May 7, 2023 – There are plenty of odd, but accepted, norms in the investment management industry. Specifically, one revolution around the Sun is noteworthy for measuring everything from a loan interest payment schedule to income tax frequency to bond duration, etc.
Moreover, we judge an investment strategy’s performance by measuring the change in its value, including dividends and distributions, for the period in which the Earth revolves around the sun. In addition, we analyze investment performance over one-fourth (quarterly) and one-twelfth (monthly) increments of this revolution. From this, we determine whether an investment strategy is good or bad.
If, all of a sudden, the speed of the Earth’s revolution slowed down, would we change the increments in which we judge investment performance? If our years became 1,000 days long, the conclusion regarding investment strategy allocation might be different.
Nevertheless, when analyzing the performance of an investment strategy or allocation, the longer, the better.
Twelve years is a long time to let an investment play out. However, that would be the amount of time required to see just one year of performance from a portfolio manager living on Jupiter, the fifth planet from the sun and the largest planet in our solar system. Unfortunately, a mission to Occupy Jupiter seems far off, given its inhospitable atmosphere, composed of hydrogen and helium, along with its minus 145 degrees Celsius temperature.
Just like Jupiter’s yearly revolution around the sun, the equivalent of 12 Earth years, specific market cycles seemingly occur with annual frequency.
One dynamic in the capital markets that appears to occur on a 12-year cycle matching that of a Jupiter year is debt ceiling crises.
The last major debt ceiling crisis occurred in 2011. Now, twelve years later, investors are walking into the buzzsaw of another potential dramatic debt ceiling debacle.
There’s a common saying, “To shoot the wolf closest to the sled.” People focus on the threats closest to them. Investors tend to focus their worries on the nearest global macroeconomic risk.
Last year it was inflation. Last quarter it was the banking crisis. Now it is time to worry about the debt ceiling.
A debt ceiling crisis occurs when the government has reached its statutory limit on borrowing and is unable to borrow more money to pay for its obligations, including paying its bills, servicing its existing debt, and funding government operations. The debt ceiling is a legal limit on the amount of debt that can be accumulated, beyond which it cannot legally borrow more money.
If a deficit-spending government fails to increase its debt ceiling while its total debt has reached its limit, then calamity will ensue.
When a debt ceiling crisis occurs, the government may face a myriad of negative consequences, including defaulting on its debt obligations, delaying payments to its creditors, and shutting down non-essential government services. These detrimental events can have serious implications for both the economy and capital markets, as they can lead to a loss of confidence in the government’s ability to manage its finances, higher interest rates, a potential recession, and most importantly, stock market volatility and significant downside for equities.
The current U.S. national debt totals $31.4 trillion. Concerningly, the U.S. debt ceiling limit is $31.4 trillion. The country has hit its debt limit and will run out of money within weeks.
Treasury Secretary Janet Yellen has warned that the U.S. may run out of cash by June 1st unless Congress raises or suspends the debt ceiling.
The clock is ticking, and investors should be concerned.
Credit default swaps (CDS) are financial contracts that allow an investor to protect against the risk of default on a loan or other debt instrument. In exchange for making payments to the CDS seller, the investor receives a payout if the borrower defaults on the debt. Credit default swap prices indicate the probability of a debt default.
Recently, CDS prices to insure against U.S. government default have surged to record levels. These securities will pay off handsomely if the government defaults on its debt.
Will Congress get its act together and raise the debt ceiling limit to allow the government to continue its budget deficits? Likely, given the debt ceiling has been raised, or extended, 78 times since 1960.
However, getting there may not be smooth or painless. Therefore, investors should observe what occurred 12 years ago as an appropriate playbook for preparing for this year’s debt ceiling crisis.
The 2011 debt crisis was a major political and economic event in the U.S. that occurred between July and August 2011.
The crisis was sparked by a political disagreement between Democrats and Republicans over how to address the country’s rising debt and deficit. Republicans, who controlled the House of Representatives, demanded spending cuts and opposed tax increases. In contrast, Democrats, who controlled the Senate and the White House, sought a balanced approach that included both spending cuts and revenue increases. Sound familiar?
As the deadline for reaching a deal approached, the U.S. faced the prospect of defaulting on its debt obligations, which could have had severe consequences for the economy and financial markets. In response, credit rating agencies threatened to downgrade the U.S. government’s credit rating, which would have been a disaster for the capital markets.
During these tense few weeks, investors were sent on a roller coaster, causing the S&P 500 to decline by nearly -20%.
Volatility surged, with the VIX Index rising from a pedestrian 16 to a white-knuckle 45.
Any VIX reading above 30 signals danger for investors and typically accompanies a significant drawdown in the equity markets.
Paradoxically, long-term U.S. Government bonds were a beneficiary of their potential default. The 10-year yield declined by 140 bps, falling from 3.2% to 1.8%. The rally in Treasury bonds helped cushion the losses from stocks in the traditional 60/40 portfolio.
As the crisis played out and weeks of negotiations occurred, President Barack Obama and congressional leaders reached a last-minute compromise that raised the debt ceiling and included a package of spending cuts. The crisis was over.
While long-term government bonds performed well during the extreme volatility during the eye of the debt ceiling storm, that may not have been the case if the debt ceiling was not lifted and the government had stopped making interest payments on its bonds.
Ergo, there may be a better asset to protect portfolios from the upcoming potential volatility caused by the spectacle of a political battle over the debt ceiling.
In 1924, influential economist John Maynard Keynes called the gold standard, and the precious metal itself by proxy, a “barbarous relic”.
A lot can change over 100 years. In an era of constant currency debasement and central bank easing, and now a level of inflation that is far too high, the yellow metal is looking increasingly like a calm amongst the storm.
Where Keynes was wrong about gold has played out over the past quarter century. Specifically, gold has produced wonderful returns over the past 25 years. Since 1998, the yellow metal has increased in price by 536.5%, or 7.7% annualized.
Over the past 25 years, or just over two Jupiter years, gold (orange line above) has outperformed the S&P 500 (white line above) by nearly 40%. Is this why we include gold in diversified portfolios?
No. Diversified portfolios allocate to gold because it has produced positive returns in an uncorrelated fashion, boosting portfolio risk-adjusted returns.
More importantly, gold can produce positive returns during periods of economic crisis and stock market volatility.
During the 2011 debt ceiling crisis, gold rallied as the stock market plunged. While the S&P 500 declined by nearly -20%, gold surged as much as 21%. There is nothing barbarous about that.
Gold has proven itself over history as an attractive allocation within a well-diversified portfolio. Its position is justified because of its attractive long-term investment returns and its track record of protecting portfolios during turbulent times. For the above reasons, we include a 10% allocation to gold in the Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC).
The timing could be shrewd – the debt ceiling wolf is now approaching the sled. Be prepared.
Accelerate manages four alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): SPAC and merger arbitrage
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
- Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Alternatives portfolio solution
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Canadian 150/50
ARB was flat during the month, while the benchmark S&P Merger Arbitrage Index rose 0.2%. The Fund has gained 0.7% year-to-date while the benchmark has declined -1.2%.
Five M&A deals closed during the month, including the long-awaited Shaw/Rogers merger, while four mergers were added to the portfolio. Seventeen SPACs matured in April and no recent blank check IPOs were added. However, ARB remains active in the secondary market, acquiring several SPACs at discounts to NAV. Offsetting these positive dynamics was spread widening in the Activision/Microsoft merger arbitrage, which faced a regulatory setback, and widening in the APE/AMC dual share class conversion arbitrage, which has been delayed due to a vexatious lawsuit.
The Fund is currently allocated 65% to SPAC arbitrage and 35% to merger arbitrage, split between strategic M&A (25%) and private equity buyouts (11%). Across the SPAC portfolio, the Fund owns 116 blank check companies.
The Fund’s portfolio management team is always looking for ways to improve the efficiency of the Fund’s operations, intending to reduce costs and increase returns for investors. Therefore, we are pleased to announce that last month the Fund received approval to move to forward currency contracts from spot hedging, which was just implemented.
We launched ARB as Canada’s first arbitrage ETF on April 7, 2020, to democrate what may be our favourite asset class. Last month, ARB surpassed its 3-year track record, attaining an 11.4% since inception return while maintaining its low-risk rating. Recently, ARB was ranked as the #6 hedge fund globally in its segment by leading alternative investment data firm BarclayHedge. ARB was the only Canadian fund in the top 10.
HDGE added 1.3% during April, with all U.S. multi-factor portfolios generating positive performance.
Interestingly, all of the individual long and short factor portfolios, representing the top and bottom decile for each factor, had a negative performance last month. However, in all long-short factor portfolios, the top decile (long portfolio) outperformed the bottom decile (short portfolio) in every instance. Long-short quality was the best-performing factor in April.
We are proud that HDGE will reach its 4-year track record on May 10, 2023. While it has produced attractive returns since its inception, its most notable characteristic is generating positive returns in periods of crisis. Specifically, HDGE was up in March of 2020, when most equity indexes were down double-digits. Also, HDGE gained 15.3% in 2022, when both U.S. stock and bonds were down nearly -20%.
The Fund’s insurance-like characteristic has helped protect investor portfolios. For example, since its inception, when HDGE was paired with the S&P 500, it reduced the downside of stocks by nearly 50%. A smoother ride, with reduced drawdowns, helps keeps clients fully invested through the rough patches for stocks.
The ONEC portfolio gained 1.6% in April, with none of the 11 alternative allocations producing negative performance – a rare feat. It was a suitable environment for both economically-sensitive risk assets and uncorrelated asset classes.
Alternative equity led the asset allocation’s performance last month, gaining 4.9%. The real asset allocation contributed positively as well, with infrastructure and real estate both adding 2.0%.
In the inflation protection allocation, commodities rose by 2.4% while gold bumped up 0.1%.
Managed futures and long-short equity added 1.0% and 1.3%, respectively. All of the other alternative strategies within ONEC, including arbitrage, leveraged loans, mortgages, and risk parity, gained less than 1.0%.
ATSX was up 4.9% in April while the benchmark TSX 60 increased 3.6%. The Fund’s long-short overlay portfolio added 130bps of outperformance during the month.
Most of the Canadian multi-factor long-short portfolio generated positive returns over the month. The long-short quality portfolio, which goes long high-quality equities and shorts low-quality “junk” stocks, led the pack with a 4.3% increase.
Long-short value, which owns undervalued stocks while shorting overvalued ones, gained 3.9%. The long-short price momentum and trend portfolios added 1.6% and 1.7%, respectively. The long-short operating momentum portfolio was the only decliner for the month, falling -0.9%.
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Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.