Manning the defences: the case for active management and diversification

THE global economic cycle is currently being impacted by 3 separate shocks: tighter monetary policy, an energy crisis and a Chinese economy whose prospects are clouded by the authorities’ zero-Covid policy. As a result, global liquidity is shrinking and leading indicators are pointing towards a rapid economic slowdown.

We have moved beyond a temporary price shock linked to supply issues following the rapid post-Covid economic rebound, with signs of high energy prices seeping into non-energy prices and wages. Despite favourable base effects, global inflation is therefore likely to remain sustained, with pressure now coming from food and services. Lockdowns in China are likely to produce further bottlenecks in global supply chains, adding to inflation in manufacturing inputs. In addition, with European countries considering embargoes on Russian oil imports, energy prices could rebound in the short term.

Oil demand is already declining, however, and the oil market could shift towards slight oversupply in H2 — especially if economic activity weakens. We expect Brent to settle at close to US$95 per barrel by year’s end. Anything lower is unlikely as supply capacity remains limited.

The primary aim of most central bankers is to ensure inflation expectations remain anchored. But the risk is growing that they tighten policy too far, pushing economies into recession in the process.

The case for active management

Faced with major geopolitical tensions, a huge commodities shock, high inflation, increasingly aggressive central banks and question marks over China’s growth prospects, the stark reality is that investors have few places to hide. Asset allocation has become particularly challenging of late, with negative performances from bonds and equities alike impacting investor sentiment.

But there is some good news: the stock of negative-yielding debt is falling fast, making government bonds look investable again. If we avoid recession and inflation and rate expectations start to subside, equities could at least return to their levels at the start of this year. Moreover, valuations in European, emerging and Asian markets have already declined below the median of the last 20 years — indicating that a large part of negative news has already been priced.

We believe an active management approach is best suited to present circumstances. This involves taking a granular approach to asset classes. Investors will need to be patient, but some investment themes could ease the wait.

Within equities, with margin pressures growing, we continue to prefer companies with pricing power that are able to withstand pressure on their margins or even improve them. Real estate vehicles such as real estate investment trusts (Reits) also afford some protection against inflation.

Commercial property rents are often indexed to inflation. The Singapore Reits (S-Reits), for instance, derive visible income streams from diverse real estate sub-segments such as retail malls, offices, hospitality, healthcare and industrial buildings.

Over the past 20 years, the sector has flourished under favourable market-oriented policies and a robust regulatory framework. The investment merits for S-Reits include their defensive characteristics, being reopening beneficiaries and a potential hedge against inflation, and their good shareholder return track record with dividend yield as one of the main attractions.

Selectivity and active management are important, either via an S-Reits mandate (diversified portfolio) or single-line equity solutions.

As we move through Q1 earnings, we are paying special attention to earnings guidance within each sector. At this juncture, we see defensive stocks, especially those with solid dividend perspectives, as being well positioned to weather the current growth and inflation scare. We maintain our overweight position in Swiss equities because of their defensive features, and we remain similarly positioned in Japanese equities due to their relative cheapness.

We have also been building up protection in portfolios via options as we continue to see volatility as an asset class in its own right. Tactically, this means avoiding taking bold directional bets while we exploit discrepancies between implied and realised volatility. Volatility can also be put to use through taking out currency options, with the Canadian dollar and Norwegian krone – currencies belonging to stable commodity-producing countries with hawkish central banks – currently being our preference.

The case for diversification

An era of unconventional monetary policy that drove yields exceptionally low is ending in Western countries, placing question marks over long-dated bonds’ safe-haven role. But we feel that markets have exaggerated the scope for Fed rate increases and the rise in real yields, and we remain neutral on US Treasuries.

Despite the drop in the nominal rate differential over US Treasuries, Chinese bonds still offer relatively high real yields. We believe the drop in the value of the renminbi will be contained. We therefore remain overweight on Chinese government bonds for now.

Along with keeping duration generally short, high bond volatility necessitates an active approach to fixed income. The investment-grade debt of companies with good fundamentals should withstand funding pressure better than lower-rated ones. Having re-priced this year, spreads in US investment-grade credit (on which we are neutral) appear to us more attractive than in high yield (on which we are underweight).

Rather than chasing returns, we remain focused on fair value across the credit spectrum. We also maintain our interest in senior leveraged loans in the US, which have posted positive returns year-to-date thanks to their relatively high carry and floating rates.

The recent sharp rise in government bond yields has coincided with a volatile period for equities. The strong correlation between the performance of the 2 asset classes calls into question the validity of a classic 60:40 portfolio (60 per cent equities, 40 per cent bonds). It also reinforces the argument for decorrelated alternatives, while bolstering the long-term case for diversifying into currencies, commodities, hedge funds and real assets.

Private equity – Still lots of promise despite the challenges

This year has seen declines in public markets and significant compression in the valuation multiples for fast-growing tech companies. The repercussions could take several months to be felt fully on private markets, but a slowdown in deal activity for growth companies is already discernible.

With conditions for market listings deteriorating, some cross-over investors are shifting towards earlier stage deals. Indeed, activity in early-stage deals remains strong and highly competitive — reflecting the fundamental quality of newly created tech companies. But it remains essential to assess the sustainability of companies’ growth prospects, separating one-off factors from the more durable ones that will determine a clear path to profitability.

Even taking into account the challenge of tighter financing conditions going forward, our latest analysis of long-term returns suggests that the fast-developing private-equity universe could deliver average annual returns of over 9 per cent in the next 10 years — some 50 per cent more than equities. Individual private-equity managers’ ability to adapt their investment strategies via enhanced sophistication and expertise and to choose the best buyout targets could push returns even higher.

The writer is global strategist and chief investment officer for Asia at Pictet Wealth Management.