Increasing Inflation risks and the scope for monetary policy changes over the quarter and the war in Ukraine have upset the geopolitical stability needed for a well-functioning global economy and ongoing investor confidence. Asia is not spared as uncertainty looms and clouds its growth prospects, just as it seemed to be on track for recovery. Specifically in Singapore, the outlook for its economy has also weakened compared to three months ago.
While alternative investment strategies did provide some relief to investor portfolios, the macro landscape was challenging enough to weigh on returns as investors had to grapple with uncertainty from an economic and political perspective.
Capital allocation drivers
At O’Connor, we believe that maintaining humility is important in environments where significant macro risks are present and evolving. Underlying this core tenet is the idea that relative value investment disciplines will work in most backdrops, even those characterised by significant macro risks, provided those risks are understood and accounted for by investors.
Instead of attempting to predict and position for changes in these macro risks, we focus on assessing the extent to which those risks are discounted across different segments of the financial markets to drive the capital allocation process.
Macro risk landscape is extremely challenging
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Institutional investors are starting to move past the war between Russia and Ukraine and are instead focused on the economic conundrum of ongoing inflation pressures, tightening monetary policy and recession risk on the horizon.
But as daunting as that economic conundrum is for investors and policy-makers, institutional investors have largely adjusted to this new risk landscape. In fact, two things are abundantly clear: the current macro risk landscape is extremely challenging on a historical basis.
It can be still a challenge in getting investors to understand the complexity of the current market landscape Often, the default reaction is to look at nominal equity index levels and corporate credit spread to gauge current market risk appetite. Investors looking at the current spread on the Bloomberg US Aggregate Corporate Index might be forgiven for not recognizing the current complexity and nuanced risk aversion. The risk indicator is currently showing a smaller premium needed to hold US corporate debt compared to during the pandemic.
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Inflation’s impact on portfolios
This state of cognitive dissonance results from the simple fact that investors have not experienced the impact of inflation on portfolios for at least 20 years, and arguably for 40 years. A generation of investors has not had to truly think about the implications of inflation for asset prices, and that has to change.
To truly dimension how unique this market environment is, we can turn to interest rate volatility as the most ideal barometer for economic, policy, and valuation uncertainty.
Interest rate volatility has been moving steadily up over the quarter and remains elevated, indicating ongoing uncertainty. High interest rate volatility is often an indicator of instability in relative value disciplines and usually a trigger for us to take down leverage across the portfolio.
Seeking opportunities
It is with cautious optimism that the extreme levels of volatility and risk aversion of the first quarter may be behind us that has led O’Connor to selectively gross up risk in some of our key sub-strategies.
We continue to favour strategies that are not too correlated to the market. The merger arbitrage strategy is one that continues to have low correlation and positive return profiles as deal-specific contracts and terms influence the value as transactions close.
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While 2022 has brought some new market challenges, we at O’Connor continue to be confident that things will increasingly normalize over the coming months. As we pen this piece, Shanghai is moving towards ending its pandemic lockdown and we are closely watching how this normalization will be followed by increased economic activities.
We should then see a pick-up in return dispersion and capital market activity that is the lifeblood of our return streams. As such, the excessive volatility and risk aversion that has weighed on alternative strategies earlier this year should transition to one more conducive to relative value disciplines.
As we have often said, environments characterized by elevated but not extreme volatility, where returns are driven not by beta, but instead dictated by corporate fundamentals, investment themes, regulatory change, and securities valuation, are generally favourable for investors, and this is the environment we expect to prevail over the coming quarters of 2022.
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Kevin Russell chief investment officer and global head of UBS O’Connor, a multi-strategy hedge fund manager within UBS Asset Management
