Some Considerations on Accepted Ideas.

Observing market levels and actions and hearing the most different set of opinions on the various topics and portfolio trading ideas, I receive constant confirmations on how some portfolio managers are not completely prepared for facing the current market volatility and they remain sometimes, and for a period longer than it should be, in a denial mindset ( the best idea is, in many cases, buy on dips). Similarly, to Central Banks, I can possibly describe them as “persons behind the curve”. And again, in sympathy with the Central banks who made and still make several monetary policy mistakes, investors, on their side, are or should be justified when they lose money and/or perform worse than their peers and benchmark.

Let’s start with a reality check.

In the past, many trading strategies and portfolio allocations have been designed to trade in low-risk conditions with controlled volatility. I have known many traders who for years implemented and lived only on one idea: selling volatility and tail risk. I have seen them living well for many months and years until that event or the series of events they did not predict in their model, wiped them out. On the opposite side of market approach (but sharing the same environment), the carry trades and “flipping strategies” have showed how their model was also flawed in their basic fundamentals. But there is a profound difference between the two styles: the carry trade philosophy did not manage to form and prepare “valid and robust” portfolio managers or traders equipped with a baggage for weathering the turbulence and traveling safe across the future difficulties. The volatility traders’ generation, I knew the ones who were active in the 90s and before the GFC, knew better the risks and the concept of stressed market conditions. They traded volatility sometimes with complicated strategies, they were pioneers in the role of financial innovation and the reallocation of financial risk. They understood to a large extent the market fluctuations and their probabilities and were able to make profit with it. Until a specific moment occurred. Everyone can remember the events of Long Term Capital Management at the end of 1998.

There is always an event which invalidates any known pattern. What did we see in the last three years?

Many events. What is staggering is the short time frame and the combinations, cause-effect, among them (something similar only happened in the GFC).

Economies which were supported and stretched beyond limits by a disproportionate amount of money courtesy of Central Banks, the COVID pandemic in Q1 2020 with secondary effects remaining for many months, the imbalance between demand and offer in many commodity markets, China’s restrictive approach to the pandemic, Russia invading Ukraine, inflation climbing to multi-decade highs and Central Banks raising interest rates markedly and signaling more sizable hikes for the future.

What have been the common mistakes recently made or perpetuated for many years?

1. Managers were excessively optimistic about the future performance of the investment positions held in the books.
2. Managers were overconfident with their portfolio style. This point is not the same as the first one.
3. The forecasts used for validating portfolio allocation were anchored on past performances.
4. The underestimation of the “beta” of the portfolio, linked or not linked to market movements.
5. The adoption of the “herd approach”: following others was a way to compensate the asymmetry of market information, or because it was the strategy which provided a comfort zone.

As we understand from the above, we should always keep in mind the logical parts of the decision-making chain:

a) definition of investment objectives which are imbedded in the investors’ preferences and mission and aligned to market conditions.

b) identification of the investment strategies: a commitment to undertake a defined set of actions rather than another for choice in the face of tradeoffs and risk-return profiles.

c) optimization of returns achieved by minimizing the risk of the total portfolio or maximizing the yield in continuous finetuning process.

A strong risk management can improve the quality of the strategies and the decision-making process by recognizing and reducing the behavioral biases and errors of judgement to which all investors are prone, resulting in more appropriate portfolio settings.

Bearing in mind the past events and the basic principles just mentioned, let’s see some of the common trading ideas where there is a certain consensus built around them. I will not comment or share my ideas on any point. My main objective is simply to draw the attention of the most popular topic and trade strategies in the financial markets that attract most conviction.

1. The US yield curve will continue to be inverted and the US economy will enter in recession forcing the FED to cut rates sooner than implied by the market. The FED is a friendly Institution. The Quantitative Tightening is not a concern (also because there is a fair amount of confusion).Yellen said the same years ago: QT is like watching a paint drying.
2. The peripheral country risk in Europe will increase with accentuated volatility in the govies’ spreads against the swap market and between “core and not core”.
3. EUR/USD weakness will continue (targets at 0.93-0,95) despite the ECB tightening mood and real actions undertaken by the Central Bank. USD strength will remain alive on many crosses because mainly on the outflows and inflows of fixed income and equity markets.
4. Credit markets will remain volatile and bearish for the investors. Defaults will go up. It is better to remain invested in non-cyclical names and to avoid the lower rating spectrums like Bs and CCCs. SMEs are better than large corporates. The sector performance for Europe will remain in line with a macro recession phase. The scenarios are typical of a recession model and the allocations should remain mainly skewed to the low beta names.
5. BBB portfolios present moderate risk profile and low volatility.
6. Some sectors and beta pockets credit names are still back tested against previous volatility moments of the market and conditions where a widening mood prevailed. This is a good analysis for understanding what is trading cheap and what is, on the contrary, expensive.
7. AT1s and Hybrids are becoming perpetual liabilities and the call dates are not relevant anymore for pricing and yield considerations. The bottom level in fair value is lower than current prices.
8. The direct lenders are always more conservative and better price arbiters in the credit markets. Borrowers prefer choosing lenders that can offer bespoke solutions with certainty of execution.

I will leave with a final consideration. Samuel Beckett in the 1983 story “Worstward Ho” wrote the phrase:” Ever tried. Ever failed. No matter, Try again. Fail again. Fail better”. I do not see things in this way and I remain reluctant to read finance under this light because it justifies risk or misplaced investment strategies against high odds to make it. A good investment decision process coupled with a strong risk management can probe into the validity of this argument and prove it baseless when it is applied to finance and financial market positioning.

Author: sergio grasso , director at iason

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