In this Q&A, Cayman Alternative Investment Summit (CAIS) talks with Mark Okada, CIO & Co-Founder of Highland Capital Management, to discuss his investment outlook for 2017.
Q: What do you make of the post-election enthusiasm from markets? Do you think the rally is overblown or is the enthusiasm justified?
The hype around the post-election rally has been interesting to watch. As a firm, we took note of the rising populist movement last year and, unlike many others in our industry, were prepared for both the Brexit vote and the Trump victory. What we were not expecting, however, was the Republican sweep of Congress.
Nevertheless, Trump’s win was what captured the public attention, and as a result, the post-election market rally has been mistakenly attributed to Trump alone. In our view, the real source of the market strength is the string of positive economic data that began in the months before the election, followed by the Republican sweep. Without those two key factors, we think the markets would be responding very differently to Trump. (For more, see: How Tech is Changing Alternative Investments.)
So while there has probably been overshooting in certain areas or sectors, we do think much of the market strength is justified given the positive economic data we’ve seen in PMIs and consumer confidence, as well as the prospect for deregulation, fiscal stimulus and other pro-business policies from a GOP-controlled government.
Q: What is your impression of the new administration thus far? How is it impacting your investment outlook?
Since Trump took office, he has confirmed our view that under the new administration we will see policy uncertainty and consequently, volatility in 2017. That said, the leadership appointments point to a pro-business environment, and again, we maintain faith in the ability of a Republican Congress to provide relief from a regulatory standpoint, so our outlook is constructive for the corporate economy. But with the communication that’s come out of the Oval Office around trade and immigration, it is clear to us that Trump will be a major source of volatility.
With this expectation about both the volatility and opportunity ahead of us, we will be looking to buy any dips in the market created by Trump and the policy uncertainty he brings. And if his executive order spree is any indication of what’s to come, there will be plenty of buying opportunities in 2017.
Q: Where do you see the biggest opportunities in 2017?
We think the volatility will lead to opportunities for investors in 2017. Any indication of policy changes will create winners and losers as markets react to and digest that type of news, which presents trading opportunities with the prospect of price swings. Investors who position capital to benefit from volatility should thrive in 2017.
Q: Does that mean you expect the flows from actively-managed strategies into passive funds to change direction this year?
The rise of passive funds is not surprising given the underperformance from active managers in recent years. But between the post-crisis regulatory environment and the effect of the over-reliance on monetary policy, markets over the last several years were artificially inflated and momentum-driven. Now we are finally in an environment where active managers can truly prove their value, and the 2016 credit market provided a glimpse of what that can mean for investors.
In credit, disciplined security selection and nimble active management produced outsized returns in 2016. Further, any regulatory easing bodes well for the function of credit markets, meaning this fundamental allocation approach should continue to be rewarded. At the end of 2016, we saw the beginning of meaningful rotations in sectors and asset classes, and those kinds of movements create valuable opportunities for active management. At the same time, correlation is dropping broadly across equity markets, as well as within sectors, meaning there is more idiosyncratic risk in stocks. All these market forces, from sector rotation to declining correlations both on a sector and security basis, present the ability to generate real alpha.
But the size and growth in passively-managed products is too significant to reverse the trend altogether, so while we don’t see the popularity of passive strategies going away, we do expect many critics of active management to be silenced in 2017.
Q: What role does the Fed play in this new environment? With the focus on the new administration, has the market’s obsession with the Fed gone away?
The contrast between the Fed’s two December rate hikes- the first in 2015 and the latest at the end of last year- is indicative of the role we think the central bank will play in this new environment. When the Fed finally moved forward with a rate hike in December of 2015, the new year began with a steady plunge in risk assets that lasted until mid-February. Conversely, when the Fed elected to raise rates again in December of 2016, the new year brought Dow 20,000, as well as new highs for the S&P 500 and the Nasdaq. Looking at the aftermaths of these two decisions, it is clear that the Fed is in much more of a position now to carry out the multiple hikes outlined in their guidance than they were at this time last year.
That, combined with the latest string of positive economic data, makes us focused less on each Fed meeting and more on the ultimate impact of rising rates.
You’ve already seen that shift take place in the demand for floating-rate credit, which has increased in recent months. Loan funds saw $6.8 billion in inflows in December alone. Rising Libor into Q4 of 2016 rewarded those flows, and as of early January, three-month Libor rose above the 1% level of the floor cap that’s in place for most loans, meaning those loans are now truly floating rate.
With much of the loan market trading around par, it’s clear that investors are looking to loans for protection from the downside of rate increases that occurs in other fixed-income strategies. (For more, see: How Hedge Funds Can Do More for Charitable Causes.)