Weekly Briefing: 3/27/22
Weathering the storm and looking ahead for potential positive surprises...
Performance & Other Observations
US equities continued to press higher last week — and volatility moved lower — as trading conditions made their best effort to “normalize” after Russia/Ukraine and other events. The Volatility Index (VIX) declined to 20.81 last week — a level that implies absolute daily price moves of ~1.3% for the S&P 500 over the next 30 days. That’s much lower than the ~2.2% price moves being projected a few weeks ago when the VIX was trading above 35. It’s not as if visibility has improved dramatically, and uncertainty still abounds, but the sense of panic has lessened. Hopefully, Armageddon will be averted. As Bespoke Investment Group said, “Markets are starting to feel ‘normal’ again after about a month of frantic news flow and large, idiosyncratic moves.”
“Markets are starting to feel ‘normal’ again after about a month of frantic news flow and large, idiosyncratic moves.” Bespoke, 3/22/22
Interest rates continue surging higher: UST 2-year yields are up 157 basis points this year, jumping 99 bps since 3/1/22 alone, but surprisingly the recent rate move has not deterred US equities, which continue to rebound from depressed sentiment levels. In fact, high-priced growth equities outperformed last week with the Nasdaq 100 (QQQ) up 2.4% compared to a gain of 1.8% for the S&P 500 (SPY). Over the last two weeks, QQQ has outperformed SPY by ~420 basis points.
With interest rates surging higher, why is the QQQ outperforming? After all, high-priced growth shares have been underperforming since late last year as inflation and rates moved higher, the Fed set the stage for a policy shift, and valuations re-rated lower.
We offer the following reflections on recent QQQ performance:
Perhaps, the valuation adjustment has already run its course. High-growth equities deserve a valuation premium, but not necessarily an excessive premium. Maybe the “excess” has been sufficiently worked off. Unequivocally, we know P/E multiples are lower compared to the start of the year since shares are trading at lower prices even though corporate earnings season delivered solid profit gains. Simple fractions: Numerator down, denominator up.
Investor sentiment had reached extreme bearishness and some of that has mean-reverted with fund flows and prices adjusting.
As rates have trended higher, the yield curve has flattened. Concerns over a Fed policy persist, especially with certain FOMC members suggesting a more aggressive pace to rate hikes in recent days. As a result, recession fears and predictions have proliferated. Recession concerns are overdone according to Marko Kolanovic of JPMorgan, but regardless, if a slowdown emerges, investors tend to migrate away from cyclicals toward secular growth. It’s a rational move for equity investors. Perhaps we are seeing early steps in that direction, especially given growth underperformance YTD.
Leveraged fund managers had been rotating from growth to value since the first week of ‘22. As a result, relative exposure to Nasdaq/Technology and other growth-oriented shares dropped to some of the lowest levels in years according to various prime brokers who service hedge funds. Perhaps the selling pressure exhausted itself and managers are rebuilding growth positions.
Finally, and probably most importantly, short-gamma conditions for options dealers were most pronounced for Nasdaq 100 shares. This is the universe where call/put buying has been heavy. As a result, technical buying pressure amplified gains as dealers (who were short volatility) chased shares higher for hedging purposes. However, short gamma conditions have faded so this impulse has been reduced for now.
To varying degrees, all these factors could be contributing to recent Nasdaq outperformance.
All that said, the QQQ still lags SPY on a MTD basis, let alone YTD. For March, SPY is up 4.0% and QQQ is up 3.8%. For 2022, SPY is down -4.4% and QQQ is down -9.6%.
Lee is Bullish on US Equities: FSInsight is affiliated with Fundstrat, the institutional research firm co-founded by former JPMorgan strategist Thomas J. Lee. As a subscriber to FSInsight, we often reference the firm’s research in our weekly briefing. Last Wednesday, Lee summarized his current market view on CNBC. Essentially, Lee sees fundamental challenges ahead but he also asserts (1) equity prices have already discounted various obstacles, (2) consumer balance sheets and accumulated savings should allow for enduring consumption, and (3) corporate managements continue to benefit from negative real interest rates and are showing collective skill at navigating difficult waters. In short, with so much bad news priced into equities, Lee sees potential for equities being lifted by positive surprises in the second half of 2022.
Relative Value Spotlight
Last Wednesday, March 23, marked the two-year anniversary of the COVID lows. During the tumultuous period since then, the S&P 500 Index (SPY) has catapulted 109.0%. However, it would be disingenuous to measure the substantial post-COVID gain without referencing the depth of the loss that preceded it. These are two sides of a related trade.
As the pandemic emerged in early 2020, uncertainty was mounting. Case counts escalated and policymakers announced the economic shutdown. After peaking on 2/19/20, the SPY plunged -33.7% over the next 23 trading sessions before it bottomed out on 3/23/20. After such a loss, a 51% gain was required just to break even; SPY achieved that threshold less than six months later on 8/10/20.
Over the entire period — spanning the plunge and the surge — SPY has delivered a cumulative (net) total return of 38.5%. That equates to 16.8% annualized over the 2.1 years. For comparison, the US Aggregate Bond Index (AGG) shows a negative return of -3.5% over that period — an annualized decline of -1.7%.
We appreciate your support and partnership as a paid subscriber.
As you know, we aim to deliver timely and relevant data/insights to help others leverage their time, make better decisions, and improve their client communications.
We are looking to add subscribers to our community, so please consider referring Coffee & Capital Markets to select colleagues, clients, and friends.
Economic Data & Trends
Based on below-average consumer/investor sentiment, markets might run the risk of underestimating the resilience of US activity. Two more data points emerged last week suggesting underlying strength: (1) Flash PMI reports from IHS Markit and (2) initial jobless claims.
US Flash Composite Jumps to 8-Month High for March: We follow the flash PMI surveys compiled by IHS Markit because they provide an early look into current monthly activity. March flash reports provide the first read on manufacturing/services activity since the Russia/Ukraine War commenced. March reports also take into consideration the imminent rate-hike policy from the Fed.
Flash US PMI Composite improved to an 8-month high of 58.5 in March from 55.9 in February. Services increased to 58.9 from 56.5. Manufacturing increased to 56.5 from 52.5. So far in 2022, PMI data is improving.
Demand improved: According to IHS Markit, “The sharp expansion in activity was broad-based and signaled a further recovery from January’s Omicron-induced slowdown. March data showed a marked rise in new orders at businesses, as an upturn in client demand strengthened for the second month running... As well as increased interest from existing clients, firms mentioned that a greater availability of inputs allowed them to be more competitive and win new customers...”
Costs and supply chain issues remain: “Meanwhile, price pressures remained a significant theme in March, as costs increased at one of the fastest rates on record. Firms stated that further hikes in raw materials, fuel, and energy costs drove inflation, but also highlighted that the war in Ukraine and China’s lockdowns were exacerbating supply chain strain.”
Non-US Flash PMIs Mixed: Across the UK and Eurozone, the post-COVID economic expansion continued in March, but at a reduced pace. In Japan, activity improved but remained under the key “50” threshold, signaling modest recession-like conditions.
Flash UK PMI Composite decreased to 59.7 in March from 59.9. Manufacturing declined to 52.6, but Services increased to a nine-month high of 61.0. However, growth activity might see additional hurdles in the days ahead. “Escalating inflationary pressures and concerns related to Russia's invasion of Ukraine meanwhile led to a slump in business optimism to its lowest since October 2020.”
Flash Eurozone PMI Composite decreased to 54.5 in March from 55.5. Manufacturing and Services inched lower to 53.6 and 54.8, respectively. Despite a modest deceleration, activity levels remain above the pre-COVID trend. Note: Following the Flash PMI report, the IFO Business Climate Index for Germany showed a sharp decline to 90.8, with the “expectations” sub-index — most correlated to future growth — dropping more than it did during the COVID shutdown. “Sentiment in the German economy has collapsed,” according to the IFO Institute. German businesses bracing for uncertainty related to Russia/Ukraine is a rational response. In stark contrast, the US is more self-sufficient and resilient.
Flash Japan PMI Composite improved to 49.3 in March from 45.8. Manufacturing flipped from contraction to expansion, rising to 50.6 from 49.3. Services increased to 48.7 from 44.2. Services have been hindered by Omicron, but with case counts falling and Japan lifting emergency restrictions, movement/activity should improve in the months ahead.
Initial Jobless Claims Lowest Since 1969: Initial claims for unemployment insurance dropped to 187,000 last week, well below estimates.
Claims are now at the lowest level since September 1969 — when the Miracle Mets rallied to overcome the Chicago Cubs to win the National League East and then proceeded to swept the Atlanta Braves for the NL Pennant and upset the powerful Baltimore Orioles to win the World Series. (Clearly, we are excited that Major League Baseball will soon begin.)
“At this point, there isn't much more to say about the labor market. It is extremely strong and this data is exactly the sort of evidence that has given the Fed confidence that they can raise rates more quickly to battle inflation.” Jefferies, 3/24/22
The US labor force was ~78 million in ‘69 compared to ~158 million today, so the current level of claims is remarkable. Jefferies: “At this point, there isn't much more to say about the labor market. It is extremely strong and this data is exactly the sort of evidence that has given the Fed confidence that they can raise rates more quickly to battle inflation.” Will Fed rate hikes disrupt a strong labor market? Initial hikes probably will not deter the jobs market, but time will tell. We highlight this data to illustrate the firmness of the underlying employment environment as the Fed begins its new policy regime.
Fixed Income, Rates & Credit
Over the last three weeks, rates have been surging. Since 3/1, yields for the UST 2/3/5 year notes have jumped ~100 basis points and 2-year yields are showing “the strongest momentum in like forever” according to The Market Ear.
US Aggregate Bond (AGG) is down -4.3% since 3/1. AGG declined -1.9% last week and is down -6.7% for ‘22. The Market Ear: “Awful: There is really no other word which better describes recent US bond market performance. While it could definitely be worse, it is awful. This year, this month, this week… Awful… unless you were short, in which case you might think this is awesome.”
Again last week, long duration bonds struggled the most. UST 20-Year (TLT) dropped -3.6%. With a duration of ~19 years and rates on 20+ year bonds up ~75 bps, TLT is down -12.9% YTD on a total return basis (after a modest offset from interest income).
Across safe-haven and fixed income assets, only the US dollar (USDU) gained last week. For 2022, USDU stands out as the only source of positive return with a gain of 1.9%.
Corporate credit spreads have been tightening over the last two weeks as spread strategies decline less than US Treasury bonds. HY spreads are +367 (as of Thursday), down from a mid-March peak of +421. IG spreads are +132, down from a recent peak of +152. JPMorgan: “HY spreads have widened, but the credit costs that companies are paying are still significantly lower than the average over the past 20 [years]. Default rates are near historical lows, both in the US and Europe, balance sheets are in general well capitalized, with high profit margins, and improving FCF yield, and debt duration has generally extended meaningfully. Our credit analysts believe the recent spread widening will not continue, and look for some narrowing into year-end.”
HY bank loans have been outperforming this year due to their floating-rate coupon structure. S&P/LSTA Leveraged Loan (BKLN) declined -0.2% last week and is down -1.5% for ‘22.
Yields Surging: As mentioned above, yields have jumped ~ 100 basis points since 3/1 for the UST 2/3/5 year notes.
Yields are higher all across the UST yield curve.
UST 2-year closed at 2.30% — up 157 bps for 2022.
UST 10-year closed at 2.48% — up 96 bps for 2022.
The 2-10 spread narrowed to +18 bps. Based on data compiled by Bespoke Investment Group, the current slope of the 2-10 curve reflects a ~36% probability of a US recession within the next 12 months, but we almost hesitate to share such “data” because there is no certainty related the duration or magnitude of any recession — assuming one occurs. Recall, the technical definition of a recession is two consecutive quarters of negative GDP growth. In some cases, recessions can be short-and-shallow.
US/Global Equities
US equities added to recent gains last week, pushing higher and demonstrating relative self-sufficiency compared to non-US markets which declined.
S&P 500 (SPY) gained 1.8% last week, but growth-oriented Nasdaq 100 (QQQ) gained 2.4%. Apple (AAPL) — the largest holding in both the SPY and QQQ — gained 6.6% last week. Over the last two weeks, QQQ has outperformed SPY by ~420 basis points. QQQ has narrowed the performance gap in recent weeks, but continues to trail SPY for ‘22. Meanwhile, small-cap Russell 2000 (IWM) declined -0.4% last week.
Commodity-related equities outperformed last week: Energy (XLE) and Materials (XLB) gained 7.6% and 4.1%, respectively. Following up its leadership last year, Energy is the top performer for ‘22 with a gain of 43.3%.
Across market-capitalization (size), value and growth performance diverged last week: Large-cap growth outperformed (modestly), but small-cap growth lagged sharply. For 2022, value is outpacing growth by ~1000 basis points or more for both large-cap and small cap shares.
Developed Markets and Emerging Markets were mixed last week. Six of the 11 markets we track were positive for the week, but MSCI EAFE (EFA) was flat and Emerging Markets (EEM) declined -0.7%.
Brazil (EWZ) added 8.8% last week. EWZ remains the top performer for ‘22 with a gain of 34.3% as commodities-based economies outperform. Saudi Arabia (KSA) added 1.1% last week and is up 16.7% YTD. Technically, Financials score among the top YTD contributors for both these markets as banks/exchanges benefit when commodities-oriented industries gain.
After surging the previous week on potential policy support — and probably a dose of short-covering — China (MCHI) resumed its downtrend last week, declining -3.6%. Germany (EWG) also traded lower after a two-week rebound; IFO Business Climate Index showed a sharp deterioration in German business sentiment, so energy/supply-chain concerns are rising due to Russia/Ukraine. Among major markets, China and Germany are the two worst performers this year.
Commodities & Real Assets
For 2022, the commodities theme song should be Every 1’s a Winner released by Hot Chocolate in 1978. After a one-week pause where all sectors traded lower, all commodity groups were positive once again last week.
Energy (DBE) resumed its move higher last week with a gain of 7.7%. Natural Gas (NG1) gained 13.2%. WTI Crude (CL1) gained 8.2% closing at 112.83 per barrel. For ‘22, DBE is the dominant leader with a gain of 43.2%.
Base Metals (DBB) added 4.3% last week and are up 16.8% for ‘22. Aluminum (LMA) gained 6.6% for the week and is up 28.4% for ‘22.
Energy Equities: Across US equities, Energy is the dominant performance leader so far this year. S&P Energy is up 43.3% for 2022 with Utilities and Financials lagging well behind with gains of 2.4% and 1.6%, respectively. Moreover, Energy (XLE) also was the top performing sector in the S&P 500 last year with a gain of 53.3%.
To begin the year, Energy comprised less than 3% of the S&P 500, but based on YTD performance the sector now has a 4.0% weighting.
Apart from Energy, the other 10 sectors in the S&P 500 have an equal-weighted average return of -4.2% for 2022.
To achieve a break-even return of 0.0% for ‘22 would have required a ~10% allocation to Energy to start the year — assuming equal-weighted allocations of ~9% to the other 10 sectors.
In other words, investors needed a substantial overweight to Energy to keep pace this year. Given the prevailing cultural/political sentiment, however, virtually nobody has positioned portfolios in this manner. Quite possibly, unrealistic objectives/policies related to “climate change” have derailed investors from identifying and pursuing attractive investment opportunities. The policy environment might be slowly shifting in light of Russia/Ukraine. The time for ignoring Energy might be passing.
Below we highlight performance trends over the last year for XLE and other Energy funds:
Below is a high-level comparison of the four funds referenced above:
S&P Energy (XLE)
Invesco S&P 500 Equal Weighted Energy (RYE)
Invesco DWA Energy Momentum (PXI)
Invesco S&P Small-Cap Energy (PSCE)
We are not recommending these funds. Instead, we are simply highlighting the point that many investment options — besides XLE — are available for those seeking Energy exposure. However, based on our observations, active fund managers seem reluctant to add traditional Energy holdings. Thus, investors seeking Energy exposure might need to make direct allocations to sector funds. Note: JPMorgan did report stepped-up buying of Energy shares by performance-oriented hedge fund managers last week.
Based on our observations, active fund managers seem reluctant to add traditional Energy holdings. Thus, investors seeking Energy exposure might need to make direct allocations to sector funds.
In short, investors are not limited to XLE, which has ~45% of its assets concentrated in two names: Exxon Mobil (XOM) and Chevron (CVX). Numerous Energy funds are available, including sub-sector funds that isolate on specific industry segments.
Volatility, Flows/Positioning & Sentiment
Volatility Fading: VIX declined again last week as markets attempt to “normalize” after being upset last month when the Russia/Ukraine War commenced. Implied volatility (VIX) closed the week at 20.81. Based on closing prices, the VIX has dropped ~40% since peaking on 3/8/22. Based on current levels, the VIX is projecting absolute daily price moves of 1.3% (up or down) for the S&P 500 over the next 30 days. That projection was 2.2% based on the recent peak levels.
Bullish Sentiment Improving: There is nothing like rising equity prices to boost investor sentiment. Bullish Sentiment increased substantially to 32.8 last week, matching the highest level of the year, but remains below the long-term average. Bearish Sentiment dropped substantially to 35.4, but remains above average. The 14.4 drop for Bearish Sentiment was the largest weekly decline since July 2010 according to Bespoke. Other sentiment indicators followed by Bespoke — Investors Intelligence and the NAAIM Exposure Index — also show improving bullish sentiment. On a combined basis, Bespoke reports that the three sentiment indicators are back to within one standard deviation of their composite average. Thus, sentiment is no longer “overtly bearish” at extreme levels that might present a contrarian “buy” signal. In fact, the large weekly swing in bullish sentiment only points to average returns on a 6-month and 12-month forward basis according to Bespoke.
Alternative Assets/Strategies
Often we highlight the advantages of low-volatility diversification strategies. These include relative value, beta neutral, and multi-strategy funds — investing primarily in equities, fixed income, and credit. The appeal of such strategies is low correlation to traditional long-only factors like simple equity beta and interest rate duration. Thus, they tend to deliver diversification attributes as well as non-beta skill-based return potential (i.e., active alpha).
In contrast, long-biased alternative strategies might behave with greater volatility and less diversification, but they still offer compelling total return and “active alpha” potential.
For instance, compared to the low-vol diversification strategies mentioned above, event-driven strategies are positioned further up the risk/return spectrum. Event-oriented situations are usually long-biased, so they entail more price volatility and incidental equity beta, but the primary source of returns emanates from situational-specific catalysts that unfold over time.
Event-oriented situations are usually long-biased, so they entail more price volatility and incidental equity beta, but the primary source of returns emanates from situational-specific catalysts that unfold over time.
Features defining event-driven investing include:
Catalyst-driven with risk/return derived from company-specific events. Includes restructurings, bankruptcies, M&A, asset sales, spin-offs, liquidations, industry consolidations, activist campaigns, board/management changes, turnarounds, etc.
Value-oriented fundamental analysis. In fact, we often characterize event-driven strategies as the truest form of active/value investing. Moreover, fund managers often have specialized expertise within select industries, including operational experience and established contacts.
Investing across capital structures. Managers who are skilled at analyzing balance sheets and structuring transactions are able to use risk management and relative value to invest in securities with the best risk/return potential. This might include senior loans, junior debt, convertible securities, preferred equities, common shares, options/warrants — or some combination of positions.
Engineering positive outcomes. Beyond passive participation as events unfold — as is the case with many traditional value investors and daily-liquid funds — event-driven specialists actively engage in restructurings and other special situations, thereby working to engineer positive outcomes. In this way, returns are more company/event-specific and less reliant on simple factor betas, general investor sentiment and fund flows, and/or macro factors.
Long-biased and concentrated. Most event-driven strategies are long-biased. For risk management purposes, hedges might be utilized to protect assets (long positions) against unwanted risks. However, as a value-oriented approach, long positions usually are initiated at deep discounts to future/potential intrinsic value. In theory, downside risk already is limited, so there is less need for hedging. Portfolios usually are concentrated into a few situations where fund managers exert meaningful control over outcomes — individually or as part of an investor group (e.g., creditor committees).
Public and private securities. Event-driven funds often invest in both public and private assets. In some cases, fund managers can be viewed as cross-over specialists. Compared to publicly-traded securities, non-public assets may be less liquid. Event strategies are best suited to private investment structures with lock-up periods and redemption terms that restrict near-term access; this serves as a protection to both investors and fund managers.
Extended time horizons. With event-driven strategies, value realization often requires time for catalysts to play out. Again, as a protection to both investors and managers, and to allow sufficient time to engineer outcomes, event strategies are best suited within private fund structures with lock-up periods and redemption terms that restrict near-term access.
Event-Driven in Portfolio Context: To elaborate on the image shared above, we believe allocators/investors are well served by defining specific “portfolio roles” within an investment program. In short, we utilize three broad classifications based on expected risk/return, correlation behavior, and liquidity factors.
We consider most event-driven fund managers as hybrid strategies, combining diversification and growth attributes.
We classify assets/strategies broadly as (1) diversifiers, (2) growth assets, and (3) hybrid strategies, which combine elements of both. We consider most event-driven fund managers as hybrid strategies.
Diversifiers provide low/limited equity market correlation — or possibly negative correlation during stressed equity environments. Normally, diversifiers provide ample liquidity. Diversifiers include high-quality fixed income, but also encompass low-volatility/non-directional strategies that invest long/short in other asset classes, including equities. The key is the risk/return profile and the correlation behavior. In general, we define diversifiers as strategies with equity beta of less than 0.20 and volatility profiles comparable to the US Aggregate Bond Index (AGG) or lower.
Growth assets are straightforward. The objective is growth over time by various means — capital appreciation, rising dividends and cash flows, trading skill — and with a tolerance for reasonable volatility. Growth assets mostly comprise long-only equities — public or private. A simple benchmark for growth assets is the S&P 500 Index (SPY) or MSCI All-Country World Index (ACWI), depending on one’s preference for the universe of growth/equity opportunities.
Hybrid assets/strategies combine attributes of both — some diversification benefits, but with more return potential and greater volatility compared to diversifiers. At the same time, hybrid strategies entail less correlation/beta and volatility compared to growth assets (long-only equities).
Some assets/strategies have overlapping attributes and we encourage allocators/investors to define portfolio roles based on their own needs/preferences.
Beyond Narrow Asset Class Definitions: In short, the idea of “portfolio roles” goes well beyond narrow asset class definitions — equities, fixed income, and cash — to facilitate precision-guided implementation of investment programs based on a rational awareness of risk/return behavior. Our definitions evolved over time as we managed multi-asset portfolios for institutions and large families.
The idea of “portfolio roles” goes well beyond narrow asset class definitions to facilitate precision-guided implementation of investment programs based on a rational awareness of risk/return behavior.
Essentially, the terminology of traditional asset allocation was too restrictive. We needed a place to position our emerging allocations to beta-neutral equities, a source of robust “active alpha” (positive risk-adjusted return) that served in the low-volatility diversification role as an alternative to high-quality fixed income. Obviously, beta-neutral equities did not invest in fixed income securities, so they did not fit within that asset class; neither did beta-neutral equities fit within the traditional equities allocation because the objectives were so different.1 We needed functional classifications. Eventually, through experience and supported by more robust risk management capabilities, we created strategy definitions based on risk/return, correlation behavior, and liquidity factors.
Field Report: Corre Partners is a $1.15 billion event-driven equity/credit specialist. Founded in 2009 by John Barrett and Eric Soderlund, Corre is a value-oriented fundamental research firm with experience in restructuring transactions. The firm invests across capital structures in special situations — including stressed balanced sheets — with an emphasis on middle-market opportunities. Corre Opportunities is the firm’s flagship fund. Since inception, Corre Opportunities is up 11.5% (annualized, net of fees) with a correlation of 0.47 to the S&P 500 Index. Since 2009, the long-biased fund has averaged ~60% net exposure, but excluding “cash recovery” and other low-beta credit positions (resulting from significant de-risking events), net exposure has averaged ~45%. As of 2/28/22, Corre Opportunities was ~90% long and ~22% short for net long exposure of ~68% overall and ~46% excluding low-beta positions. Note: Corre Opportunities is a private fund available to accredited investors and qualified purchasers.
Ideally, event-driven strategies derive most of their risk/return from idiosyncratic (non-beta) factors. It’s on this basis that we consider event-driven to be hybrid — as lower correlation and non-beta factors equate to diversification (even if volatility levels are elevated). Over the trailing 24 months, Corre has delivered an annualized total return of 10.5%. Over that period, the fund’s equity beta versus the S&P 500 has been 0.21, which is below the fund’s average net exposure and illustrates the way event-oriented strategies are so company/catalyst-dependent. As a result, Corre has produced positive alpha approaching 7% over the last two years.
Note: We view rolling 24-month periods as an important time horizon for evaluating performance for “active alpha” strategies. In our judgment, 24 months represents a minimum holding period; one-year periods include too much and not enough data points, but extended periods of three-years or more entail too much smoothing.
Research Insights from Corre Partners: When allocating to independent fund managers, investors get more than just portfolio management; they also gain access to valuable hands-on research to the extent they are working with reasonably transparent managers willing to share insights. So called “information flow” is an important consideration for allocators/investors as they cultivate relationships with fund managers.
When allocating to independent fund managers, investors get more than just portfolio management; they also gain access to valuable hands-on research.
In recent years, Corre Partners has maintained cyclical/value exposures via positions in the Industrials, Energy, and Materials sectors. Corre’s selection process is not based on macro theme-based positioning, per se, but on bottom-up company-specific and catalyst-driven opportunities. Nonetheless, it’s important to understand broadly defined “style” exposures from a risk management perspective.
In a recent portfolio update, Corre shared several observations:
Russia/Ukraine has added uncertainty to energy/materials production, global supply chains, and the policy outlook as central banks work to control inflation. “And while the US economy remains generally strong, cracks are appearing in the global economy where energy inflation is more problematic given higher reliance on costly and uncertain imports. This only adds to the difficulty of the Federal Reserve and other central banks to start pulling back at a time of uncertainty while engineering the soft landing for which the markets have been hoping.”
Even if the US economy remains strong in aggregate, rising cost pressures could stress over-leveraged businesses. Smaller companies with fewer economies of scale and less pricing power could be challenged. “While the macro picture is uncertain, the likely impact of this backdrop on middle market companies is clearer. Events are causing business conditions to change quickly and more dynamically, especially as cost inputs fluctuate. Cracks in the global supply chains are shaking confidence in a system and business models that over the past several decades have taken advantage of low-cost production elsewhere without much concern around the cost of logistics or surety of supply. These pressures and uncertainties should lead to further challenges for companies of all sorts and sizes to preserve margins; however, this impact will be disproportionately felt by companies of smaller size who are levered and don’t have enormous resources or pricing power to battle back against inflation or logistical challenges.”
On a positive note, portfolios with exposure to “inflation winners” can benefit from rising commodity prices as highlighted by Tom Lee of FSInsight (see Portfolio Construction & Trading Ideas below). “Fortunately for our existing portfolio, while certainly not immune to these headwinds, we are afforded some exposure balance by having investments in companies that are net beneficiaries from higher commodity prices…” Corre has exposure to businesses in the Energy/Materials sectors.
Going forward, Corre sees a challenging environment where assumptions are being reassessed and risk is being repriced. “To conclude, we think the current backdrop is shifting in a more unstable direction, and risk is being repriced in markets as key assumptions around the global economy and interdependence are being reexamined. The interplay around trade, supply chain and inflation with knock-on effects on rates has been the big question for several months. Now an additional, large exogenous shock beyond the pandemic exists with the conflict in Ukraine pulling in the United States, the rest of Europe, and China as each look to shape the outcome. We think this will make investors more cautious in allocating capital and likely push against growth in 2022… Now dislocation is slowly creeping across a variety of sectors with caution framing the investor mindset as risk premiums are repriced. All of this flows into our belief that 2022 will be a very active year for Corre.”
Despite challenging headwinds, we believe hands-on active managers can find opportunities. Event-driven strategies epitomize this, where risk/return potential is derived primarily from company-specific events/catalysts as opposed to macro factors.
Portfolio Construction & Trading Ideas
“BEEF” is an acronym referenced by Tom Lee of FSInsight (FSI) to highlight several themes he has been favoring this year. BEEF represents the following: (1) Bitcoin, Bitcoin-related equities and the digital/crypto ecosystem; (2) Energy equities; (3) FAANG, and more broadly, quality/secular growth equities.
Here is how the FSI themes are trending over the last 12 months:
To an extent, FSI is outlining a value-and-growth barbell approach.
Bitcoin and broadly-defined digital/crypto assets are a secular growth theme favored by FSI. Based on historical demographic analysis, Lee says it pays to invest in areas where 30-somethings have focused their attention. Crypto has captured the imagination of this segment. According to CB Insights (as relayed by The Market Ear), one in five US adults reports owning cryptocurrencies with 36% of Millennials having exposure compared to just 6% of Boomers. As an aside, FSI’s Lee believes recent geopolitical events have emphasized the need and demand for alternative currencies and discreet/secure digital finance.
Energy fits the cyclical/value theme, although Lee sees this as a more enduring opportunity — the under-supplied super-cycle. This theme has been outlined by JPMorgan’s Marko Kolanovic and others. Moreover, Russia/Ukraine is making energy independence a national security priority. Lee favors equities where EPS are positively correlated to inflation — “inflation winners” as Lee refers to them. FSI’s equity buy-list includes XOM, CVX, MPC, PSX, and DVN.
FAANG equates to secular growth. Technically, FAANG refers to Meta Platforms (Facebook), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOG/L) — but these specific names are not necessarily recommended by FSI. Lee is using this term as a euphemism for quality/secular growth; he also referenced the Nasdaq 100 (QQQ). Finally, Lee offered a reminder: “If [the] global economy slows, growth stocks lead.” FSI’s equity buy-list includes AAPL, MSFT, NVDA, AMZN, TSLA, and GOOG/L among others.
In a research note on 3/25, Lee summarized: “In our view, our existing strategy of BEEF remains valid. Even in war. Even with inflation. In fact, the last few weeks are strengthening the case for our ‘BEEF’ strategy.”
What Others Are Saying
The Market Ear, 3/27/22: “A fun fact is that Energy’s percent weighting in the S&P 500 is only now recovering to pre-COVID levels (still just 3.99%), which means we may be getting closer to the point where the sector can no longer be completely ignored by generalist investors that previously didn’t need to get Energy ‘right’ to have a great year.”
The Market Ear, 3/25/22: “SPX has exploded higher. The move from below 4200 to current levels has been very violent. The panic to the upside beats what we saw on the way down. We remain of the opinion that this market lacks a new trend and that one should trade the 4200/4500 range. Note the SPX futures tried the 100-day moving average at the 4530 level. This is a huge resistance level, but note there is more resistance slightly higher as well. Chasing longs here is a very late trade.”
Marko Kolanovic, JPMorgan, Global Markets Strategy, 3/23/22: “A time of big risks, but even bigger market opportunities. In 2021, we warned about (1) the commodity super-cycle and energy crisis; (2) the bubble in innovation, renewables, etc., and; (3) geopolitics as a key risk in 2022. These forecasts have now nearly fully materialized. While the commodity super-cycle will persist, in our view, the correction in bubble sectors is now likely finished and geopolitical risk will likely start abating in a few weeks’ time. We think it is time to start adding risk in many areas that overshot on the downside. Not all assets are cheap but there are great opportunities in high beta, beaten-down segments that now include Innovation, Tech, Biotech, EM (especially China), as well as more broadly in smaller capitalization and more volatile stocks.”
Andreas Steno Larsen, Lead Economist, Heimstaden, 3/25/22: “The zero-COVID policy is extremely inflationary in nature, as it limits the supply of both goods, services, and labour.” Note: Stenos Signals is published via Substack.
The Bespoke Report, 3/25/22: “The recovery in US equity indices has continued to flummox investors who are focused on the surge in bond yields and the insistence by the FOMC that they will act aggressively to tamp down inflation. On the one hand, earnings per share estimates reflect what hard economic statistics do: That even the largest war in Europe since World War 2, soaring bond yields, WTI exploding above $110, rapidly tightening fiscal policy, and every manner of supply chain disruption can’t derail the economic expansion that is still under way. But if inflation doesn’t reverse, there is a rocky road ahead, with Federal Reserve officials committed to reducing demand... It’s a strong economy indeed, but some level of Federal Reserve monetary policy shock will derail it; the question for investors is whether markets realize how big the tightening juggernaut is... or if inflation will reverse and allow stocks to dodge the large caliber hikes that the Fed seems ready to fire.”
Piper Sandler, Macro Research, 3/24/22: “The on-shoring/re-shoring and domestic investment behind the decade-old US Manufacturing Renaissance will keep growing. Worsening overseas economics, geopolitics, and security concerns, all point to more CAPEX in the US. And that job-generating investment will be focused on Middle America — our favorite Emerging Market. The US Manufacturing Renaissance is [due to both] the return of supply chains (companies on-shoring) and companies expanding manufacturing facilities here in the US… It all started back in 2010, when it became increasingly clear that manufacturing outside the US was becoming dis-economic for lots of reasons. Both on-shoring and domestic production expansion have been in clear rising trends for a decade. Yes, there’s cyclicality (2017 & 2020), but the uptrend is clear… Think autos, chemicals, technology, and apparel. From where? China, Japan, Germany, etc. The US is the largest consumer in the world. If you sell it here, you want to make it here.” Note: Despite deceleration to an estimated 4% growth rate by Q4, PS expects inflation-adjusted CAPEX to be the strongest component of US GDP in 2022.
FSInsight, Signal from Noise, 3/24/22: “Pricing power is a key consideration in markets subject to inflation risk. There are several ways companies can achieve pricing power, by selling essential components, having strong brand value, or continually providing more value to consumers. Inflation has been persistently high as a result of supply chain kinks and an anomalous ratio of goods consumption to services consumption. We believe inflationary pressure from the war in Ukraine could be prolonged, but it could also collapse quickly if a peaceful resolution is unexpectedly achieved. In alpha-driven markets, where stock picking becomes more important, the pricing power of a company should always be a key consideration. We discuss five of our favorite names that have this capability.”
Christopher Wood, Jefferies, 3/24/22: “The US bond market has chosen to react this week to Jerome Powell’s somewhat surprisingly hawkish comments on Monday... Powell, among other things, conceded that inflation is ‘much too high’ and admitted, horror of horrors, to the possibility of a 50bp rate hike. GREED & fear continues to have a hard time seeing the former Reverse Volcker and his colleagues maintaining the hawkish line for as long as suggested by the money markets, let alone the ludicrous ‘dot plots.’ But for now investors must take Pivot at his word which is, so far as GREED & fear is concerned, bearish for stocks... Meanwhile, GREED & fear continues to favor cyclical stocks over growth stocks and value has continued to outperform year-to-date... Still, it also should be noted that the more monetary tightening actually proceeds, the more it raises risk to the growth outlook, which at some point will be a definite negative for cyclicals. In this sense, investors should be prepared for growing downgrades of US real GDP growth forecasts in coming months... This negative monetary tightening dynamic is in addition to the negative consequences of the massive energy and food shock stemming from the Russian invasion of Ukraine. This will hit Europe most... But America is certainly not immune. While in Asia there will be growing bearish focus on the rising cost of imported food and energy. Indeed it could be called the ‘revenge of the physical’ after the all-consuming focus of markets with ‘digitalia’ during the pandemic.”
BlueBay, Emerging Markets Credit Alpha Fund, 3/18/22: “The war in Ukraine rages on, but peace talks running in parallel have offered some respite to the market and allowed for a moderation in commodity prices. Despite this near-term moderation in prices, inflationary concerns are rising. Central banks across the globe are being forced to react despite the likely pull-back in growth that will be associated with these price rises... EM fixed income has rebounded over the last week, but year-to-date returns remain extremely poor... A decent portion of these losses can be ascribed to Russia as its assets move towards a mark of zero ahead of their exit from the index at month-end. However, there is no escaping the fact that EM fixed income has had a challenging start to the year and that this is being exacerbated by the move higher in core yields as central banks continue their hawkish rhetoric. In our view, the positive side of the weakness so far this year is that headline yields are now at levels where 12-month forward returns have historically been positive for the asset class... Overall, we reiterate the point that higher levels of volatility will create opportunities for investors who are patient and can add risk at opportune moments.” Note: BlueBay is a division of RBC. The long/short EM Credit Alpha Fund was up 11.1% YTD as of 3/18/22 compared to a loss of -9.9% for the JPMorgan EM Bond (EMB). In recent weeks, BlueBay benefited from short positions in Russian debt, but positions have been mostly covered.
Please consider sharing Coffee & Capital Markets by giving a gift subscription to:
Clients — to keep them alert to relevant data and trends
Colleagues and team members who need to leverage their time
Students or young up-and-comers who thrive on learning
Seasoned investors looking to keep an edge
Family members who follow the markets
This material is for informational and educational purposes only. All data has been compiled from sources believed to be reliable, but there is no guarantee of its complete accuracy.
Readers should conduct their own research or consult with their advisory team before making investment decisions.
For a period, we classified beta-neutral equities as “alternative strategies” but this was too broad since we used alternatives up and down the risk/return spectrum to serve different portfolio roles.