Macro Themes We Are Discussing
Will inflation expectations continue to rise given vaccinations, global financial conditions and expected economic growth?
The start of 2021 offers a new beginning in the sense that the economic slowdown due to COVID-19 appears to be coming to an end. Individuals and corporations have been buoyed by enormous stimulus from governments, and for the most part, have weathered the storm of 2020. Structural trends of e-commerce, deglobalisation of supply chains, health care, security, software and sustainability were accelerated due to the economic environment and global lockdowns.
Going forward, if economic growth, earnings and sentiment overreact to the upside in speed and magnitude, inflation will inevitably surface. However, we could have a period of reflation without inflation, which would be very favourable for equities. Conversely, there are many paths to a derailing of the recovery such as failed vaccination implementation, a mutated virus, a sustained second wave or even another global lockdown.
Currently, the markets are quickly moving to price in perfection, reflation with minimal inflation and a robust global economic recovery. We expect challenges to this pricing to arise periodically over the course of 2021, keeping volatility and dispersion elevated and creating rich opportunities for active management.
Will the global chase for yield continue but deemphasise sovereign fixed income in favour of alternative yield products?
Many assets are priced to a flat forward curve, putting a high premium on forward cash flows. If the forward curve were to rise (steepen), a repricing downward of these duration assets would be expected in 2021. Given that real interest rates are historically low, we expect sovereign fixed income to be challenged and for interest rates to eventually rise. Investors that are yield- and income-centric will most likely have to rotate into alternative yield products such as ILS that provide yield for taking on insurance risks.
Dispersion in credit markets coupled with the need for yield should also provide a good opportunity for long/short credit managers and dispersion trading as many industries and companies are disparately dependent on a speedy recovery. We expect that the bigger, stronger companies will be very active in strategic business dealings to further strengthen their advantages over weaker competitors.
Will emerging markets recover faster than developed markets?
If the global recovery is strong and fast, commodities should experience dispersion due to supply/demand dynamics, and emerging market (EM) risk assets could follow suit. That is especially true in countries exporting commodities and those that have already dramatically devalued their currency. Additional fuel to these dynamics would be a weakening US dollar.
Finally, global yield hunters should be enticed by the developing market’s yield premium in fixed income. As a result, we find both EM equities and foreign exchange attractive on a relative valuation basis.
With that said, investors do have to be selective in EMs due to challenges of operating in these countries. EM companies face challenges from foreign companies entering their markets, ongoing global trade tensions, and vaccination distribution challenges. In addition, fiscal and monetary stimulus has been led by developed markets relative to EM counterparts.
Summary for 2021
As we enter 2021, we are very optimistic about the opportunity set while recognising that our views are based on a swift global recovery that is becoming consensus among allocators. Our underlying hedge fund managers are identifying many opportunities, both on the long and short side, and think that active-management alpha will be key to success in 2021 as beta-driven momentum slows. With data throughout the year, we will be constantly challenging our own thinking and making adjustments as necessary. As a result, we believe it is prudent to be growth-oriented in our portfolio positioning while also holding hedged alternative investments that exhibit low correlations to broader risk assets.
First-Quarter 2021 Outlook: Strategy Highlights
Given the impressive recovery of US equities since the first quarter, we believe that international long/short strategies are poised to outperform. European and Asian markets have generally traded in tandem with the United States throughout the COVID-19 pandemic, but foreign companies, as captured by the MSCI EAFE Index, have consistently underperformed their US peers over the last decade.
Moreover, non-US equity markets could be further buoyed by their natural bias towards cyclical and value-type names in contrast to US market reliance on the overstretched technology sector and growth companies more broadly. In addition to non-US developed markets, we believe emerging markets may outperform. The reopening of local economies should benefit their respective economically sensitive industries, and any incremental stimulus in the United States should weaken the US dollar.
More importantly, EM countries are in a strong fundamental position given the creation of long-term wealth through a rising middle class and more recently, less reliance on fiscal support during the pandemic.
Emerging markets may benefit from a confluence of rebounding growth, sustained policy support, and improving fund flow dynamics. Many investors reduced their exposure to growth-sensitive emerging market assets in the wake of the pandemic. If recent momentum in the recovery persists while policy remains accommodative, these regions may see a resurgence of interest. Macro specialists focused on emerging markets may benefit from these tailwinds as well as wider dispersion in country and asset-class performance in the wake of the last year’s crises and divergent policy responses.
Swiss Re Institute estimates natural catastrophe events caused $76 billion of global insured losses in 2020, 6.6% above the previous 10-year average. While 2020 resulted in a record number of North Atlantic named storms (30), US hurricane-insured losses were much lower than 2005 and 2017 stress years as 2020 landfalls were in lower-insured, less-populated areas.
Willis Towers Watson estimates an additional US$32 billion to US$80 billion of insured losses from COVID-19, which is supporting higher pricing across the insurance industry. Cat bond spreads remain attractive versus US corporate high yield as we enter a lower risk part of the ILS calendar prior to the next US hurricane season in June 2021.
What Are the Risks?
All investments involve risks, including possible loss or principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Investments in alternative investment strategies and hedge funds (collectively, “alternative investments”) are complex and speculative investments, entail significant risk and should not be considered a complete investment programme. Financial derivative instruments are often used in alternative investment strategies and involve costs and can create economic leverage in the fund’s portfolio which may result in significant volatility and cause the fund to participate in losses (as well as gains) in an amount that significantly exceeds the fund’s initial investment. Depending on the product invested in, an investment in alternative Investments may provide for only limited liquidity and is suitable only for persons who can afford to lose the entire amount of their investment. There can be no assurance that the investment strategies employed by K2 or the managers of the investment entities selected by K2 will be successful.
The identification of attractive investment opportunities is difficult and involves a significant degree of uncertainty. Returns generated from alternative investments may not adequately compensate investors for the business and financial risks assumed. An investment in alternative investments is subject to those market risks common to entities investing in all types of securities, including market volatility.
Also, certain trading techniques employed by alternative investments, such as leverage and hedging, may increase the adverse impact to which an investment portfolio may be subject.
Depending on the structure of the product invested, alternative investments may not be required to provide investors with periodic pricing or valuation and there may be a lack of transparency as to the underlying assets. Investing in alternative investments may also involve tax consequences and a prospective investor should consult with a tax advisor before investing. In addition to direct asset-based fees and expenses, certain Alternative Investments such as funds of hedge funds incur additional indirect fees, expenses and asset-based compensation of investment funds in which these alternative investments invest.
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