Among other predictions for the rest of the year, Natixis sees a sharp split between winners and losers in the stock market, spelling middling results for indexers.
Natixis held a webinar on Thursday from the 2014 Morningstar conference in Chicago. Evan Cooper, editorial director for Asset TV, moderated a panel on market outlook for the remainder of the year with executives at firms associated with Natixis: Chris Wallis, CEO, CIO and senior portfolio manager for Vaugh Nelson Investment Management; David Rolley, vice president of the fixed income group at Loomis, Sayles and Co.; and Scott Schweighauser, partner, president and portfolio manager at Aurora Investment Management.
Wallis said equity markets are “fairly valued” and that investors can expect low- to mid-single-digit returns if they buy the broader market.
The challenge, he said, is that there market is no longer “bullish or bearish. It’s just going to be a market; it’s going to churn.” That will lead to greater dispersion between winners and losers, which means investors will be much better off looking for highly active managed, targeted investments instead of investing in broader indexes.
Wallis said that the days of buying an asset class or buying a sector are over, to the benefit of investors. “What we like about the current environment is there isn’t one area you can focus on. We may in fact not like banks, but have a large position in a specific bank.”
We’re at a point where “policy actions have had their intended effect,” he said. Now we have to manage the “unintended consequences” that come out of the decision to keep current policies or change them. “It’s going to create distinct winners and losers,” Wallis said.
Wallis said that his firm hasn’t reduced its expected return, but they understand that it’s going to come from “very stock-specific factors, not any generalized market or sector factors.”
He added that there isn’t a large valuation disparity between market cap ranges, but acknowledged that outside of small-cap environment is more targeted, but expects it to normalize over the medium term.
Yield and volatility are low and spreads are tight, Rolley said. “All of this is by policy intention because if you think about it, what central banks have been trying to do is reflate the global economy, but they’re doing it by deflating the income opportunities in our asset class,” Rolley said.
The current bond market is in a “pause,” he said. “It’s very calm and very quiet, but I don’t think that the yield environment today is the same one that we’re going to have in a year.”
“It’s an easy-money world, and it’s not just the Fed that’s providing extraordinary liquidity. You could say the same thing about the European Central Bank and you could say the same thing about the Bank of Japan. That’s most of the global benchmark right there.”
Rolley said that as value managers, Loomis Sayles has been able to find opportunities when investors get concerned and react to global changes. For example, “last year when taper talk began and emerging markets were sold off, we were able to find values in both some of the currencies there and some of the companies.”
Another place Loomis Sayles is finding value is in the corporate space due to “investors’ fear of event risk,” Rolley said. “There’s been more merger and acquisition activity and most of the time you think that would be bad for a bond investor” because that usually results in a more aggressive capital structure, which lowers the price of bonds. “You have to under-own those companies going in so you can look at the story, see what they’re going to look like after a transaction, and maybe then you can buy them and make some value.”
One of the biggest debates in global fixed income, he said, is future liquidity provision. Some investors believe that the Fed will stop quantitative easing soon and that there’s a “reasonable expectation” of an interest rate hike in 2015, but that “it won’t matter however, because we’re going to get the liquidity from the Europeans and the Japanese.” He couldn’t fully support that outcome, though. “I still think the U.S. dollar is the biggest market in the world. The Federal Reserve is the most important central bank in the world, and when they go back to something that looks more like the traditional central banking rule book, the market will struggle with these valuations.”
He added, “In four years, we’ve become addicted to excess liquidity. I don’t know that we’re going to be able to go cold turkey.”
Schweighauser, however, expressed optimism. “We’re actually very excited about the opportunities we’re going to face in the alternative universe.”
Managers are investing long and short in equities and fixed income, he said, as well as commodities. Correlation is coming down and dispersion is going to increase, he said. “We think that rational volatility is going to be very good for alternative strategies.”
As Fed continues to wean off QE and interest rates begin to normalize, fundamentally oriented strategies will be able to earn outsized rates of return, he added.
He referred to the corporate events Rolley mentioned, saying, “Event-driven strategies that benefit from corporate activity, whether it’s restructuring or spinoffs or mergers, that pace is accelerating right now, and that’s going to drive returns” in the alternative space.
In fact, he said, companies are rushing to complete these events before interest rates go up. “This is a cycle we’ve seen in the past. If you look back at the merger arbitrage or the merger cycle and corporate activity, it does follow interest rates. There’s a certain ‘keep up with the Joneses’ element to that, and I think we’re going to see an increasing pace as we go through 2014 into 2015.”
Cooper paused to ask Schweighauser to define alternatives, noting “everybody’s definition of alternatives is different.” Schweighauser said his firm is looking at hedge fund managers and looking for ways to engage them to manage their capital. “When we find great investment managers, people who we think have an identifiable and sustainable edge to their trading strategy, we want to partner with them so that we can take advantage of their investing skills.”
He said that managers have an absolute return orientation; they’re not trying to follow the market. “They’re trying to generate absolute returns to generate a very attractive Sharpe ratio.” What’s more, he said, “the tools that they have to do that are numerous. They can be long and short. They can use derivatives to hedge their exposures or to accentuate certain exposures that they want to add to their portfolio. The arsenal that they have is much more substantial than a long-only manager.”
What’s the Worst That Could Happen?
Cooper asked the panelists to share challenges that worry them the most, even if they think might not necessarily happen. Wallis cited cybersecurity as a major disruptor. “The advances from an offensive standpoint are infinitely larger than they are from a defensive, and we tend to address these issues after problems arise. It’s only a matter of time before something catches us by surprise. The deficits are not an issue, health care spending is not an issue, the dollar is not about to collapse. The concept that we’re all going to suffer through deflation is not going to happen. There are a lot of things out there people are worried about that we shouldn’t be.”
“There’s no such thing as a growth bond,” Rolley said, “so we’re mostly worried about almost everything.” However, he pointed to the transition to a high-yield environment as one specific concern, and “we’d be almost as worried if we never have that transition. Think what that says about global growth.”
Schweighauser said he worried most about those unforeseen black-swan events. “Markets are very path dependent. As something unfolds, policy decisions, policy responses that are intended to be productive and control volatility or that are intended to give investors confidence in the system may in fact be the wrong policy and we embed things for later problems.”
He pointed to 2008 as an example. “The quantitative easing that we’ve seen has pumped an enormous amount of liquidity into the system that really hasn’t had the effect people expected.”
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