Risk-Free Return or Return-Free Risk: The Hunt for Yield

Macroeconomic Outlook and Fiscal Regime Shift

• Secular Stagnation Debate: Panelists agree that the era of secular stagnation driven by central bank activism is ending, replaced by a regime shift toward fiscal policy and active government intervention following the 2016 US election.
  • Marino's View: The US 10-year Treasury yield will rise to 2.75%–3.25% (10-year forward) due to debt-financed fiscal expansion and weakening demand from central banks and emerging markets.
  • Bob's View: Credit markets may outperform sovereigns if fiscal policies successfully stimulate growth, allowing credit improvements to offset rising yields.
  • Roger's View: Central banks have reached diminishing returns; the "central bank put" is eroding, and future policy will be driven by specific government actions rather than monetary easing.
  • Mark's View: Global economies are diverging, requiring region-specific analysis rather than a single macro lens.
    • US: Strong fundamentals with 3.2% GDP growth and 4.6% unemployment.
    • China: Facing an 80-100 billion monthly capital outflow risk if the transition from export-led to consumption-led growth fails.
    • Europe: Struggling with high debt and political fragmentation.

Yield Curve, Inflation, and Risk Factors

• Yield Trends: Investors anticipate a significant upward move in yields, with 33% of developed market bonds currently offering negative yields.
  • Inflation vs. Deflation: The consensus leans toward inflationary risks due to trade barriers and potential "helicopter money" policies post-crisis, though deflation remains a concern in Japan.
  • Market Reactions: Markets have rapidly priced in election results, shrinking reaction times from days (Brexit) to minutes (Italian referendum).
• Specific Regional Risks:
  • Europe: Top risks identified include the Dutch elections (potential negative surprise), French political instability, high energy prices squeezing consumers, and Italian banking sector fragility.
  • China: The primary long-term risk is the uncontrollable nature of domestic consumption compared to state-controlled exports; the market may underestimate the speed of adjustment.
  • US Policy: The "Trump Trade" is viewed as potentially overdone due to a lack of differentiation among policy priorities, though infrastructure spending and tax cuts could boost the S&P 500.

Asset Allocation and Diversification Challenges

• The 60/40 Portfolio: Traditional 60/40 diversification is considered structurally compromised due to:
  • Rising positive correlation between bonds and equities during stress.
  • Negative real yields in fixed income reducing diversification efficacy.
  • Anticipation of the next crisis potentially originating from the fixed income market itself.
• Return Objectives: Achieving a 5% annualized return over five years is deemed challenging for liquid portfolios, requiring exposure to private assets to boost equity risk premiums.
  • University Superannuation Scheme: Increasing private asset allocation from 23% to approximately 29% over 18 months to capture liquidity premiums.
• Alternative Assets:
  • Private Markets: Panelists favor private debt and asset-based investing over public assets, citing higher expected returns (7-8% for senior secured loans) and better risk-adjusted outcomes.
  • Gold: Viewed as unattractive during Fed tightening cycles.
  • Currencies: Investors are hedging currency risk, with a specific focus on the Yen's negative correlation to risky assets and potential opportunities in Mexican inflation-linked bonds.

Investment Tactics: Hedge Funds, Passive vs. Active, and Commodities

• Hedge Funds: Generally viewed with skepticism due to high fees (carried interest) and lack of alpha in rising markets; exposure is recommended only for strategies impossible to replicate internally (e.g., merger arbitrage).
  • Roger: Highlights that hedge funds often suffer when "all boats rise," retaining 100% of downside while giving away upside.
• Passive vs. Active:
  • Passive: Effective for large-cap equities and government bonds but criticized in credit markets for failing to differentiate between issuers during drawdowns.
  • Active: Preferred for credit, emerging markets, and private assets where liquidity premiums and security selection drive returns.
  • Mark: Advocates for a core-satellite approach but warns against assuming passive managers will thrive in a more dynamic, divergent market environment.
• Commodities: No strong consensus for broad allocation.
  • Oil: Cap predicted at $60–$65 due to US technological improvements in extraction.
  • Credit Exposure: Indirect commodity exposure is managed via leveraged loans and high-yield credit, though volatility remains a concern for preservation-focused portfolios.

Specific Investment Recommendations for 2017

• Assets to Buy:
  • US High Yield: Marino identifies this as the largest position due to a 7% coupon buffer and upside potential in the US economy.
  • Syndicated Loans (CLOs): Bob recommends collateralized loan obligations with triple-B average ratings and low default rates.
  • Emerging Market Equities: Overweight positions suggested, particularly in Latin American equities and high-yielding EM FX.
  • Mexican Inflation-Linked Bonds: Roger suggests these offer ~5% real yields with favorable currency dynamics.
  • Infrastructure: Long-term allocation recommended for inflation-linked income, with specific US port investments noted.
• Assets to Avoid:
  • US Investment Grade Debt: Marina warns against duration risk and concentration in this sector.
  • Market Timing: Mark advises against attempting to trade trends in a high-volatility, divergent environment.
  • "Income" Assets with No Yield: Roger cautions against asset classes labeled "fixed income" that fail to provide actual income.
  • Overconfidence: Roger identifies lack of caution in a post-election environment as a primary risk.
• Long-Term Themes (5-10 Years):
  • Robotics and Automation: Marino highlights the demographic policy dilemma of job displacement.
  • Fintech/Regtech: Mark sees significant opportunity in blockchain and regulatory technology.
  • Emerging Markets: Roger sees EM as a primary engine for returns.
  • Liquidity Premium: Marino emphasizes capturing value in illiquid private markets.

Emerging Market and Liquidity Deep Dive

• Emerging Markets (EM):
  • Risks: Dollar-denominated debt becoming more expensive as the Fed tightens; potential for volatility if the dollar strengthens significantly.
  • Outlook: Underperformance is ending; earnings and economic growth are finally visible in EM numbers.
• Credit Market Liquidity:
  • Liquidity Status: Despite reduced investment bank balance sheet usage, credit market liquidity has improved, with trading volumes remaining high even during drawdowns.
  • Mechanism: Market structure has diversified, allowing more investors to find counterparties without reliance on traditional dealer inventories.
  • Caveat: Liquidity may deteriorate if the ECB or other major holders of debt are forced to sell en masse.