Wake Up: Active Management is Back

In financial markets it pays off to detect changing conditions early. Today, we discuss whether the current macro uncertainty and fragilities in market structure favour active management Across both realities one notices that the probability for skilled active managers to outperform has risen markedly. First, some context will be provided on how volatile macro indicators and market structure tensions interact across the fixed income and equity sectors. In the last couple of paragraphs, we will list the criteria that allow active managers to have a better set of cards in their hands than passive or ETF aficionados.

In early 2022, the episode of central bank large-scale asset purchase programs, or quantitative easing (QE), entered its 14th year. The first innings of a multiple-source inflation dynamic reared its ugly head. What followed was nothing less than a 14-month shock treatment, leading DM central banks to adjust policy rates aggressively. The treatment will kill off most inflationary drivers. Tight labour markets carry most of the uncertainty and might keep core inflation higher for longer. Yet, business cycle dynamics will eventually also bring core inflation towards target levels or lower. The second largest economy in the world, China, leads the way reflected by shallow deflationary consumer price inflation but deeply deflationary conditions for goods leaving producer factory gates (PPI). Granted, China’s economy remains predominantly export-driven, with services and service inflation not as prevalent and problematic compared to developed market economies.

Predicting various paths of key macroeconomic indicators from this point onwards is a precarious exercise. However, be aware – as often repeated – that policy rate instruments are blunt. We find ourselves in an investment environment that is characterised by a high propensity to witness tail-risk events.

Both realised and unrealised tail risk are on the rise.

The UK gilts government bond market turmoil fed by spiralling long-term interest rates, has destabilised pension funds as their applied liability-driven investment (LDI) framework nearly collapsed. An imbalance between synthetic receiver interest rate swap hedges, related automatic collateral calls as rates went up and illiquid ‘growth’ assets that could not be monetised, forced the hand of the Bank of England, which implemented a temporary dose of QE.

Over March, a first batch of US regional banks defaulted as mismatches between assets and liabilities were ‘too high for purpose’. As soon as depositors hit the online rewire button, victim banks were forced to sell ‘ held-to-maturity US Treasury bonds’ that were valued at a steep discount to par given higher rates. Effectively they had to lock in unrealised losses that were supposed never to materialise if ‘held-to-maturity’. Game over. The US counts a total of 4844 commercial and savings banks, a number that has been in decline over the past 40 years. Still, compared to Canada, counting a total of 80 banks (including foreign banks), the concentration is high. Per trillion of GDP, Canada has 40 banks, the US almost 250. With a FED still leaving the door open to new policy rate hikes, it’s not a question of if, but when the next wave of banking defaults will hit. The exposure to commercial real estate (CRE) for small banks with a balance sheet size below USD 100 billion sits at 14.4%…on average. If we apply FDIC concentration criteria, some 700 smaller banks are too heavily exposed to CRE. Remember that around USD 1.5 trillion of CRE requires refinancing before the end of 2025, creating an intimidating maturity wall. A total of USD 140 billion of commercial mortgage-backed securities (CMBS), or repackaged CRE, are due to mature in 2023. On balance CRE valuations have dropped by about 15%. Difficult to estimate, as demand-supply conditions are not in equilibrium and the buyers stand to win with time on their side.

Within frontier-market hard-currency government-bond markets, stress is spiking and a growing number of countries seek debt restructuring (e.g. Zambia, Ghana, Suriname, Argentina, …). Busy days for supranational institutions trying to solve (read: step-in) a funding drought as the international emerging market (EM) investor base exhibits a buyer-strike or deepens its underweight stance.

The next sector that exhibits froth is the leveraged loan market. The sector represents loans originating out of M&A, leveraged management buy-back operations, refinancing or dividend recap funding. The loan instruments are paying coupons based off floating short-term interest rates such as 3-month LIBOR or 3-month SOFR (Secured Overnight Financing Rate). From 2007 to 2022, the average default rate of the sector sat at a mere 2.4%. The US high-yield bond market printed around 2% over that period. Elevated tightening standards in the US Senior Loan Officer Survey point to increased default rates across US High yield and leveraged loan markets going as high as 8%+ and 10%+ respectively over 2024. Again, these are average numbers that mask high variability among sectors. The message is clear: avoiding losers when invested in such high risk/reward pockets of the market is essential. Indeed, with current yields at 8.75% for US high yield and 9.50% in US leveraged loans one can withstand some froth. However, you get the picture. Moving from a historical ultra-low default regime over the past 15 years towards a regime that sees a tripling of average default rates will require some good studying and astute credit analysis.

In a winner-takes-all fashion, companies directly and indirectly surfing on generative AI technology components and related services have been the main contributors to 2023 US equity performances. The comparison to the internet and telecom bubble that unravelled from 2000 till 2002 are not far away. History does not repeat but it does rhyme. The details are different, the fear-of-missing-out behaviour across market participants is visible.

 

Common sense has it that “The price is what you pay, value is what you get”.

 

The moment you pay too high a price for an, on all grounds, quality-defined asset, the future realised cash flows (i.e. return) might disappoint. The moment an investor buys an asset far above its intrinsic value, he locks in a subpar pay-out experience. Assessing fair value when innovative technology hits the marketplace, opens up to a high dispersion of outcomes. Outcomes that can surprise to the up as well as to the downside. Today, investors flock to global technology leaders, hoping to seek insurance against an upcoming growth deceleration. A small bunch of quality stocks act as if they were German 10-year bunds (i.e. safe-haven) assets. Safe-haven assets work as long as the music plays in their favour. The German Bund 0% February 2032, issued at the start of 2022, exhibits a negative performance of 18.7%. Last Friday, this risk-free zero c-upon bond priced at 82%, offered a 2.38% gross return till maturity.

Active investment management has several advantages within an environment that lacks momentum. Simple narratives like TINA (There Is No Alternative) or TARA (There Are Reasonable Alternatives) have little merit as the opportunity set across equity and fixed income markets has grown substantially over 2022 and 2023.

As long as one can count on a solid interbank network, inefficiencies in fixed income are abundant – given a steady flow of primary issues and thousands of secondary issues that can be bought and sold. With the participation of price unsensitive central banks retreating, price and value discovery can rely on fundamental research once again. Adding proper knowledge of index rules and reconstitution effects will enable the active manager to outperform.

Within equity markets, tracking and selecting from a pool of small or midcap stocks helps managers to steer away from nasty surprises caused by potentially-unhealthy concentrations of large-cap companies. Current concentration readings have reached 20-year highs. Applying active sector rotation and fundamental, ESG research to stock selection will allow the active and skilled equity manager to stage a comeback.

Central banks are preparing for a lengthy episode in the shadows. Idiosyncratic tail risks are on the rise. Each of these factors individually might not destabilise financial markets. It begs the question: what will occur when the dots connect as central banks, engaged in policy mistakes by overtightening, break the back of inflation and the economy? A risk-averse market place can ensue. What are the odds? Hard to say. What we do know is that active managers will have a greater opportunity to cope than passive or ETF solutions. The latter’s is forced to accept a market beta performance outcome. Alpha is the fruit of active managers that avoid losers and select attractive or fair value at the right price.

Disclaimer

Degroof Petercam Asset Management SA/NV (DPAM) l rue Guimard 18, 1040 Brussels, Belgium l RPM/RPR Brussels l TVA BE 0886 223 276 l

Marketing Communication. Investing incurs risks.

The views and opinions contained herein are those of the individuals to whom they are attributed and may not necessarily represent views expressed or reflected in other DPAM communications, strategies or funds.

The provided information herein must be considered as having a general nature and does not, under any circumstances, intend to be tailored to your personal situation. Its content does not represent investment advice, nor does it constitute an offer, solicitation, recommendation or invitation to buy, sell, subscribe to or execute any other transaction with financial instruments. Neither does this document constitute independent or objective investment research or financial analysis or other form of general recommendation on transaction in financial instruments as referred to under Article 2, 2°, 5 of the law of 25 October 2016 relating to the access to the provision of investment services and the status and supervision of portfolio management companies and investment advisors. The information herein should thus not be considered as independent or objective investment research.

Past performances do not guarantee future results. All opinions and financial estimates are a reflection of the situation at issuance and are subject to amendments without notice. Changed market circumstance may render the opinions and statements incorrect.