03 May 2023
Portfolio managers Ben Wallace and Luke Newman consider what a dramatic change in market conditions could mean for long/short investors.
Key takeaways:
Changes in the investment paradigm and new regimes for market structure are not common events, but it has become clear over the last six or seven months that we have entered a new period for markets and economies.
A long period of dormant inflation, which had lasted for more than a decade, seems to be behind us, triggered by events in Ukraine and supply chain issues in the post-COVID era. With that we have seen a coordinated policy response from central banks, with a series of ‘aggressive’ interest rate hikes indicating that policy makers are determined to rein in inflationary pressures. While the scale and speed of interest rate hikes suggests we may be closer to the end of this global tightening cycle than the beginning, it has left us with a strong sense that the era of near-zero interest rates could be well and truly behind us.
This new period will have different ramifications for economies and businesses, impacting decisions for both policy makers and investors. Inflationary pressures in 2022 steadily added to expectations of a global recession in 2023. While any eventual slowdown may prove milder or shorter than many expected at the end of 2022, the chances of a higher default cycle, given the increased cost of borrowing, is very real. We have seen investor appetite change and an end to the speculative spending from businesses that have characterised the past few years.
Alpha opportunities for long/short investors
While higher financing costs represent a fundamental change in market conditions, when we look back to earlier points in our investment careers it is clear that this is a much more natural environment, when it comes to putting money to work.
Highly accommodative monetary and fiscal policy has meant that corporates and enterprises have been under very little pressure to generate cash flow and profitability over the past few years, reflected in a persistently low default rate. A return to an environment of higher dispersion levels between individual securities brings with it the opportunity for stock pickers to be able to employ valuation techniques and approaches that have been largely relegated to the sidelines over the past decade. No longer are investors faced with managing to a single dominant factor or style bias to generate performance.
This is a dramatic change of environment for long/short investors. It has created an opportunity set that is much richer in alpha opportunities, opening up the potential to achieve better levels of investment returns, relative to the past few years, without increasing risk and volatility.
The question now turns to the persistency of this new regime. How long will these new dynamics last within equity and fixed income markets?
Recent inflation data has been mixed, with stickier-than-expected inflation in the euro area and US (see Exhibit 1). In the US, after consistent surprises to the upside through 2021 and much of 2022, negative inflation surprises over the past few months have opened the door to those hoping to see the US Federal Reserve (Fed) quickly reverse its stance on interest rates (the ‘Fed pivot’). In Europe, warmer-than-usual weather meant that demand fell short of expectations, contributing to lower gas prices. Longer term, the energy crisis, driven by Europe’s previous dependence on Russia for key inputs – particularly gas – has led to a rapid decoupling, and pressure to adopt alternative sources of energy.
Exhibit 1: Are negative inflation surprises setting us up for a Fed pivot?
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Source: Refinitiv Datastream/Fathom Consulting, at 15 February 2023. Information based on Reuters Polls forecasts, which provide consensus for economic indicators. ‘Surprise’ here represents the difference between those forecasts and CPI data.
We believe that all policy makers in the western world; central banks and governments, are keen to permanently move away from the era of cheap borrowing. And there is a determination, even if it does lead to more sluggish growth, and potentially recessionary forces, to avoid negative or zero interest rates in future. Price pressures are expected to wane as 2023 progresses, and the risk of a wage-price spiral seems to have been avoided. Nevertheless, inflation is likely to settle at higher levels than we have become used to over the past decade.
A rising tide doesn’t lift all boats
Clearly, there have been unintended consequences, both economic and social, in terms of social and wealth inequality; trends that have been caused by ever-more accommodative policies. But in terms of investments, we have seen a potentially significant improvement in opportunities for stock pickers over the past few months. Particularly for long/short investors, who can benefit from both those businesses capable of rising with the tide and those that sink with it. The opportunity to do that is higher, thanks to stock dispersion that is much higher what we have experienced over much of the last decade.
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