As interest rates in developed markets begin to rise, as we expect them to in the coming six months, we anticipate what has been an eight-year quantitative easing-driven tailwind to diminish. With a rise in interest rates, fundamentally weak companies typically face increased pressure, as they are no longer able to potentially take advantage of low interest rates to fund operations. This adversity has often resulted in a decline in operating performance for those weaker companies, and hence greater price dispersion between those firms and companies with stronger fundamentals.
Accordingly, strategy managers who can diagnose the fundamental strength of companies should enjoy increased opportunity to seek to select winners and losers. We saw this effect during the third quarter of 2016, as many long short equity managers were able to capitalize on an earnings season in which stocks primarily reacted to company-specific developments. We have also observed the recent widening between the best- and worst-performing S&P 500 sectors, which has historically accompanied robust hedge strategy performance relative to US equities, particularly for long short equity managers.
We expect more pronounced volatility over the next six months, particularly with uncertainty surrounding the health of the global economy, the pace of US Federal Reserve interest-rate increases, the path of Brexit (the United Kingdom’s referendum vote to leave the European Union) and the strength of European Union financial institutions. We also expect to see a pickup in market volatility. Factors such as challenged global equity earnings, price-to-earnings ratios1 near 12-year peaks as of late 2016, and currency fluctuations may also add to market uncertainty. Overall, we believe higher volatility and dispersion should create an attractive environment for long short equity strategies, particularly those with low net exposures or uncorrelated strategies.
Corporate credit/relative value strategies: Bond volatility appeared subdued for much of 2016, which favors volatility arbitrage managers
Despite pervasive uncertainty among equity investors, both near-term implied and realized volatility remained low as we entered the fourth quarter of 2016. However, when we examined elevated pricing for put-protection and longer-dated volatility—both typical measures of aggressive hedging behavior—evidence of a significant amount of investor unease was apparent to us. Exacerbated by excessive central bank easing and buying by systematic volatility managers, we believe these technical pressures have been creating inefficiencies in the pricing of volatility, which we think should continue to favor volatility arbitrage managers.
Similar factors have been impacting other volatility-sensitive instruments, including convertible bonds, which many investors favored in 2016 due to their combination of positive yield and long volatility profile. From our perspective, generally muted trading liquidity in all but the largest indexes will likely continue to result in significant inefficiencies for smaller issuers, which can serve as both a source of opportunities and a potential risk. Although fixed income arbitrage managers are likely to contend with many of the same factors as the other strategy sub-sectors, going forward we remain concerned about potential headwinds due to the significant reliance of the strategy on leverage, as well as its sensitivity to central bank actions.
Event-driven strategies: Sluggish growth environment in developed markets should foster continued merger-and-acquisition activity
Although it would be challenging for merger-and-acquisition activity in 2017 to match the record level of 2016, we expect the opportunity set to remain healthy as corporate cash balances remain high and many companies continue to proactively pursue value-enhancing actions. A sluggish environment for economic growth will likely make it difficult for companies to increase earnings per share without acquisitions. In addition, persistently low interest rates and, perhaps, additional accommodative monetary policy globally may also serve as a tailwind.
We expect activists to continue to target mismanaged companies, but the “quick fixes,” such as buybacks, appear likely to play a less pronounced role. In our view, activists may need more time for strategies to come to fruition when employing a restructuring approach as opposed to financial engineering.
Global macro strategies: Opportunities accompany economic growth in emerging markets
In our view, the opportunity set in emerging markets should continue to be strong for global macro strategies. We believe fundamentals and technical conditions should continue to support long positions in emerging markets, particularly in Brazil, Argentina and Venezuela.
In terms of developed markets, we anticipate continued uncertainty with regard to economic growth potential and possible central bank policy actions. This could continue to present challenges for discretionary global macro managers. However, a potential contraction in the UK economy as the country progresses with its separation from the European Union could offer opportunities. While this uncertainty could weigh on discretionary macro managers, the resulting elevated market volatility across asset classes would likely benefit systematic macro managers, in our opinion. Additionally, systematic managers who trade based on fundamentals could benefit from what we expect to be a continually improving environment for value investing.
As a final note, at the time of this writing in November 2016, Donald Trump was elected president of the United States. The overnight reaction from global financial markets reflected large spikes in volatility, although the US equity market soared over the next few days, with the Dow Jones Industrial Average reaching a record high level. Prices for US Treasuries also plummeted in initial trading amid speculation the president-elect could expand fiscal spending and spark inflation. It remains to be seen how the next chapter will unfold. Our initial assessment is that, with Republicans controlling the US Senate and House of Representatives as well, this development may ultimately serve as a tailwind for US economic growth. We remind readers that much will depend on developments in the coming months. We and our subadvisors remain diligent in assessing the implications for our investments.
(Left to right) David Saunders is founding managing director, Brooks Ritchey is senior managing director, head of Portfolio Construction, and Robert Christian is senior managing director, Head of Investment Research at K2 Advisors