Perspectives for strategic asset allocation
Observations, Markets & News
The new virus, 2019-nCov, is hard to spot and therefore hard to stop. The following thoughts estimate that the coronavirus outbreak dissipates by spring. We need to assess the development daily though. Should the virus lead to a deep, long-term economic fallout the tactical asset allocation would need to be changed quickly and drastically.
What the virus does show tragically, is the need for a balanced approach with tail hedges in a world where bonds no longer offer the desired diversification from equities.
A supply/demand imbalance drives prices more reliably than any other factor. High demand for a good with limited supply is like a force of gravity to the price in contrast to the proverbial random walk on Wall Street.
Such imbalances are found in battery technology, in bond yields, in gold and in palladium. Demographics can cause long-term imbalances.[i] We like thematic investing based on such imbalances to provide alpha while enhancing diversification.
Economies & Monetary Policies
Synchronous asset purchases in the US and in the Eurozone are positive and will last until spring for all one knows.
Among Central Banks a new theme of 'going direct' is emerging as part of the discussion of how to address an economic slowdown at current low or negative rates. Stanley Fischer, Mark Carney and Christine Lagarde have all publicly addressed the issue.[ii] Central banks are sending the clear signals that they still have arrows in the quiver.
In the European Union policy conditions have improved. The political dynamics in Brussels and Berlin have shifted in a direction more favorable to European cohesion.
For one, we are in a liquidity driven bull market. They tend to go on for longer and further than most expect. For another, the downside momentum could be sharp if sentiment changes.
Themes we like include Ageing Population, Cyber Security, Digitization, Automation & Robotics, Artificial Intelligence & Big Data, Water, and Biotechnology. The common denominator underpinning the investment thesis for each of these themes is a strong demand and lagging supply growth. Sectors with a wider dispersion require active managers though.
Interest in Biotech remains tepid despite an increasingly apparent boom in drug innovation. After strong Q4 2019 performance, the sector remains in the second quartile from the bottom of historical valuation ranges, despite low interest rates and higher valuations elsewhere.[iii] The number of companies trading below 2x cash remains high at about 177.
Fixed Income & Credit
Markets are stretched. Duration risk is high. Tight valuation limits the potential for outperformance. Bonds no longer diversify stocks with yields and spreads as low as they are.
Inflation risks look underpriced. Inflation linked bonds offer a resilience against risks of regime shifts even as such scenarios have a low probability.
High yield credit spreads narrowed to a record level at year-end but have widened this year with a positive correlation to equities.[iv] Lower rates have facilitated financing and reduced default risk. Meaningful increases in rates will result in defaults and widening of spreads of debt-laden companies.
Sovereign bond yields underprice their inherent risks. What is perceived as a strong, balanced system one day could blow up the next just like Prince Rupert’s Drop (“larme de verre”).[v]
"Cash is trash.", said Ray Dalio at the WEF[vi] while Bridgewater was in the news betting on the gold price to rise by 30% with a target of $2'000/OZ.[vii]
Precious Metals also remain a complementary asset class to equities. The small negative carry from holding physical gold is still better than the negative sovereign yields.
We remain bullish on Precious Metals because of an overall supply/demand imbalance.[viii] Gold has proven its place as a diversifier during the recent virus driven equity sell-off.
With rising volatility, market inefficiency rises in parallel enhancing alpha opportunities for hedge funds.
Overweight equities vs. bonds. Stick to liquid asset classes to stay flexible and nimble without opportunity costs since the premium for lack of liquidity has been eroded in public markets.
We are amidst a megatrend of technological disruption. As the world goes digital overweight the disrupters. In sector allocation, consider healthcare, biotech and technology.
Consider adding tail hedges. Regard CHF as an asset class. Alternatively, add active strategies with uncorrelated returns and convexity.
Keep your equities, increase precious metals, and consider adding commodities.
February 3, 2020
[i] Japan is a prime example: As of January Japan has 70'000 centenarians, people aged 100 years or older. There are 56.34 centenarians per 100,000 people nationwide. See also: https://www.japantimes.co.jp/news/2019/09/13/national/japan-centenarians-top-70000/#.XgePK_xOlaQ
[ii] Elga Bartsch, Jean Boivin, Stanley Fischer, Philipp Hildebrand (August 2019), Dealing with the next downturn: From unconventional monetary policy to unprecedented policy coordination, BlackRock Investment Institute; Available at: https://www.blackrock.com/corporate/literature/whitepaper/bii-macro-perspectives-august-2019.pdf (Accessed: Jan 29, 2020)
[iii] The Nasdaq Biotech Index is now at a Price to Sales ratio of 6.2x, and large cap biopharma (NQ US Lg Cap Pharma Index) at a P/E of 14.4x.
[iv] We use the Markit CDS North American High Yield Index as proxy and compare it to the S&P 500. Equities started selling off after the news from Wuhan on January 17 when spreads widened from less than 280 to 310 in a matter of only four days.
[v] Wikipedia: “Prince Rupert's Drops (also known as Dutch tears) are toughened glass beads created by dripping molten glass into cold water, which causes it to solidify into a tadpole-shaped droplet with a long, thin tail. These droplets are characterized internally by very high residual stresses, which give rise to counter-intuitive properties, such as the ability to withstand a blow from a hammer or a bullet on the bulbous end without breaking, while exhibiting explosive disintegration if the tail end is even slightly damaged. In nature, similar structures are produced under certain conditions in volcanic lava.
The drops are named after Prince Rupert of the Rhine, who brought them to England in 1660, although they were reportedly being produced in the Netherlands earlier in the 17th century and had probably been known to glassmakers for much longer. They were studied as scientific curiosities by the Royal Society and the unravelling of the principles of their unusual properties probably led to the development of the process for the production of toughened glass, patented in 1874.”
[vi] See also: https://www.cnbc.com/2020/01/21/ray-dalio-at-davos-cash-is-trash-as-everybody-wants-in-on-the-2020-market.html
[vii] See also:
Quote: "The world’s largest hedge fund, Bridgewater Associates is betting on gold to surge by 30%.
The price of gold has already climbed in 2020, Ray Dalio’s Bridgewater believes that gold could reach $2,000 from its current price of $1553 (rounded up).
Bridgewater have been encouraging investors to “sell the news” and put their cash into gold prior to a further surge.
Greg Jensen, Co-CIO has outlined 3 main reasons for the climb.1) Permanent shift in Federal Reserve Policy
Jensen disagreed with unpopular opinion that the bank would normalise rates the moment the economy became stable.
Jensen believes the Fed and other central banks will hold interest rates low even if inflation begins to exceed stated targets.
He continued by warning of weakening market confidence and how it could result in equity investors taking profits, which may spiral into a “deep correction”.2) China and Iran brewing conflicts
Gold rallied in the aftermath of Soleimani’s death, when investors fled from risk assets.
Geopolitical conflicts may continue to benefit gold, particularly Iran and China as Wall Street are not confident a deal will arrive.
Jensen spoke on the matter; “People should be prepared for a much wider range of potentially more volatile set of circumstances than we are mostly accustomed to.”3) US political turmoil
In November Bridgewater placed a $1.5b options bet that the stock market would plunge by March this year.
The political implications of this bet are enormous as the Democratic Primary outcome will be evident by this time, and investors may dive for haven assets like gold.
US economic growth is slowing as the largest expansion in history continues into uncharted waters.
Jensen believes the weakness of the economy could increase tensions between rich and poor people. Once again gold would become a staple."
[viii] Gold could be the harbinger of bad news in the sovereign debt markets. See comments by the Dutch Central Bank, known as De Nederlandsche Bank (DNB), which wrote on October 15, 2019 that gold would be indispensable in the event of a fiat meltdown. (!) The Central Bank wrote: "Gold is the perfect piggy bank – it's the anchor of trust for the financial system. If the system collapses, the gold stock can serve as a basis to build it up again. Gold bolsters confidence in the stability of the central bank's balance sheet and creates a sense of security."
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