Newton philosophy Archives

Key Points

In the aftermath of Covid-19 the financial regime has changed and is dominated by strong trends such as inflation, reshoring, and supply-chain disruptions, which creates more opportunities and challenges for investors.
Humans and machines have complementary strengths that we believe can be harnessed to help achieve better investment outcomes in the changing environment.
In our view, cross-team collaboration between fundamental and systematic investors can enhance decision making.

The aftermath of the 2007-8 global financial crisis was characterized by historically low interest rates and abundant liquidity as central banks stepped in to administer repeated waves of quantitative easing (the process by which central banks purchase government bonds or other financial assets to stimulate economic activity). Financial markets benefitted from this largesse, and mere exposure to beta delivered a handsome return while alpha was left largely unrewarded.

The financial regime has now changed, accelerated by the onset of Covid-19, which saw government spending play a more dominant role as the baton passed from monetary to fiscal policy, fueling a surge in inflation. Dominant themes have emerged which characterize this new regime:

It looks increasingly clear that a higher level of inflation is here to stay, and central banks have had to row back on their original assertion that inflation would be transitory in nature.
Reshoring is the order of the day as countries retrench and are less willing to share their intellectual property and collaborate in global initiatives.
Supply chains are also disrupted, being affected by geopolitical tensions which have resulted in bottlenecks and longer lead times.

In summary, the world is likely to be less efficient than in the aftermath of the financial crisis, and there will be more friction, uncertainty and volatility across different economies. We believe this will give rise to a greater dispersion of returns and a richer set of opportunities, and that there will be a need to increase the breadth of asset classes deployed.

Working in Tandem Towards a Common Investment Aim

There has recently been much excitement around the potential for machines to enhance the human experience and push out traditional boundaries. In a new market regime, is there perhaps an enhanced role for human/machine symbiosis in investment strategies? Undoubtedly there is a need for investors to be nimbler and more flexible than ever. However, the machine does not exist without humans and will only reflect what humans have programmed it to do. In this context, we see the real power of the machine as being its ability to aggregate a large volume of information to produce indicators or matrices that capture the essence of multiple data points.

The machine process creates mathematical rigor around it to create an outcome, expressing what we, as humans, are trying to assess in a more intuitive fashion. It can also help evaluate the level of uncertainty of outcomes and the likelihood that there will be sufficient compensation for the risk taken. The reality, in our view, is that both humans and machines can ‘feed’ one another, each working at different points in time and in different ways, with the aim of achieving a superior outcome. We therefore think it is misleading to think of humans and machines as distinct entities, but rather that we should see them as two parties working in tandem towards a common aim.

Fostering Cross-Team Collaboration

In order to accelerate this cross-fertilization process, the appropriate resources need to be in place. These include employing the right investment professionals, harnessing cognitive diversity and exploiting a flexible mindset. We do not think a siloed approach will work and we favor a horizontal structure with a strong focus on cross-team collaboration and an ability to fine tune the mix of individuals.

There will be times when human insight will have the upper hand. For example, during the post-Covid period, central banks and authorities implemented a backstop to underpin markets, followed by a massive liquidity injection. Quantitative models were unable to react to the sharpness and the severity of the shock, which prevented investors from participating in the asset rebound. Furthermore, the nature of the shock was very different from what had happened historically; it delivered both a supply and a demand shock simultaneously. Models struggled to find the best way to react to such an unusual dynamic. However, the sheer speed and scale with which quantitative techniques are able to operate can provide valuable input for more fundamental approaches.

Supporting Better Decision-Making

We would contend that the current environment is one in which a hybrid approach should thrive. There is a need to be faster and apply risk allocation to a much broader set of decisions, with the ability to integrate portfolio insurance to cushion against a range of uncertain outcomes. The multiplicative effect of unifying systematic and fundamental approaches has ample scope to shine against the backdrop of a new regime and requires a seasoned investment team. The capacity to bring experienced fundamental investors together with experienced systematic investors is a relatively rare approach for asset-management firms that traditionally have tended to promote the attributes of each separately without thinking about the benefits of combining the two.

It is our belief that blending the two approaches to manage portfolios can lead to greater efficiency of decision making and, ultimately, better outcomes. For example, fundamental investors who have access to the output from a systematic team can save considerable time in collating macroeconomic and market data. Furthermore, there are large amounts of money managed using quantitative approaches in the market, and knowing the signals these other investors are using can inform the debate.

Fundamental and Systematic – The Best of Both Worlds

Markets have expanded, both in terms of size and the number of instruments used, and we are in a new regime that is likely to drive greater volatility. Standing still is not an option for investors confronted with evolving markets and expanded data sources. The market is influenced by both fundamental and systematic investors, and while having both skillsets within an organization is rare, we believe it will be increasingly important to help understand the underlying drivers of markets.

Key points

In the aftermath of Covid-19 the financial regime has changed and is dominated by strong trends such as inflation, reshoring, and supply-chain disruptions, which creates more opportunities and challenges for investors.
Humans and machines have complementary strengths that we believe can be harnessed to help achieve better investment outcomes in the changing environment.
In our view, cross-team collaboration between fundamental and systematic investors can enhance decision making.

The aftermath of the 2007-8 global financial crisis was characterised by historically low interest rates and abundant liquidity as central banks stepped in to administer repeated waves of quantitative easing (the process by which central banks purchase government bonds or other financial assets to stimulate economic activity). Financial markets benefitted from this largesse, and mere exposure to beta delivered a handsome return while alpha was left largely unrewarded.

The financial regime has now changed, accelerated by the onset of Covid-19, which saw government spending play a more dominant role as the baton passed from monetary to fiscal policy, fuelling a surge in inflation. Dominant themes have emerged which characterise this new regime:

It looks increasingly clear that a higher level of inflation is here to stay, and central banks have had to row back on their original assertion that inflation would be transitory in nature.
Reshoring is the order of the day as countries retrench and are less willing to share their intellectual property and collaborate in global initiatives.
Supply chains are also disrupted, being affected by geopolitical tensions which have resulted in bottlenecks and longer lead times.

Working in tandem towards a common investment aim

The machine process creates mathematical rigour around it to create an outcome, expressing what we, as humans, are trying to assess in a more intuitive fashion. It can also help evaluate the level of uncertainty of outcomes and the likelihood that there will be sufficient compensation for the risk taken. The reality, in our view, is that both humans and machines can ‘feed’ one another, each working at different points in time and in different ways, with the aim of achieving a superior outcome. We therefore think it is misleading to think of humans and machines as distinct entities, but rather that we should see them as two parties working in tandem towards a common aim.

Fostering cross-team collaboration

In order to accelerate this cross-fertilisation process, the appropriate resources need to be in place. These include employing the right investment professionals, harnessing cognitive diversity and exploiting a flexible mindset. We do not think a siloed approach will work and we favour a horizontal structure with a strong focus on cross-team collaboration and an ability to fine tune the mix of individuals.

Supporting better decision-making

Fundamental and systematic – the best of both worlds

Since our fundamental and systematic investors started working together, our fundamental investors have been able to improve their own models by using the engineering platform of their systematic colleagues. This has allowed greater efficiency to filter through and has given the fundamental investors more time to focus on new ideas. For our systematic investors, having a fundamental team highlighting when trends are about to change can help them de-emphasise certain signals and make them quicker to react to a change in direction. Ultimately, clients will look to benefit from the best combination of tools to inform both approaches.

Markets have expanded, both in terms of size and the number of instruments used, and we are in a new regime that is likely to drive greater volatility. Standing still is not an option for investors confronted with evolving markets and expanded data sources. The market is influenced by both fundamental and systematic investors, and while having both skillsets within an organisation is rare, we believe it will be increasingly important to help understand the underlying drivers of markets.

Key Points

2024 is likely to be the third consecutive year of a new market regime with stubborn inflation, a worsening economic backdrop and heightened volatility likely to continue.
An economic slowdown that significantly increases unemployment remains possible owing to the cumulative effects of higher interest rates and higher costs which will gradually undermine both investment and consumer spending.
Avoiding capital losses from failing companies or from rising interest rates will be vital for investors, and we believe that global absolute-return strategies that can diversify their return opportunities, and build in downside protection, will become more important.
We think that tactical asset allocation can also play an important role in the context of shorter economic and market cycles, which may display greater amplitude in their moves.
Agile strategies can take advantage of dispersion and dislocation, and should be well placed to thrive amid the pronounced market regime change.

We believe 2024 is likely to be the third consecutive year of what we have described as a new market regime. If our assumptions are correct, this new regime will remain volatile and difficult to predict, with stubborn inflation (albeit lower than last year) and continuing concerns about an economic slowdown. These factors are likely to have a major bearing on market behavior, alongside changing interest-rate trends and geopolitics.

Hard or Soft Landing?

We expect the investors’ obsession about whether a recession or a soft landing is on the way will continue. For now, the soft-landing camp has the upper hand. Investors who have been concerned about inflation on the one hand and economic contraction on the other, may welcome a scenario that places economics firmly in the middle. In our view, an economic slowdown that significantly increases unemployment remains possible owing to the cumulative effects of higher interest rates and higher costs which will gradually undermine both investment and consumer spending.

For some economies, the soft-landing scenario could therefore gradually morph into a hard landing. Once such a scenario is identified by central banks, we would expect them to react by cutting interest rates. This ‘bust and boom’ environment is typical of the new regime, and safe-haven and risky asset classes alike may be kicked around in this changed economic backdrop.

For investors, avoiding capital losses from failing companies or from rising interest rates will be vital, and we believe that global absolute-return investment strategies that can diversify their return opportunities, and build in downside protection, will become more important.

The previous market regime followed the global financial crisis of 2007-2008, when a combination of subdued inflation and meagre economic growth led to dovish monetary policy being deployed over an extended period. As a result of this ‘easy money’ and ultra-low interest rates, volatility was dampened in most asset classes and waves of quantitative easing lifted all boats.

The tide has now turned, in part catalyzed by the Covid pandemic, and, since early 2022, we have witnessed a material increase in inflation that has compelled central banks to remove liquidity and raise interest rates, which have seen the steepest and fastest rise in a generation. This has had the effect of increasing volatility across most asset classes, and we are likely to witness casualties as many of the so-called ‘zombie’ companies, which have been able to survive owing to easy access to capital, come under pressure.

New Regime Looks Very Different

During the last market regime, many absolute-return approaches failed to deliver for their clients. The drive towards very low rates and the corresponding narrowing of opportunities meant that some approaches strayed too far into illiquid assets and others into taking on too much risk. As a result, when investors required liquidity, some strategies were unable to respond. Once we moved into a higher interest-rate environment, those that had too much risk were caught out as well. Over the last 15 years the number of absolute-return offerings has fallen as a result.

Meanwhile, it has become clear that the ‘new regime’ looks very different to the previous one. There is increased appetite among electorates for governments to play a more dominant role in economic management, and fiscal policy is increasingly being used as a tool to satisfy voter demands, as well as for ‘crisis’ prevention and management.

Geopolitical tensions and great power competition mean that unfettered globalization is no longer flavor of the month, and reshoring and ‘friend-shoring’ are more in tune with the prevailing national moods of retrenchment. There is also a generational power shift underway, with Generation X and Millennials set to become the biggest voter bloc in Western democracies. We have already witnessed the rise of populism as wealth inequality grows.

Favorable Backdrop

We believe that these factors create a favorable backdrop for absolute-return investing, as they throw up a myriad of exciting opportunities for discerning and active investors. This contrasts with the recent past, when conventional wisdom had it that passive exposure to equities and/or bonds was best practice for many. Locking into one source of market return can prove to be inefficient at best, and a threat to capital at worst. The trend towards higher and more volatile inflation reflects a more dramatic response from central banks, necessitating maximum flexibility from investors to navigate these risks (for example, the ability to diversify into bonds with floating coupons that rise with cash rates can prove valuable).

Elsewhere, an equity market driven by extremely narrow leadership of the US technology giants represents an overreliance on a particular sector, whereas our view is that a nimble, dynamic approach would be more successful in generating positive returns over the long run. We believe the same is also true from a geographic perspective, as investors can pivot towards countries that have beneficial interest-rate policies or better economic growth prospects.

Broader Range of Investment Options

Some markets and strategies fell out of favor in the previous regime that was characterized by a backdrop of low rates and low inflation. The diversification benefits of commodities, currencies and rotating between assets were not required as much as the main markets trended higher. In a higher-inflation environment with greater economic volatility, we believe that asset classes such as currencies and commodities can offer significant value as well as greater diversification opportunities. Being able to move across asset classes as the fortunes of economies ebb and flow can also be more rewarding, in our view.

We contend that the opportunity set is significantly wider than equities and bonds alone, and the ability to draw on a broader panoply of investments, including commodities, infrastructure, renewables and non-directional alternatives (such as alternative risk premia), is valuable, particularly in an environment of volatile interest rates, which places some of the more fragile businesses under threat. Put simply, the macroeconomic backdrop has changed and the investment tools deployed need to evolve to fit this new reality.

We think that tactical asset allocation can also play an important role in the context of shorter economic and market cycles, which may display greater amplitude in their moves. The days of static beta harvesting look to be over; in fact, in this new regime, the only constant may be change, as investment leadership waxes and wanes. Our view is that judicious downside protection through hedging strategies can play a part here in helping to smooth investment returns. Yield is another attribute to be exploited, and one that can help to ensure that a portfolio is being run as efficiently as possible, in an environment where market returns may well be lower.

Conclusion

In summary, we believe this could be a golden age for absolute-return investing, and one in which investors need to think differently, rather than simply following the playbook of the past. A potent combination of deglobalization, unfavorable demographic trends and more interventionist governments provides a backdrop that requires a new investment palette. The new market regime also means calling time on rigid portfolio structures which do not have the flexibility to invest in a significantly wider range of opportunities. We believe that agile, active strategies can take advantage of dispersion and dislocation, and should be well placed to thrive amid the pronounced market regime change we are currently experiencing.

Key points

2024 is likely to be the third consecutive year of a new market regime with stubborn inflation, a worsening economic backdrop and heightened volatility likely to continue.
An economic slowdown that significantly increases unemployment remains possible owing to the cumulative effects of higher interest rates and higher costs which will gradually undermine both investment and consumer spending.
Avoiding capital losses from failing companies or from rising interest rates will be vital for investors, and we believe that global absolute-return strategies that can diversify their return opportunities, and build in downside protection, will become more important.
We think that tactical asset allocation can also play an important role in the context of shorter economic and market cycles, which may display greater amplitude in their moves.
Agile strategies can take advantage of dispersion and dislocation, and should be well placed to thrive amid the pronounced market regime change.

We believe 2024 is likely to be the third consecutive year of what we have described as a new market regime. If our assumptions are correct, this new regime will remain volatile and difficult to predict, with stubborn inflation (albeit lower than last year) and continuing concerns about an economic slowdown. These factors are likely to have a major bearing on market behaviour, alongside changing interest-rate trends and geopolitics.

Hard or soft landing?

We expect the investors’ obsession about whether a recession or a soft landing is on the way will continue. For now, the soft-landing camp has the upper hand. Investors who have been concerned about inflation on the one hand and economic contraction on the other may welcome a scenario that places economics firmly in the middle. In our view, an economic slowdown that significantly increases unemployment remains possible owing to the cumulative effects of higher interest rates and higher costs which will gradually undermine both investment and consumer spending.

The tide has now turned, in part catalysed by the Covid pandemic, and, since early 2022, we have witnessed a material increase in inflation that has compelled central banks to remove liquidity and raise interest rates, which have seen the steepest and fastest rise in a generation. This has had the effect of increasing volatility across most asset classes, and we are likely to witness casualties as many of the so-called ‘zombie’ companies, which have been able to survive owing to easy access to capital, come under pressure.

New regime looks very different

Geopolitical tensions and great power competition mean that unfettered globalisation is no longer flavour of the month, and reshoring and ‘friend-shoring’ are more in tune with the prevailing national moods of retrenchment. There is also a generational power shift underway, with Generation X and Millennials set to become the biggest voter bloc in Western democracies. We have already witnessed the rise of populism as wealth inequality grows.

Favourable backdrop

We believe that these factors create a favourable backdrop for absolute-return investing, as they throw up a myriad of exciting opportunities for discerning and active investors. This contrasts with the recent past, when conventional wisdom had it that passive exposure to equities and/or bonds was best practice for many. Locking into one source of market return can prove to be inefficient at best, and a threat to capital at worst. The trend towards higher and more volatile inflation reflects a more dramatic response from central banks, necessitating maximum flexibility from investors to navigate these risks (for example, the ability to diversify into bonds with floating coupons that rise with cash rates can prove valuable).

Elsewhere, an equity market driven by extremely narrow leadership of the ‘magnificent seven’ technology giants represents an overreliance on a particular sector, whereas our view is that a nimble, dynamic approach would be more successful in generating positive returns over the long run. We believe the same is also true from a geographic perspective, as investors can pivot towards countries that have beneficial interest-rate policies or better economic growth prospects.

Broader range of investment options

Some markets and strategies fell out of favour in the previous regime that was characterised by a backdrop of low rates and low inflation. The diversification benefits of commodities, currencies and rotating between assets were not required as much as the main markets trended higher. In a higher-inflation environment with greater economic volatility, we believe that asset classes such as currencies and commodities can offer significant value as well as greater diversification opportunities. Being able to move across asset classes as the fortunes of economies ebb and flow can also be more rewarding.

Our view is that the opportunity set is significantly wider than equities and bonds alone, and the ability to draw on a broader panoply of investments, including commodities, infrastructure, renewables and non-directional alternatives (such as alternative risk premia), is valuable, particularly in an environment of volatile interest rates, which places some of the more fragile businesses under threat. Put simply, the macroeconomic backdrop has changed and the investment tools deployed need to evolve to fit this new reality.

Conclusion

In summary, we believe this could be a golden age for absolute-return investing, and one in which investors need to think differently, rather than simply following the playbook of the past. A potent combination of deglobalisation, unfavourable demographic trends and more interventionist governments provides a backdrop that requires a new investment palette. The new market regime also means calling time on rigid portfolio structures which do not have the flexibility to invest in a significantly wider range of opportunities. We believe that agile, active strategies can take advantage of dispersion and dislocation, and should be well placed to thrive amid the pronounced market regime change we are currently experiencing.