UBS: Active opportunity knocks II

In the May 2017 issue of Investment Insights we suggested that the market environ- ment in major asset classes was likely to be well suited to active investors in the following year to eighteen months. We forecast low stock correlation, high stock return dispersion, a broadening macroeconomic narrative and a moderate increase in equity market volatility from very low levels.

In truth, it is only since early February that rising bond yields and concerns about the potential for a more sustained step-change in inflation and policy interest rates have impacted equity market volatility in any meaningful way. And while stock correla- tions within the S&P 500 did indeed stay low for the remainder of 2017, they have risen more recently.

Nonetheless, we have an even higher level of conviction now than we did then that the market environment going forward is likely to be opportunity-rich for high conviction active managers.

It is important to note that neither the analysis nor commentary is meant to infer that we side structurally with either active or passive in what is now a well-worn debate. In our view, it has never been nor never should be a simplistic case of ‘either or’. But it is our strongly held belief that some market environments simply

offer a stronger opportunity set to active managers than others. This paper therefore is intended to highlight that the scope for outperformance for an active manager is variable and dependent, all else equal, on specific market characteristics.

In equity markets those characteristics include pairwise stock correlation — the degree with which securities move directionally together — and dispersion — the scale of difference in average returns. Changes in these characteristics can be both short-lived and long-lasting. It is our view that we are in the early stages of a multi-year higher volatility and higher return dispersion regime that is likely to offer high conviction active managers the opportunity to generate significant alpha.

Macro backdrop suggests higher volatility regime

Our view is that the global economy is in good health. Yes, the rate of growth acceleration appears to be tempering from very strong levels, but we believe that the residual rate of growth remains strong and well supported. Monetary policy conditions in aggregate are still accommodative and due to the breadth of drivers, we believe global recession risks are low. With corporate profits growth strong and likely to remain so, there are clearly still meaningful potential supports to global equities.

But while the overall backdrop remains supportive to corporate earnings growth, there are some important shifts taking place within markets that warrant close attention. At the heart of these changes is the shifting narrative on inflation and interest rates in the developed world. 

Moderate rises in inflation and interest rates have not prevented equity markets from rising in the past. But as investors weigh the potential impact of some- times opposing structural and cyclical forces, the range of potential growth, inflation and interest rate outcomes in the developed world is broadening from the very narrow range of the ‘lower for longer’ narrative. More specifically the uncertainty is focused on issues includ- ing the outlook for China as the pace of deleveraging policies accelerates, the interaction between unemployment and inflation as jobless rates in the devel- oped world continue to fall, the potential for increased fiscal stimulus in a number of major developed econo- mies, the ‘neutral’ rate in the US and how quickly and to what level the Federal Reserve will raise rates. All else equal, this increase in uncertainty is likely to lead to higher risk premia and volatility across asset classes. 

Nor do we believe that this is just a short-term change in macroeconomic and market dynamics. The liquidity provided by central banks under quantitative easing programs has been a key factor in suppressing risk premia and in doing so, keeping price volatility low across asset classes.

Read the full Investment Insights here.