Trends Watch: Questions for Alternatives

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, and this week goes beyond that definition to include the views and insights of an executive from IVOL, a fixed income fund. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks with Nancy Davis, Managing Partner & CIO, Quadratic Capital Management.

What is your outlook for alternatives?

We like diversifying at this stage in the cycle, and we see a need to give investors a new way to access OTC option markets.

What is your outlook for the economy?

Let’s look at the macro environment right now. Equity markets in the U.S. are at or near all-time highs. Unemployment is the lowest it’s been over the last 50 years. In many parts of the country, unemployment has never been measured this low. Core inflation, as measured by Consumer Price Index, is 1.6%, under the Fed’s 2% target. And, in this rosy, perfect picture of a market and an economy humming along about as perfectly as can be imagined… the Fed is cutting rates. The Fed is so worried that they just cut rates and the only debate is by how much and how quickly will they continue. What on earth is going on? Why is the Fed so worried? 

Broadly speaking, there could be three outcomes…

1. The Fed is right to be worried, and we are headed for a recession.
2. They might be wrong, and by cutting rates now, they just end up putting a rocket under a strong economy.
3. We don’t know, and things will stay uncertain.

In each of these scenarios, asset prices will move differently.

• If we are headed for a recession, equity markets will come under pressure. They can’t stay up at all-time highs if the economy is slowing. If equity markets fall quickly, then all financial markets will come under stress across the board. I would call this the “risk off” scenario.
• Or, if the cut was just insurance that the Fed didn’t really need to take out, and the economy roars back into life, that will create inflation. Bond markets will struggle to deliver returns that can beat this inflation, particularly with interest rates as low as they are these days. We could call this the “risk on” scenario.
• Or, we might try out both of these scenarios as the market tries to figure out what’s really going on. That means everything will move around a lot more. The “volatile” scenario. 

What keeps you up at night?

The big risks right now are portfolios being overly concentrated. Most portfolios/alpha are net short volatility and need some form of long convexity exposure. We are increasingly worried that the financial markets are very highly leveraged but in less obvious ways – with private investments (direct lending, private credit, private equity) as well as psychologically, algorithmically, and structurally. For instance, privates that cannot be sold will mean more volatility, and perhaps a liquidity crisis, in public markets. In my view, there are too many assumptions from the last crisis. Such as, private credit protecting a portfolio with equity beta. When equities sell off, credit spreads widen. The next crisis will not look like the last one.