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Weekly market insights from the Global Investment Strategy team
What it may mean for investors
Alternative Investment Opportunities in 2017 and Beyond
"Life can only be understood backwards; but it must be lived forwards."
- Søren Kierkegaard
As 2016 comes to a close, we find ourselves looking backward on a pivotal year for global markets—and forward for opportunities arising from several important events. The acute selling experienced in the early weeks of 2016 produced hedge-fund outperformance and reignited a dialogue among investors about their benefit within a portfolio. Unfortunately, the global risk-asset recovery was just as fast, eroding much of the alpha produced in January and the first half of February. Hedge fund managers seek to generate investment "alpha"—that is, performance that exceeds the manager's stated investment benchmark. Hedge funds spent the remainder of the first and second quarters lagging global markets, only to see a tremendous third-quarter improvement in alpha generation in the wake of the U.K.'s Brexit referendum. As markets grappled with the unexpected U.S. election outcome, hedge funds benefited from a supportive environment for equities, along with several key trends for other global assets. Performance continued to improve through the fourth quarter as steeper yield curves and pronounced equity dispersion provided managers with a favorable backdrop for security selection. While hedge fund performance was challenging in the first half of 2016, market perspective has quickly shifted to one of optimism that 2017 could be quite fruitful for active management in the alternative investment space.
Against the backdrop of the 2016 elections and a dramatic transition in the U.S.-government leadership, the Wells Fargo Investment Institute's (WFII) 2017 Outlook report titled "Seeing Things Differently" addresses five shifts that are likely to influence the investing landscape for next year and beyond:
As we enter 2017, we believe that these five factors could provide opportunities for specific alternative-investment strategies to provide compelling risk-adjusted return potential.
A Resurgent Consumer
WFII believes that consumer spending should benefit from higher employment, rising wages, and housing-market strength in 2017. Yet, equity-market valuations may not advance broadly next year, and WFII is forecasting that the S&P 500 Index will end 2017 in the 2230-2330 range. Given the recent equity-market surge, the S&P 500 Index was only 3.1 percent away from the high end of the 2017 range given today's S&P 500 Index "market open" value. Therefore, we are forecasting that equity gains could be more limited and harder to capture in passive index index-replicating strategies. As a result, we believe that active equity management could outperform passive strategies in 2017.
From an alternative-investment-strategy perspective, we believe that the Resurgent Consumer factor could be most beneficial to the Equity Hedge strategy. Specifically, we believe that hedge fund managers with a lower-net profile (defined as hedge fund managers with 20-35 percent net long exposures)—with portfolios that are broadly diversified both geographically and by sector—could outperform. The Equity Hedge strategy could benefit from increased stock dispersion between winners and losers. This could, in turn, create a market environment that allows managers to generate gains and create alpha on both the long and short sides of their portfolios. Equally important, the Equity Hedge strategy could help to insulate and diversify investors' long-only equity allocations by reducing downside exposure in the event of volatility stemming from geopolitical events and diverging monetary policies. In anticipation of potential investment "potholes," Equity Hedge can offer qualified, financially sophisticated investors a strategy that has the potential to participate and protect—while unlocking value and complementing allocations to traditional equity allocations.
Our view is that the Federal Reserve (the Fed) will tread cautiously next year, but also may allow inflation to run between 2.0 percent and 2.5 percent to promote economic growth. While we do not believe that a rapidly-rising inflation environment is a near-term threat, inflation has been trending toward historical averages. From WFII's perspective, a normalizing rate of inflation is a positive—and is one sign of an improving economy. However, we think inflation that rises significantly above three percent could cap equity valuations and generate additional volatility in fixed-income markets.
From our perspective, there are two alternative-investment strategies that could benefit from a rising-inflation environment—Discretionary Macro and Equity Hedge. Of all the alternative-investment strategies, we believe that Discretionary Macro stands alone as possibly the most flexible and opportunistic. While no two Discretionary Macro managers are exactly alike in terms of style or strategy, they all employ a "top-down" investment approach that analyzes the economic landscape below, trying to spot anomalies, mispriced assets and major economic-pattern shifts. Discretionary Macro managers construct their portfolios by first assessing economic variables such as interest rates, government policies, and inflation. We believe that a rising-inflation environment that results in a cap on equity valuations and increased fixed-income-market volatility plays into the strength of the Discretionary Macro strategy—that anticipates pronouncements from a country's central bank, attempting to predict monetary decisions and the impact of these decisions on financial markets. Similar to the Resurgent Consumer factor, we believe that, in a rising-inflation environment in which equity valuations could be capped, the Equity Hedge strategy complements our cautious, but constructive, outlook on the equity markets, while seeking to reduce risk.
WFII is forecasting two interest-rate rate increases from the Federal Open Market Committee in 2017. WFII continues to expect the Fed to raise interest rates at a gradual pace next year—and our year-end 2017 target range for the federal funds rate is 1.00-1.25 percent. However, the Trump administration's fiscal-policy initiatives could impact the pace of domestic economic growth, and inflation, in ways that remain largely unpredictable at present. This fiscal and monetary policy uncertainty may increase bond-market volatility in 2017. This all adds up to a potentially challenging situation for bond portfolios with interest-rate sensitivities.
Given the uncertainty surrounding interest-rate fluctuations in 2017, the alternative-investment strategy that we would recommend is Structured Credit. We continue to believe that the opportunity for Structured Credit remains robust—supported by generally strong fundamentals within residential and commercial real estate. While we remain cognizant that fundamentals may weaken in a rising-rate environment, we currently view the risk/reward profile within Structured Credit as more attractive than for traditional fixed income and believe that investors can benefit from the high cash-flow potential of these securities. The Structured Credit strategy has more flexibility around trade structure, long or short exposure, available securities, and even investment horizon than many long only fixed-income managers. This can give Structured Credit managers the ability to potentially reduce both credit and duration (interest rate sensitivity) risk while still providing the opportunity for achieving an attractive yield. This capability will be increasingly important in a rising-rate environment, where even small increases in rates can significantly erode total return for many fixed-income investments. Further, the ability to actively hedge interest rates is a significant competitive advantage for Structured Credit managers. This is particularly true for strategies investing in residential mortgage-backed securities, for which a shift in rates can have a direct impact on mortgage prepayment activity. For example, one of the Structured Credit managers on the WFII alternative-investment platform hedges across primary, secondary and tertiary risks to protect against interest-rate movements, duration risk, spread risk and macro risks. We believe that this type of strategic flexibility can make Structured Credit an attractive alternative for qualified, financially sophisticated investors who still desire yield but who are concerned about the impact of rising interest rates on their bond portfolios.
While many commodity prices appear to have bottomed in 2016, we expect prices to move sideways in 2017 with less volatility. This is typical for commodities at this point in the bear super-cycle, following five years of sometimes sharp commodity-price declines. We continue to believe that sideways price action is likely for the next couple of years, but tactical opportunities may arise in individual commodities and sub-groups.
Given the historically high volatility and uncertainty associated with commodity investing—and our expectation of sideways price action for the next couple of years—we are hesitant to recommend a more liquid hedge-fund strategy to investors. Instead, we believe that qualified, financially sophisticated investors with a longer-term investment horizon of 6-10 years may be best served by utilizing Private Capital solutions that opportunistically focus on the commodity sector either through equity, debt or infrastructure investments. President-elect Trump's pro-growth fiscal policies may boost growth and inflation, which may be generally positive for buyouts, real estate, and other real-asset strategies. Importantly, an increased emphasis on U.S. infrastructure and energy investment may create pockets of opportunity as investors may be able to capitalize on loosened energy regulations—particularly those involving natural gas and coal production along with pipelines.
As new industries emerge and manufacturing struggles globally, widening income inequality could fuel political dissent and spark financial-market volatility. The potential for inflationary surprises and geopolitical stresses leads our tactical guidance toward a more conservative stance—reflecting a change from the environment of the past several years. As such, WFII favors investing in higher-quality assets to help mitigate the potential for volatility.
Spotting investment opportunities currently can be challenging, especially with trillions of dollars of global government debt offering negative yields, and equity indices trading at historical highs. As noted, we believe that one of the best alternative-investment strategies for navigating a more volatile market environment today is the Discretionary Macro strategy. The Discretionary Macro strategy is a "go-anywhere" strategy that has historically offered non-correlated returns to equity and fixed-income investments over a full market cycle. Historically, when markets have been extremely dislocated, this strategy has delivered strong absolute returns. In 2017, we expect to see diverging growth in emerging-market countries. Associated with this is a divergence in central-bank policies. Some emerging-market countries are on a rate-hiking cycle (e.g., Mexico, Colombia, Egypt), and have raised rates recently—while others are on the accommodative side (e.g., India, Kazakhstan, and South Korea). The variance in economic-growth rates and division in central-bank monetary policies can support the alpha-capture potential for the Discretionary Macro strategy.
Hedge fund strategies employ aggressive investment techniques, including using short sales, leverage, swaps, futures contracts, options, forward contracts and other derivatives which can expose the investor to substantial risk. Investment returns, volatility and risk vary widely among the different strategies. Equity Hedge strategies maintain positions both long and short in primarily equity and equity derivative securities. Discretionary macro strategies seek to profit by taking long and short positions based on future movements in the equity, fixed income, currency and commodity markets. The use of short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss for the investment. In addition, taking short positions in securities is a form of leverage which may cause a portfolio to be more volatile. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks which may hurt a fund's performance. Investing in derivatives carries the risk of the underlying instrument as well as the derivative itself and may not be successful, resulting in losses to the fund, and the cost of such strategies may also reduce the fund's returns. Structured credit strategies aim to generate returns via positions in the credit sensitive area of the fixed income markets. The strategy generally involves the purchase of corporate bonds with hedging of interest rate exposure. Such strategies involve taking advantage of mispriced credit exposure at certain points in the term structure of single name credits relative to other points in the same term structure. Positions may use, but are not limited to, traditional fixed income and credit securities, as well as other structured credit products and credit derivatives, such as credit default swaps. Private capital funds use complex trading strategies, including hedging and leveraging through derivatives and short selling and other aggressive investment practices. They may also involve tax consequence which should be discussed with your tax advisor. It is possible to lose your entire investment investing in these funds. Investments in infrastructure companies expose an investment to potentially adverse economic, regulatory, political and various other risks, including, governmental regulations, high interest costs associated with capital construction programs, costs associated with compliance and changes in environmental regulation, economic slowdown and surplus capacity, competition from other providers of services and other factors. Successful hedging strategies may require a manager's skill in assessing corporate events, the anticipation of future movements in securities prices, interest rates, or other economic factors. No assurance can be given that such judgments will be correct or that a manager that uses these strategies will be successful.
Forecasts are not guaranteed and are subject to change.
The information contained in this document has been prepared by Global Alternative Investments (GAI) and the opinions are those of GAI. The views expressed are subject to change and are not intended as investment advice. GAI does not undertake to advise you of any change in its opinion or of the information contained herein. The information or analysis contained in this material has been compiled or arrived at from sources believed to be reliable but GAI does not make any representations as to their accuracy or completeness and does not accept liability for any loss arising from the use thereof.
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