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Julian Howard, GAM

The sideways scenario


Julian Howard, Lead Investment Director for Multi Asset Solutions, GAM Investments writes that in the famous café scene of 1995 thriller Heat Robert De Niro’s bank robber Neil McCauley faces off with Al Pacino’s obsessive cop Vincent Hanna. 

The tension and the acting of course made the scene legendary, but it also had an important bearing on the plot: the two protagonists run through a reasonable scenario analysis of what each would do should they meet again in less neutral circumstances. 

Investors, while facing lower stakes, must also perform scenario analyses on a regular basis. Stock markets over the last two decades have charted a generally strong upward course interspersed with violent downward shudders triggered by episodes including the technology bubble, the global financial crisis and the recent pandemic response. 

With interest rates likely to remain accommodative in the face of an extended period of low growth as the world emerges fitfully from the pandemic response and then almost immediately faces a climate, demographic and inequality crisis, we believe a reasonable base case can be made for continued upside potential in equity markets. Faced with low risk-free rates, investors will have little alternative but to hold equities as a major component of their portfolios. 

But there is also a strong argument for sideways markets and this will demand a different approach to investing that will need to transcend the standard ‘levers’ at most investors’ disposal, namely how much equities versus bonds to hold.

Sideways markets have not been a regular feature of recent stock market history. In the last ten years, just 21 per cent of the S&P 500’s monthly returns have been within the -1 per cent to +1 per cent range, while 56 per cent have been above 1 per cent and 23 per cent have been less than -1 per cent. 

The case for sideways today rests on a combination of stretched market valuations as well as a sense of permanent crisis in the global economy and geopolitics. 

Should a stalled markets scenario indeed play out, investors will need to seek out sources of return that are at once attractive, consistent, and independent. Within equities, we believe cash-generative and economically agnostic sectors like technology, communications and healthcare should still offer the ability to generate on-going returns. However, the so-called ‘quality growth’ sector cannot do all the heavy lifting alone and will not be able to outright defy broader index gravity in an environment characterised by high valuations and deteriorating investor sentiment. 

This latter point also rules out long-dated corporate bonds whose spreads over risk-free rates – and by implication principal capital – are vulnerable to rising defaults as the economy slows. Government bonds could also suffer from a slow-motion policy error in which central banks obsess with, and act on, inflation regardless of the highly unusual and temporary nature of the post-pandemic recovery. 

The most convincing response to the sideways challenge surely lies in the field of alternatives. While the hedge fund sector in broad terms has probably suffered from too much correlation to equities, and might therefore struggle in sideways markets, we believe there are pockets of the alternatives world which merit more serious consideration. Within liquid alternatives, one compelling area that might potentially deliver consistent returns of over 5 per cent per annum is that of convertible arbitrage. A well-managed portfolio of convertible bonds should be able to benefit from periods of market volatility by participating in even brief upward moves more than they conversely fall in downward markets. Strategies that also short the equity of the same name as the convertible could benefit further. So even if markets are flat over time, any intervening volatility can be a source of profit. This so-called volatility yield is a unique by-product of enhanced convertible arbitrage investing and could be a way to transcend sideways markets.

But it is arguably Illiquid investments that offer the most definitive solution to the sideways problem. 
Investors are of course right to proceed cautiously. J.M. Keynes – arguably as good an investor as he was an economist – once said of real estate investing: “Some bursars will buy without a tremor unquoted and unmarketable investments in real estate which, if they had a selling quotation for immediate cash available at each audit, would turn their hair grey.” Today, professional managers who have spent their entire careers in the sector can steer investors through the world of illiquid assets via dedicated research and clear communication, thus avoiding the premature grey hair outcome. 

Sideways markets present a unique and challenging investment scenario to all investors, whether retail, high net worth, charity or institutional. Investment managers will need to bring the full resources and expertise of the house to bear in navigating investors through such an eventuality, even if only part of the portfolio will be assigned to specifically deal with it as will likely be the case. And to avoid the yield over-reach trap that so often catches out both manager and investor, a holistic approach will likely need to replace the hands-off discretionary set-up that characterises standard 60:40-style investing. At the end of the café scene in Heat, McCauley muses to Hanna “Maybe we’ll never see each other again.” But, of course they did, and investors should similarly prepare for sideways even if they don’t know exactly when the moment will come.

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