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