The peaks of the early 80s gave way to a compression trend for US Treasury yields that has lasted almost four decades. Since yields were last in the 13% range, the global economy has witnessed the launch of the euro, emerging and global crises, unprecedented levels of QE and a prominent shift in the role of banks.
The result: a more complex investment environment where alternative strategies are emerging as a potential solution for alpha-seeking investors.
June 1984 proved a marker for two significant events. In the world of entertainment, moviegoers were treated to the release of future cult-classic Ghostbusters. The investment community marked its own milestone as 10-Year US Treasury yields reached a peak of 13.95%.
Through subsequent decades, yields went into a compression trend, prolonged by the global financial crisis (GFC). But with the removal of the accommodative monetary policies, the cycle is finally starting to turn.
Navigating the new environment calls for a different investment approach:
- a greater level of open-mindedness
- dynamic positioning
- a toolkit that empowers managers to exploit market movements and mispricings.
This toolkit can take the form of alternative investment strategies, which we believe offer the most compelling way of capitalising on the return potential of more discriminating markets.
Implications for yield increases
As yields normalise dispersion starts to increase. As financing costs rise, asset prices begin to feel the bite of a tailwind becoming a headwind, and there is a bigger strain on company profitability due to the burden of higher-cost liquidity facilities and debt refinancing. This strain will test which business models pass the bar of elevated financing costs. The likely result is the repricing of securities with weaker balance sheets.
Return of volatility
Volatility is another metric that was heavily suppressed during the QE years. Together with the lack of dispersion, lower volatility has constrained managers' ability to materially enhance performance per round of leverage. The result?
- Long duration strategies will likely not be such good structural positions going forward
- Greater dispersion should bring more relative value opportunities
- An ability to be nimble and tactical become even greater assets.
The bigger picture
While the GFC and subsequent QE efforts have been the most impactful events in recent times, there have been a number of other changes since the start of the century that have collectively reshaped global markets – resulting in an environment where alternative investments are, in our view, the most promising source of alpha generation within a diversified portfolio.
The evolution of the sovereign landscape is marked by a series of shifts:
- The introduction of the euro in January 1999
- Transition back to treating certain eurozone issuers as credit concerns, rather than interest rate products
- Regulation on short selling by the European Parliament
- Developed market sovereigns holding unprecedented debt-to-GDP levels
- 60% of EM sovereign issuers being rated investment grade (as at July 2018) – reflecting the integration of EM economies into the political and economic mainstream.
In the corporate landscape we have seen:
- A shift in the role of banks – resulting in changed lending practices and capital structures
- Concentration within the banking landscape
- EM corporates using bond markets as a funding source.
Alpha over beta
If we transition to an environment more akin to the 1980s and 1990s with higher rates and inflation, we could see a shift towards a positive correlation between bonds and equities.
“This will likely lead to an environment where alpha should be a better source of returns than beta.”
The need for immediacy
Alongside market developments, we have witnessed an evolution in how information impacts market operators, and how this information is digested and transacted in the markets.
Technology now exposes us to more frequently updated information, rather than to deeper or more varied information on each topic.
These communications can provide valuable insights given the context, biases of the communicator and expected audience response.
Critical thinkers required
As we learn to question our news sources, we should also turn a scrutinising eye on conventional wisdom and challenge foregone conclusions. True critical thinking is essential.
Using a repeatable, proven process helps with planning and not being overcome by sudden events. Having a good grasp on the business/political model of the issuer and the motivation of the decision makers is also of phenomenal importance. In tandem, a thorough understanding of political circumstances has become essential.
“Economics is the daughter of politics. Whereas the number of actors in the economic sandbox is in the millions, the number of performers in the political theatre is more reduced.”
Intellectual honesty and being coherent with one’s thoughts is what may differentiate successful investors in the future.
Continuing with the favoured tools of the past is a risky strategy in the new economic environment, where the ground rules have changed and the future likely features rising rates, elevated volatility and the return of dispersion – an environment where long-only beta products are likely to underperform.
We believe the best way forward is to approach the world with a revised mindset, reduce reliance on the flagging beta horse and harness the alpha opportunities markets are presenting through the dynamic investment approach employed by alternative strategies.