Four strategies to consider amid economic uncertainty

AT THE start of 2023, few would have predicted that equities would roar through the first half, with US stocks returning over 20 per cent to the end of July, and Europe not far behind.

Macroeconomic uncertainty surrounding inflation, interest rates and corporate earnings caused nervous investors to shun riskier assets and flock towards perceived safety. The result has been huge flows into cash and low-duration fixed income. Indeed, money market funds and Treasuries are both on track for record years of inflows, according to Bank of America.

Many investors find themselves caught among the attractive yields available in government bonds and cash, falling but high inflation rates, and the need to generate real return for their clients.

In this environment, there are a number of strategies and asset classes which might be worth considering or revisiting. Here, we highlight four such opportunities.

Insurance-linked securities

As a floating rate instrument, an insurance-linked security (ILS) has little interest-rate duration to speak of, leaving it relatively unscathed by the latest bond market rout. If inflationary pressures persist – as most major central banks believe they will – higher rates may be with us for a while. More interest-rate rises feed through to ILS investors as part of their coupon.

In short, the current market represents one of the most attractive markets in which to invest since the ILS market came into being, with yields at very high – indeed record – levels.

Here are some key drivers behind the current market dynamics:

• Demand for reinsurance protection exceeds supply in both the traditional and ILS markets.
• Profitability in the traditional and ILS markets in the past few years has been below investors’ expectations. This and the above point on demand have led to record multiples of spread to expected loss.
• Higher interest rates are contributing to yields; the vast majority of ILS investments earn an interest-rate-related return on the invested capital in both catastrophe bonds and private ILS.

Here are some reasons demand for reinsurance exceeds supply:

• Insured values are increasing, due to the growth in economic activity and population globally, as well as the effects of inflation.
• Insurance and reinsurance capital have not increased at the same rate, leading to the emergence of a protection gap.
• The world has experienced apparently heightened loss activity in recent years, resulting in lower-than-desired returns for investors in the traditional and ILS markets.
• Capacity to accept risk among reinsurers is constrained by the appetite for risk among equity investors, equity analysts and credit rating agencies.
• Climate change and its impact on natural catastrophe events, from both a frequency and severity perspective, underscore the above points.

Securitised credit

With securitised credit, investors can earn an 8 per cent yield on an AA-rated investment grade portfolio – with zero duration and little correlation to corporate bonds.

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Securitisation involves bundling the cash flows from various loans, such as mortgages, car loans and credit card payments, into bonds. The largest securitised sectors are mortgage-backed securities and asset-backed securities.

The opportunity today across the securitised market is stark, given that the two largest buyers of the past 15 years – the US Federal Reserve and the banks – are absent. This has created a vacuum, with willing buyers able to earn significant diversified income on high-quality assets, without taking on duration, and without giving up liquidity.

Renewable infrastructure

Amid a challenging economic backdrop and rising risk of recession, it’s worth noting the low volatility and defensive qualities of sustainable infrastructure. The sector offers more stable earnings growth, lower price volatility and better long-term Sharpe ratios, a measure of risk-adjusted return.

But what is a renewable infrastructure strategy? It involves investing in listed equity of economic infrastructure owners that are aligned to the UN Sustainable Development Goals (SDGs) and/or contribute to an environmental objective. There is a particular focus on regulated utilities (electricity and water networks), low-carbon transport (rail) and telecommunications (towers).

With higher inflation seemingly here to stay, the inflation-hedging elements of infrastructure come to the fore. Companies are generally able to pass the impact of inflation through to the costs of their services – often with a debt cost pass-through. The sector typically outperforms during a period of higher inflation, even if inflation is falling.

The listed infrastructure sector also provides a liquidity benefit versus unlisted infrastructure, as well as a valuation arbitrage opportunity. Listed infrastructure has recently lagged the performance of both MSCI World and unlisted infrastructure valuations, despite strong long-term performance and correlation between listed and unlisted.

Annual spending in the water, rail and telecommunication infrastructure sectors needs to increase by more than 15 per cent from current levels for targets laid out by the SDGs to be achieved.

We think investment spending levels have reached an inflexion point, driven by systems struggling to accommodate dramatic transformational changes, such as the energy transition, pollution control, growth in streaming and artificial intelligence.

The need for infrastructure investment is forecast to reach US$94 trillion between 2016 and 2040, with a US$15 trillion investment gap. The electricity, telecommunications, rail and water sectors are expected to account for over 60 per cent of the required investment.

Call overwriting

We see equity call overwriting as a powerful income tool, and right now it is a good opportunity for these types of strategies. First, call overwriting strategies can add value to equity portfolios when markets are moving down, sideways, or rising more slowly. Second, such strategies are effectively sellers of volatility, which tends to increase during periods of uncertainty.

For those unfamiliar with the strategy, covered call overwriting involves selling a call option on a stock or index that an investor owns. When selling out-of-the-money call options, the seller retains the potential capital growth up to a certain level (the strike price). But potential growth above that level (over a set period of time) is sold in exchange for an upfront payment.

Selling out-of-the-money means the underlying price of the share or index is below the strike price, at the point at which the option is sold. Thus, the fund still benefits from any share price growth up to the strike price.

In this way, a call overwriting strategy exchanges some potential share price growth for the certainty of an income payment now.

This exchange makes such strategies structurally different from pure equity funds. When markets are rising strongly, we would typically expect the strategies to underperform the same equity model without options.

When share prices are not rising above the strike prices, the option strategy can add to performance. This is because the strategies have the upfront option premiums. If the shares remain below their strike prices, there are no settlements to pay on the options, and any upside up to the level of the strike price is retained for the fund.

Over the past couple of years, these strategies have been able to deliver on their income requirements, while also seeing either additive performance from the options or strong participation in the equity upside when markets have rallied.

Currently, if you want to invest in income paying stocks using a call overwriting strategy in the US, for example, you can earn a dividend yield of 5 per cent versus the index yield of 2 per cent.

You can even hold stocks within an income generating strategy that doesn’t pay any dividends, and still generate a yield from them – such as holding the big US tech stocks at market weight.

The writer is head of UK intermediary, Schroders