Inflation has been higher and more persistent than any of the central banks thought, and has become compounded by geopolitical events. It is clear that inflation expectations have become de-anchored and that the central banks are fighting an uphill battle to regain control. In this situation, central banks have to tighten aggressively, which some are signalling they might do. It has been a long time since central banks have been this far behind the curve, and it is very difficult to soft-land the economy starting here, so the risks of a recession are very high.
Central banks have few policy options as they cannot allow inflation expectations to be permanently de-anchored. This is starkly different from the economic landscape of the last 30 years when inflation was persistently low. Virtually, every time financial conditions tightened and equity markets fell, central bankers rode to the rescue. Today, we are faced with a situation where bond yields are going up because inflation is high and central banks are tightening, while equity markets are threatened by both higher interest rates and the prospect of a recession. This is actually quite a lethal and unhelpful combination, which then means that the 60/40 portfolio is significantly challenged, just as it was in the 1970s.
In this uncertain environment where equities and bonds are increasingly correlated, the need for diversification is palpable. Portable alpha approaches are very well-suited to today’s challenging investment landscape because of their low correlations with equities and bonds, and the likelihood that there is some return being produced, with somewhere in the neighbourhood of cash plus 4 per cent being a plausible expectation. The diversifying role these approaches can play in portfolios is as an equity risk mitigator. For example, replacing a passive equity allocation with equity futures frees up cash that is then invested in a diversifying strategy. This produces the return of the equity index plus a little extra alpha, and importantly, mitigates the equity risk. This allows investors to put some insurance in place, but without it actually costing them any money. Of course, the right kind of hedge fund can be a part of a portable alpha solution.
From past experience, central bank interest rate-setting committees tend to demonstrate inertia in the face of regime changes. Similarly, investors demonstrate inertia because it is difficult to tell whether a regime change actually has occurred. This is a perfect environment for a hedge fund strategy like trend following to do well. Trend following does best when it’s exploiting inertia. And if trend following does well, then systematic macro and discretionary macro, which are country cousins of trend following, are also going to do well.
There is a well-above average probability of a recession in the US and the UK in the next two years, and that represent a significant discontinuity in economic behaviour. Trend followers are great at exploiting such breaches. The combination of regime change, and recession risk should make strategies like trend following, systematic macro, and discretionary macro attractive.
Ironically, the biggest threat to trend following would be a drastic improvement in the macro environment. If supply constraints ease, inflation suddenly starts declining, and markets settle down, then the trend following positions that have prospered this year may suddenly reverse. At that point, the challenge will be discerning if what we are seeing today is a bull market correction or a secular change. This scenario is one that would benefit those who combine trend following with other investment styles within a single fund. Even in portable alpha solutions, diversification can be helpful.
Dr Sushil Wadhwani, chief investment officer, PGIM Wadhwani
