OPINION

Dangers, and opportunities, lie ahead

If 2016 reminded us of anything, it’s that forecasting, especially political forecasting, is tough. With few pollsters or commentators having accurately predicted the outcome of either the Brexit referendum or the US presidential election, it would be wise to keep an open mind in relation to elections taking place in 2017. Growing nationalism, fragmentation and what some have dubbed “the death of liberal politics” are likely to remain prominent influences on the political landscape for some time.

Against this backdrop of geopolitical tumult, here are four themes it will be important for investors to consider when building portfolios in 2017.

  1. Fragmentation

Taken together, Brexit, the election of President Donald Trump, the rise of populism across Europe, and the increasingly nationalist tone of presidents Vladimir Putin and Xi Jinping, suggest a fragmentation of the prevailing global political order.

In an environment of heightened political risk and fatter tails, stress-testing portfolios against large moves in equities, bonds and currency will be important when assessing portfolio risk exposures. Volatility-sensitive investors may wish to consider approaches to managing their downside risk exposure via hard or soft hedges.

As the performance of sterling following the Brexit vote illustrates, political surprises create the potential for large currency moves. Protectionism and trade tensions could also lead to currency volatility. This increases the importance of having a clear policy on hedging currency risk and may also create opportunities for active currency or global macro-managers.

  1. Shift from monetary to fiscal stimulus

Last year may have brought the high point in monetary stimulation. Policymakers are increasingly recognising the limits and unintended consequences of quantitative easing and negative rate policies. At the same time, increasing calls for fiscal stimulus have been supported by both mainstream economic voices and populist politicians. The speed and magnitude of any shift from monetary to fiscal stimulus could have important implications for investors in the years ahead, not least in relation to the potential build-up of inflationary pressures.

Investors should, therefore, have a clear understanding of the impact that higher inflation could have on their ability to meet their objectives. For portfolios lacking in inflation protection, investors may wish to consider direct inflation hedges or real assets.

Regardless of the direction of yields, an increase in bond market volatility due to an increase in uncertainty around monetary and fiscal policy (following a period in which policy has been one-directional) should create more opportunities for strategies such as global macro, absolute-return bonds and unconstrained fixed-income.

  1. Capital abundance

Following eight years of central bank largesse and low levels of business investment, the world is awash in financial capital seeking yield. The exceptional returns of the past eight years will not be repeated and there is a scarcity of “easy beta” to be harvested. We believe portfolios dominated by traditional beta (that is, equities, credit and government bonds) offer a relatively unattractive risk/return trade‑off looking ahead. Investors will, therefore, need to prepare for lower returns or consider less familiar asset classes and more flexible strategies in order to deliver on their return objectives.

In this environment of low yields and low to moderate risk premia, we believe investors should place a greater emphasis on diversification of return sources. This can include systematic factor exposures (or “smart beta”) and idiosyncratic alpha (a function of manager skill) across a range of liquid markets.

While many private markets have had significant inflows in recent years, opportunities remain for high-quality managers to extract returns from a combination of illiquidity and complexity premia and direct asset management (or hands-on value creation). This is especially true for areas of the private markets where there is still a structural imbalance between the demand and supply of capital – notably private debt finance for smaller companies that have limited access to the capital markets.

Less familiar segments of the credit markets (such as asset-backed securities, private lending, trade finance and receivables) offer investors the potential to generate a premium to cash of 2 per cent to 4 per cent a year as compensation for complexity and illiquidity risk. Secured finance strategies provide one potential access route to such assets.

  1. Structural change

Amid the short-term discussion of politics and economics, longer-term structural forces, such as demographic trends, climate change and technological disruption, could also have far-reaching, if less obvious, implications for investors.

There is clearly some uncertainty around the future direction of US climate change policy under the Trump administration. However, climate change remains an issue of global importance, and we continue to believe investors should review portfolios’ exposure to carbon-intensive assets to assess the impact policy developments (such as carbon pricing or a carbon tax) could have on them. Carbon footprint analysis on listed-equity portfolios and recent developments in low-carbon indices can be valuable tools in addressing this source of risk.

The investment implications of demographic trends are far from clear, not least because changes in working patterns over the coming decades could mitigate the impact of ageing populations, thereby halting or even reversing any rise in dependency ratios. However, it is clear that some countries will be more challenged by these trends than others (either because their demographic trends are further advanced or because cultural factors make them less likely to be able to adapt in time). This will probably create differences in economic outcomes at a regional level.

Lastly, technological disruption will create winners and losers at a corporate level. This should generate opportunities for long/short equity investors, perhaps particularly on the short side of the book, as identifying the losers from technological change may be easier than picking the winners. An extension of this point is that market cap indices may be at particular risk of technological disruption, given that they hold large weights in the incumbents across many sectors.

The year ahead is sure to bring its share of challenges and opportunities. Investors who seek a clear understanding of their exposure to various sources of risk and build portfolios able to capture opportunities as they arise will probably have a more positive experience than those who do not.

 

Phil Edwards is European director of strategic research at Mercer.

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