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Managing Equity Risk Under Trump-onomics

Structured Equity can tailor outcomes when market views are increasingly polarized…

Equity markets will always be uncertain, but the range of potential outcomes both to the upside and the downside has significantly increased with the prospect of new economic policies under the Trump administration. These include tax reform, de-regulation, increased spending and trade barriers. There is uncertainty over the exact form of these policies and whether they will be enacted at all. Structured Equity can be used to manage equity risk in this environment and tailor exposure to reflect specific views or concerns.

Shaping Exposure to Views

The potential for equity market surprise to both the upside and downside has increased.

We examine how Structured Equity can be designed against this backdrop with strategies that align to either a more optimistic view or a more pessimistic view.

In both cases we reduce overall upside and downside sensitivity because of the desire to reduce risk, thereby accepting the fact that each view may not come to pass.

Not only is the economic outlook uncertain, but the market response to policies, events or data can move counterintuitively due to political responses or monetary policy intervention. For example, both the Brexit referendum and the US Presidential election result moved equity markets up in the months after, when market participants were expecting them to fall given the result.

What is structured equity?

Structured equity changes the shape of the return we receive from equities. A standard equity investment will increase (or decrease) $1 for every $1 increase (or decrease) in the equity markets. Many investors do not wish to have 100% exposure to the equity markets, so they diversify with bonds, cash and other alternative assets. While asset diversification will work to dampen equity volatility under most conditions, it does not do so under all. Equity returns can be shaped more explicitly using structured equity.

The precise manner in which an investor shapes their equity exposure is determined by a number of factors…

  • Downside Protection: What market falls do you want protection against – the first 30%, the first 40%, the first 50%?
  • Exposure: How much return do you want to earn if the equity market rises? Structured equity can help a portfolio obtain a given return through a more than one-for-one exposure to equity market gains. Leverage effectively allows returns to accelerate over a particular range.
  • Upside Participation: If the equity market rises by a certain amount, how much more return is required? Can an investor afford to give up all returns above this level, or a proportion of them in order to purchase some downside protection?

The diagram below illustrates the way these factors determine the shape of the payoff:

Right Tail – Growth Enhancing Reforms

Tax reform

Transition away from traditional corporate taxation to a value added tax with border adjustments, if enacted, would be a significant boost to exporters and should strengthen the US Dollar further. This would also be combined with lower overall taxation.

De-regulation

Dismantling of Obama-care, reduced Wall Street regulation and lighter environmental restrictions could be supportive of growth.

Fiscal policy

Increased spending, for example on infrastructure and the military, at a time of falling unemployment has the potential to boost growth and inflation.

Fed hikes

In the event of the above growth enhancing reforms, we expect higher inflation and a stronger dollar. The Federal Reserve would need to balance a tight rope between managing inflation through higher interest rates, without hiking rates too fast as to constrain growth or creating an overly strong dollar.

Structured Equity Example with Right Tail View

Structure Type and premium: Overlay on existing physical equity exposure with zero upfront premium. Total return = Equities + Price Hedge + Dividends

Term: 3 years

Upside/Downside desired: Retain significant upside exposure. Desire some protection in the event of a significant market correction.

Right Tail structure combined with existing equity investments retains 100% upside exposure on equity markets to a 20% price rise, after which 1/3 of price upside is retained.  Protection below a 15% price fall.

Left Tail – Political Dysfunction and De-Globalization

Policies fall short of expectations

It is possible many of the ‘upside’ policies have been priced in to the equity market, therefore any failure to deliver on expectations can result in market falls.

Protectionism

While protectionist policies may support individual companies or industries, in aggregate we expect these policies to be disruptive to commerce and a drag on growth and equity market earnings. China could also retaliate to such policies and weaken its currency.

Overseas shocks

Political disruption in the Euro-zone, a stall in Chinese growth and geo-political events have posed risks in recent years and continue to do so.

Fed lower for longer

In a low growth scenario, the Fed would likely hold interest rates at lower levels for longer.

Structured equity example with Left Tail view

Structure Type, premium and term: As Right Tail structure

Upside/Downside desired: Buy protection to protect capital value.

Left Tail structure, combined with existing equity investments, gives at least 0% total return over 3 years should equities fall down to 35%, after which downside participation is resumed. Forgo all upside above 14% price rise over 3 years.

Summary

Long term investors are often able to live with volatility within a range but wish to reduce exposure to the potential downside. In a world where both upside and downside are more likely, unhedged equity risk is higher and structures can be used to forgo some upside to fund downside protection. The balance between the two will depend on views and risk appetite and can be designed bespoke to the requirements of each investor.

Ryan McGlothlin

Managing Director
Industry Since: 1997
Bio: Click Here

James Walton

Investment Director
Industry Since: 2004
Bio: Click Here