Asset management in the new abnormal

Stagflation, megathreats, the Wild West that is crypto. These are just some of the risks and opportunities that investors are facing as they look to a future beyond the COVID pandemic. I'm Anna Pavlova, Professor of Finance at London Business School and Academic Director of the AQR Asset Management Institute. To help asset managers navigate the new abnormal, we convint global leaders in academia, industry, and policymaking for last December's Insight Summit.

The insights you are about to hear on higher for longer interest rates and how to benefit from volatility to help boost returns are from the one-day event. We hope the discussion will inspire industry best practices both now and in the future. First, Dr. Nouriel Roubini from NYU Stern School of Business speaks about the wide range of mega threats to peace and prosperity, starting with what he saw as a geopolitical depression.

so we live in a different world a world in which uh the last 75 years of relative peace prosperity and progress may be challenged by this kind of a mega threat uh we live in a world in which as i said there is a geopolitical depression and the risk of war and great powers is rising it could happen for a number of various reasons we live in a world in which uh there is severe climate change and the losses and the cost of it are not just 10 or 20 years from now. Look at the last summer.

You had droughts in Pakistan, in India, Western Europe, sub-Saharan Africa, all the way in the US from Colorado to California. 80% of Mexico is in a drought, most of Latin America, and you name it. And the costs are becoming severe. The economist who predicted the 2008 financial meltdown also highlighted a process of deglobalization with major implications for global supply chains.

But today's geopolitics that is driving it. We talk about fair trade or secure trade rather than free trade. We think about reshoring rather than offshoring or friend-shoring rather than offshoring. An increase in the restriction to trade in goods, in services, in the movement of capital, FDI, labor, technology, data, information.

And the trend is going in that direction of more deglobalization, more decoupling, more fragmentation, more balkanization of global supply chains. And of course, that may make trade more secure, but it has cost in terms of increasing cost of production. Adding to that, Dr. Rubini said the double blow of pandemic and war in Ukraine has caused inflation to surge and growth to slow around the world.

Because of that, he said stagflation is back on the cards. The painful mix of high prices and low growth witnessed in the 1970s. But we're also in a world in which there is a debt trap, the way the economists and the BES call it. There is so much private and public debt in the system that if you try to fight inflation and raise interest, that's enough to bring back inflation to 2%, not only you cause a hard landing, and it's not going to be a short and shallow recession, it's going to be a severe one, but you cause a crash in the equity markets, a crash in the bond markets, a crash in the credit markets, like it started to happen this year.

And that financial crash makes the recession more severe, and the more severe recession makes the financial tightening more severe in a vicious circle In my view faced with this economic and financial crash central banks are going to blink They going to blink and they going to wimp out They not going to be able to raise rates and fight inflation Rubini's message is clear. The threat of recession is rising. So what can be done about it? The challenge for policymakers is raising interest rates just enough to quell high inflation without causing a severe downturn, known as a soft landing.

However, that is a tight rope to walk, something that was noted by Patrick Honohan of Trinity College Dublin, the former governor of the Bank of Ireland. But he pointed out that fiscal, not monetary, policy bears most of the blame for the current inflationary shock. Clearly central banks need to fully understand what's been going on in this complex environment and to communicate this to relevant economic actors. And the contribution of monetary policy?

Is the inflation an inevitable consequence of the huge expansion of central bank balance sheets in the previous decade, as many superficial observers say? That's a question they have to answer very, very clearly. For me, probably not. Though if there had not been that pool of liquidity, the price rises might have been slowed a bit more quickly, quasi-automatically, by the liquidity squeeze.

I'll grant you that. Arguably more important than the pool of excess liquidity has been the pent-up demand from the huge pool of excess savings that accumulated in the pandemic. But the former central banker saw one silver lining in an otherwise gloomy prognosis for policymakers. Inflation has gone so high now that there is a chance for the main central banks to reset the global reference point for price stability from its current somewhat arbitrary value of 2%.

With R-star much lower than it was 30 years ago, that's for sure, most economists realise that a 2% inflation target is too low to provide enough policy room for combating a recession. Now, shifting the consensus target from 2% is hard, but it's not as hard as it was before this inflation. The overshoot has offered an opportunity to reset that consensus at a much preferable 3%. So it seems inevitable that interest rates will need to continue rising into 2023 to keep inflation in check, even as growth slows.

That was a view aired by Jordan Brooks of AQR Capital Management. But while the bond markets seem attuned to this darkening macroeconomic backdrop, the asset manager said that equity markets look shakier. Equity valuations remain extremely rich, in fact, richer than the peaks before most drawdowns, let alone richer than the troughs of most drawdowns. And in terms of investor expectations of fundamentals, while the earnings outlook has flattened, these are earnings forecasts on the bottom, but this is flattened, right?

You're seeing nowhere like the earnings drops that we tend to see during recessions. Equity markets seem to be pricing in what I would call an impossible trinity. The impossible trinity is that we going to have lower rates we going to have disinflation and earnings are going to remain resilient It hard to see all three of those things coinciding So, what does this mean for investor portfolios? Brooks pointed to strategic asset allocation.

He challenged the conventional wisdom around balancing portfolios between stocks and bonds, which have moved in opposite direction for the past decade and counterbalanced each other. In 2022, prices for both asset classes plunged. We want to think about diversification in our strategic allocations and think about a more risk-balanced approach, or at minimum, some allocation to commodities and other diversifiers in our strategic allocations. Well, one market phenomenon that we observe that tends to be robust that we're seeing again this year is that it takes markets time to price in new information.

Markets systematically underreact to catalysts. And this is the motivation behind trend following strategies. So trend following strategies might be one way to capitalize on higher macroeconomic volatility. So it's clear that investors should be looking for assets that have low correlation with stocks or bonds, which have been hammered by high inflation and market turmoil.

So far, we've looked at how inflation, higher interest rates and wider macroeconomics have depressed asset prices and how to benefit from volatility to help boost returns. Now let's turn our attention to another major investment theme, low or falling cryptocurrency prices. Last year, more than $2 trillion in market value vanished from crypto tokens as the flow of cheap money was turned off by central banks. The crypto winter even exposed fraud and mismanagement at some crypto firms, something that Fabio Panetta of the European Central Bank underlined when he spoke about how policymakers are reigning in the wild west of financial markets.

The crypto dominoes are falling, sending shockwaves through the entire crypto universe. The crash of stablecoin TerraUSD and the recent bankruptcy of the crypto exchange FTX and 130 affiliated companies each took only a few days to unfold. This is not just a bubble that is bursting. It is like froth, multiple bubbles bursting one after another.

The sell-off is exposing those swimming naked. It has revealed some unbelievably poor business and governance practices. And similar to the subcrime crisis, it has uncovered the interconnections and opaque structures within the crypto house of cards. This is said to dampen enthusiasm in the belief that technology can free finance from scrutiny.

The crash has served as a cautionary reminder that finance cannot be trustless and stable at the same time. Trust cannot be replaced by religious faith in an algorithm. It requires transparency, regulatory safeguards and scrutiny. Does this mean we are witnessing the endgame for crypto?

Here is what Panetta thinks. People like to gamble. on horse races, on football games and many other events. And some investors will continue to gamble by taking speculative positions on crypto assets Today I will argue that we need to move rapidly from the debate on cryptoassets regulation and taxation to decision and implementation And to harness the possibilities of digital technologies we must provide solid foundations for the broader digital finance ecosystem.

This requires a risk-free digital settlement asset which only center bank money can provide. So it seems there is a lot of work to do to protect investors from the negative externalities and lack of regulation in crypto. But that hasn't stopped many asset managers, including BlackRock, from finding ways to monetize investors' enthusiasm for digital assets. And indeed, Christine Parler at UC Berkeley Haas School of Business sees the potential for decentralized ledgers, which underpin cryptocurrencies to shake up the plumbing of financial markets in terms of clearing and settlement trading, as well as margins and collateral.

What is very specific about what's happening in decentralized finance is new types of business models for all of these elements are emerging. And the risk and reward to the different participants, how they're balanced, is changing. So risk is shifting from intermediaries to markets and back again. And I think everyone who works in this space has to really think about what's coming down the gangplank, as it were.

Let's look at the example of stablecoins, a type of digital asset that offers price stability as they are pegged to a fiat currency, and how they could emerge as an alternative to commercial bank deposits. If you think about it, one thing that banks do is they take these deposits and they make loans. They use the information that they have to make loans to worthwhile businesses, positive NPV projects we like to say. If it is in fact the case that the banks are no longer holding those pools of capital, but instead those pools of capital are sitting with stablecoins, and those stable coins are regulated and being forced to essentially put their money into safe assets, i.

e. government debt. What you have is a world where money has moved from the banking sector, which was doing its business of maturity transformation and lending to small businesses. That money is now shifted into some sort of entity that is being forced to essentially lend to the government.

Where does the growth in the economy come from if banks are not making lending to small businesses? This is something that we should think about. So it's clear that decentralized finance could reduce the resources available for banks to inject into the economy. This is a big question for policymakers to ponder.

Whether it is shared digital ledgers, crypto assets or the sudden rise in inflation, it has been a landmark 12 months for asset managers. And that means the industry is starting the new year far behind. It will force asset managers to make tough decisions about where to invest for growth. This is the new abnormal.

thank you for listening to our insight summit event podcast for more information on the aqr asset management institute please visit our pages on london.edu and for more faculty research insights go to london.