The first half of 2022 brought sustained losses for both stocks and bonds, an outcome not seen for more than 40 years. Near-term inflation forecasts were still being revised up, even as growth forecasts were steadily revised down. Economists are divided on the appropriate policy response, and central banks face tougher choices than they have for decades.
Have prospects improved for stocks and bonds?
Stock and bond markets are both cheaper now than they were when the year began. But how much cheaper? Not much. A portion of the last few decades’ stock and bond returns were ‘borrowed from the future’ in the form of falling yields, in other words, rising valuations. As of the 3rd quarter, those borrowed returns are not even close to being fully paid back. Much more cheapening of stock and bond markets would be needed for yield-based expected returns to regain historical average levels.
The macroeconomic environment remains unfavorable for traditional portfolios with heightened risks from continuing inflation uncertainty, growth headwinds and tightening monetary policy.
Are macroeconomic headwinds easing?
Macroeconomic storm clouds are still gathering. Even if the level of inflation has peaked in some markets, there’s still room for upside surprises if inflation remains high for longer than the market expects. And if there is a recession, central banks won’t be able to ride to the rescue as they have in the past. Finally, we show that periods of monetary policy tightening have been challenging for both stocks and bonds.
Investors have flocked to private assets in recent years, seeking higher returns and diversification, but many of the headwinds faced by public assets apply also to their private counterparts, albeit with some smoothing due to private investments being infrequently marked to market. The key tail risk for private assets is a sustained period of low growth and poor market performance, where smoothing does not help and underlying economic exposures (‘slow beta’) materialize. For investors with substantial allocations to private assets, the most valuable diversifier is a strategy expected to outperform specifically during these prolonged bear market scenarios.
How might investors mitigate tail risk associated with private assets?
If there is a prolonged bear market, there is nowhere to hide… Even for privates. How can investors mitigate this tail risk associated with their large private allocations? Trend following. A prolonged bear market is just another way of saying a sustained, downward trend… Which a trend following strategy is designed to profit from.
The formidable headwinds for traditional assets – low expected returns and heightened macro risks – may tip the balance in favor of a liquid alternatives allocation.
How should investors seeking true diversifiers navigate the complex world of liquid alternatives?
The right liquid alternative for you will depend on your objectives. In the case of inflation protection, you are going to want to have a larger allocation to trend and macro and commodities. If you are more interested in recession protection, trend and macro will still be beneficial to overweight, but you’re also going to want to have more market neutral multi-Strat and alternative risk premia strategies.
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