Over the past year, the second stage of our investment process—understanding Why prices of markets and currencies differ from fundamental value—has been very influential in the setting of our strategy. As such, we have been maintaining a low-risk posture in order to keep our exposure to macro-thematic headwinds dampened.
Recent strategy changes, however, have been in the direction of increasing risk, mostly in markets. Why the change? In our view, a few of the more influential macro themes are starting to weaken in influence.
Our investment process always starts by identifying where fundamental opportunities exist. Once we identify these opportunities, we asses Why they exist and what may compel prices toward fundamental value or, conversely, act as barriers to that value being realized. This analysis includes assessing our risk exposure to macro themes. Currently, these themes include the commodity super cycle, external financing vulnerability, populism, and Chinese growth.
Macro themes sometimes can disrupt the opportunities that fundamental valuation offers us.
Risk exposure to macro themes is not the same thing as risk exposure to asset classes, markets, and currencies because themes tend to cut selectively across the geographic investment landscape. Macro themes also can sometimes disrupt the opportunities that fundamental valuation offers us.
Sometimes, macro themes enhance those fundamental opportunities. That means they push markets or currencies in the same direction that valuation pulls them. Here are a couple of examples:
- The commodity super cycle theme negatively influences the Australian dollar and South African equity market at the same time that the first stage of our process determined they were both fundamentally unattractive (short opportunities).
- Populism risks related to Brexit were negative for the British pound at the same time that the pound was slightly overvalued.
So, in navigating our exposure to themes, we have in some cases taken more risk in certain markets or currencies than the valuation opportunity alone warrants.
But, in general, over the past year, macro themes have tended to work against these opportunities. That means the macro-thematic influences have pushed in the opposite direction of fundamental value. Here are a couple of examples:
- The external financing vulnerability theme negatively influences several emerging currencies that are fundamentally attractive from a valuation perspective. That’s partly why we have smaller exposures to currencies like the South African rand, Turkish lira, and Brazilian real.
- Populism is also weighing against fundamentally attractive equity markets such as Spain, Italy, and the U.K.
As a result of these macro themes largely pushing in the opposite direction of valuation, our risk exposures have been lower than valuation opportunities alone would have warranted.
Why and Where We’ve Started Re-Risking
We review our macro themes on a regular basis and assess how they impact the near-term outlook for risk and return for markets and currencies. If our conclusions change, we adjust our portfolio accordingly.
We believe that the influence on return—not risk—has recently diminished for the commodity super cycle and the external financing vulnerability macro themes. As a result, over the past couple of months, we have increased our risk exposure to these themes, mostly by increasing exposure to emerging market equities.
Commodity super cycle macro theme analysis: We still think this theme significantly increases the risk of commodity-sensitive prices, but we believe it will have less impact on return. Commodity prices are still a driver of markets and currencies and are perceived to be a real-time proxy for global growth. But the price of commodities, in particular energy, have already fallen a long way and we, therefore, believe the potential for oil prices to swing well above or below our long-term fair value assessment of $40 to $50 per barrel is less likely in the near-term.
External financing vulnerability macro theme analysis: Many emerging market countries have adverse economic, balance of payments, or political governance issues, which leave them vulnerable to capital flights. That hasn’t particularly changed, except that some of the negative effect and resulting weaker growth is already reflected in market prices as a result of geopolitical events, such as Brazil’s presidential impeachment and South Africa’s government losing its popularity in recent elections.
But the global backdrop also matters. And the extended pause in tightening from the U.S. Federal Reserve, more accommodation from the Bank of England, and continued accommodation from other central banks in the developed world ease the pressure on emerging markets that would normally be quite vulnerable to capital flight.
As a result of our reassessment of the intensity of these two macro themes, we’ve slightly increased our risk exposure in recent weeks. Having said that, we continue to have a bias toward using options to gain exposure to our modest equity positions. We use these options in an attempt to protect against extreme downside events while maintaining the ability to participate in the upside.
Again, we continuously re-evaluate these macro themes and will dynamically adjust our market and currency exposures. We also continue to seek exposures that provide macro diversification that are not particularly aligned with macro themes and are not correlated with systematic market (beta) exposure over time.
Extreme downside market events may lead to investing in financial derivatives that are expected to increase in value during the occurrence of said events. Investing in an Option instrument could lose all or a portion of its value even in a period of severe market stress. Any extreme market event is unpredictable; therefore, investments in instruments tied to the occurrence of a market event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.