Perilous markets make the case for absolute returns

By

05/12/2017

In a world of increased volatility and lower returns, absolute return strategies focused on capital preservation are more important than ever.

 That is the firmly held view of Netwon Investment Management portfolio manager, real return, Aron Pataki, who argues local institutional investors need active, flexible approaches with “return-based” objectives in the face of increased volatility and lower returns.

Constrained economic growth that is heavily dependent on state support, combined with high asset valuations, underscore the need for strategies that focus on income, preserve capital and aim for asymmetry of return, Pataki told the 2017 Conexus Financial Absolute Returns Conference.

Pataki said the global economy faces some major structural headwinds and distortions. President Donald Trump’s America has languished at 4 per cent real GDP growth, despite promises of greater change, showing constraints on factor inputs are checking the preference for faster growth.

Central bank liquidity continues to flow, and the global economy remains heavily dependent on state support to fuel demand, Pataki said. Global central bank security purchases have remained at a similar level over the last decade, despite different banks playing the lead role at different times.

Credit-fuelled demand

 With the credit tap flowing, 2016 was “another vintage year for the increase in debt,” Pataki said. Total credit increased by 38 per cent of GDP in 2016, second only to 2009 at 40 per cent; the difference being that China was the marginal source of stimulus in 2016, adding US$4.2 trillion of new credit, compared with US$2 trillion in 2009.

At the end of 2017, global debt is now 40 per cent higher than it was in 2007, Pataki said, creating excess supply and intense competition in most parts of the economy.

A debt explosion in emerging markets, unprecedented credit growth in China, and other financial imbalances in key areas of the global economy are consistent with an elevated risk of financial stress, he said.

If markets turn illiquid, the increasing financialisation of investment in recent years could lead to narrow exit opportunities as investors charge for the gates, he explained.

With little change in the economic tools being used to support growth, it is hard to see normalisation in the global economy and continued weakness is likely. Unconventional strategies are needed, Pataki said.

Conservatism warranted

The choices for investors have narrowed. Capital gains have run ahead of earnings, with the MSCI World Index of equities rising steadily despite a constant Price-to-earnings (P/E) ratio since 2008.

Historically, buying at high P/E multiples has led to a higher probability of poor forward returns, Pataki said. The return for taking risks is low and there is an elevated probability of sharp drawdowns.

The current economic expansion since 2009 has been relatively long and profits have already peaked, suggesting the end of the cycle could be close. Caution is warranted.

Sound businesses are practising prudent capital allocation, reflecting a focus on capital preservation, Pataki said. Asset valuations warrant a conservative approach to risk.

While the decades between 1980 and the mid-2000s were characterised by relatively high returns and lower volatility, recent history shows greater volatility and lower returns have become a normal feature of the market. This calls for return-based objectives, strategies that preserve capital and an emphasis on income.

Newton Investment Management’s approach is to aim for 4 per cent above the LIBOR benchmark rate, with a mix of stabilising assets and hedging positions and a “return-seeking core” of assets such as infrastructure, emerging market debt, corporate debt, equities and renewables.

Conexus Financial is the publisher of Investment Magazine, top1000funds.com, and Professional Planner. For details on upcoming events visit conexusfinancial.com.au/events.