Reflections from our global manager trip
Bev Durston, Oct 2018
We sound out our best managers and strategists on the economic outlook and investment climate, what it means for investment strategy - and what investors are doing about it. We also come across some hidden gems for our investing clients.
Market commentary and uncovered investment opportunities:
1. Market sentiment
The U.S. economy is less invincible than it looks as global political risks intensify. Concerns abound about valuations in both equities and credit markets, credit margins are very thin and fears are mounting of growing U.S. inflationary pressures. China seems still to have some room for easing, whilst two specific risks govern the outlook in Europe.
- Most people we spoke to agree that the shift away from globalisation toward domestic markets poses a threat to global growth and economic resilience.
- Another worry is that risk is not being rewarded adequately, which may presage market fragility.
- Structural trends, such as increasingly-heavy use of ETFs and passive investing, could exacerbate market price distortions, risk concentrations and market volatility.
- Many fund managers fear that competition for skilled workers in some sectors could push up pay and other labour costs, fuelling a re-emergence of inflation.
- Macro managers take the view that China, faced with the escalating trade war with the U.S., will seek to maintain its domestic growth with measures to stimulate specific sectors. They also expect a steady yet managed depreciation of the yuan.
- Brexit dominates the U.K. and European landscapes. Most (70%) of the investors we spoke to expect a deal to be pulled out of the hat in time for Brexit Day, 29 March, 2019. Edgehaven, however, is less sanguine, putting the likelihood of a “hard” or “no deal” Brexit at higher than 50%. Despite the high-profile campaign in its favour, most people believe that constitutional hurdles make the likelihood of a second referendum very low. Given the dampening effect of a “hard” Brexit and the likelihood of its happening, the growth outlook for the UK economy looks bleak, at least for the next few years.
- Brexit may dominate the European news focus, but many we spoke to also agree that the dangers posed by Italian debt combined with the hardening anti EU stance from Italian politicians should not be safely ignored. Brexit merely proves a welcome distraction for Europeans from the worsening Italian situation.
2. Strategy implications
No one can say exactly when or where a market fall will come, but de-risking is the order of the day
- Currency traders may in fact take over from the bond market as the new vigilantes causing significant market surprises. There is a spotlight on sterling and the euro. Brexit and the Italian issues both threaten to surprise investors who haven’t protected their exposure to those currencies.
- Some investors told us that in time the US will be proven to have made a mistake in implementing the largest ever suite of tax cuts at the very end of an extended bull market cycle. While the cuts may have prolonged U.S. growth, they weaken fiscal and budgetary flexibility and crimp room for manoeuvre in the event of another US recession. Impending likely bad news for both bonds and equities.
- With apparently strong U.S. growth masking underlying fragility and Europe facing some big threats, there is plenty to feed the market for stressed and distressed assets. If they haven’t already done so, investors would be well advised to add this asset class to their investment to-do list. Indeed, many of the investors we spoke to are readying themselves to expect an expansion of opportunities that will benefit from market stress and distress.
- Manager selection and downside risk protection will be the win-or-lose factors in this environment. Asset backing, seniority in the capital structure, and well-designed hedges are all good ways to ensure you will be in a position to underwrite an extended weak market. That is the big strategy focus for portfolios right now.
- A bright spot is Japan, which seems to have hit after many years on the right policies to dig itself out of deflation. Opening itself to managed immigration enables it to harness its long-established competitive strength in electronics and tech, convincing some investors that the equity market is positioned to do well. With few managers currently invested in Japanese equities, a number of investors we spoke to are quite bullish on this market.
3. New investment opportunities uncovered
Astute investors can do well in this environment - if they know where to look.
- We uncovered opportunity in the form of a small cohort of promising, absolute return managers, who earned their stripes in well-established firms but have recently started up on their own. Typically less than $500 million in assets under management, these managers are much more nimble than the large firms they graduated from. They are hungrier for success too, with more competitive terms and fees biased towards performance.
- We are investigating a thematic closed-ended fund investing in Asian healthcare companies with already-profitable operations. A fraction of the size of its counterparts in OECD economies, the Asian healthcare market stands to benefit from transfer of know-how from other parts of the world and this looks a solid growth opportunity.
- Due diligence is advanced on a closed-ended fund to invest globally in complex, special situations, including direct lending, work-outs and distressed opportunities.
- We are working with an existing management team to create a closed-ended fund to invest globally over the next three years in structured credit with a focus on less liquid or stressed tranches. Collateral for these investments will be broad ranging and may include mortgages, commercial property, corporate assets, student loans and other receivables.
- Work is in progress with a US energy manager to earn net returns to investors of 15% by exploring opportunities in uni-tranche or mezzanine lending to drilling partnerships held by large, stable oil companies that are enhancing unused or currently-drilling wells. Development risk is low, while lending is secured with asset backing.
4. Topical comments of interest
Asset management firms are structuring their analyst teams around investment themes instead of industry groups. Debt issuance is up and quality down - yet defaults remain lower than average. Meanwhile the Shiller CAPE index hits a recent high.
- Many fund managers are re-orienting their portfolios away from traditional industry sectors toward investment themes that cut across sector lines. As with the switch from country to sector in the 1990s this new orientation increases firms’ flexibility to exploit global themes yet means an internal reorganisation of staff groupings.
- Issuance (funding expansion, acquisition and buy-backs) in the U.S. corporate bond sector has been prolific, especially in BBB, the lowest “investment grade” rating category. Approximately 50% of the $5 trillion in investment grade issuance is classified as BBB, which is almost two and a half times more than the $1 billion high yield paper issued in the same period in 2009. 2019 issuance is forecast to be $2.3 trillion. This stock of BBB paper is now so big that even if only some of it is downgraded, it would unleash massive selling pressure by investors who are permitted to hold only investment grade bonds.
- Coupled with this is a marked rise in the proportion of covenant-light loans, from 60% in 2015 to 76% in late 2018.
- Quantity is up and quality is down in U.S. private corporate debt. Leveraged-loan issuance in the year to end June 2018, at $465 billion, was triple what it was in the comparable period to end June 2012.
- Leverage multiples of EBITDA of 6.0X in the second half of 2018 are up from the 2012 average of 4.75X, well above the 5.5X high of pre-crash 2007.
- High yield default rates dropped to 3.6% at the end of June 2018, below the long-term historical average of 4.3%. The exception is retail, where High Yield spreads are 10% (1,000 bps) above treasuries - with some rising to 21%. This combines with default recovery rates that are expected to be only 50% of their historical average.
- The Shiller CAPE index is 85% higher today than its historical mean, and higher than at any time except in 1929 and 2007.
De-risking may be the order of the day, but investment opportunities still exist for astute investors who position their portfolios thoughtfully, select managers skilfully and implement both capital preservation mechanisms and appropriate hedges.
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