Absolute return: a ‘new’ long/short paradigm
Portfolio managers Ben Wallace and Luke Newman consider what a dramatic change in market conditions could mean for long/short investors.
4 minute read
- The scale of central banks’ response to inflationary pressures has brought an end to the speculative excesses that have characterised the past few years, with ramifications for markets and economies.
- While higher financing costs represent a fundamental, potentially more uncertain, change in market conditions, we see this as a much more natural environment for businesses to operate in, and for investors to build their strategies.
- Higher stock dispersion has created what looks like a rare opportunity for stock pickers, particularly long/short investors focused on company-specific factors that can determine success or failure.
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?
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.
Inflation: The rate at which the prices of goods and services are rising in an economy. The CPI (consumer price index) and RPI (retail price index) are two common measures.
Tightening cycle: A tightening cycle is where central banks are increasing interest rates.
Discount rate: The discount rate is a calculation of expected future cash flows discounted to present value. Measuring the present value of future earnings allows an investor to have a better idea of the value of a business today.
Recession: A significant and prolonged downturn in economic activity, commonly considered to be at least two consecutive quarters of falling GDP (gross domestic product).
Default/default cycle: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due. A period in the market cycle when default levels are increasing in response to more difficult economic conditions.
Fiscal/fiscal policy: Connected with government taxes, debts and spending. Government policy relating to setting tax rates and spending levels. It is separate from monetary policy, which is typically set by a central bank. Fiscal austerity refers to raising taxes and/or cutting spending in an attempt to reduce government debt. Fiscal expansion (or ‘stimulus’) refers to an increase in government spending and/or a reduction in taxes.
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money. See also fiscal policy.
Net and gross exposure: The amount of a portfolio’s exposure to the market. Net exposure is calculated by subtracting the amount of the portfolio with short market exposure from the amount of the portfolio that is long. For example, if a portfolio is 100% long and 20% short, its net exposure is 80%. Gross exposure is calculated by combining the absolute value of both long and short positions. For example, if a portfolio is 100% long and 20% short, its gross exposure is 120%.
Stock dispersion: How much the returns of each variable (eg stocks in a benchmark) differ from the average return of the benchmark.
Alpha: A measure that can help determine whether an actively managed portfolio has added value in relation to risk taken relative to a benchmark index. A positive alpha indicates that a manager has added value. Alpha is the difference between a portfolio’s return and its benchmark’s return after adjusting for the level of risk taken.
Wage-price spiral: The phenomenon where prices rise as a result of higher wages, leading to demand for higher wages to cope with increasing living costs.