An Increasingly Uncertain Global Investment Landscape

Published on 12th May 2015

There used to be a time when finance gurus and economists alike would smirk at the idea that the US housing market was in effect a bubble that was waiting to burst. During these days when low quality loans could be packaged and sold the very next day after their creation, such concepts did not matter until of course part of the pyramid burst. Today within the boring field of strategic asset allocation, pension funds and institutional investors have come to understand and respect what is known as tail risk, i.e. low probability events which are no longer not so low and which, when they occur, can cause high losses.

We are living through interesting times. Despite all the talk about a global economic recovery, the US Federal Reserve is still awaiting more favourable data before it hikes near zero interest rates by a moderate fashion. Bond yields in much of what is considered safe Europe is now negative, not only at the short end of the yield curve but increasingly at the longer end as well, while credit spreads, that is the difference between credit risky investments and the equivalent maturity government bond yield, are near historic lows making credit quite expensive. Is the mother of all asset bubbles now the 100 trillion dollar global bond market, and how can all of this turn out?

The risk return dynamics

There should be no doubt for anyone with a bond heavy portfolio that rates are more likely than not to rise even if they do so moderately in the coming five years, and in this environment of rising rates, if one is wrongly positioned, it could lead to substantial losses. When bond yields rise, bond prices fall leading to negative returns. What is currently worrying pension funds and institutions is that in other rate hike cycles of the past 50 years, bond investors at least had the cover of a much higher coupon rate to protect themselves. Today, this is no longer the case.

The risk return dynamics are in fact terrible. Worse, new regulations in both Europe and the United States are causing a drop in liquidity in the secondary bond market, which can not only create more volatility but, more importantly perhaps, create havoc when one rebalances his bond portfolio on a monthly basis. In Europe, the cap of -0.2% lower bound for ECB bond purchases is forcing the European Central Bank to buy longer and longer term bonds, forcing investors to rotate outwards on the curve, leading to a major flattening of the higher quality sovereign yield curves. Sure, the likes of German bund yields have sold off in recent days, but it remains too early to tell whether German bund yields have bottomed already, or whether the current up move is but a counter trend phenomenon.

Be it in the United States where the fiscal deficit is now getting better, or in austerity doped Europe where the ECB is buying a lot of bonds, supply of bonds in general is falling especially when it comes to the higher credit rated bonds, and it is forcing investors to take on either more interest rate risk or credit risk. As this happens, higher and higher prices are worsening the risk return dynamics.

During the first couple of years post the last financial crisis, many higher yield seekers rotated towards higher yielding emerging market debt and even frontier debt such as Africa. But in 2013, the minute the Federal Reserve first began to talk about the end of its own quantitative easing program and signal that it would eventually increase rates, the currency volatility which ensued reminded investors that investing is not as simple as simply chasing away yield. Besides this, many emerging market economies such as Russia, South Africa and Brazil (and developed markets like Australia, New Zealand and Norway) had an investment story which depended heavily on the now dead commodities super cycle.

As commodity prices collapsed, once the Fed announced the end of their Quantitative Easing programme, so did currencies which were highly correlated to this story. Today, many investors, if they have not been able to get into a less volatile Chinese onshore or offshore bond market, have found better risk return dynamics within the derivatives space than within the cash bond market. For example, it can make more sense these days to sell credit default swaps on a basket of credit in a moderate global recovery story and get a positive yield than even attempting to play the market the old way.

Rather than playing European bonds today, there is perhaps more value in playing the EUR/USD and earning a premium by selling options. With elections in the United Kingdom creating more volatility for the pound sterling, option strategies such as the sale of strangles (selling puts and calls which are out of the money) can earn much higher premiums than if one were to manage a bond portfolio. Recent easing moves in China, when coupled with some geopolitics, may have led to a commodities rally of late with oil prices appearing to have bottomed, but these are quite volatile markets to be in right now.

All of this sounds nice, but is the cash bond market in the developed world in particular a bubble which will soon burst and create global havoc like we have not seen before? The answer is not exactly. There should be no doubt that any rational investor would prefer European equities to European bonds, but we often exaggerate about the extent of the current global economic and in particular US economic recovery. The United States are doing better, and Europe is gradually getting out of its glut, but the improvements are so moderate, the central banks so dovish and the dollar currently so strong, that inflation is not likely to be a big concern anytime soon, something which could create rising rate volatility.

That is not to say that bonds are a terrible place to be invested in terms of risk returns. In fact, any asset return projections in a multitude of forward looking interest rate scenarios would currently indicate that one should keep a duration that is roughly equal to one half of his investment horizon with the 3 year point being an optimal pivot to maximizing the risk reward ratio. What is also true is that no bond portfolio could possibly make decent money unless the fund manager engages in a high degree of unconstrained curve strategies. With the Fed becoming increasingly data dependent, it may even make a lot of sense to sell rate volatility via the swap option market.

When it comes to European bonds, the long term outlook is clearly bearish while on the currency side, a recent move by the EUR/USD above 1.10 appears to have halted the bearishness for now. But with deposits still leaving Greece like there was no tomorrow, and with Greek banks increasingly relying on debt funding, it is hard to be more than neutral on this trade.

Nontraditional way of investing

Overall though, we have a very unattractive and expensive bond market, we have a rising equity market which is being sustained by the unattractiveness of the bond market, especially in Europe and Japan. Over the next 5 years, more money will be made within the currency market (profiting from volatility via derivatives and earning a premium) and by selling insurance than by the traditional way of investing. While it is true that equity investments have gone up a lot in recent years, there is simply no other choice right now, and secondly a lot of the tail risk with equities can partly be hedged via options. For example, one could have a long position in equities, sell out of the money calls on a rolling one month basis, and use the proceeds to purchase downside protection via puts. Smart beta strategies, which for example combine popular strategies often associated with active fund managers such as momentum and carry, are increasingly becoming popular and are increasingly being used as overlays on the bond portfolio or even the equity portfolio. Perhaps the best way to invest in such a market with diverging trends in economic outlooks and monetary policies is to have a non traditional barbell strategy. In a traditional barbell, investors simply buy long term bonds and short term bills and cash, but right now it is best to be replacing the long duration bonds with long term less liquid investments which may not be traditional in nature.

The purpose of this article was then to describe where the world of investing is going, and indirectly perhaps, how much work we in Mauritius still need to do in terms of capacity building if we wish to move from the current back office model to the front office model. The world of investing is becoming increasingly risky and dynamic, but we are not in a new bubble, at least not yet. Mauritius will simply not become a front office hub just like that, and in many ways, my view is that we have missed the boat unless we really open up our shores to immigrants and improve air access. The Mauritian market is too small, and sufficient seed capital is lacking.

Even then, the area which holds the most promise despite all the recent gloom on Africa remains private equity within the small to medium scale company space. This can in effect replace part of an investor’s long end of the barbell. I have argued for years that we need to put more money behind locally sourced Eastern and Southern Africa focused and locally managed (even if it means getting a foreigner here) private equity funds, especially within the mezzanine financing or venture cap buckets. You need at least 100 to 200 million dollars in seed capital to even attract credible international investors, and of course you need to sell the niche of being focused on companies of key sectors in hospitality, insurance, clinics, telecom, microfinance and distribution (not big infrastructure where the Indians and Chinese rule) to international investors. Only then will they bother stopping over on their way to Africa.

By Sameer Sharma

The author is a chartered alternative investment analyst and a certified financial risk manager. This article reflects solely the personal views of the author.

Courtesy: Conjoncture.


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