In our view there are eight major macro-economic themes that are driving structural or cyclical trends in the global markets right now:
- Low inflation – persistently low inflation globally with labour markets yet to regain pricing power looks set to continue, as a new leg down for commodities weighs on headline inflation.
- Global policy divergence – multi-speed recoveries around the world are reflected in differing regional policy responses. The US Fed is still likely to move this year in contrast to further easing from the European Central Bank and the Bank of Japan.
- Supply side weakness – low developed market productivity may cut equilibrium yields but raise cyclical capacity pressure. Although UK productivity appears to have somewhat improved, US wage pressure is still soft.
- US economic strength – the US economy remains pretty healthy, consumer spending is well positioned to drive growth and inflation is positive. Higher uncertainty exists surrounding the US Federal Reserve’s decision to (not) raise rates which will continue as the markets grapple with an inevitable transition to a rising rate environment.
- Europe gradual growth recovery – bank lending is picking up across the region, with an easier flow of credit giving lifeblood to the recovery. More borrowers are asking for loans, a good indicator that lower oil prices and a weaker Euro are starting to evolve into a more robust recovery.
- Japanese economic recovery – the government and the Bank of Japan are aligned in their reflationary agenda, and although Japanese economic data has disappointed, consumption and growth should gradually build. Recent corporate governance reforms made by the government have the scope to make a significant impact on capital markets and will be key.
- Emerging markets rebalancing – emerging markets recently have taken a turn for the worse, part of a longer trend of unfavourable global conditions and fading credit booms forcing slower EM growth and external rebalancing. High debt, low commodities prices and a strong US dollar are acting as headwinds.
- China in transition – China is slowing as it digests a rapid accumulation of credit. Rebalancing is happening as growth slows. In August the partial devaluation of the renminbi reflected internal pressures and the need for liberalisation.
These eight themes are the key anchors for making investment decisions and for dictating how investors should take risks, not just by investing in traditional asset classes like shares and bonds, but also by using more sophisticated strategies such as dynamic hedging to reduce correlation to the direction of markets.
As a function of these views, we’ve brought down overall market risk meaningfully; making our returns less dependent on the direction of the markets and de-risking. Earlier this year, we had 60% of our risk in traditional strategies (long equities and bonds). Now we have just 30% in long equities and bonds, with 70% in sophisticated strategies such as dynamic hedging, in an effort to make our portfolio less correlated to traditional markets.
Where we do have beta exposure in traditional markets, our explicit preference is for developed markets equities, such as US, Eurozone and Japanese equities. We have a long position in US financials, precisely targeted to capture growth in US banks, which should benefit from higher loan growth as the economy recovers. They should benefit from higher net interest margins as interest rates increase. We continue to be long UK equities, specifically domestic UK growth plays.
We’ve maintained a consistent and significant bet on the strength of the US dollar. Our strong US dollar view has been in the portfolio for almost two years now. This position is offset by significant shorts on a variety of predominantly emerging market currencies, including the South African rand the Chinese renminbi.
In our sophisticated strategies, some current trades include:
- Long Asian credit default swap protection: This trade stems from our view that credit may be too expensive and it acts as a form of insurance on the Asian credit market. The trade will benefit from further worsening of Chinese and general emerging markets sentiment. The trade is particularly attractive because it is short liquidity risk and we worry that the recent credit market weakness may be the start of a longer-term trend.
- Shorting emerging market FX: emerging markets are struggling with disappointing growth and external rebalancing, the managers are actively shorting EM commodity related currencies, such as the Australian dollar, the Korean won and the South African rand.
- Zero duration: to keep interest rate sensitivity low, the portfolio is hedged to have no duration risk, although the managers keep developed market fixed income exposure which should benefit from the lack of inflation
- Chinese Remnibi US dollar call spreads: We believe the August Renminibi devaluation did little to alter the dynamics of what is a slowing Chinese economy and we think the currency may have further to fall. In order to implement a trade based on that view, we have taken advantage of attractively priced option valuations to position the portfolio to benefit from a further fall in the value of the currency, whilst holding protection that limits the downside should the currency value remain intact.
- Short European energy and autos: this trade is premised on excess capacity in both sectors leading to margin compression as the market digests expectations of slower global growth. Also, oil and commodities are falling in part as a function of China’s economic transition, which is another macro-economic theme.’
