image AFR: Traditional approach to the tech ‘treadmill’ image AFR: Antipodes says disruptors distract from main tech game

Investing in the face of uncertainty

If we begin with certainties, we shall end in doubts; but if we begin with doubts, and we are patient with them, we shall end in certainties – Sir Francis Bacon

Fat tails

Perhaps the most challenging aspect of risk management is accounting for uncertainty. Unlike risk, uncertainty implies an inability to determine the likelihood and/or impact of a future event. As risk managers, our role is to transform uncertainty into a probabilistic assessment of risk. In truth, this isn’t always possible, and one must be prepared to wear some level of uncertainty.

Conventional statistics offer a false sense of security. Many investors have been conditioned to think about risks and probabilities in terms of normal distributions, or bell curves. These distributions imply that catastrophic events are extremely unlikely to happen. The reality is that these “rare” events – credit crises, sovereign defaults, currency devaluations, terrorist attacks, wars, and political upheaval, to name a few – occur with much higher frequency than statistics would imply. 100-year climatic events, for example, happen far more often than once a century. In financial markets, there is enough empirical support to suggest distributions that measure the likelihood of risk and their impact bulge around the edges, creating “fat tails”. Fat tails tells us that even though we might be capable of assigning probabilities to regular events, we’re especially bad at predicting the irregular.

 

This does not mean the prediction of unlikely events is impossible. Observable risks such as the extension of credit and wealth inequality can cumulatively result in low probability catastrophes, with risks that have the potential to spread uncontrollably having a higher degree of uncertainty attached to them. Whilst it’s unlikely one could predict where the pieces of a fallen Jenga tower may come to rest, the points of fragility become increasingly evident as the tower grows. There is significant value in observing the things we can, and a holistic framework for monitoring the build-up of risk is paramount to early defence.

The age of populism

The idea of liberalised international trade and investment flows, free flow of human and financial capital and de-regulation is facing fresh scepticism and new challenges. Decades of rising wealth inequality, made acute by lower real wages in the de-leveraging aftermath of the global financial and European sovereign crises, has stoked the most recent wave of populist revolt across the US, Europe, South-East Asia and Latin America.

The essence of populism is the belief that society can be divided into two antagonistic classes – the people and the powerful. The powerful are presumed to be devious and corrupt, determined to feather their own nests and adept at using intermediary institutions such as the courts, media and politics to frustrate the people. Around the world charismatic populist leaders are finding success selling deceptively simple answers to difficult questions, using the failings of free trade and mass migration as a convenient whipping boy for rising inequality. Giving a voice to people’s frustration is one thing, addressing the cumulative long-term effects of privatisation, de-regulation, corruption and technological change that have silently eroded the economic rights of the individual is another.

A global economy flush with cheap capital has not helped, generating asset price inflation to the glee of the wealthy and accelerating a boom in skill-biased technological innovation. Arguably, it is the failure of policy makers to equip their labour forces with the skills of the future that has been the most profound contributor to the growing angst around wealth differentials. The real question for policy makers is how to return opportunity to the people, with the societies that prove more resilient being the ones that can afford to balance the need for equal opportunity with unequal reward.

What matters for investors is that populist policies almost always result in looser fiscal policy, often at the expense of productivity enhancing structural reform with negative short-term social consequences. The euro area is a case in point. Following the European sovereign crisis, the European Central Bank embarked on an asset purchasing program with the design of creating a more favourable environment for unleashing market mechanisms in Europe’s rigid economies and bloated welfare systems – a precondition for steady and balanced growth. The short-term impact of fiscal austerity, for example, created socio-political problems of rising unemployment and falling state revenues – a policy outcome no euro area government had a mandate for. Witness the social turmoil and political changes in Greece, France, Italy, Spain and Portugal as these countries experienced a powerful pushback to labour reform and austerity.

The rise of populism across Europe has also been accompanied by a surge in tensions between autonomists and centralisers, with the potential to further exacerbate fiscal risks. Interestingly, this trend is not a reaction to economic woes, being most pronounced in Europe’s most successful regions. Northern Italy, the wealthiest part of the country, has long flirted with the idea of floating off to form a country called Padania. Catalonia, the most productive part of Spain, has been fighting for independence to cut its payments to poorer Andalusians. The continent’s integration was meant to solve such questions, but they are surfacing once more to the angst of Europe’s leaders.

Not even the United Kingdom, where the House of Commons plays the role of one of the oldest representative institutions on Earth, has been immune to the spread of populism. Britain has succumbed to the populist wave because it decided to apply the most powerful tool in the populist toolbox – the referendum – to the most profound question regarding its relationship with its main political and economic partner. Whilst the visible result has been the re-shaping of British politics by “Brexiteers” claiming that the people have spoken, the less visible result has been a constitutional revolution. Before the referendum, Parliament reflected the best interests of the sovereign. Now, for the first time in Britain’s parliamentary history, MP’s feel obliged to give in to a populist revolution.

Recent events in Italy are a timely reminder that populism, fiscal policies, bank balance sheets and lending to the private sector are inextricably linked. Through rising yields, bond markets sanction any perception of unsound fiscal policies likely to aggravate budget deficits and public debt, or in the case of the euro area, violate commitments to deficit and debt targets. Rising bond yields shrink the value of bank assets which consist of large holdings of government bonds, in turn making banks more risk averse and less inclined to extend credit to the private sector. With Trump’s populist policies seeking to widen US fiscal deficits to levels last seen in times of war or recession, markets may soon begin to discount the US government’s EM like sovereign risk profile (Figure 3) and increasingly limited fiscal firepower.

With the populist locomotive now set in motion, increasing political risks have the potential to stress nations that have rapidly accumulated public/private debt, reliant on external capital and/or have weaker institutional frameworks. Set against a backdrop of tighter global monetary liquidity and the potential for slower growth/higher inflation, the financial and political tail risks are elevated.

Overindulgence

A decade of overindulgence has led to another set of tail risks. As generationally low interest rates and QE induced yield curve flattening has throttled excess capital towards increasingly risky financial assets, investors have been willing to pay a premium for the illusion of durability in an uncertain world.

Intensifying competition and “structural” growth

The bubble in “structural” growth is perhaps the most poignant example. Technology products and their suppliers have changed the world, making up a higher proportion of global market capitalisation than ever before (globalisation has been a conduit for even greater industry concentration and risk). Tending to dominate their early niches, businesses such as the FAANNGM’s (an ever expanding acronym), Alibaba and Tencent have generated tremendous value protected by deep moats. In search of the next legs of growth, this value is being reinvested in the seemingly “won” opportunities of their competitors. Whether it’s Amazon and Netflix competing on content streaming or Amazon’s Alexa threatening Google’s core search business with its voice search capabilities, the titans are bumping heads.

For competing software and internet businesses, barriers to entry are being eroded. The ability to deploy, then effortlessly scale their technology on platforms offered by Amazon Web Services, Microsoft Azure and Google Cloud reduces up-front capital expenditure. Combined with large addressable markets and a boom in cheap venture capital funding, particularly in the US and China, the seeds for intensifying competition have been sown. The next frontier of technological disruption won’t be so easily won. With valuations for structural growth implying more of the same, the risk to investors is that this type of growth succumbs to cyclical forces. Seemingly stable businesses may prove to be anything but over the next decade, with active management affording one the luxury to own those least likely to be disrupted.

Debt accumulation

In a similar vein, a world awash with cheap capital has nurtured the accumulation of debt. Studies of financial crises[1] have shown that rapid debt accumulation, whether it be by sovereigns, corporates or individuals, contribute more to systemic risks than the absolute stock of debt. In the case of China, whilst the sheer level of debt (~250% of GDP) is reason enough to pause, it’s worth highlighting the pace at which it was acquired, and thus the potential for misallocation. Figure 2 shows the most extreme “credit gaps” today, i.e. the difference between credit to GDP and long-term trend. Hong Kong and China stand out in a global context, driven largely by their corporate sectors, followed closely by the US government and property driven debt cycles in Canada, Singapore and Scandinavia.

 

In response to this debt overhang, over the course of the last three years China has implemented strict measures to control excesses in the shadow banking system, including forcing banks to re-classify shadow loans as traditional corporate loans (thereby bringing the loans back under regulatory scrutiny), take on more nonperforming loans as over-capacity industries shut down and reduce their reliance on wholesale funding to alleviate liquidity pressures. Monetary conditions are likely to remain tight as the long-term nature of Chinese policy remains committed to working off these excesses and supporting the transition from capital-intensive industrial to capital-light consumption and services driven growth. Ironically, this may reverse should the trade war escalate and exports continue to slow.

Another defining characteristic of the current cycle is the explosion of US non-investment grade (“high yield”) debt, with the stock of debt outstanding and the average leverage ratio high relative to the recent “goldilocks” combination of low base rates, tight credit spreads and high profit margins. Against a backdrop of relatively subdued inflation, US growth has been resilient, with Trump’s domestic policy analogous to burning all the furniture in the room. Whilst some indicators, such as the corporate profit cycle, industrial production, unemployment and consumer confidence suggest the economic cycle is maturing, residential/corporate investment and wage inflation is still at early or mid-cycle levels. Increasingly, the risk to the cycle is monetary policy, with an increasingly limited fiscal backstop.

Preparing for uncertainty

The challenge with the current environment is the number of low probability, but potentially material events that are difficult to build a portfolio around. With central banks and passive liquidity having acted as shock absorbers to risk assets more broadly[2], the normalisation of global monetary policy and spread of populism represent the most likely near-term catalysts for disturbing the current state of fragility. Accordingly, over the long-term, we believe that a holistic framework for managing uncertainty is likely to prevail.

To summarise the Antipodes Partners approach:

  • At the position level, seek to own attractively priced businesses (margin of safety) with investment resilience (characterised by multiple ways of winning). The opposite logic applies to our shorts, i.e. no margin of safety and multiple ways of losing. Rather than relying on momentum or passive beta, our research effort is directed at uncovering sources of idiosyncratic alpha – the essence of our pragmatic value approach
  • Build an awareness of fragility through quantitative and macroeconomic risk assessment. To exemplify, our macroeconomic risk framework (Figure 3) is a comprehensive measurement of a nation’s resilience to cyclical and structural external funding pressures and the velocity of credit accumulation in the household, corporate and public sectors. Whilst this framework doesn’t capture the resilience of a nation’s institutional framework or political risk, these qualitative assessments are made in the context of a broader financial risk assessment, with special attention paid to risks that have the potential to “spread”. Insights from this style of analysis feed into the margin of safety requirement at the position level and the management of overall portfolio concentration risk.
  • Looking beyond the more simplistic model of regional or sector diversification, our investments are grouped into clusters that share overlapping sentiment, idiosyncratic, end-market and quant/macro sensitivities. As stocks within clusters are likely to exhibit a higher correlation to each other, we limit cluster sizes to no more than 15% of the portfolio whilst attempting to minimise the correlation between clusters. In this sense we aim to control, to a higher degree, concentration risk within the portfolio and mitigate the impact of the unknown unknowns.
  • Multiple levers – longs, shorts and active currency/cash management to offset building portfolio risk
  • Around the edges of the portfolio, the implementation of low cost/high payoff tail-risk hedges. Despite being an equity manager, Antipodes Partners has a multi-asset toolkit at its disposal.

 

 

[1] “This Time Is Different: Eight Centuries of Financial Folly”, Carmen Reinhart and Kenneth Rogoff, 2009

[2] See our blog post “Volatility: Dead or in Hibernation” at antipodespartners.com/Volatility-dead-or-in-hibernation