CURRENT MARKET CONDITIONS SUGGEST THE TIME IS RIGHT FOR STRUCTURED PRODUCTS


With the FTSE 100 and Nasdaq 100 share indices up some 160% and 220% from their 2020 COVID-19 lows, the rally in equity markets is potentially becoming a little long in the tooth. In addition, with unemployment in Western economies around the world still stubbornly low, and central banks globally needing to engineer a slow down in order to keep a lid on inflation, there is a question mark over whether markets can continue to perform in the coming months.

A Turning Point for Interest Rates

Over nearly a 40-year period between 1982 to 2022, we have seen an unprecedented march downward in the Western world’s interest rates. US interest rates (US 10-year bonds) fell from 15% to 1.38% and in Europe we saw negative rates. This was a boon for bond markets because bond prices move in the opposite direction to interest rates.

However, interest rates seem to have reached a turning point, and perhaps seen their lows. In such a case, the tailwind for bond prices will become a headwind. If interest rates move towards their long run average level of 6.5%, the effect on investors’ bond portfolios will be damaging – 2022 was acutely difficult year for many fixed income investors.


Broad Equity Valuation Metrics Seem Stretched

Currently, broad equity valuations appear to be stretched on a number of metrics. Robert Shiller, the noted US economist, developed what has historically been a reliable measure of US equity market under- and over-valuation using data from the last 140 years. On his measure (10-year average inflation-adjusted earnings relative to price, called the Shiller P/E ratio) large US equities (the S&P 500 index) currently record a valuation of 30, whereas the longer term average is nearer half that. At such times, stock market returns going forwards are typically muted.

This is because, according to this metric, stock markets are currently expensive. Moreover, markets face the prospects of sticky inflation and hence interest rates remaining higher for longer. A quick re-adjustment to the long run average Shiller P/E ratio could mean a fall in the S&P 500 of at least 20% from here. So both bond and equity markets face challenges in delivering attractive real returns over the medium term from this starting point.


The Case for Structured Products

Where can an investor turn? One such area that can deliver positive returns in a rising interest rate and poor equity market environment is structured products. They are currently able to generate a return in excess of 7% a year even if equity markets fall by up to 30% (perhaps back to the long run Shiller P/E ratio level).

In addition, “autocallable” products that give investors the chance to redeem early have the particularly attractive benefit of being relatively insensitive to rises in interest rates. Certain structured products allow investors to combine the benefits of buying equities at an attractive valuation – they pay a positive return as long as the equity index does not fall by, say 30%, from its starting level – and the benefits of being fully capital protected, like a bond; unless equity markets hit valuations not seen since the early 1980’s, (which was the start of a 20-year bull market).


Risks and Opportunity Costs

Structured products can allow investors to generate an attractive return in a flat or even falling equity market environment, whilst protecting them from anything but a major depression style sell-off. Structured products are, however, not risk free. In essence, investors are giving up the potential for (in theory) unlimited upside returns (for a given return), but also benefitting from a downside protection buffer. In short, an investor swaps some of the potential up (and down) side, for a higher probability but potentially lower and capped return.

Investors also need to remember that the accepted benefits of diversification also apply to structured products. Buying a diversified structured product portfolio (or investing via a fund) allows investors to diversify a number of key risks, including counterparty risk. Counterparty risk describes the changes of the issuer of a structured product – typically a bank – not being able to meet its obligation and return the capital at maturity. Credit analysis of the issues is one of the jobs of any fund manager running a fund of structured products, like the ARIA Target Income Fund.

There is also the risk that a downside protection levels of some structured products may be hit, whereby the underlying company or stock market which the product is linked to, falls significantly and uses up the buffer or protection built into the product. However, investors into a Fund have daily liquidity and hence the ability to buy and sell should they feel uncomfortable with the stock market environment.


Conclusion:

Increasing volatility in the inflation or the prices of everyday goods and products we consume will mean volatile stock market conditions. Without the tailwind of falling interest rates, stock markets may find difficulty in generating the returns that investors have been used too in recent years. Moreover, the greater volatility can improve the returns or income yields offered by structured products – something that active management can take advantage of.

Structured products targeting income, or a fund that invests into them, allow investors to diversify some of their reliance on traditional markets performing well, by using diversified and liquid structured product portfolio for a portion of their overall portfolio. Current valuations historically would suggest that now is a sensible time to begin to take on such diversification.


General disclosure:

This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Aria Capital Management or any of its related companies to participate in any of the transactions mentioned herein. This material may contain estimates and forward-looking statements, which may include forecasts and do not represent a guarantee of future performance. This information is not intended to be complete or exhaustive and no representations or warranties, either express or implied, are made regarding the accuracy or completeness of the information contained herein. The opinions expressed are subject to change without notice. Reliance upon information in this material is at the sole discretion of the reader. Investing involves risks. Past performance does not guarantee future results. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.


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