An alternative option

Mayank Markanday of Architas explains why he believes that assets offering something different to investors could become increasingly attractive. Here he puts two different sub-asset classes under the microscope.

Having enjoyed broadly positive and relatively calm markets for the past few years, heightened volatility is now back on the agenda.

Geopolitical risks, the fluctuating strength of the pound and Brexit uncertainties have all buffeted the UK equity and bond markets this year. This has resulted in both the FTSE All-Share index and the Markit iBoxx GBP Gilts index registering only marginally positive returns of 0.16% over the eight months to the end of August.1

In this environment, investors seeking diversification may want to consider gaining exposure to investments that tend to behave differently to the ‘traditional’ equity and bond asset classes. We believe an asset class that has the potential to play this role is alternatives.

Here, we put two different sub-asset classes under the microscope. We take a look at one we currently believe has a strong outlook, as well as an area of the market we think is under pressure.

Breaking down alternatives

The alternatives umbrella covers a broad variety of investments. It ranges from ‘real’ bricks and mortar assets like specialist property, to asset-backed securities that pool together a group of loans such as high-grade residential or commercial mortgages.
Different sub-asset classes have their own unique strengths and are suited to different economic backdrops. Some, like infrastructure, may offer an element of inflation protection through inflation-linked cash flows, while others such as commodities are quite cyclical and tend to be influenced more by economic developments. There are also investments with payments linked to interest rates to protect investors from rate hikes, for example asset-backed securities.

What do we like right now?

Energy infrastructure

North American energy infrastructure is an area that ticks a lot of our boxes when analysing a sub-asset class’ strengths and weaknesses. In this area we are focused on assets that have the potential to generate a healthy level of income from the huge recovery seen in the North American oil and gas industry over the last few years.

This recovery has largely been down to technological advancements in the shale industry. They have brought down the average break-even price per barrel by over 50% from 2012 to 2017, falling from $73.70 in 2012 to an estimated $36.50 in 2017.2  This means that many projects that weren’t previously viable are now back on the table.

Looking at the global picture, demand for oil has remained high, while there have been supply constraints in other major oil producing nations. This has contributed to the oil price climbing from around $45 per barrel two years ago, to nearly $80 in mid-September this year.3

Falling costs combined with steady demand and rising prices have seen the number of active oil & gas drilling operations in the US more than double in the two years to 14th September 2018, increasing from 506 to 1,055.4
Charted below is the oil price per barrel vs. the number of active drilling rigs in the US over the last two years.5

This surge in activity has led to some attractive investment opportunities within the infrastructure space, as there is increased usage of many existing facilities as well as demand for further investment in new facilities.

We think assets that invest in pipelines are a good way to gain exposure to shale’s recovery. They have the potential to provide a good level of income if supply levels remain healthy, as revenues are based on the volumes that pass through pipelines. Another attractive factor is that, although influenced by the price of oil, their performance isn’t typically as tied to it as many other types of energy investment.

What’s under pressure?

Broad basket commodities

This asset class comprises a wide range of sectors, from industrial and precious metals to livestock and agriculture and is therefore influenced by a lot of different factors.

Focusing on raw materials and industrial metals, although demand is still robust the outlook for both looks more challenged this year. This is due to a combination of: concerns around global growth decelerating, the continued strong dollar and the escalation of trade war tensions between the US and China.

President Trump’s recent decision to impose a further raft of tariffs on $200 billion of Chinese imports has - as expected - resulted in retaliation from China.6 We do not see this kind of tit-for-tat exchange going away any time soon. With November’s US mid-term elections fast approaching, it seems unlikely that President Trump will change his hard-line stance on what he deems unfair trade practices.

When the threats of a trade war started earlier in the year, many viewed this more as political posturing. However, as tensions have grown, the effects are now starting to be seen in the markets. The Bloomberg Industrial Metals Subindex (TR), which is composed of longer-dated futures contracts for the key industrial metals aluminium, copper, nickel and zinc, is down just over 15%7 this year. However, much of this fall has been concentrated over the summer months, reflecting the recent growing uncertainty in the sector

Despite this, an argument can still be made for having a smaller allocation to the sector. Although it’s been a mixed year so far and the outlook is slightly clouded, a lot of the recent negative sentiment has been built on expectations. Fundamentals remain fairly robust.8

An opportunity to diversify

On a global level, UK investors are currently navigating their way through an environment of rising interest rates, reduced quantitative easing and geopolitical risks, as well as Brexit-related uncertainty on a domestic level.

We believe assets that can offer something different to investors could become increasingly attractive, as it seems unlikely that the periods of equity and bond market volatility we have seen this year were a one off.

Morningstar Direct, September 2018.
Thomson Reuters, Rystad Energy, 2017.
Morningstar Direct, September 2018.
Baker Hughes, a GE Company (BHGE), September 2018.
Morningstar Direct and Baker Hughes, a GE Company (BHGE), September 2018.
FT. China retaliates against new US tariffs as trade war escalates, 18 September 2018.
Morningstar Direct, September 2018.
FT. Metals rally after latest trade war salvo, 18 September 2018.

Issued by Architas

This is for professional clients only and should not be distributed to or replied upon by retail clients.

The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The views expressed within this article are those of Architas, who may or may not have acted upon them.

Architas Multi-Manager Limited is a company limited by shares and authorised and regulated by the Financial Conduct Authority (Firm Reference Number 477328). It is registered in England: No. 06458717. Registered Office: 5 Old Broad Street, London, EC2N 1AD.