Global Tactical and Strategic Asset Allocation and investment strategy/risk management consulting for asset owners and their advisor as an Integrated Investment Strategist -- chaired Investment Committees since 1997, 30 years experience
That Sneaky Second Derivative
Investment Outlook – 1Q/2017
• Inevitable breakdown of spurious or transitory relationships are often cathartic and unpredictable. Valuation may not be sufficient in the short-run or by itself, but contributes to tactical asset allocation in a multifactor context. Valuations eventually normalize to equilibrium (mean reversion). Our focus is on anticipating inflection points and That Sneaky Second Derivative also known as acceleration.
• Effects due to a shifting balance-of-power usually lag, but the economic consequences of this election are likely to be more immediate. Executive and Legislative political alignment is unusual, but can result in significant changes more quickly. Economic impact should be transformative and constructive for potential growth, productivity, competitiveness, fiscal balance, and exports.
• Shifting investment risks are increasing uncertainty. Anticipating fundamental changes requires adapting return forecasting, risk management, and many assumptions. Strategies that worked well when yields fell may disappoint as interest rates rise. Our warnings about evolving market risk and correlation between asset classes now appear perceptive, but there is still confusion about what to do. Many strategists still underappreciate interest rate sensitivity, currency risk, and secular change.
• Global interest rates are rising, led by U.S. rate hikes. International bond yields may not rise as fast, but they will rise too. Investors should be vigilant about interest rate sensitivity, even within private market and equity portfolios. Emergency monetary policy is no longer needed, so the consequences of monetary normalization are significant, including winding down bond holdings. Changing Federal Reserve policies have global effect, but also will be under new management within a year.
• Years of manipulating market interest rates have created imbalances, and we believe bonds are most at risk. Global bond valuations are stretched, and a Great Inflection Point is evident with rising bond yields. A three decade long bond bull market led investors to adopt unrealistic bond market risk and correlation measures. Rising interest rates will affect equity valuations, but global equity indices are not extended particularly relative to bonds. Fundamental economic expectations have improved, which justify recent re-rating of stocks and bonds.
• Economic divergences should continue to increase. Volatility and correlation are evolving, thus more uncertain. Bond and currency volatility have increased, but equity volatility declined dramatically in 2016, although many expected it to increase. S&P 500 volatility should average 10-12% and we continue to expect greater variance-of-volatility. International diversification should also increase.
• Exponential innovation is driving a manufacturing renaissance and new industrial revolution. Adaptive systems leveraging machine learning and additive manufacturing to ubiquitous sensors and Internet of Things are bolstering productivity beyond measure. Labor and energy intensity have collapsed.
• Expecting higher global bond or currency volatility should be intuitive, but we have also suggested that higher variance-of-volatility is more appropriate for global equities, rather than simply higher volatility. Average volatility fell further during Q4, but equity variance-of-volatility has risen. That Sneaky Second Derivative is important for risk measures too.
• Active management can be a novel alternative investment providing greater liquidity, holdings transparency, and diversification at lower cost. Ability to add value is a scarce resource. Various misconceptions can persist for extended periods, and may result in decisions that yield inferior portfolio performance. An overload of information may blind us with too much data, so we seek to filter the noise and highlight what matters most.
• Corporate and individual tax reforms, combined with targeted deregulation, are among the top priorities of Congress and the new Administration. Rolling back Executive Orders will have an impact, but legislative policy changes take time, and effects usually lag significantly. However, we expect economic effects of policy changes will be more immediately evident. While details are yet to be determined, policy direction is clear. Alignment of political control can result in the greatest changes in the least time.
• Greater infrastructure investment is likely, but we believe how it could be financed is misunderstood. Should heavily indebted governments borrow to fund infrastructure spending or let eager investors finance investment opportunities? Financing of infrastructure through private investors can increase investment capacity at lower taxpayer cost, and generally increases operating efficiency of managing such assets. We can’t spend our way into enhanced productivity any more than we can tax an indebted society into prosperity.
© Strategic Frontier Management (www.StrategicCAPM.com). 2017. All rights reserved.
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