2017 Outlook: Value in Volatility

 

2016 reminded many that predicting economic and geopolitical outcomes is a difficult task. Global stock and credit markets started the year with a substantial two-month sell-off on the heels of the energy price crash. Bond yields declined and, in many markets, moved into negative territory. On the political front, a wave of populism swept the globe, starting with the Brexit vote in June and culminating with Donald J. Trump’s election in the U.S. in November.

We begin 2017 with efforts to handicap President-elect Trump’s agenda and amid shifts in monetary policy. For the year, carry trades are likely to move out of favor, value investing appears poised to return, and providers of liquidity and traders of volatility should be rewarded. The benefits of constructing a portfolio of diversified return streams are likely to be clear.

Inflating Expectations
While President-elect Trump’s ultimate agenda is hard to handicap as he has no record on which to judge his political abilities or leadership style, we see two primary factors to monitor closely: the outlook for inflation and the expected shift to a domestic (rather than global) focus. Many of the initiatives Trump has spoken about are more likely to be inflationary rather than deflationary. He seems to have a firm belief that to stimulate economic growth we need to spend more on infrastructure and the military, ease regulations and lower taxes. In response, bond markets have shifted from interest rate curves that exhibit negative term risk premiums due to deflationary fears, something very unusual during most of our lifetimes, to ones that seem more normal and in line with central bank guidance. Put another way, the rate moves since November 9th have taken the negative term premium out of the rate markets, as fears of deflation have abated. Inflation expectations at the moment are fairly benign. However, should Congress exhibit a willingness to enact most of the new administration’s spending plans and/or tax cuts, expectations for inflation could pick up quickly. We will need to be careful that the uptick in inflationary expectations is indeed accompanied by renewed growth otherwise we run the risk of experiencing stagflation

The other outcome of the surge in global populism is that economies are making a substantial shift to be more inwardly focused. It is hard to say how this will play out in the investment world. We have spent the last 40 years becoming a globally-connected economy. Such an abrupt and significant change in course is likely to have negative consequences for global trade and development across the emerging markets. It could also create new opportunities as cross-border tariffs and restrictions may open up the door to more localized production and employment opportunities. This would likely bring with it substantial new production costs, however, as most of the globalization to date has focused on accessing cheap labor and productive capacity elsewhere in the world. A more nationalistic world would likely come with higher prices feeding back into the inflation theme mentioned above.

Investing with Uncertainty
2017 may mark the end of the tide of global monetary accommodation; if so, riding the “carry train” will be much more difficult. Just in the last few months, in some circumstances, a few years’ worth of return evaporated as bond yields rose approximately 75 bps. That move in yields represented about a 6% price decline for intermediate maturity fixed income or about 2-3 years’ worth of coupon income on the 10-year note. In place of carry trades, for 2017 we anticipate opportunities for value investors, providers of liquidity and volatility price makers.

Rewarding Value
For the past several years, passive strategies have beat active ones. After a few years of headwinds, 2017 is likely to mark a new era for value investing. Recently, value has been obfuscated by coordinated central bank policies causing investors, both retail and institutional, to grab for income-based products in an otherwise zero-yield world. Thus investors positioning for value have been often left in the dust by those agnostic to value but investing to earn yield. Many investments in a world supported by easy central bank policy became fixed income alternatives on the presumption that rates would stay low. A more volatile environment of uncertain tax and regulatory policy, coupled with the potential for higher inflation, will make passive carry-based returns harder to come by. This will create more opportunity for investors to find value among asset classes, sectors, and company-specific stocks and bonds, as the individual pricing of each will no doubt overreact as the various policy agendas are debated. In a world where yield instruments are demonstrating duration/rate risk, fundamentals will again start to play an important role in asset pricing. Building diversified portfolios will no doubt be challenging given the uncertainty about which policies can in fact be implemented, but it will likely be more productive to make active security selection rather than just “hug” the indexes. Hedge fund managers tend to be skilled at finding value across and within asset classes. Such skills are expected to be rewarded in this new era.

Liquidity Providers to Benefit
Managers who run strategies which aim to provide secondary market liquidity will likely be paid higher returns in a more volatile world. The liquidity provided by the banking system is unlikely to increase in the near term. Despite talk of a roll back of Dodd Frank, the likelihood of a near- term increase in proprietary activity on the part of the banks is small. Given that the economic picture is likely to remain uncertain, investors will look to trade as they reposition portfolios, creating a need for liquidity. Providers of such capital – hedge funds and other non-bank financial institutions – will likely benefit from the extraction of liquidity-related risk premiums.

Volatility Price Makers Well-Positioned
Managers who are more focused on trading volatility products as opposed to those who are either direct or indirect sellers of volatility should also stand to benefit from this new environment. In a less certain policy environment, hedging equity and fixed income risk becomes more of a priority. Whether hedging exposure to interest rates, downside (or upside) risk of stocks, or more volatile currency exchange rates, hedgers tend to be price takers rather than price makers. Thus those who are in a position to make prices on volatility-related products should have an edge in structuring relative value portfolios of volatility instruments that can profit from the less price discriminate behavior of hedgers.

Rewarding Alternative Approaches
The turn in the year has brought significant change on a number of fronts, many of them unimaginable a year ago: the United Kingdom is negotiating its exit from the European Union, the United States is undergoing a transition that extends beyond the routine hand-off of the reins from one party to the other and monetary policy globally is shifting. The impact of these – and other – changes on financial markets is likely to be significant. Carry trades and index hugging are likely to be remnants of yesteryear and we anticipate a return to value investing. Providers of liquidity and traders of volatility should be well-positioned, and diversification should be rewarded.

Basil Williams is a Managing Director and Co-Head of Portfolio Management for the Fund of Hedge Funds Division.

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