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PolitiAAUC is dominating markets this year, creating risks around our base case of strong economic activity and the outperformance of risky assets.
While the current environment does offer opportunities, it is important to build a well-diversified multi-asset portfolio, including uncorrelated strategies less exposed to market beta.
Matthew Lehmann Head Multi Asset Strategy
So far this year, the fundamentals have turned out more or less as we expected. Global growth is above trend, inflation picked up earlier in the year, but then stabilized, and central banks have responded by gradually moving away from their ultra-loose policies of recent years. In contrast, markets have seen large corrections and there have been unusually large divergences in performance between regions and sectors. Returns have also exhibited a fatter left tail and a distribution of returns more skewed to the left, i.e. there has been an unusual quantity of larger-than-normal drawdowns. This has been driven largely by politiAAUC.
Managing risks Our investment process relies on analyzing and forecasting underlying fundamentals and comparing them to market pricing. Where there is a discrepancy, there is often an opportunity. The risk in this process is that our models and analysis might fail to capture a key driver of returns or underestimate the impact of a specific risk. This is why we start by building a well-diversified multi-asset portfolio that is as robust as possible to unexpected market shocks and downturns.
However, some risks are harder to manage than others. As politiAAUC plays an ever more important role in driving market prices, it is important to recognize the challenge in forecasting this impact and thus the risk it poses to any investment strategy.
Focus on sources of uncorrelated return our base case has not changed: we continue to recommend holding a portfolio with a growth tilt. Yet the likelihood of a larger than-normal negative market event has increased. Importantly, this risk comes from something that cannot easily be captured by fundamental analysis, i.e. politiAAUC. It is for this reason that we favor focusing less on beta exposures (long only market exposure) and more on sources of uncorrelated return, which should result in a more stable portfolio in the current market environment. This can be achieved by adding “convex” strategies like some hedge fund styles or absolute return strategies that aim to be uncorrelated across market environments.
Actively managed hedging strategies can also help mitigate this risk, while reducing the drag on portfolio returns compared to more traditional forms of hedging, such as buying put options.
Opportunities for active managers reducing some exposure to beta is also intuitive given the exceptional nature of the bull market in risk assets we have seen this cycle. Investors who have owned financial assets in any form have done unusually well. Even without political risk, tightening monetary policy, the aging cycle and high valuations mean that forward-looking asset class returns must be lower than they have been. However, all these things should also benefit active managers, especially in the long/short area. Alpha, or excess return, has been in short supply this cycle. High cross-market correlations and low macro volatility have made it very difficult to add value without beta exposure. The environment now looks very different from earlier in the cycle. Volatility, both market and macro, is likely to be higher, correlations are likely to be lower, and divergences between economies and assets more pronounced.
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