A year and a half after the onset of the COVID-19 pandemic, an uneven economic recovery is taking hold across markets – and other risk events on the horizon are foreshadowing even more volatility ahead. We spoke with Oleg Mogilny, Managing Director, Public Market Alternatives and Factor Investing, to get a sense of how his team is creating value and generating returns in an uncertain environment.
Based on what you’re seeing in the markets right now, what’s your perspective on how the post-pandemic recovery will unfold?
It’s clear that just as the economic impact of the pandemic was spread unevenly across the globe, the recovery is unfolding at different speeds across regions as well. This is being driven in large part by the degree of fiscal and monetary support across different countries, but also by rates of vaccination and the response by governments and public health authorities to address emerging COVID variants. All these factors affect economic reopening plans – and therefore the pace and strength of the overall recovery.
The tone has certainly shifted to the negative as the year unfolded. In the first few months of 2021, we saw economies reopening, supported by abundant fiscal and monetary stimulus while a market consensus around higher inflation took place. Now, as the Delta variant continues to spread, we’re seeing a deceleration in economic growth, a lack of progress on fiscal spending in the US and an ongoing uncertainty on the inflation outlook. This has led investors to take a more defensive approach such as unwinding the reopening trades and focusing on less cyclical segments of the markets. We are likely to see more market volatility and change in relative leadership before the year end.
As for our portfolio, we managed to navigate macro rotations well throughout 2021. Our investment goal in this sort of environment is to maintain a diversified strategy mix, deliver value-add independently of a market regime and avoid uncompensated risks.
Inflation remains a hot topic for investors. What’s your view?
We believe that while the current pace of inflation is relatively high, this is largely being driven by transitory factors like supply chain disruptions and labour shortages, which can constrain production and drive prices higher. Rising commodity prices – energy, industrial metals and so on – have also contributed to a degree. We are closely monitoring the potential longer lasting impact from rising wages and housing costs. The remaining questions are what would be expected long-term levels of inflation after transitory factors fade, whether inflation surprises will continue to be positive, on balance, and whether inflation becomes detrimental for the demand.
Another big question is what shape monetary policy will take against this backdrop. As we move into the final months of the year, we expect to see some central banks begin reducing or tapering the monetary support they’ve been providing, but in a very controlled way. That’s because they want to avoid over-reacting to what we believe are temporary dynamics driving the rate of inflation right now, while providing enough forward guidance for investors.
This has also been a period of transition for IMCO’s Public Market Alternatives program.
Yes, we spent the last two years restructuring the bulk of the program, moving away from funds-of-funds towards more direct and transparent investments in public market alternatives. This coincided with rapidly changing market conditions driven by the COVID-related economic shutdown and subsequent recovery.
Despite the volatility throughout the pandemic, we continued to transition the structure of our core portfolio while delivering absolute returns and diversification. This year we accomplished most of our core portfolio transition, and we are now focusing on finding niche and idiosyncratic opportunities where the risk-return profile continues to be attractive.
Our view is that most of the “low-hanging” opportunities created in the pandemic have been exploited by now, and that a balanced approach is required to succeed in a market like this. We believe the portfolio needs to stay aware of midcycle rotations, avoid crowded strategies while minding key fundamental and structural trends, and tilting towards pockets of tactical and niche opportunities in a measured way. Asset valuations aren’t cheap either, driven by depressed yields, tight credit spreads and equity markets that rallied in 2021 without any significant correction. It’s critical to pay close attention to managing risk and diversifying the portfolio in this context.
What sort of specific risks are you paying particularly close attention to right now?
As always, there are downside and upside risks, and you must watch both to effectively navigate this environment.
There is a good chance that upcoming elections in Europe could lead to larger fiscal stimulus, higher rates and steeper curves in the region, which could ultimately have an impact globally. As we enter a key period where the Federal Open Market Committee is set to reduce its stimulus, we’re of course watching for any policy signals from the United States, and how it will address the ongoing economic uncertainty in its fiscal plans. The more contagious Delta variant is also creating a potential risk to the recovery despite higher vaccination rates, raising the concern about other future variants. Thanks to high vaccination rates and public measures, the Delta risk is expected to roll over soon. Other factors such as higher consumer prices and lower housing affordability is an emerging concern for consumers. China’s recent regulatory actions added volatility at a time when its economic growth peaked.
What’s your long-term outlook?
I think any investor should be wary of predicting the future in an environment as uncertain and unprecedented as this one. That said, some longer-term themes have immediate implications to investment portfolios today. There are a few we are closely monitoring.
Against the backdrop of low rates, potentially increasing long-term inflation expectations and higher weight of riskier and less liquid assets in investment portfolios, finding diversification and managing liquidity come to the forefront of our asset allocation discussions. Investors can search for relative value, strategies with an inflation hedge component, and/or active mandates such as market timing or tail hedging that can generate value add in falling markets to complete a portfolio of riskier assets.
Among long-term themes, climate change has taken the center stage. Later this year, many world leaders will gather at the UN Climate Change Conference to aim for a path towards net zero emissions, which could give some hints as to what policy will look like in the years and decades to come, and how effective it will be. This also might provide some insight or affirmation about what sorts of investments and regulations are more likely to happen in developed and emerging markets to achieve meaningful progress on climate change, with market implications for many impacted sectors.