All eyes were fixated on the central banks last month. After years of ultra-loose monetary policy, the longevity of such stimulus is increasingly being called into question.
A refusal by European Central Bank’s president, Mario Draghi, to acknowledge the council had even addressed expanding the current quantitative easing (QE) programme, alongside hawkish comments from key Federal Reserve members, led to a sell-off in core bonds and equities during the first half of the month.
The spike in correlations was reminiscent to the taper tantrum of 2013, albeit on a smaller scale. In this period, very few assets were able to generate positive returns.
Markets were comforted in the second half of last month as the Fed refrained from raising rates and the Bank of Japan introduced yield targeting across the Japanese government bond curve. Government bonds recouped their losses while major equity markets finished the month broadly flat.
The conundrum for multi-asset investors, should they believe the historical negative correlation between bonds and equities has broken down, is how one aims to build a diversified portfolio. The natural hunting ground has been liquid alternatives, albeit many managers in this sector have faced a challenging year.
For equity long-short managers, by far the largest sub-sector in the liquid alternatives universe, persistently lower bond yields have acted as a material drag on performance.
A lower discount rate has led to ever higher ratings of stable free cash flow businesses. If you believe in the lower for longer argument, these businesses arguably do not look expensive.
The problem has been managers do not believe in using a lower discount rate and instead prefer using a normalised rate, making these companies look expensive and un-investable.
To compound matters, very few managers have caught the recent rally in the energy and mining companies which the vast bulk of the active management industry has picked up considerable alpha in the past two years by being underweight versus the index.
In other words, one needed to own the most expensive and/or the worst businesses to perform well running an equity long-short strategy during 2016.
On a more positive standpoint, the bottom reached in bond yields during early July has marked a material turnaround in the fortunes of active managers and by extension those of equity long-short managers.
Defensive – bond proxy – names have underperformed significantly versus cyclicals. So while headline equity indexes have made little progress and core bonds have lost capital value, several equity long-short managers have generated positive returns.
An outright or stealth tapering of stimulus from the Bank of Japan and the ECB could be an even more powerful force for bond yields to rise than a Fed trying to play catch-up.
While the most likely scenario is not for bond yields to rise significantly going forward, if one would expect these to stay relatively constant, then business fundamentals should become a more important driver of stock prices, to the benefit of the majority of active managers.
This environment would be particularly beneficial to equity long-short managers who, compared with long-only managers, will also be able to gain from shorting companies on which they have negative outlooks.
As we move into the fourth quarter, attention now turns to the upcoming US presidential election. Outside broader risk sentiment the impact on currencies, bond yields and equity sectors could all be material.
Similar to Brexit, the initial market reaction may not reflect how markets trade in the medium term. However, there are clear winners and losers at a sector level dependent on which party ends up being victorious. Investors should have a clear vision of how they position one’s portfolio given the various possible outcomes.
Nicholas Roberts is a senior portfolio manager and Ilaria Calabresi is a vice president at JP Morgan Private Bank.
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