Monday, November 11, 2019

KKR survey on returns - Expectations are lower for next five years

The KKR Insights: Global Macro Trends "Wisdom in Curiosity" October 2019 thought piece provides more sobering information on return expectations for the next five years. Every investment return is expected to be lower except for cash, hedge funds, and emerging market equities. Cash and hedge funds will be higher but still below any pension discount rate.

However, on a relative basis, private equity should do better and will be the only investment with double double digit expected returns. It is the only investment that will have the opportunity to offset the low returns from traditional assets. Overall, the only places to get return are asset classes of greater risk and lower liquidity.

The KKR CIO survey suggests that those investments that have less liquidity will be the sectors that are expected to have the most attractive risk to reward. This should not be surprising. The illiquid investments usually have lower volatility given accounting practices for pricing (no daily mark to market), and investors should expect higher returns for the same level of risk given the investments may not be sold immediately. There is a illiquidity risk premia. Of course, the measurement and size of this illiquid risk premium is up for much debate.

The strong demand for private equity is just the continued response to low bond yields, continued low cash rates, and less favorable equity valuations. If there is the expectation of a financial downturn, some investor perceive that private transactions will not be disturbed by any rush for liquidity. However, there are limits to illiquid allocations, so investors still have to be on the look-out for unique opportunities or risk premia that may offer liquidity with upside.  

Those inflation expectations stay low

The New York Fed conducts monthly surveys of consumer expectations and the number show inflation expectations still moving lower (see Center for Microeconomic Data). The current reading for one year ahead expectations is the lowest on record since the survey began in 2013 at 2.33%. The same low expectations exist for home price changes with only a slight increase from the all-time lows in September. The drivers for lower inflation include lower medical costs and college education.

All survey data show persistence in low inflation expectations. The Fed has not been able to change these expectations and their behavior of lowering rates only reinforces views that there is no inflation on the horizon. There may be future surprises in inflation given the tightening labor markets, but earnings growth expectations are consistent with the inflation numbers at 2.3%. 

Inflation expectations will not be a driver for interest rates and only seem to place a lid on how high rates may go. It is hard to get nervous about sustained rate increases.

Saturday, November 9, 2019

Factor-based investing across the business cycle - There are defined patterns

Key investment factors such as momentum, value, size, quality, and volatility are time-varying and related to changes in the business cycle. Compensation or a return premium is necessary to offset the risks to consumption during an economic slowdown. This is fundamental to the market beta risk premia as well as factors such as size. 

Holding other factors may mitigate some of the risk from holding the market portfolio, but business cycle risks will not be eliminated through factor diversification. Nevertheless, we have history to tell us what will be the returns from different factors conditional on different points in the business cycle. These conditional returns are presented in the short white paper, Factor-based equity strategies in the business cycle – some basic analyses by the researchers at Vontobel. 

In a recession, there is value with holding small cap, quality, and min volatility factor exposures and avoiding value and momentum. More specifically, if we are in a late expansion period, there should be a tilt to momentum and quality but the return profile will flip to other factors if we move to an early recession. 

The market seemed to focus on the minimum volatility factor when recession warnings increased only to see a rotation to other factors as recession fears have declined. The risks to investors increase when market expectations about a recession switch quickly as seen over the last few months. While timing is never easy, investors should be aware of the conditional returns across economic environments.   

Friday, November 8, 2019

Senior Loan Officer Survey - No real change over the quarter

All the talk can be about what whether the Fed is lowering interest rates, but if credit conditions are getting tighter because banks are being more stringent on their approvals, then the intended effect will not occur. The price of credit is not the only mechanism for rationing the supply. The loan standards matter.

The Fed's senior loan officer survey shows that there is an overall neutral balance in standards, limited change in spread conditions, and weaker demand for loans. On balance, the survey suggests that there is limited change in credit availability conditions. If there was fear of an imminent recession, it is not showing up in these numbers.