The gradual descent from “peak growth” appears to be underway. Last week’s U.S. inflation data were the first to undershoot expectations for almost a year. The latest U.S. payrolls number was disappointing. Other data show a moderation in corporate and consumer activity.
Just as growth is slowing, the stimulus impulse is receding. Tapering appears imminent on both sides of the Atlantic, and the current debate within the Democratic party signals the potential for at least a slightly tighter fiscal rein in the U.S.
The Delta variant and supply bottlenecks take some of the blame for the slowdown, but it also reflects the natural shift from recovery to mid-cycle expansion. A slower rate of growth is still growth—it’s just a question of how much slower it will be and whether that is priced into markets. Add unusually high longer-term uncertainty, full equity valuations and rock-bottom bond yields, and we could be facing a low return outlook with higher volatility and elevated equity-bond correlations.
How can asset allocators position for this environment? This was the topic of a webinar that we hosted for clients last week, which you can replay here.
No Single Solution
More than 60% of our webinar audience expects equity markets to be more volatile over the next decade than the last. When we asked whether they had considered replacing core government bonds with a broad array of alternative diversifiers, every suggestion received a vote from 15 – 40% of attendees. Private markets and liquid alternatives were most favored, but investors recognize that there is no single solution to this challenge.
In simple terms, that challenge is twofold: to gain exposure to growth and risky assets, but with a cautious bias to dampen potential volatility, what we call “defensive return strategies”; and to find sources of portfolio risk mitigation that are not overpriced core government bonds, what we call “defensive protection strategies.”
Defensive Return Strategies
Defensive return strategies can be sought in equities, fixed income and alternatives.
In equities, a tilt to quality stocks can help, particularly those exposed to long-term growth themes. The relative value case for quality is stronger after a year of outperformance from value and cyclical stocks. For those investors able to lock up capital, this quality theme can be pursued further in private markets.
In fixed income, defensive return strategies can be sought with more credit risk, particularly at the shorter end of the high-yield curve: Spreads are tight by historical standards, but we think they compensate adequately for the low projected default rate. There are also regional markets that offer extra yield while tending to benefit from flights to quality, such as China’s onshore government bond market.
In alternatives, investors can look to mainstream hedge fund strategies that have exhibited positive but moderate correlation with equities: Long/short equity or credit, event-driven, distressed and special situations strategies are good examples. Collateralized equity-index put-option writing is a useful way to turn elevated market volatility into a persistent and relatively steady source of premium income—effectively taking some of the ups and downs out of equity exposure. There are also structurally uncorrelated return opportunities available from asset classes such as insurance-linked securities.
Defensive Protection Strategies
Defensive protection strategies can be similarly diverse.
In equities, investors could make the quality tilt market-neutral, by offsetting a long position in higher-quality stocks with a short position in lower-quality names. This would be likely to generate positive returns in a selloff and flight to quality.
In fixed income, rather than a simple long position in core government bonds, investors could adopt a long/short strategy with a curve-flattening bias: This would also benefit from a flight to safety, while mitigating any downside associated with the entire curve rising, particularly given the current, extremely low rates at the front end.
In alternatives, hedge funds that have historically tended to maintain or enhance their performance during equity market selloffs include equity market-neutral, short-term trading, systematic trend-following and global macro strategies.
Options strategies that are structurally long volatility—buying put options as opposed to writing them—are often the best performers during the biggest market corrections, but they can be costly when stocks are going upward or sideways. An active approach, which seeks to retain the long-volatility bias while offsetting some of the costs, can deliver a more sustainable defensive strategy.
Away From 60/40
Bringing these strategies into a portfolio takes us away from the traditional 60/40 approach in two ways: It introduces additional asset classes, but it also involves a more innovative and active implementation of equity and fixed income allocations. The result may forego some return in the most positive scenarios, but it remains exposed to growth without relying on already low-yielding government bonds for diversification and downside protection.
In our view, this represents a prudent, genuinely diversified stance as we shift into a mid-cycle expansion beset with unusually high levels of uncertainty.