Posted inAsset managers

Liquid alts help offset uncertainty and diversification challenges

As part of a new initiative, FSA is talking to market participants about key trends that shape fund selection. This week, Sushil Wadhwani, chief investment officer at PGIM Wadhwani, discusses the role of liquid alts.
Illustration of man changing direction, surreal abstract choice concept

The recent bout of financial instability set off by the collapse of Silicon Valley Bank seems to have been allayed by the Fed’s swift contagion-limiting actions, with stock markets steadying yet pricing in a somewhat higher probability of an eventual recession in the US Fixed income markets, too, appear to reflect more confidence in a recession and/or lower inflation.

Inflation is slowing and is likely to be substantially lower this year compared to 2022. Nevertheless, wage inflation remains elevated at rates that don’t align with the Fed’s 2% inflation target. Add to that the financial sector difficulties and inflation could be allowed to stay higher for some time if central banks put the brakes on interest rate hikes to ensure financial sector stability. And in the longer run, rising “green” investment and higher defence spending following Russia’s aggression in Ukraine suggest that inflation is likely to be higher over the next 10 years than it has been in the last 10. As market volatility and concerns about interest rates and inflation transform into recession concerns, we feel there are three plausible scenarios for the US economy:

Soft Landing: The Fed likely pauses and inflation gets back to target without a recession. The Fed can then cut rates after some time to take them back toward the assumed neutral rate of 2.5% to 3%. Equity markets may have significant further upside if this scenario comes about, as earnings forecasts would likely move higher and actual short-term rates go lower.

No Landing: It is possible that wage growth and services inflation remain too high. Therefore, even if the Fed pauses tightening, it may resume later in 2023, sending short-dated bonds lower. This scenario is likely a temporary situation that eventuates either in a “soft landing” or a “hard landing.” The impact on equities is uncertain in the short run as it depends on if markets believe the eventual destination is a soft landing or not, which may not be evident until sometime in 2024.

Quick Hard Landing: In some past recessions, the economy appeared resilient but then suddenly crumbled. It is possible that banking sector woes persist, or build further, and that this proves to be the catalyst for a quick hard landing. In this scenario, earnings forecasts would have to move lower very quickly, taking equities with them, but bonds would do well.

Liquid Alts Better Diversifiers Than 60/40 Amid Turmoil

Historically, a “quick” recession caused by financial stress has been painful for equities. So while sovereign bonds typically held up well, 60/40 portfolios struggled. But there’s the possibility of a different scenario: Fed tightening is paused for a time, but then resumes interest rate hikes that eventually lead to a recession. This recession scenario is very bad for a 60/40 portfolio because both equities and bonds decline.

The added diversification of liquid alternatives has historically benefited investors, as trend following and macro strategies have tended to do well in both recession scenarios described, compared to a 60/40 portfolio.

If a recession doesn’t materialise and instead we get a soft landing, liquid alts strategies are very adaptable and can adjust as the probability of a soft landing increases. Liquid alts can be thought of as a form of relatively costless insurance, providing protection when a 60/40 portfolio does poorly but still generating positive returns when a 60/40 portfolio does well. 2023 might represent a low point in headline inflation, with inflation rising again in 2024 and 2025. If that turns out to be the case, it won’t be surprising if a 60/40 portfolio does poorly again and liquid alts outperform.

We think that, on average, investors are still not diversified enough in their portfolios. We believe that the last stages of this tightening cycle, along with financial fragility and a potential recession, could generate significant opportunity for liquid alternatives strategies for the balance of 2023 and beyond.

Sushil Wadhwani is chief investment officer at PGIM Wadhwani.

Part of the Mark Allen Group.