Alex Cathcart, portfolio manager at Drummond Capital, says equity markets haven’t become disconnected from reality after the huge rally in recent months.
Cathcart says there are a number of factors that explain the rally, including the relaxation of lockdown laws across the world starting from late April.
“That should lead to a relatively sharp recovery in growth. So growth that will look like a ‘V’. Markets like growth, markets are forward looking.”
Cathcart notes that earnings in six, 12 and 18 months will be higher than the June quarter in 2020, which is favourable for markets.
There has also been a “capitulation in expectations for higher interest rates”, Cathcart adds.
“Everyone is discounting assets based off risk-free rates. I can’t image many people thinking the risk-free rate is going to rise meaningfully in the short to medium term, and potentially not the long term either”, he says. “That makes equities look more attractive on a relative basis.”
The third factor is liquidity provided by central banks and stimulus from Governments around the world.
“This isn’t the GFC. I don’t think people think the financial system is going to implode here.”
Instead, it is an exogenous shock where demand was artificially suppressed by the Government to try to prevent the spread of COVID-19.
“You can see light at the end of the tunnel.”
A trinary world
When it comes to strategic asset allocation (SAA), Cathcart says he is taking a scenario approach with the world feeling “trinary” with three possible scenarios.
The first scenario is where current coordinated monetary and fiscal stimulus morph into something resembling MMT or helicopter money. There might even be some coordinated approach of the two leading potentially seven years plus out, producing some spike in inflation. “No portfolio is really constructed against this at the moment”.
The second scenario is a Japanese-type scenario of deflation. And the third is a repeat of the past 10 years with very low-interest rates, inflation below targets but still reasonable earnings growth which sees equities outperform.
“We’re trying to construct our SAA to diversify against those three possible outcomes,” he notes.
Regarding specific asset classes, Cathcart says illiquid assets such as infrastructure, which Drummond Capital doesn’t use in their portfolios, make sense from a liability hedging perspective for super funds, but it has become clear there is a lot of “idiosyncratic risk” embedded in those assets.
Drummond is using alternatives in both the defensive and growth side, and Cathcart says the addition of alternatives to the defensive side is a new innovation. “Bond yields everywhere are incredibly low, and we don’t have as high a conviction as we would have done five to 10 years ago; the bond yields can rally meaningfully in a significant equity market drawdown, that’s a mechanical reality.”
That means Drummond is looking for things that diversify against equity risk and potentially inflation risk, such as CTAs and very-low volatility market-neutral funds.
“There is an issue of market structure with some of these. The last two bear markets probably happened too quickly for investment structures like CTAs to capture and benefit from market drawdowns,” he says.
Asset allocators, therefore, need to determine whether they think the big drawdowns in the future will be protracted like the tech bubble and GFC, or sharper 1987 crash and COVID-style drawdowns.
“We think there is a reasonable chance of both, so there is a place in the portfolio for those alternatives.”
A role for retail
There has been concern that the recent equities market rally has been turbocharged by retail investors, but Cathcart says it is hard to distinguish the true extent to which retail investors have driven the really.
He notes position surveys show the rally was underbought by institutional investors. “There’s definitely some weird stuff happening in specific securities,” he says.
But he’s as concerned about them as he is about Bridgewater or AQR Capital Management de-risking a risk parity fund because of bond volatility spikes.
“It’s good from the perspective of an asset allocator that there are other people doing things that aren’t following the exact same investment process as you are. If the world was just purely long-only passive the opportunity to add value through active asset allocation would be a lot less.”
The big issue
There are a number of concerns, including US and China tensions which have become embedded, but Cathcart says the prospect of either deflation or inflation is the big issue. “That lends itself to changes in an SAA rather than tactical changes.”
He notes that 70/30 and 60/40 portfolios were set up, and gained popularity when inflation was under control and declining.
“If you have a period of potentially higher inflation, there are things that people don’t tend to have in the portfolio, like commodities and gold, that would play a role if we thought that was the central case and we’d embed into the portfolio. You’d probably have a lot less government bonds structurally in that world as well.
“That’s a big thematic that we spend a fair bit of time thinking about and trying to build a defence against.”
To listen to the recorded interview with Alex Cathcart on the Market Narratives podcast find the series on Apple Podcasts, Google Podcasts, Spotify or click above.