“The dreamers need the realists to keep them from soaring too close to the sun. And the realists? Well ... without the dreamers, they might never get off the ground.” - Modern Family
What better way to describe the importance of diversity of opinion? For a healthy functioning society, the existence of both dreamers and realists is critical. So too in markets. Disagreement, bulls and bears play a critical role in market stability. The problem arises when the balance is tipped too much in either direction or when disagreement is replaced with group think.
Taking the good with the bad
Consider 2006/2007’s extreme in greed versus the recent years’ extreme in aversion. Too many dreamers and no realists saw markets soaring too close to the sun. Having been burnt badly following the GFC, global growth still can’t get off the ground. It feels like a low-flying plane that constantly hits air pockets causing both occasional lifts and near-death experiences.
This is good and bad. It’s good because blind optimism hasn’t led to economic excesses and greed that tend to end in disasters. But it’s also bad, because there is little conviction in investing for the future at both corporate and household levels.
Still, good and bad is not necessarily unwelcome when it comes to investment opportunities. The divergence in investor opinion and the general lack of conviction in economic growth is leading to many opportunities as well as risks, and a world of extreme divergences.
At the heated extreme (not too far from the sun) is anything yield related, while down near the ground is anything risk related. The rationale is clear: the world is a mess, central banks are out of ammunition, the population is aging and judging by the experience of the past few years, growth will continue to disappoint for many years to come. It’s hard to argue with that logic and we don’t intend to. Our investment philosophy is built on scepticism. The sceptic in us says “when it is so obvious, it’s obviously wrong”.
And that must be what Mark Twain had in mind when he said: “It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so.”
What’s certain?
So what does the market know for sure? That inflation will never come back, growth is as good as it will get and interest rates will remain near zero for many years to come. The polar extreme in relative performance and relative valuation of the low volatility theme (for example yield and defensive growth) versus the risk theme (for example value and cyclical growth) and the fact that more than 40% of the global sovereign bond index has a negative yield reflects the perceived ’no growth, no inflation forever’ backdrop.
In fact, much of the market appears crowded away from risk and value and into quality and low volatility.
Irrational investment behaviour
The search for yield started as a perfectly valid strategy following the GFC. But by now, a theme that was anchored around perfectly rational investment logic has morphed into irrational investment behaviour (when shares are bought for income and bonds are bought for capital gain).
The chase for yield, low volatility and quality has now become a crowded momentum trade. The self-fulfilling cycle of money pouring into low volatility and quality stocks leading to strong price gains, further supressing volatility, encouraging more flows and price gains has led to a false sense of security and confidence in making easy money. Our inner sceptic tells us it can’t be that easy. The momentum spring can’t stretch forever. Eventually it will snap or it will spring back.
Here’s why: five years of fiscal austerity is giving way to fiscal neutrality, and while important risks persist and need ongoing assessment, there are signs that 2017 could mark a return to a more synchronised global economy, at least in US dollar terms.
The stability in the US dollar, improving commodities performance and rebounding inflation expectations all point to an unfolding regime shift. If so, the recent back up in sovereign bond yields has further to go. This poses both risks and opportunities.
Subsequently, this is how we’re managing our dynamic asset allocation funds:
- To manage downside risk where diversification is extremely hard to achieve, we are increasingly using option strategies.
- We’re staying away from low interest rate/low inflation winners of the past few years such as nominal bonds and bond proxy equity sectors.
- We have a diversified exposure to low interest rate/low inflation divergence theme such as commodities, global banks, Japanese shares, emerging market equities, and currencies.
- We have higher cash holdings as a defensive buffer.
Bottom line
The world’s glut of savings has now ended back in the US where it started, this time in low volatility, defensive, quality themes. These themes are expensive, over-owned, over-loved and vulnerable (ticking all the boxes for ‘avoid’ under our investment process). Still, we doubt any unwinding will be disorderly as central banks remain friendly, real yields remain negative (despite rising nominal yields), and global growth is showing signs of broadening.
Nader Naeimi is Head of Dynamic Markets at AMP Capital. This article is a general view and does not address the specific circumstances of any investor.