It has been all about ‘Carry'?!
Most have heard of a carry trade, even if not everyone using that term knows what it means. A carry trade is one where one borrows money cheaply with the expectation of receiving a return higher than the borrowing cost. That is, assuming nothing goes wrong. Traditionally, one of the better known carry trades is to borrow in yen, a currency with low interest rates – also referred to as the ‘funding currency', to buy Australian dollars, a high yielding currency. Such trades work well when ‘risk is on', in the context of this discussion, I might say when ‘the world is right side up.' However, when the yen rises versus the Australian dollar, any extra yield captured by the interest rate differential can turn a winning trade into a losing proposition. Because borrowing tends to be involved, moves tend to be exaggerated.
Carry trades aren't limited to the yen. The euro with negative interest rates has also been employed as a funding currency; as such, when there's fear in the market, the euro at times appreciate as carry trades are being unwound.
Let's take it as step further: buying equities is a carry type of trade, as investors borrow cheaply (usually U.S. dollar cash) to buy a higher yielding asset (equities).
Negative carry carries the day?!
What if I told you that when the market turns, negative carry may carry the day. What the heck is that supposed to mean? Well, in plain English when the market turns, anything that's gotten expensive might get cheaper; conversely, the stuff that people borrowed in might appreciate. That is, cash might suddenly get a hell of a lot more attractive. The yen and euro might appreciate (like anything, though, there are no guarantees, and this isn't investment advice).
More abstractly speaking, it is negative carry that may shine. If you take it a step further, it means the types of investments that are expensive to hold might carry the day. Take gold. Gold doesn't pay interest, and it costs investors to hold it, yet it might do well when the tide turns. Take shorting stocks. Shorting stocks is not suitable for many investors, not least of which because it can be expensive: you constantly have to pay the dividend yield rather than receive it.
Or shorting bonds. Think shorting U.S. government bonds – the one investment that - by regulation - is considered safe. Betting against bonds may cost you. Except, of course, that when bond rates are extremely low (or even negative), shorting such securities might not cost you much. There have been stories of some homeowners in Europe actually being paid for holding a mortgage, so the upside down world may indeed by arriving.
Here's the problem: in the long-run, negative carry investments are an expensive proposition. At the same time, if indeed we see a bursting of a bond bubble; or if we see a sharp correction in equities, such negative carry investments might be the place investors wish they had been.
Gold is one of the less expensive ways to have a longer-term exposure to what is in the class of ‘negative' carry. Shorting stocks may be a more expensive way.
Absolute Return: Alternative Investments for Today's Markets?
Tying this all together, we believe investors may want to have a closer look at absolute return strategies. As a class of alternatives they have had a patchy track record, but we believe they deserve a second look.
Correlation: Such strategies tend to provide uncorrelated returns by design; they tend to do that with long/short strategies.