It is not unusual for us to note the Knightian uncertainty that lies ahead of us (the unknown unknowns) and question the nth-decimal-place accuracy of VaR-based risk budgeting when the next long-only strategist suggests 90% allocation to high-dividend-US-Equities. In a quick and thought-provoking Q&A from the Swiss Private Bank Pictet, they see the world in a similarly non-normal manner and focus in one case on the growing tension that globalization has created between winners and losers. As the crisis of confidence spreads from asset class to asset class and from sovereign to financial entity to macro-economy and back in its viciously circular manner, the realization that forecasts are useless when judged in the linear normal bias that investors have carried with them for decades, must bias current and future investment decisions to more asymmetric or 'hedged' perspectives. With the veil of financial complexity (and implicit opacity) being taken down brick-by-brick (by us as well as many others), we suspect the credit creation process and project-financing in general will shift from a game-theoretically optimal 'one-in-all-in', to a more nuanced 'if-you-don't-know-who-the-sucker-is-at-the-table-it's-you!' view of investing - especially given the balance between indefinitely long low real rates and the insatiable need for yield - leaving the cost of funding indefinitely floored at a much higher premium than in the past.
Q: How do you see the next decade in global financial markets?
Globalisation has created a tension between winners and losers. When the winners are succeeding, there is fast growth; when the losers drag the global economy down, we have low growth or recession. It is worth remembering that in the last ten years we have had six years of the highest growth rate in human history, especially between 2003 and 2008.
When 2.5 billion people emerge from the deep ditch they dug for themselves 300 years ago, this has to be a positive process and there are ample opportunities.
But this is a Ricardian process where there are winners and losers: the winners are the ones located in the intersection of the Ricardian exchange where they enjoy the benefits of cheap labour, cheap capital, cheap commodities, technology and organisation. The losers are not confined to the developed world, but certainly include labour facing wage competition and long-term savers facing depressed interest rates and elevated liabilities in the developed world. This tension is creating an intensely binary outcome world with bimodal returns across risk assets.
However, by the end of the decade, we will be likely to be living in a very different world — one where engineering growth through low exchange rates and low interest rates in countries like China is no longer possible because they run into severe raw-material shortages; elementary things like water, food, energy. This would be a situation analogous to the one in the late 1960s when Europe and Japan ran out of surplus labour. We will then be heading into an era of lower real growth globally, in which emerging-market exchange rates are rapidly appreciating. And although my primary fear today is of the risk of deflation or at least disinflation, I fear that by 2020 the risk will be one of inflation in the developed markets as the appreciation of emerging-market currencies exports inflation to the West.
Q: How do you hedge your portfolios?
The world has become very unstable in GDP terms and much more unstable in earnings terms. Where there’s a good outcome, profits are extraordinary and so, therefore, are returns on equities and high yield debt. When the economy sinks, profits collapse, equities collapse, high-yield collapses — risk assets collapse. This produces bimodal distributions of return outcomes.
The most powerful defence against disaster in a portfolio is to invest in assets that because of the environment or a valuation that is depressed or elevated present asymmetric pay-offs. Interesting long positions lie in assets where if bad things happen, their valuation goes down only so much, but if good things happen, it goes up a lot. An asset that goes up very little if good things happen but collapses if bad things happen is an interesting short. I combine these to produce an efficient asymmetric-type portfolio with a smile. I layer onto this option strategies, often short-dated, that take advantage of opportunities where this asymmetry, or bimodality, is inappropriately priced in volatility markets.
While the suggestions may be broadly unsatisfying in their non-specificity (and obviousness), the perspective is absolutely correct and investment managers should spend their time in search of these asymmetric assets as opposed to riding the next 10-minute trend. While mandates may limit the ability to take advantage of the asymmetries for some, arrogantly sticking to decades-old investing approaches and crowding into and rushing out of the trade-du-jour seems short-sighted even when pitched as for-the-long-run. Our 'gift' yesterday suggests maybe the simplest asymmetric assets are staring investors in the face, no matter how much it hurts to admit it.