As a golfer, I received what I initially thought was a pretty cool gift this Christmas: a laser range finder, a handy tool that gives me the precise distance to each flag stick. The only problem, as the small print on the box revealed, is that the measurement was “accurate to within 100 yards.” Any golfer knows that can be quite a problem on the golf course (and why it wasn’t a very good gift!). If I were actually 150 yards from the hole, this “trusty” range finder might say I was 250 yards away. Or 50. Hardly the precision one needs to pick the right club. In other words, the range of outcomes was potentially huge and any club I selected based on this instrument’s advice might get me into trouble if the actual yardage turned out to be different.
2014’s Investment Landscape
This is the exact problem as the one investors face in today’s market landscape: the range of possible outcomes seems larger than ever. For example, if the Fed tapers too quickly, interest rates could rise rapidly and anything with duration will suffer significantly. Then again, if GDP growth stagnates and employment gains slow or reverse, the Fed’s printing press could be turned on for longer than anticipated and equity prices could continue to grind higher. Worse yet, if global central bankers lose credibility by orchestrating anything other than an orderly transition from a liquidity-driven to a growth-driven market, risk assets could be in for a wild ride. As a result of this uncertain landscape, investors need to position their portfolios to give themselves the most ways to win in a variety of potential scenarios.
Base Case Scenario: Transition from Liquidity- to Growth-Driven Markets
In our view, a healthy exposure to equity-oriented risk is still the place to be. Our base case is that the market will continue to absorb tapering effectively, and indeed we’ve already experienced the equity market’s initially positive reaction to the Fed’s December 19 announcement of a $10B per month reduction in stimulus. Our view is based on the belief that the Fed is tapering (and ultimately removing) stimulus because the economic recovery has become self-sustaining. U.S. corporate and consumer balance sheet metrics (e.g., cash flow, liquid assets as a percentage of liabilities, household debt service, capital spending relative to profits, etc.) are quite healthy. We also observe that the longer-term trend of employment continues to improve as initial claims, corporate profits and small business hiring plans are all trending positive. When these critical ingredients for sustained economic expansion are met with synchronized and significant monetary accommodation by the Fed, BOE, BOJ, and ECB it creates a powerful elixir for risk assets, particularly equities.
Other Potential Scenarios
If our base case is wrong and instead global growth decelerates, unemployment increases and macro risk dominates (i.e., Washington dysfunction), we believe the Fed (and other central banks) will re-accelerate their accommodative stimulus to markets just as they have done over the past three years. In this scenario, equity risk should still be relatively attractive. We’ve seen this movie before and know that equity markets have generally followed balance sheet expansion seemingly at the expense of other asset classes, namely fixed income and investment grade credit. While we still feel equities have legs in this scenario, we note that there are diminishing returns for each new dollar of stimulus and future equity performance is not likely to repeat that of the past two years. And certainly, the eventual removal of this massive accumulated stimulus will be a large and untested risk we’ll need to deal with in the not-so-distant future.
If neither of these scenarios play out and instead we find ourselves trading a market in which central bank intervention is no longer perceived to be credible, the largest impact is likely to be a rise in interest rates and interest rate volatility, both of which have been artificially suppressed for over three years. Fixed income assets with any actual or perceived duration (e.g., investment grade credit, Treasuries, agency mortgages, etc.) are likely to suffer significant losses. While equities certainly could suffer in this environment as well, we feel that, on a relative basis, equity-oriented strategies would still have the best chance to outperform other asset classes.
Equity Risk – Not Just a Directional Play
To be clear, we’re not advocating assuming undue amounts of equity directional risk. We are most interested in equity-oriented strategies that can capitalize on the unique internal qualities and characteristics of today’s equity markets – namely high dispersion and event risk. The currently low levels of S&P 500 correlation (i.e., high dispersion) suggest that the ability to make money by selecting the right stocks (versus picking the market’s direction) is better now than at any point in the past three years. Similarly, a market that exhibits greater choppiness and even some correction should give managers a chance to make money from shorting, something that has recently been next to impossible (90% of stocks in the S&P 500 exhibited positive performance in 2013). Indeed, we expect 2014 to be the year when hedge funds begin to show their true colors and actually profit (not just add alpha) from their shorts.
Equally as attractive for equity risk, corporate M&A activity is at its highest level since the 2008 crisis. Companies are putting money to work and corporate events such as mergers, spin offs, IPOs, and recaps can provide catalysts to unlock shareholder value, regardless of market direction. We think this trend will continue and be a fruitful hunting ground for equity-based hedge fund strategies, specifically merger arbitrage, long-short equity and event-driven equity. Also, specifically within those strategies, we are increasing our exposure to Europe and Asia, which continue to exhibit more unique growth catalysts and more attractive valuations than the U.S.
Risks to Our Equity-Focused Stance
Of course we realize that equity risk, certainly after a 32% increase last year for the S&P 500, is potentially tumultuous. It concerns us that much of the run-up the past two years has been due to multiple-expansion. We also note that valuations are at the high side of fair value, particularly in the U.S., and that 2014 consensus earnings estimates are stretched. Another rising risk is the potentially polarizing discussion that will soon begin when the U.S. re-visits the debt ceiling debate in February. These risks, if they materialize, will certainly cause us to reevaluate our portfolio positioning and dynamically shift capital away from equity-oriented risk.
The key for our portfolio construction going into 2014 is to acknowledge that the range of possible market outcomes is perhaps greater today than at any point in the past four years and that the accuracy of our assessment, our market range finder if you will, may produce a bad yardage to the pin. That said, given the ripe internal ingredients and opportunity set relative to other asset classes, equity-oriented hedge fund strategies should be “accurate to within 100 yards” and give us the best chance to make attractive returns in 2014.
Jeff Willardson, CFA, CQF is a Managing Director and member of the Portfolio Construction Group. His chief responsibility is to set top down portfolio strategy and construction across PAAMCO’s diversified Moderate Multi Strategy solution. Prior to joining PAAMCO Jeff spent five years at Goldman, Sachs & Co. in the Investment Management Division. He received his MBA (Dual Finance and Real Estate Major) from The Wharton School, University of Pennsylvania, and he holds a BS in Management (Finance Major) from Brigham Young University.
Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Araştırma Hizmetleri A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively.
This document contains the current, good-faith opinions of the authors but not necessarily those of Pacific Alternative Asset Management Company, LLC and its subsidiaries (collectively, “PAAMCO”). The document is meant for educational purposes only and should not be considered as investment advice or a recommendation of any type. This document may contain forward-looking statements. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements. Any forward-looking statements speak only as of the date they are made and PAAMCO assumes no duty to and does not undertake to update forward-looking statements.
Pacific Alternative Asset Management Company is a registered trademark in the United States, Canada, Japan, Singapore, Australia and Mexico. PAAMCO is a registered trademark in the United States, Canada, Europe, Japan, Australia and Mexico. Pacific Alternative Asset Management Company Europe and PAAMCO Europe are registered trademarks in Europe. Pacific Alternative Asset Management Company Asia and PAAMCO Asia are registered trademarks in Singapore. completeAlpha is a registered trademark in Singapore, Japan, the EU, the U.S. and Canada and it is a trademark of PAAMCO in Australia.