term gains if you might need those funds, perhaps for a new property investment or for other personal or family needs.
In short, there will be more volatility in the next few months, but on a long-term view, valuations are indicative of reasonable returns in the future. These are not the heady returns we have come to expect in recent years, but they should still be reasonable. And remember, markets are in a correction now – the S&P 500 year to date is off around 10%, so that's somewhat of an entry point for a long-term investor.
In the meantime, there are things that can be done to try and protect nominal capital in the medium term. For example, there is convertible arbitrage, mortgage-backed securities, catastrophe bonds, and others, although most will not beat inflation if it is running as currently at 6% or 7%. They will, however, keep investors somewhat protected from erosion. And private credit offers IRRs of about 8%, and no short-term market pricing, so this sidesteps worries over volatility!
In short, these are avenues to make the ride somewhat less turbulent, to help you stick in for the bigger prize, which is the long duration investments in a world of low growth, low inflation and low rates. In that environment, equities will perform.”
More from Julian Howard, GAM Investments