Monday, 28 July 2014
Last updated 7 hours ago
Feb 7 2013 | 6:19am ET
By Anne-Gaelle Pouille, Director, PAAMCO -- Investors had plenty to be anxious about in 2012. Political, fiscal and societal fractures endangered some of the best thought-out investment theses. Many world economies exhibited tepid growth at best. To counter this, central banks provided intravenous support in the form of purchase programs and monetary and fiscal interventions, resulting in lower risk premia. Ultra-low-yielding U.S. Treasuries and high grade bonds made it challenging to reach return targets, particularly after the cost of any tail-hedging programs. In our view, this environment is likely to persist into 2013 because, fundamentally, little has changed.
Risk Premia: Likely to Continue to be Compressed
This risk premia compression has pushed many investors into less familiar waters in an attempt to reach yield targets. Asset prices were bid up by some bulls, but also by more than a few “bears in bull suits.”
In our view, this “surrender to yield” accelerated in 2012. This acceleration, as opposed to improving fundamentals, is likely the main driver behind solid asset returns in 2012 (in contrast to 2011 when this surrender had not fully happened, and many major investable equity and credit markets were down to slightly up). In equities, the S&P500, Eurostoxx50 and Asia ex-Japan indices gained 16%, 18% and 16%, respectively in 2012, while high yield was up 15% and bank loans were up 9%. The trend towards more aggressive financing at historically cheap rates continued (and was not always supported by stronger balance sheets) with record high yield issuance and the return of CLOs. Clearly these investment trends could end badly. How then should investors deal with higher swells without capsizing?
Expectations for 2013
REITs, high yield, bank loans, RMBS and some equities are examples of assets that may have overheated under these pressures. For example, unlevered cash yields on US RMBS last year were in the 8-12% range, versus 4-8% expected in 2013. Avoiding “overstretching for yield” involves finding situations in which short-term dislocations may be taking place, investor bimodal risk appetite has caused mispricings, and/or complexity or liquidity premia exist.
Equities present a mixed outlook with an alpha tailwind of increased dispersion counterbalanced by the certainty that any global monetary and/or fiscal policy shocks will drive equity risk premia. In developed markets, we therefore believe that limiting equity market beta and focusing instead on long/short idiosyncratic exposures and trading skill makes sense. Japan is interesting on a hedged basis given the recent election and the stimulus package announced on January 11, 2013. In emerging equities, several markets have reflected what appear to be overly pessimistic scenarios based on inflation concerns and slowing growth. We are constructive on the BRICs (particularly China) over the next 3-6 months. Given expected volatility, corporate hard events are helpful (bringing decorrelation from markets). This thesis is further supported by well-documented high cash balances on corporate balance sheets. Merger arbitrage spread trading (taking advantage of macro fears to time entry into spreads) may continue to be profitable as was the case in 2012. We also expect that as the need for yield continues, capital structure changes to fulfill that need will provide alpha opportunities.
In credit, we think idiosyncratic long/short situations with short to medium-term (3-12 months) catalysts are currently attractive. US corporate default levels remain muted (sub 3%) and while we do not expect a substantial pickup in default opportunities in the short term, existing liquidations should continue to be profitable. In Europe, we do expect an increase in the defaulted opportunity set by the second half of 2013. Structured products should be very interesting throughout 2013 given risk-adjusted yield properties. We believe the most attractive opportunities are less the popular 2012 RMBS exposures but rather other ABS types, such as structured bank loan exposure, on the basis that CLO spreads are attractive versus those of the underlying loans and high yield bonds. Finally, we tend to agree with the widely held view that investment grade is unexciting and high yield looks expensive. It is possible that 2013 may signal a return of the directional credit short, depending on the technical strength of inflows. Equally, though, one should be cognizant of credit spreads’ ability to plateau for extended periods of time.
The fixed income opportunity set has been limited by low interest rate volatility in recent months as well as unpredictable policy effectiveness. “Crowdedness” has also hurt relative value trades. As we enter 2013, we would expect these exposures to remain relatively unattractive, but they may come back if used as a hedge or if trade asymmetry improves.
Volatility and Commodities
Spikes in volatility are expected in 2013 given persistent structural and other uncertainties as well as exaggerated greed/fear cycles. We expect these uncertainties to introduce both arbitrage and directional opportunities in volatility. Equity market neutral strategies are expected to continue performing well particularly for diversified portfolios (by factor and geography). Despite recent lower volatility, government and central bank actions are expected to provide interest rate and equity opportunities, such as the recent S&P500 one-month skew collapse to one-year lows as we entered 2013. In convertibles, the outright rally in 2012 would bias us even more towards relative value and volatility arbitrage for 2013. Finally, in commodities we continue to prefer fundamental opportunities, as opposed to trend-following strategies. There is also relative value in dislocations, such as those that occurred in 2012 after the US climate droughts and changes in technologies being used in the energy field.
Anne-Gaelle Pouille, CFA, CQF is a Portfolio Manager and a member of Pacific Alternative Asset Management's (PAAMCO’s) Portfolio Construction Group.
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