With the QE regime coming to an end, so is the suppression of asset price dispersion. As the economic environment turns on the beta trade, now is the time to shift to alpha capture.
20 September 2017 marked a watershed moment for global financial markets – the beginning of the end of quantitative easing (QE).
The world’s most influential central bank - the US Federal Reserve - announced that from October it would start to shrink its balance sheet, bloated by more than US$4.2 trillion of Treasury and mortgage-backed securities amassed since the 2007–08 financial crisis.
The peak in QE has passed with important implications for asset markets and investment strategies.
QE and the investment regime
The wash of stimulus money that flooded markets from 2007 suppressed asset price dispersion and elevated cross-asset correlations. Yields were pushed artificially low, valuations moved upward and the classic negatively correlated relationship between bonds and equities became distorted.
Rewards from asset and security selections became more limited with returns dominated by the QE-induced ‘beta’ rally that favoured passive benchmark tracking over active investment strategies.
But as the stimulus regime begins to unwind, we are witnessing the first signs of a shift in the investment environment.
Stock correlations across the S&P 500 index fell throughout 2017 and dispersion in stock performance is rising, helping active equity managers to outperform passive investment vehicles. Similarly, dispersion in credit is also moving higher as investors recognise greater differentiation in borrowers’ credit profiles.
Three post-QE shifts
We believe the new investment regime will result in three shifts:
- lower asset correlation
- greater dispersion in asset performance
- lower beta (market) returns
1. Lower asset correlation
For much of the post-crisis period, markets moved in lockstep, signalling high correlation. Within fixed income, regional differences in the performance of government bonds and credit have become less pronounced. This ‘rising tide lifts all boats’ environment thwarted active managers as low-quality companies followed markets upwards without the fundamentals to back their inflated valuations.
But we are now seeing early signs that correlation levels are beginning to ease, with the 2017 numbers similar to those recorded pre-2008. We expect this shift to continue as QE is withdrawn.
2. Greater dispersion in asset performance
As developed market government debt has yielded so little, investors have chased yields into more risky areas of the fixed income market, accepting higher levels of default in anticipation of higher returns. Fortunately, in line with falling correlation levels, we are starting to see greater differentiation within sectors. This should pave the way for active managers to put their selection powers to work, scrutinising underlying fundamentals to select the best-quality positions, rather than any issuer doing well on a combination of hype, overblown equity prices and guaranteed market security as QE flows were indiscriminate in the companies they ultimately supported.
3. Lower beta (market) returns
As the global bulk bond buying campaign is unwound, overall market performance (market beta) will likely ease off. Declining market values could cause alarm for investors following broad-brush passive approaches, as they hold all index constituents indiscriminately. But any good active manager will have cherry picked the best of the universe for their clients’ portfolios, minimising downside exposure. Lower beta returns lead the way for true alpha generation.
Bottom line: dispersion is key
Active fixed income managers do not need high volatility to outperform passive strategies, but they do require greater dispersion. Markets must differentiate between sectors and issuers for intelligent credit selection to be rewarded.
Political noise & activist policies
One factor driving the increase in dispersion is the rise of populist politics and more interventionist governments – a trend we expect to continue as central banks wind down QE.
Greater political and policy volatility and uncertainty requires investors to have access to a broader range of sources for political intelligence. The rise of unreliable news sources and ‘fake news’ means that investors have to be smart and selective in what they consume.
Not so safe – traditional debt now vulnerable
With duration levels at record highs, many traditional holdings have become portfolio dead weights: they offer record low yields (negative in some cases including Germany, Switzerland and Japan) and will be hit hard by higher interest rates and volatility.
The liquid alternatives universe – which is typically unconstrained by benchmarks – spans a range of strategies designed to provide diversification away from traditional asset classes, either by trading the same underlying securities in a non-traditional manner, or by investing in non-traditional and new asset classes.
Both approaches increase diversification, providing downside protection when traditional allocations weaken, generating superior risk-adjusted returns.
Selecting the right fixed income allocations to ensure performance in a post-QE world comes down to discipline and expertise in managing interest rate, currency and credit risks. Manager skill, a global opportunity set and a commitment to active portfolio management are the factors that will separate those who will succeed from those afraid to trail blaze.
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Published January 2018