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As late cycle challenges arise, how can investors continue to build discipline in alternative portfolio construction?


/ 22:30
David Lebovitz , Pulkit Sharma

Alternatives outlook: A macro view and late-cycle asset allocation considerations

As growth slows and risks rise, should investors expect the unexpected in this late cycle environment? Join us as David Lebovitz and Pulkit Sharma explore a strategic framework for alternative asset allocation with insights on portfolio solutions for today’s market environment.  

 

TRANSCRIPT

Chris Hayward:  Welcome to the Center for Investment Excellence.

David Lebovitz:   Thanks for having us.

Pulkit Sharma:    Happy to be here!

Chris:  In a year of transition and change, we wanted to help our clients navigate market adjustments to a variety of things, including global quantitative tightening, volatile equity markets and a long in the tooth economic expansion.

This backdrop in this changing investment landscape has given rise to a new publication at JPMorgan: The Global Alternatives Outlook.  With nearly 50 years of experience investing in alternatives and more than 800 alternative professionals around the globe, we are one of the leading industry lineups for alternative investment strategy and we're excited about this new alternatives outlook.

Today I had the pleasure of discussing our alternatives outlook with two of my finest colleagues, David and Pulkit.  So let’s jump in and get into the investment strategy discussion.

David, while we acknowledge that the U.S. economy is late in the cycle, we believe that both the economic and markets outlook have room to run.  Can you talk a little bit about the growth outlook from here?

David: Absolutely.  It’s been an interesting couple of years in the global economy. I think back to 2017, which was a year of broad-based synchronized global economic expansion. We then, moved on to 2018 where we saw a much more bifurcation in terms of where the growth was coming from in the global economy.

Last year, you saw that element of U.S. exceptionalism with fiscal stimulus and tax reform really providing a boost to growth rates here in the United States.  But at the same time, you saw the rest of the world kind of struggle and the rest of the world struggled for a number of different reasons.

In Europe, you saw some drags from the manufacturing sector.  Those were primarily related to new emissions equipment being installed in the auto sectors and issues moving chemicals and pharmaceuticals around the Eurozone broadly due to actually lower levels of rivers of all things. 

So you saw this one-off kind of idiosyncratic drags materialize across the European economy – but at the same time, the consumer looked relatively healthy.  So we think that those types of drags are going to fade.

Thinking about Japan, obviously hit by a series of national disasters, and expecting some rebound from that as well.  2019 to us really looks to be a year of global resynchronization with respect to growth, but resynchronization at a slightly lower level than was the case in 2017.

Now, some people have called this a bad resynchronization.  I'm not sure that we should label it good or bad.  I think what investors need to be cognizant of is that as the growth differential between the U.S. and the rest of the world continues to narrow, in theory, that could take some of the wind out of the sales of the U.S. dollar, opening or release volatility for the emerging market economies and helping them grow a little better in 2019 than they have over the past couple of years.

So it's very much a glass half-full view.  We recognize the risks that stem from lack of resolution on trade with China, that stem from the ongoing government shutdown.  We're temporarily open.  Will we be still open a week from now?  That’s anybody’s best guess.

You know, there are kind of still some things that we're monitoring which could impact the pace of global expansion this year.  But, generally, we are looking for that resynchronization and global growth of somewhere between 2.5% and 3% for the year as a whole.

Chris: Very good insights.  With that economic background, let’s turn particularly to two areas that we get a lot of questions on, inflation and interest rates.  What's your take on them going forward?

David: So with respect to inflation, We saw inflation heating up over the first three quarters of 2018.  But in the fourth quarter of last year, given a slowdown in the pace of economic growth, given a pretty sharp decline in food and energy crisis, you actually saw inflation cool off relative to where it was at the end of the third quarter.

Now, we don't expect inflation to be terribly problematic this year.  In the U.S., we tend to focus on the personal consumption deflator, PCE, that’s what the Fed also looks at when gauging levels of inflation.  We actually think that due to slightly slower economic growth in the U.S. this year, as fiscal stimulus works its way through the system, coupled with lower commodity prices, should people lead on headline inflation?

We actually see headline PCE dipping down to around 1.5% by the middle of this year, before we're accelerating to around 2% at the end of the end of the year.  And so, you know, I think we'll talk more about monetary policy here in just a few minutes.

But with respect to the direct implications of this growth outlook and this inflation outlook for the Federal Reserve and monetary policy, these lower levels of inflation should give the Fed some additional cover if they choose to remain on the sidelines with respect to interest rates going forward.

So not looking for inflation to be terribly problematic, we think that the core inflation figures, which exclude food and energy, will remain relatively stable.  Again, but with the Fed focused on the headline measure and that headline measure is expected to soften over the first half of this year, we don't really expect any significant hawkish shifts in monetary policy nor do we expect runaway inflation that ends up negatively impacting consumer purchasing power.

Chris: So you mentioned the Fed and the central banks, and so as we look at what the ECB, the European Central Bank, and what the Federal Reserve have been doing in terms of slowing their classic quantitative easing stance as they pull back and we've already started to see the emergence of a quantitative tightening environment, what is the stand of those central banks going forward and how do you think about impact on things like rates and inflation as you were discussing?

David: So it's interesting, when we penned the outlook a few months ago, I think expectations for the Fed and central banks broadly were somewhat different than they are at the current juncture

Our view going into the end of the year was that the Fed would probably hike rates a couple of times this year.  They would continue to allow the balance sheet to run down.  In a world of stable and moderate economic growth, perhaps we would see a technical hike from the ECB to bring rates back to zero and we were looking for, you know, one, maybe two hikes out of the Bank of England over the course of 2019.

Given all the volatility that we saw in markets late last year, you know, the Fed has really led the charge and come out to say, “Look, you know, we're not as rushed when it comes to the normalization of monetary policy as perhaps we were suggesting at the end of 2018.”

So the Fed seemed to have sent a signal that at least for the short-term, they're going to be sitting on the sidelines.  I think that there are two potential outcomes for the Fed this year.  I think that they will either hike twice, which is in line with their current forecast, or they're not going to hike at all.

For people who say we're going to see one hike from the Fed this year, I just find that as literally being a simple average of the two outcomes that I see materializing.  I think either growth is going to be moderate; inflation is going to continue to grind higher into the end of the year.  Financial markets are going to be well behaved.  Perhaps we see some resolution on trade.  And in that type of world, the Fed is going to want to hike rates.

But if we see financial markets remain volatile, if we see economic growth cool faster than what we're expecting, perhaps further deterioration in terms of trade relations with China, I think that will firmly keep the Fed on the sidelines.  And I furthermore expect that other central banks around the world will take their cues from how the Fed behaves this year.

So a little bit of haze covering the water as we try to look through the other side of the pond, but still expecting that the path of least resistance for long-term interest rates which have come back down and kind of failed to move higher as equity markets have begun acting a little bit better here. I do see room for long rates to grind back towards 3% on the 10-year even if the Fed is on the sidelines with respect to the policy rate on the short end of the curve.

Chris: All right, terrific.  So let’s take that great background around economics and markets and pivot over to think about investment solutions.  So let’s ask Pulkit, what are your thoughts when people are thinking about navigating this environment that David just succinctly put through to all of our community out here?

How do people invest?  How do they think about portfolio construction?  How do they think about frameworks for assembling investment opportunities and what are your thoughts in that arena?

Pulkit: Absolutely.  What we see, first of all, for many of the challenges that David had lain earlier is that alternatives allocations are rising across the board, and there are several reasons and several pain points and I'll highlight a few which we see - which we hear a lot from clients.

The first one being, you know, the monetary policy and several years of monetary easing, and we expect the output of that is rising rates.  And as David said, inflation is lurking somewhere there in the horizon.

Volatility also is a big factor for rising alternatives allocations.  We are - and so the end of a 10-year Bull Run, economic cycle expansion and economic cycle volatility, actually, we saw a 100-year low in volatility in 2017, 2018, except the fourth quarter.  And then you know, as David said, growth has been moderating.

If you look at the long-term capital market assumptions, the 60-40 portfolio on the next 10, 15 years probably delivers 5.5% total return.  But those are return gaps for most investors around the world, and alternatives will come to the rescue in terms of fulfilling that return gap and helping investors achieve their return objectives; but more importantly, also give better income and lower volatility.

So that’s the fundamental reason why we see rising allocations.  But then there is also the idea of understanding what you own in the alternatives space.  It's also the concept of how do you shape the portfolio to where you are in the economic cycle.

And for that, we view that we have to look at framework-given approach to organize alternatives categories in regards to what they do for investor portfolios.  Because allocations are rising, if the allocations are 1%, 2%, 5%, the concept of using the best idea of mindset which is, “Do I like this particular strategy at this particular point?” and that makes sense.  But at 10%, 15%, 20%, 25% alt allocations, it make sense to have a proper framework.

So what we have done is divided the alternatives world into three simple buckets according to what they do.  The first, the modern building block is what we call the growth foundation, so think of core real assets, think of core credit.  Most of returns comes from income and they are mostly stable - generates stable outcomes.

Then the second layer is what we call core complement.  The classical category there is hedge fund, and then return enhancers which do just that, so think of distress credit or private equity.

There are two key tenets which are really important for alternative asset allocation.  The first one is right-size the mix of these asset classes in the portfolio, how much will be in real assets or spread equity versus hedge funds.

And the other one which is equally or maybe more important is to right-size risk, which is to right-size the combination of the core and the core complements versus the return enhancers.  And that’s really more important in late cycle, where our view was that those core foundation categories should be overweight.

And then just giving you a little flavor on what I mean by these asset classes, so talking about the core foundation, think of essential hard assets which are building blocks of productive societies, office, industrial, retail, multifamily assets in great quality locations with long term leases; think of infrastructure assets, renewal and solar; think of utilities which are essential assets; think of bank bond assets, transportation, energy, logistics, aircrafts.  These are all essential assets which generate solid source of income.

In general, 70% to 80% of the total returns from these types of assets come from income, but they are local in nature so they're non-correlated stocks and bonds.

Another core foundation category is called private credit, so think of the residential sector or the consumer sector and then market direct lending.  The majority of the return in this segment also comes from income.  So that’s a pretty solid growth foundation.

What doesn’t make sense in this segment as far as the alternatives is to go with categories where the majority of the return comes from leverage or multiple expansions especially in the late cycle environment.

In the core complement category where, you know, we talked about hedge fund, there been a period of low volatility that has impacted their performance.  But what we are seeing is a pick-up in volatility.  So think of strategies which really take advantage of price dislocation, so long/short strategies which are market neutral; but take advantage of either rising rates or high volatility, so relative value strategies.

And also with the proliferation of beta quantitative strategies, our all-low beta can be really powerful tool especially in the late cycle environment.  And finally, the return-enhancing category which we talked, so private credit or private equity have seen a lot of capital flowing into that direction over the last two years, a $1 trillion in the private equity space.  So discipline is very important there.

Financial engineering is sort of an underweight.  We think operational improvements were very selective in the credit space and we need to be prepared corporate stress in the credit space as key tenets.

So remember four key items in terms of where we are in the late environment:  It would be strategies in which the majority of the return come from income and growth of income probably in multiple expansion which are - the strategies which are lowly levered rather than highly levered, where the alpha comes from operational improvement rather than financial engineering.

And with the late cycle environment, there is typically more dispersion, so manager selection also becomes a key element.

Chris: Fantastic.  There's a lot of good content and there’s very creative ideas about how to think alternative investing especially given this market in an environment that David highlighted earlier for us.

And so there're a lot of private vehicles that manifest themselves and the expression of individual private investments associated with what you highlighted.  What are some other advantages to private investment vehicles in the alternative space?  And as I deliver against your framework, again solutions for investing in this environment, what are those advantages?

Pulkit: Yes, there are some structure advantages which private investments have unlike the public markets.  One of them is a structural control premium, so think of infrastructure, think of private equity.  There is a control premium which does exist in the public markets.

There's also the idea of an information advantage because whether public market or private markets, there is not enough data and you can actually create an alpha just from having the special information advantage that they've been giving these investments.

And then real estate, for example, is structurally local and heterogeneous.  So these are structural attributes which are unique to private markets, where that translates into - it's not only a return premium, but also volatility dampening effect.  So it's just not volatile return, but risk-adjusted return.

And we encourage the investors to evaluate private investments from a variety of lenses especially as it relates to risk.  They should again look at their portfolio and evaluate the value proposition of private investments from a volatility dampening, income enhancement perspective, from a beta dampening perspective especially in an environment that many plans are thinking of de-risking their portfolios, and also inflation premium perspective which can all be evaluated from private investments.

Of course, the benefits come with certain risks.  So operational challenges, execution challenges, manager selection, managing the liquidity are all key tenets which have to be evaluated and solved for.

What we have found is that a 20% allocation to alternatives can actually move the needle from not only enhancing the return and income outcomes, but also dampen the volatility, dampen the beta and enhancing the inflation sensitivity.  And not only enhance allocation to alternative is important, it's also the diversified allocation to alternative is important.  And it should also be not only diversified, but diversifying in the context of the overall portfolio.

So our view is that the complexity of alternative invest can be simplified by looking at it from a framework lens, looking at what these investments do for the invested portfolio, applying the principles of more science and less art in building that resilient portfolio especially in this challenging environment.

Chris: Fantastic! A lot of good advice there. Let me take a moment to thank you both David and Pulkit. And thank you all of you for joining us for the Center for Investment Excellence.

David: Thanks for having us!

Pulkit: Thank you.

Today’s episode is alternatives outlook, a macro view and asset allocations considerations, and has been recorded for institutional and professional investors.

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