- 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.
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.
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.
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