Embracing alternatives amid market turmoil
Not even three months into the year and 2022 is breaking records, but for all the wrong reasons. The list of factors that have buffeted markets and frayed investor nerves is not getting any shorter and there is little solace found in the traditional safe havens.
A REMARKABLE START, FOR THE WRONG REASONS
The dislocation in capital markets in the last few weeks has been remarkable.
Equity markets across Europe are either in or close to bear market territory. The US benchmark, the S&P 500, is in correction territory and the technology-focused NASDAQ has, at times, been down more than 20%.
Meanwhile, bond markets are once again proving that negative correlation to equities cannot be relied upon in times of stress. The yield on the US 10-year Treasury has increased by more than 50 basis points since year end, and the Australian 10-year government bond yield has increased by more than 80 basis points over the same period. The US MOVE index, which tracks volatility in the US Treasury market, is at its highest since the Global Financial Crisis (GFC), outside of the initial COVID-19 shock.
However, the greatest volatility is seen in commodity markets. The week ending 4 March, 2022 saw the largest move in Thomson Reuters Core Commodity Index since the mid-1950s. Trading in nickel was suspended for a period after a 250% intra-day move over the span of two days. Finally, the weekly change in the price of wheat in the first week of March was the greatest in 60 years.
This was not how the year was meant to unfold. COVID-19 risks were fading and mobility data was indicating a return to normal across many developed economies.
The re-opening was meant to create a burst of activity in the first quarter of the year, followed by more modest economic expansion. Meanwhile, inflation was meant to have peaked by now. However, the global macroeconomic outlook has coalesced around a redistribution of growth and an assessment of how strong any stagflationary impulse may be in different regions.
In an environment where inflation is looking to be stickier, the growth risks are to the downside and the only certainty in public markets appears to be volatility. This is where alternatives assets come into their own as they can enhance returns while minimising downside risks in portfolios at a time when public markets are challenged to do the same.
HYBRID WORKING IN YOUR PORTFOLIO
Hybrid, the buzzword being thrown around as we explore new working arrangements during and post the pandemic, can also be implemented in alternatives investing in these challenging times. Inflation rates are likely to be higher than expected just a few months ago and central banks are pursuing the normalisation of interest rates as the outlook for economic activity is moderating. All this points towards investment strategies that can deliver upside to returns while offering some downside protection.
Investors have already been seeking out alternatives that can complement, or even replace public market, investments to boost returns, add income or increase diversification. In 2021, private capital fundraising amounted to almost US$1,400 billion, the most in a decade.
This year will likely be another strong one. However, investors should look beyond the equity-like or fixed income-like attributes of alternatives and consider those hybrids alternative assets with similar characteristics of both equity and fixed income (Chart 2).
At either end of the hybrid spectrum are equity-like hybrids such as private equity and non-core real assets. Meanwhile fixed income-like hybrids would capture subordinated credit and direct lending to real assets. In the middle there are the more pure-hybrid assets that offer return and diversification to public markets. The types of alternative that match these criteria are hedge funds and core real assets.
Hedge funds can use the higher degree of dispersion in public markets to their advantage and tend to perform better when there is more volatility in equity markets.
Meanwhile, their ability to short can prove to be a powerful diversification tool and historical data shows that when equity and fixed income markets are severely challenged, hedge funds can act as ballast in a portfolio.
Core and the extended core real assets are another asset that can be defined as being more like a pure hybrid given their income driven returns are often uncorrelated to public markets. Many of these types of assets have a yield that comes at a meaningful premium to the public bond market, despite having a counterparty risk that is relatively similar.
REFLATIONARY TO STAGFLATIONARY
The inflation outlook has shifted from one of reflation to stagflation. While stagflation is not our base case in terms of the economic outlook, it’s hard to deny that inflation pressures will be more persistent and that the landing point for inflation is likely to be higher once all the temporary forces acting on prices have passed.
Investors are now needing to position for something that has not been an issue for some time - higher, rather than lower, rates of inflation.
There are assets within public markets that have some element of inflation protection. It’s said, for example, that inflation is good for stocks. Companies will adjust their selling price as input costs rise, passing on the inflationary impacts to end customers and protecting their bottom line. But in reality, inflation could be a lot more like chocolate to stocks. Too little and you’re not satisfied, too much and you start to feel unwell.
This is because not enough inflation can signal weak demand but too much will see central banks increase rates, financial conditions tighten and economic activity may slow and earnings expectations can fall.
Then there are inflation-protected securities, but these types of assets will only offer upside should the rate of inflation prove to be higher than what was also priced by the instrument, and there is a lot already in the price.
Gold has been a long-standing inflation hedge and a store of value. But it’s an expensive one given it offers no income and the price of gold would fall as real rates rise and investors seek out positive real yield assets elsewhere.
While inflation could erode the purchasing power and value of income in portfolios, there are plenty of income-generating alternative assets that offer yields above the rate of inflation in Australia and capture the pass-through effects of rising prices to the cash streams that generate those yields.
Real estate is one that many investors are familiar with, and rents are often linked to the rate of inflation. But it’s also an area where investors need to be careful to distinguish between demand that is strong relative to supply and where demand is challenged by structural issues. For example, the hybrid working model may be putting structure pressure on the demand for retail properties, while the demand for industrial and logistical real estate may be strong for this same reason.
Infrastructure assets are another option where the cash flows will deliver inflation-adjusted income to investors as the pricing structure of many utilities are adjusted to the rate of inflation. It’s also worth noting that utilities are critical to the economy and spending habits do not change with the economic cycle. These less GDP-sensitive assets offer a layer of diversification against the economic cycle not found in public markets.
Commodities are an obvious choice when it comes to addressing an inflation threat that is driven by rising commodity prices. Timber may not be the first commodity that jumps to mind but the price of timber is closely associated with prices in the broader economy given it is an input into a wide array of final products and economic sectors, from housing, furniture to packing materials.
The store is in the stump, as the saying goes, and as timber prices rise so does the value of forestry, another income-generating real asset that can be considered when assessing inflation protection of alternative assets. Not to mention the clear benefits of carbon sequestration.
QUALITY AND CORE
For both public and private markets, 2022 is about focusing on quality assets with strong fundamentals. This often implies the core parts of the alternative universe which encompass the ‘pure hybrid’ style of assets that mimic characteristics of equities and bonds. These assets often come with inflation-adjusted income streams from higher quality counterparties.
Just like any investment, there are risks and trade-offs. With alternatives, that trade-off is often liquidity, as well as larger tail risks and the dispersion of returns across alternative asset managers. These trade-offs represent a lower hurdle in the current market environment and the troubled start to the year for public markets.
When public markets are breaking records for the wrong reasons, private markets are likely to break them for the right ones in 2022.
Kerry Craig is a global market strategist at J.P. Morgan Asset Management.
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