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Scott Richardson shows how a systematic fixed income investment approach can provide asset owners with attractive diversifying returns
By Scott Richardson, Dan Atkinson
Investors are looking for signs that inflation has peaked and central banks can slow the pace of monetary tightening, but interest rates are likely to remain higher for longer, according to the AQR Asset Management Institute Insight Summit on navigating the “new abnormal” of market ructions.
Those macroeconomic headwinds are already depressing asset prices, with stocks and bonds struggling this year. Prices for cryptocurrencies have also slumped, and they pose wider risks to financial institutions and are likely to be more aggressively regulated in the coming years.
Those market shifts are rendering tried and tested investment strategies redundant, and they are forcing a rethink of strategic asset allocation and greater diversification. Moreover, as financial markets wobble, there is a heightened risk of a global economic downturn, further perpetuating market woes.
Those were the major themes to emerge from this year’s Insight Summit, which focused on the interplay between inflation and asset management, as well as the challenges and opportunities of crypto assets and the risks to the global economy.
Nouriel Roubini, Professor Emeritus at NYU Stern School of Business and the economist who predicted the 2008 financial meltdown, underlined a wide range of “megathreats” to stability — which include geopolitical tensions, climate change, increased automation, polarisation and populism as well as global pandemics.
Compared to previous times, he said, “We live in a different world, a world in which the last 75 years of relative peace, prosperity and progress may be challenged by these kinds of megathreats.”
He also underscored the increasing risk of deglobalisation driven by heightened geopolitical tensions. “We talk about fair trade or secure trade rather than free trade, we think about reshoring rather than offshoring and increases in restrictions of trade in goods and services, in the movement of capital, FDI, labour, technology, data, information,” Roubini said.
“And the trend is going in that direction of more deglobalisation, more decoupling, more fragmentation, more balkanisation of global supply chains. And of course, that may make trade more secure. But it has costs in terms of increasing cost of production.”
More widely, he was concerned about the risk of “stagflation” – the toxic combination of high inflation and slow, or no, growth. He expected to see a “vicious cycle” of high inflation causing interest rates to rise, thereby causing a debt crisis and a recession that leads to a crash in financial markets. At that point, he expects “central banks to blink” and curb their tightening, threatening their ability to keep a lid on inflation — cuing stagflation.
Patrick Honohan, Honorary Professor at Trinity College Dublin and former governor of the Bank of Ireland, further underlined the challenge central banks face in quelling fast-rising inflation.
He said that, after undershooting central bank targets of 2% for many years, global inflation has overshot because of a range of factors. These include soaring energy prices linked to Russia’s invasion of Ukraine, the disruptions to global production and trade, as well as the huge pool of excess household savings accumulated during the pandemic.
The challenge for central bank policy is raising interest rates just enough to stop high inflation, without causing a severe downturn. As they work towards that goal, Honohan called for a change in price stability targets. “Most economists realise that a 2% inflation target is too low to provide enough policy room for combating a recession,” he said.
He added that inflation has gone so high now that there is a chance for the main central banks to reset the global reference point for price stability from its current somewhat arbitrary value of 2% to 3%.
Even so, he questioned whether financial losses at central banks could impair their ability to seek and maintain that level of price stability. “There is actually some academic evidence that central banks with weak balance sheets tend to operate fewer effective policies,” Honohan added. “They tend to have higher inflation rates but have resorted to quasi-taxes.”
Jordan Brooks, Principal at AQR Capital Management, underlined the worsening macroeconomic outlook and spelt out what this means for investment portfolios. The tightening of monetary policy has already depressed asset prices. “Stocks are down, bonds have crashed,” Brooks said.
He expected no let-up, with futures markets expecting interest rates to continue rising. “Higher for longer is something we are going to be accustomed to,” he said.
Yet Brooks suggested this was not fully priced into stocks. “Equity markets are pricing in an impossible trinity – lower rates, disinflation and earnings are going to remain resilient. It’s hard to see all three of those things coinciding,” he said.
That has important implications for strategic asset allocations. Brooks said the mainstay of the investing world, the 60/40 portfolio, will “massively underperform in an environment when inflation is surprising to the upside”. He added that “commodities are something that tends to do well in a rising inflation environment”.
Moreover, Brooks said that “trend-following strategies”, which attempt to capture value through the momentum of an asset in one overall direction, are one way for investors to capitalise on higher macro uncertainty.
“One market phenomenon that we observe, that tends to be robust, that we’re seeing again this year is that it takes markets time to price in new information,” he added. “Markets systematically underreact to catalysts. And this is the motivation behind trend-following strategies.”
Financial markets are facing potential further disruption from crypto assets, which are not without their detractors. Fabio Panetta, Member of the Executive Board of the European Central Bank (ECB), likened crypto to the “Wild West” and warned about the risks stemming from the “irrational exuberance” of investors, as well as the negative externalities and lack of regulation.
He underlined the near-total crash of the terraUSD stablecoin and the bankruptcy of crypto exchange FTX. “The crypto dominoes are falling, sending shockwaves through the entire crypto universe,” he said.
Those collapses have revealed some “unbelievably poor business and governance practices”, Panetta said. And, like the subprime mortgage crisis that contributed to the 2008 global financial crash, he said this has highlighted the “interconnections and opaque structures within the crypto house of cards”.
That was set to dampen the belief that technology can free finance from scrutiny, he added. “The crash has served as a cautionary reminder that finance cannot be trust-less and stable at the same time. Trust cannot be replaced by religious faith in an algorithm; it requires transparency, regulatory safeguards and scrutiny.”
And yet, he did not think this meant we are witnessing the end game for crypto. “People like to gamble — on horse races, on football games and many other events. And some investors will continue to gamble by taking speculative positions on crypto assets.”
He argued the financial sector needed to move rapidly from the debate on crypto assets, regulation and taxation to decision and implementation, as he called for a new “settlement asset” that maintains its value under stress conditions.
“To harness the possibilities of digital technologies, we must provide solid foundations for the broader digital finance ecosystem,” said Panetta. “This requires a risk-free digital settlement asset, which only central bank money can provide.”
But there are opportunities as well as risks for financial institutions when it comes to digital assets.
Christine A. Parlour, the Sylvan C. Coleman Chair of Finance and Accounting at UC Berkeley Haas School of Business, underlined how decentralised ledgers, which underpin cryptocurrencies, are changing financial market architecture, which is having an impact on areas including clearing and settlement, trading, as well as margins and collateral.
But the key takeaway from her session was how those ledgers are enabling new business models, such as stablecoins — a type of digital asset that offers price stability, as they are pegged to a fiat currency.
She said that stablecoins could emerge as an alternative to commercial bank deposits, as this type of “decentralised finance” grows in popularity. At the same time, Parlour said regulators were starting to look at curbing any potential risk to financial stability by ensuring stablecoins are backed by “safer” assets such as government debt.
That would result in a substantial shift away from household wealth being held as deposits at commercial banks to other entities, she said, via stablecoin providers. The risk she saw was that this shift would reduce the resources available for banks to inject into the economy, with implications for growth.
Parlour said: “What you [may] have is a world where money has moved from the banking sector, which was doing its business... lending to small businesses. That money is now shifted into some sort of entity that is being forced to essentially lend to the government. Where does the growth in the economy come from if banks are not lending to small businesses?”
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Tether is the largest operator in the stablecoin space. Paolo Ardoino, Tether’s Chief Technology Officer, demystified how it all works. Initially, he said Tether was established to reduce the friction of moving real currency through the crypto ecosystem; the coin now plays a key role in facilitating trading across the crypto market.
But it also has a role in the broader market because Tether is pegged to a fiat currency. That provides traders with a place to store money when making bets on digital assets, which can be volatile. Tether also links digital assets with the mainstream financial system, as it aims to maintain a value of $1 at all times, by keeping a store of reserves of traditional assets.