How to invest in an environment full of uncertainties?
We are currently in a complicated environment for investors. This year, stock markets have recovered, but the volatility in financial markets is likely to continue. The correction we saw in May showed us once again that the future depends too much on politics – and especially the never-ending trade conflicts. In April, we thought that a trade agreement between the United States and China was imminent. The escalation in late-April and May was a surprise to a lot of us, though President Trump’s unpredictable U-turns should not really surprise us. In fact, it became clear that even an signed agreement could be questioned or undone anytime, which was illustrated by Trump’s threat to impose 5% tariffs on Mexican imports. The good news is that the conflict with Mexico was short lived and no new tariffs were implemented, by now. This helped to calm investors’ nerves and the markets have rebounded once again. However, an agreement between China and the United States is still far way. If we’re lucky, both parties might agree to reassume high-level trade talks, which could be part of a discussion in a face to face meeting between President Trump and President Xi during the G20 summit later this month in Osaka.
However, a lot of damage is already done. Global supply chains are completely interconnected. The majority of major companies depend on international trade. The recent uncertainties with changing rules all the time have made hard for companies to make strategic decisions. As a consequence, many multinational companies, exporters and importers have begun to reduce their capital expenditures. This results in a continuation of the global economic slowdown. If politicians fail to reestablish confidence, it is very likely that the slowdown will lead a recession within the next two years, given the fact the current growth rates are far from being stellar. The good thing is that a possible recession might well be short and shallow. It is important to note that the last two bear markets were rather unusual. The burst of the technology bubble and the Great Financial Crisis caused massive losses, mainly due to previous excesses and the inflation of asset prices in the technology and housing area. Currently, there is very little evidence of bubbles or excesses that could cause a crisis as strong as the previous ones. Therefore, it is likely that the next bear market ends with a typical correction of “only” 20% to 30% in global stock markets.
The short-term outlook could be less negative. Interest rate cuts and trade reliefs might lead to temporary rallies. Two important facts support this view. First, Trump need to stimulate the economy to have a chance to be reelected in 2020. He needs to strengthen consumer and business confidence. This is unlikely to happen without some sort of agreement with the Chinese before the end of the year. Second, the lack of inflationary pressures allows the Federal Reserve – and other central banks – to be more aggressive if necessary. The market is already expecting three rate cuts this year.
What does this whole scenario mean for investors?
First, there is no reason to panic. The bull market has not ended yet and we expect the next recession (if there is any) to be more moderate. For now, investors should maintain (but not increase) their equity holdings. Nevertheless, if the current rally continues and equity markets reach new all-time highs, it might be a good time to take some profits and reduce the equity exposure. Afterall, we estimate that equity market returns are very unlikely to surpass 5% annually over the next five years, which is not a lot for a risky asset class.
Second, we believe in increasing duration and to reduce credit risks in fixed income portfolios. For example, we would accumulate positions in the 10-year treasury bond if yield get close to 2.5%. This gives investors protections in turbulent times, which is not a bad idea, even if it means locking in relatively low return.
Finally, investors should increase their exposures to alternative assets. Alternative assets improve the return profile and reduce risk substantially, if implemented in the right way. However, investors need to be very selective and a proper due diligence is key. We would avoid structurally challenged segments. For example, many real estate areas are threatened by the strong trend towards online shopping, coworking spaces, Airbnb, etc. Many commodities are negatively impacted by Chinese economic transformation from an infrastructure/export-driven economy towards a consumption-driven economy. Also, alternative sources of energy are likely to begin to reduce the growth in the demand for oil, coal, etc. Finally, many hedge funds have failed to improve their reputation and remain opaque, volatile and correlated to traditional asset classes. Last year, the HFRI index fell 7%, given investors no protection in a challenging year. We strongly believe that the best risk/reward can be found in private markets, such as infrastructure, private equity and especially private debt.
There is a strong economic explanation for the attractiveness of private debt. Many opportunities arose after the Great Financial Crisis as governments (because of their indebtedness) and banks (because of new regulations) reduced their financing activities in many areas. The banks’ retreat from the loan market has left a gap that private institutions, such as private equity firms and other asset managers, have been eager to bridge. They have filled the lending vacuum to provide crucial financing to the real economy – and particularly to small and medium-sized enterprises, the backbone of our economies. Newly created investment vehicles have attracted substantial interest from institutional investors hungry for yield. Following the financial crisis, the massive monetary stimulus has inflated the price of liquid assets, especially in fixed income markets, depressing yields for investors. At the same time, the lack of capital provided to smaller companies has kept yields for smaller loans at elevated levels. Typically, private loans pay interest rates between 5% and 15% without leverage, based upon a floating base rate (LIBOR) with very low market volatility (standard deviations below 2%). In addition, strong collaterals, personal guarantees, and relatively low nominal amounts favor low delinquency.
Katch Investment Group identified these trends and decided to launch open-ended investment vehicles that invest in short-term lending and financing opportunities.