Global credit funds & CLO's
February 2020
| Issue 220
Published in London & New York.
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Opinion credit
Putri Pascualy
You need a balanced portfolio that’s ready for calculated risk taking — so consider a barbell approach
Senior credit strategist & PM
Paamco Prisma
February 2020
|
Issue 220
quotation mark
Investors can’t afford to be too conservative as they prepare for the end of the cycle
In 2019, the high yield market posted a return in excess of 14% and the S&P 500 registered 33.6%. The equity market has also started 2020 with a bang, as the S&P 500 climbed above 3,300 for the first time. This poses a dilemma for conservative investors who are waiting to pounce at the first sign of stress.
As valuation multiples stretch tighter, many investors are grappling with conflicting signals and pondering how to position their portfolios. Waiting for the ‘fat pitch’ is theoretically attractive, but holding too much cash can have significant opportunity (and career) costs. Even as the most risk-averse investors prepare for bearish scenarios, many of them will acknowledge that the timing of a dislocation is uncertain.

Furthermore, if an investor de-risks a portfolio too early, missing out on returns may force them to play catch-up. This could mean they have to re-enter the market at even higher valuations closer to the downturn.

The not-so-little secret is that buying opportunistically is an option only if one is not burdened by legacy deals. If an investor has entered into too many late-cycle bets when the dislocation finally comes (ironically because they’re having to play catch-up after de-risking too much, too soon), precious time and resources may need to be prioritised to rescue legacy assets rather than spent on buying opportunistic new deals.

With that in mind, the goal for many investors in 2020 is to create a balanced portfolio that’s poised towards calculated risk-taking. To do so, a barbell approach should be considered: part of the portfolio can be focused on risk-taking and the other on risk absorbers. The latter should have low to no beta to broad market risks, positive alpha, and low to moderate correlation to the risk-seeking sleeve of the portfolio.

The blend between the two strategies depends on the overall mandate. A family office with higher appetite for risk may have a 90/10 blend of risk-taking versus risk absorbers, while a fully-funded corporate pension wanting to minimise volatility may require a 50/50 split. When choosing the right mix for a particular situation, it may be helpful to analyse some potential events in 2020.
Second term for president Trump
Expect more stimulus and further deficit-funded tax cuts should the Republicans take congress. A second term would also open the possibility of a more dovish Fed chair in 2022.

As far as risk goes, the threat of a trade war with China remains, regardless of the positive tone of recent talks. Despite the recent agricultural deal, which has been followed by an increase in US soy exports to China, prices have not risen, reflecting a potential lack of economic impact.

Furthermore, a change in tenor regarding trade with China can happen at the drop of a hat. This may translate into higher uncertainty in business investments.
Brexit and the European malaise
The fundamentals in the UK have improved. Wage growth is off its recent highs, but remains elevated, which is positive for UK consumers.

In the EU, various indices that measure sentiment and expectation for German economic growth have shown significant improvement. The European Central Bank continues to be on an easing path, ready and willing to provide backstop support to the economy.

However, the potential downside surprise is the risk of a hard Brexit. Although the market is currently discounting an orderly separation from the EU, the risk of an unintentional free-fall exit remains high.
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Recession risk is muted
The Goldman Sachs US Financial Conditions index points to continued easing, a tailwind for economic growth. Retail sales are rising in the US. But manufacturing net new orders remain weak. With continued strength in consumer activity in the US and the UK, expected improvements in German economic growth, steady-as-she-goes growth in China and continued global easing, the risk of a 2020 recession is muted.

Investors are rightly concerned about macroeconomic risks on the horizon. Nevertheless, given the risk of being under-invested and having to catch up later, a thoughtfully positioned portfolio can prosper in multiple scenarios.
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