The Global Investment Landscape: Navigating the Right Side of Change
Overview
In spite of government intervention, economic recovery in most developed economies remains anaemic and equity markets volatile. At the same time, the emerging markets continue to surge. This keynote address given at the 2012 Global Investment Forum by a respected investment strategist examined the structural forces that are reshaping the investment landscape and addressed the optimal investment strategy for families in the short and long-term. Key areas of focus:
- What are the mega trends impacting the world economy and investment landscape?
- How do short-term opportunities co-exist and interconnect with long-term investment strategies?
- What is the strategic advantage of longer-term family capital over institutional mindsets and timeframes?
- A best practices family enterprise investment governance framework and how this can promote a longer-term investment approach
Recovering From the Great Recession
- Recoveries from financial crises are different from cyclical fluctuations. The world economy has experienced significant damage to key systems through finance-induced instability. Over the medium-term, the U.S. is likely to recover to around trend growth rates, but this is unlikely in Europe due to the fiscal drag associated with austerity and the structural problems, including labor market rigidity, besetting the eurozone* There has been a rise in risk premia which has been triggered in part by geopolitics, in part by sovereign debt concerns. Insolvency by a big country could precipitate an outright credit freeze.
- The European Central Bank can – via its Long-Term Refinancing Operations (LTRO) - only resolve shorter term liquidity deficits, but not longer-term solvency issues (either of banks or nation states).
Role of Emerging Markets
- The emerging markets are not only experiencing continued rapid (catch-up) growth vis-à-vis developed economies including Japan but are also much less heavily indebted than the developed world. Favorable inflation trends, strong economic fundamentals and potential rate cuts continue to support the case for Asian bonds. However, investors should bear in mind the following caveat: emerging market sovereign bonds haven’t entirely shaken their reputation as risky investments. In recent crisis situations, they declined in step with risky assets.
- If current trends persist, we may see a de-correlation of developed vs. emerging financial markets.
- Investors are advised to avoid the economies of Central and Eastern Europe, dragged down by the travails of the eurozone.
Investment Themes
- Real interest rates are now below zero – a consequence of U.S. Fed intervention to buy U.S. Treasuries with longer-term maturities. This situation is exceptionally favorable to debtors, including both the state and (private) investors willing to use leverage to buy risky assets such as equities.
- Volatility in global financial markets has fallen markedly since October 2011. With volatility as low as it currently is, there is a risk that investors have become too complacent and that a correction could be around the corner.
- Periods of heightened inflation, volatility or sovereign risks have tended to drive stock and bond correlations sharply positive. Investors should consider hedging strategies to afford themselves protection from the prospect of rising interest rates (in the event that monetary policy becomes more restrictive).
- High yield (corporate) bonds offer a significant yield advantage relative to sovereign debt. With declining default rates and healthy corporate balance sheets, high yield bonds look appealing
- For families with a private equity component to the overall portfolios, they should strive for both geographical diversification and between later stage vs. leveraged buy-outs vs. mezzanine, and actively monitor all investments through rigorous investment governance.
Broader Implications for Families
- Families are advised to focus on risk management in their investment portfolios. Dynamic and tactical hedging strategies can help achieve attractive risk-adjusted returns and meet portfolio objectives while tactically managing risk. Use volatility strategies for all asset classes by management of the portfolio’s underlying investments or as an overlay solution to existing exposure. Manage downside risk reduction using options, swaptions, volatility instruments and futures across asset classes.
- The following considerations are important for families to factor into their thinking going forward: the use of enhanced risk management techniques; differential growth outlook between emerging vs. developed markets (implying a staged increase in allocation to the emerging economies); vigilance with respect to regulatory developments; rising correlations among risky assets; the use of currency as a hedge or as a tactical opportunity; the importance of ‘patient capital’, both for investment returns and a source of family legacy.
*For further reading on why financial crises cause such protacted downturns, see Kenneth Rogoff and Carmen Reinhart's This Time Is Different: Eight Centuries of Financial Folly