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      ROBUSTNESS, FLEXIBILITY AND OPPORTUNISM IN LATE‐CYCLE INVESTING

      Re-Assess Strategic Asset Allocation


      The fundamental late-cycle investing challenge is to maintain exposure to growth potential without losing control of overall portfolio risk. Using equity rallies to rotate into government bonds, which have tended to enter the late stage of a cycle with high yields, is unlikely to work this time around.

      Low bond yields require investors to re-think diversification

      A decade of central bank intervention and concerns about long-term growth and inflation have left government bond yields low or even negative. That exacerbates the common late-cycle challenge of rising stock-bond correlation and leaves the more cautious investor with no obvious place to go when they underweight their equity allocation. In any case, the prospect of a longer-but-shallower downturn questions the very idea of adopting a meaningfully defensive stance.


      When it is not clear whether investors should be overweight or underweight equities, credit or government bonds, the obvious conclusion is that they should try to maintain genuine balance and diversification—which means a thorough re-assessment of how diversification is achieved in strategic asset allocation.

      Diversifying genuinely, not cosmetically

      Perhaps the two most important things to remember when it comes to portfolio diversification is that the traditional “balanced” 60/40 allocation is not genuinely diversified and that allocations drift with movements in markets.


      The first step in diversifying genuinely rather than cosmetically is to ensure that a portfolio is not dominated by equity risk. Turning to government bonds for ballast is not as simple as it has been in most previous cycles, however. While rising interest rates and bond yields are not in themselves enough to impose losses on bondholders, the second step in diversifying genuinely is to think about the key risks facing bonds, and ways to mitigate them.


      The clearest risk is inflation. For structural reasons, we think the probability of lengthy periods of high inflation is low, but it is prudent to expect some rise in inflation during the mature part of a business cycle. Within bond markets, that suggests a case for Treasury Inflation Protected Securities (TIPS) and other inflation-linked bonds, as well as floating-rate securities such as carefully selected bank loans. Beyond bond markets, commodities have often performed well during inflation spikes and the later stages of the cycle, and publicly traded real estate securities offer an attractive mix of defensive growth, inflation-linked cash flows and real-asset exposure. Because inflation expectations are so muted, many of these markets remain attractively priced.


      Another way to maintain income in a portfolio while limiting sensitivity to rising rates is to take bond positions at the shorter end of the yield curve. Finally, while an allocation to liquid alternatives is perhaps the only non-problematic overweight to be carrying into the later stages of an investment cycle, this too requires careful consideration. We would favor paying special attention to “uncorrelated strategies” that derive substantially all their returns from market-agnostic trading strategies: these include equity market-neutral and statistical arbitrage, trend-following, macro, volatility and arbitrage strategies, as well as strategies exposed to non-financial risks, such as insurance-linked securities. Quantitative investment such as alternative risk premia strategies, which can be structured to be market-neutral or market-agnostic but are not generally categorized as hedge funds, also have a role to play here.

      Diversifying across regions and investment styles

      As more and more investor assets move to passive management in search of cost savings and governance simplicity, it is worth remembering the important role that active management—both within asset classes and in multi-asset mandates—has to play in the later stages of a cycle. This is partly about maintaining exposure to the value and liquidity premia that are increasingly left behind by the herding and momentum biases of passive investment, particularly as volatility rises. It is also about maintaining desired regional, sector and style exposures.


      For example, while we may speak of the late cycle dynamics of the global economy, the fact is that different regions appear to be at different points in their cycles—and China and other emerging markets are navigating their own mega-cycles of economic development and fiscal reform. In recent months that has been evident in numerous value opportunities.

      Within the U.S., where late-cycle characteristics are more evident, we would broadly favor a tilt toward larger, more liquid stocks, and higher quality businesses with lower balance-sheet leverage, more visible earnings, higher free cash flow and lower beta to the broad equity market. A tilt to quality, while taking care to avoid excessive valuation multiples, could help to dampen downside volatility, mitigate the impact of multiple compression as earnings growth begins to deteriorate, and impose discipline during a stage in the cycle when bubbles tend to inflate to their limits. This discipline may turn out to be very important in this cycle: the main risks that we identify are near-term, and should they fail to materialize it is difficult to discern a catalyst for recession in 2020 or even 2021—potentially setting the scene for a sentiment-driven rally that runs ahead of the reality of corporate earnings.


      Investors should also consider regional cyclical differentials when allocating domestically: in the U.S., for example, our central scenario of a soft landing for the U.S. economy, engineered by a more accommodative Federal reserve, and a gradual recovery in the rest of the world, powered by stimulus out of China, makes a case for companies with high foreign sales and high non-U.S. dollar revenues.

      Diversify onto less crowded paths

      When valuations look stretched in many traditional markets, it can pay to seek out new or niche markets and strategies that are less crowded.


      Some of these can be found in the hedge fund and uncorrelated-strategy worlds: insurance-linked securities are a good example of a market that moves according to its own cycle of reinsurance supply and demand, itself driven by the incidence of natural catastrophes rather than the ebbing and flowing of corporate and consumer balance sheets.


      In private markets, while leverage and valuations in traditional U.S. buyout are still lower than we see in public markets, they are nonetheless touching all-time highs. Buyout certainly brings its own diversification benefits, such as greater exposure to operational improvements in businesses and innovative products, as well as lower mark-to-market volatility and an illiquidity premium. It also delivers cyclical diversification: some of the best returns to buyout funds have come from vintages raised when public markets were at their peak, because those commitments were put to work during the ensuing downturn. Nonetheless, further diversification is possible, not only by allocating to venture and growth-capital funds, or to the less-exuberant European buyout markets, but also by exploring idiosyncratic opportunities via co-investment and secondaries (which often come with more favorable fee structures), and by investing in cash flow-generative niches such as private debt, trademarks or royalty streams. Private markets allocations can also be a good way to underwrite particular investment themes through a cycle, and investment themes that are independent of the cycle.


      Other less crowded paths include alternative ways of extracting returns from traditional asset classes. Alternative risk premia strategies are the obvious examples, but they would also include the writing of collateralized equity index put options. Over time, a “PutWrite” strategy can be shown to have delivered similar returns to its underlying equity market with around two-thirds of the volatility. Late in the cycle many investors are likely to tilt their equity allocation toward more defensive, income-generating stocks—but in an environment of low and rising bond yields there may be less appetite for the marginal interest-rate risk that entails: PutWrite is one way to add lower-volatility equity exposure without adding to interest-rate risk.


      Finally, there are examples of entirely new asset classes. Still a largely European phenomenon, hybrids are very long-dated but callable subordinated bonds, whose coupon payments can be deferred just like dividend payments, which are mostly issued by large, high-quality telecom and utility companies. Hybrids have typically offered four to five times the spread of the same issuer’s senior bonds: as the cycle matures and low-quality balance sheets deteriorate, picking up extra spread by moving down the capital structure of a high-quality issuer may be less risky than chasing yield from lesser-quality issuers.

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      LATE-CYCLE INVESTING
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