With the recent announcement of Fed tapering due to start in January and the expectation of tighter U.S. dollar policy as normalization of growth gets underway, the investment landscape is likely to be transforming. In aggregate, fundamentals are likely to become the predominant driver of outperformance, with risks to simple yield or carry strategies increasing substantially. Focus on borrower quality could indicate that recent bond issuances have been priced too generously. Hedge fund strategies are likely to offer great risk-reward attributes as correlations continue to trend lower and fundamentals reassert themselves as key return drivers.
The Fed's decision to delay tapering comforted markets that easy money was back, at least temporarily. Sentiment quickly reversed and a return to carry trades unfolded. Since the agreement reached between the Democrats and Republicans in early October, equity markets reached new highs. Global monetary easing and improving Purchasing Managers Index and other regional Institute of Supply Management data have helped risk assets continue to provide gains and, despite valuations starting to look a little rich across various asset classes, positive tailwinds have continued to blow, particularly in the U.S. Continued loose but normalizing monetary policy, clarity on the fiscal front and revenue growth remain the necessary conditions for gains to continue.
While some investors are exercising caution, U.S. and developed market sentiment continues to strengthen. There are, however, real risks around these policy-oriented expectations. It isn't difficult to imagine a scenario of a significant sell-off if prices detach further from fundamentals. Having lower market beta exposures into a correction will afford investors a more flexible approach to adding risk in the aftermath, should the expected positive developments continue to unfold post a sell-off. It will also allow for moderate upside participation should the markets avoid any significant corrections.
The significant opportunities in the U.S. are with long/short sector specialists pursuing undervalued sectors with catalysts for rerating. One such example is financial equities. There is a combination of thematic tailwinds supporting the sector, ranging from regulatory change driving corporate actions to potential for earnings growth and normalization in rates and improved net-interest margins. In contrast, less compelling sectors such as consumer discretionary and staples appear overvalued in both absolute and relative terms. They are at risk given expectations of higher interest rates, rising gasoline prices and the potential for slowing earnings for those reliant on emerging market consumers. They might not fall materially if the overall economic picture improves but could tread water because of these challenges, or fall substantially should there be a sell-off driven by economic deterioration or broad-based fear.
Europe has bounced off the bottom of its double-dip recession and investors who had been largely underweight in those markets have rushed back in, closing the discounts that existed in many stocks. It is still a bifurcated market, however, with funding markets only selectively open and credit still contracting. Continued deleveraging of the banking system leads to opportunities, both long and short. This is creating a favorable environment for event-driven and low net exposure equity and credit managers. Recently, the higher-beta strategies have outperformed, however, given the expectation the eurozone economies will oscillate in a range of low growth, periods of greed and fear with intermittent political flare-ups are likely to add to volatility. This volatility will be punitive to investors with significant equity exposure. If however, correlations are expected to continue to trend lower, the more idiosyncratic strategies again should prove their merit given their lower correlations.