12 October 2018
Please find below the notes from GAM Investments’ Weekly Investment Meeting held on 10 October 2018 – this week’s speakers were Michael Biggs, who talked about the importance of whether interest rate rises are being driven by growth or inflation expectations; Jack Flaherty, who highlighted that downside protection is key in high yield bond portfolios; and Gianmarco Mondani, who rounded up the current opportunities in European long / short equity.
- Our growth outlook remains unchanged, with the macro environment looking fine fundamentally, in our view. The latest PMI figures were a little soft, whereas IP numbers were stronger than expected. Recent data points have not impacted our overall view, but we would like to see PMI numbers improve going forward.
- US bond yields have increased sharply since the start of the year, with a further 40 bps rise in the last month. In our view this does not threaten the asset price outlook. Yield increases are a problem if they are due to higher inflation, but not if they are due to stronger growth. The real yield indicators and stable inflation expectations suggest this move is about growth.
- The reasons behind this move to increase rates are important, particularly with regard to emerging markets. IMF research shows that if developed economy interest rates increase when there has been a growth shock, this traditionally boosts risk appetite and causes capital to flow into EM and production growth to rise. On the other hand, if hikes are due to inflation shocks, money typically flows out of EM and production growth slows.
- An important indicator underpinning the outlook for risky assets has been the negative correlation between bond and equity returns since 2000. We think it is unlikely that this will revert back to a positive correlation unless the Fed becomes concerned about inflation. If bonds move up gradually or go sideways from here the negative correlation should remain, which will likely support asset prices.
- While the correlation remains negative, then decent growth is a sufficient condition for reasonable equity returns. An upside surprise in US inflation numbers (later this week) would not be good for bonds on the day, but unless inflation expectations rise the outlook for risky assets remains positive.
- People seem to have a perception that high yield is expensive. Some have been drawing parallels with where the market is now versus where it was in 2007; however, in our view there are some fundamental differences. The duration is currently closer to four years and the mix of quality has shifted, with BBs making up 49% of the market, while Bs account for 40% and CCCs 11%. The very senior part of companies’ capital structure has less protection than it did previously; this is better for the bond part of the structure.
- We also feel there is a lot to be said for a concentrated and actively managed strategy in the high yield space, which has the ability to avoid certain sectors and with a combination of fixed and floating-rate notes and actively managed duration.
- Our model-based strategies, which use risk-free assets as a way to hedge risks in times of market stress and are one of the key ways we differentiate ourselves from our peers, have been important in terms of protecting on the downside, helping to reduce downside volatility while increasing the Sortino ratio. Our absolute return mentality focuses on this downside protection and aims to limit any big tail risks, with the models kicking in only at times when the world has gone into a negative tailspin and risk-free rates are widening.
- We have a strong focus on seeking alpha utilising a fundamental bottom-up approach. Our process includes the macro background, sector based analysis and a deep drill down into individual names.
- Our underlying strategy is a fundamental one based on earnings revisions, where we seek to identify stocks that will surprise by either exceeding or falling sort of analysts’ expectations. For strong behavioural finance reasons our strategy is deeply correlated to share-price momentum, which helps to explain why 2016 proved a difficult year and why performance has been much better during 2017 and year to date. The wide embracement of the reflation trade during the second-half of 2016 prompted an abrupt rotation into cyclicals, catalysing a sharp upward re-rating of stocks that had been suffering from deeply negative earnings revisions. Meanwhile, stocks experiencing positive earnings momentum were not rewarded accordingly. Our portfolios suffered because of this disconnect between share price and earnings momentum, which is typical of major turning points in macroeconomic fundamentals. However, we have subsequently developed a range of risk-management indicators to help better navigate through periods when momentum is under pressure.
- The first of these risk-management tools endeavours to value momentum by considering the price / book differential between the best and worst performers over the last 12 months. This helps us to gauge the risk / reward potential of momentum at any given time and align that with the gross exposure of the portfolio. At present, this analysis does not indicate that momentum is expensive and therefore we are comfortable with our current exposures.
- The second of our proprietary risk-management tools draws from a basket of European economic indicators, which highlights when the economy appears weak or in good health, versus the beta of the best performing stocks over the last 12 months. We track these indicators because we have found that the most dangerous time for momentum strategies tends to be when economic indicators are very weak and the beta of the best performing stocks is very low. At these times, just a minor improvement in economic sentiment can give rise to a chase for cyclical stocks even in the midst of profit warnings. Right now, the indicator is signalling a slowdown in the economy and prompts us to look out for potential weakness across markets, although this is currently well away from the dangerous levels for momentum described previously. It is important to note that as a long / short strategy we have the ability to add value during market weakness by taking more aggressive short positions, as well as being highly selective in any long positions.
- In terms of current positioning, we are keen to focus on the visibility of earnings in the long book as well as seeking to avoid any companies with negative news flow in a slowing economic environment. We currently see some opportunities within the luxury and technology sectors, while from a cyclical perspective we are looking at companies with cheap valuations and have observed the return of pricing power among packaging companies. We are also seeing some opportunities in energy stocks, as gas and oil prices are now proving to be more resilient than expected; therefore companies should be able to return more cash to shareholders.
- In the short book, we are looking at areas with structural problems such as retailers – both food and clothing – who are facing fierce competition from online disrupters. We are also seeking companies on very high multiples, but with unsteady fundamentals.