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In hindsight, since the Great Financial Crisis (GFC) of 2008-2009, the debate around base case versus risk scenario was a sterile one. The base case was risk-on for financial markets, as monetary authorities were dominant. Indeed, central banks applying, nearly continuously, for large scale asset purchase programs relegated the impact coming from economic and fiscal policy to the backseat. The past 13 years resulted in financial asset inflation rarely witnessed post WWII. Most of the time, macro-economic risk scenarios were short-lived or attributed to specific country or regional stress. Not even the more-synchronised emerging market growth slowdown between mid-2013 and mid-2016 was unable to destabilise globalisation. The sharp deflationary shock and global growth contraction that hit the world over Q1 2020 with the outbreak of the pandemic was extremely brief given the mind-boggling liquidity provisioning by central banks.
Ongoing central bank interventionism blurred the lines between base case and risk scenarios. In this weeks’ piece, I take some distance and reflect on the dynamics of base case versus risk scenario building across three levels: Economists’ perspectives on the global macro-economic outlook, the perspectives of actors responsible for portfolio construction, and finally the views and attitudes of the respective investor classes.
Firstly, the base case narrative at the level of the global economy is built around the observation that real growth across DM and EM economies will print above historical averages over 2022 and 2023, whilst labour markets recover. Even more so, persistent bottlenecks across labour and the supply side of the economy have driven global inflation to uncomfortably high levels. The only exception is China that is forced to figure out a soft landing from a bursting real estate bubble. Japan lived through a similar moment end of the 1980’s. Food for another musing’s moment. Fact is that economists reached consensus that central banks have to tighten monetary policy. Their base case on the FED’s upcoming policy hiking path calls for 4 hikes over 2022, followed by another 3 to 4 hikes over 2023. That the FED will also start running down their balance sheet somewhere over 2022 is not contested. What strikes me is that the moment risk scenarios are developed, these focus less on the consensus hiking path but rather on external events such as a Chinese hard landing, new COVID-19 variants or growth-destabilising geopolitical stress. This translates into a distribution of base case scenarios that is very thin i.e. they cluster around a rise over the next 2 years of FED policy rates towards a 2.00% – 2.50% bracket. That might result in an uptick of US 10-year rates towards 2.25%. The Bloomberg consensus forecast by economists end of 2022 for the 10-year US rate sits at 2.13% right in the middle of the 2.01% priced by 10-year rate 1-year forwards and the often quoted 2.25%. The following risk scenario is rarely staged: what if the FED hikes rates 7 meetings in a row this year, starting from the March 16th FOMC meeting. That would pull policy rates towards 1.75%-2.00% by December 14th 2022. Of course, FED governors, as well as the FED Chair and Co-Chair Powell and Brainard in particular, are aware of the impact that such a scenario might unleash. It would result in market uproar. That reflection pushes you back towards the 4-hike consensus. When taking an 80% probability for 4 hikes and a 20% probability for 7 hikes, you land at 1.275%, resulting in a 5-hike path over 2022. Interesting, as this path would seal the credibility status of the FED. Such a tightening path, alongside a slipping inflation outcome (core PCE) towards the FED 2.7% estimate by year-end, would deliver the best of both worlds. Market stability could ensue with the 10-year rate coming under less upside pressure than feared today. Real rates should normalise more than nominal rates.
That brings us to our second level, where the base case vs. risk scenario is implemented in the context of portfolio construction. Between 2009 and 2021, with the liquidity gates open for business, performances across passive, indexed, solutions (passive funds and ETFs) were strong. Active managers had to be top-notch in their narrow, conviction-led portfolio construction in order for them to beat their benchmarks or reference indices. A defence play was not required. Harvesting the market beta, the optimal path.
As we prepare for ‘an across the board’ tightening by DM and EM central banks episode, the easy times might be over. The passive solution, even if well diversified, across asset classes might start playing second fiddle. Active managers that have proven to resist well in moments of risk-off, moments of market stress, should receive a tailwind coming from smart selectors. Active investors have been on the look-out for protection over the past decade. Risk indicators, such as the VIX index futures, have exhibited steep contango (future price is higher than the spot price) but also high skew as the option cost that buys protection (through higher implied volatility pricing), rises aggressively further out in time. Similar profiles exist across equity, credit indices or main FX pairs. Over more than a decade, uncertainty was always around the corner but effectively such paranoia was a bit ill-placed as the central bank put was guaranteed. Still, active managers remained wary and bought protection. Such attitude might receive a better pay-out going forward.
The base case narrative prepares us for the latest innings in the pandemic. The health crisis is becoming endemic. Yearly vaccination shots, better treatments and easy intake medicine pills will represent the solution mix. EM central banks kicked-off monetary tightening over 2021. Some DM central banks (UK, New Zealand, Norway) initiated their cycle. Bank of Canada will start end of January. This time is different. Many, even most market participants never experienced a synchronised global monetary tightening cycle. Such an episode awaits us. Awareness of such conditions brings us to the last perspective.
At a third level, we assess the conduct of institutional end-investors, across active, passive and less liquid alternative solutions versus the behaviour of the retail investor. Institutional investors that opted for the passive solution across public equity and bond markets in combination with illiquid alternatives might ponder the robustness of their mix the moment risk scenarios unfold. Illiquid investment solutions across private equity, private debt, leveraged loans or infrastructure debt have also enjoyed the effects of abundant central bank liquidity. As such, even if investors do not receive ‘a daily valuation’ confrontation, valuations have been lifted as well. As valuations or production in alternatives settle lower, the lack of drawdown management on the liquid component might reduce funding ratios rapidly. The positive news is that, on average, the institutional players invest across cycles and should maintain an almost fully invested stance.
For the retail investor, who entered the market highly committed, with conviction, over the past 2 years, panic is never a good advisor. However, such an outcome, where the retail public hits the sell button might be around the corner the moment tighter financial conditions lead to lower valuations.
After more than a decade-long monetary rising tide we are about to embark on a falling tide. The flood gets replaced by ebb. Differentiating and attributing probabilities alongside base case and risk scenarios become an edge that will split the wheat from the chaff. Economists, professional money managers and institutional or retail end-investors will behave differently in the art of navigating future market conditions.
Passive solutions might become less obvious as a quick stop fix to preserve and grow capital. Selectivity, conviction and drawdown management skills offered by genuine active investment management professionals deserve closer attention.