February 14, 2022 – The U.S. consumer price index (CPI), a barometer of inflation, rose 7.5% compared with a year ago.
Core CPI, which strips out volatile food and energy prices, rose by 6.0% year-over-year.
These stunning inflation readings are the highest in 40 years.
Source: Bloomberg
If inflation, defined as the decline in purchasing power of the dollar, is not at the top of mind for every investor, it should be now.
Remember last year when central bankers would have you believe that inflation was “transitory”? Surprise! It was not transitory.
The central bankers were wrong about inflation, blaming temporary supply chain disruptions caused by the pandemic to deflect the blame from themselves.
As economist Milton Freedman said in 1970, inflation is always and everywhere a monetary phenomenon.
The U.S. M2 money supply has increased a jaw-dropping 40% over the past two years, as the government printed over $6 trillion of greenbacks. That’s more than twice the rate of monetary expansion following the financial crisis of 2008-09 and significantly greater than the money printing of the inflationary 1970s.
Source: Board of Governors of the Federal Reserve System (US)
When trillions of dollars are printed, inflation is the result.
Source: Accelerate
Out-of-control levels of inflation have massive implications for asset prices.
First, and most obvious, bond yields are rising and bond prices are going down.
The 10-year U.S. Treasury bond yield just breached 2.0% for the first time since 2019, seemingly on its way to 3%.
Source: FT
A 3.0% yield on the 10-year implies an additional -8% loss for holders of government bonds. Treasury bonds are looking not so safe these days.
Not only do bonds have a poor outlook with yields expected to rise, but bonds have also had a poor recent performance.
Source: Google Finance
A negative outlook combined with poor recent performance gives most investors pause concering allocating to bonds.
With the poor recent performance of the traditional 60/40 stock and bond portfolio, it is becoming clear to allocators that the last remaining reason to own bonds, being the expectation of positive performance when stocks are declining, is no longer justifiable. Stocks and bonds have not been negatively correlated recently and may both do poorly in a rising rate environment.
Over the past few years, the record monetary stimulus led to unprecedented speculative activity in the capital markets. Specifically, easy money conditions led to record valuations for growth stocks. As a result, the valuation premium for growth stocks relative to value stocks reached its highest ever, exceeding the excess valuations during the 1999-2000 tech bubble.
Source: AQR
If the tremendous rally in, and accompanying record-high valuations of, growth stocks happened primarily due to the dramatic decline in interest rates, it is only logical to conclude that a rise in rates would cause the opposite effect.
Recently, as rates have begun to increase, growth stocks have been hammered. We expect this to continue as rates rise over the next several years.
As this mean-reversion dynamic has begun to play out, we have already seen value stocks outperform growth equities by the largest margin in recent history.
Source: FS Investments
With the accrued valuation excesses and outperformance of growth stocks over a multi-year period, we can expect the outperformance of value portfolios to play out over the next several years.
Given that rising rates are expected to continue to pummel growth equities, investors should be transitioning to a value investing mindset (if they haven’t already).
As discussed in our 2022 Outlook, we expect energy, financial and industrial stocks to outperform. The market has agreed with our sentiment thus far in 2022, as financials and energy have been the only stock segments that have experienced positive returns.
Markets are now pricing in more than six interest rate hikes in 2022.
U.S. equity indexes, such as the S&P 500, are stuffed to the gills with growth stocks. The tech sector now accounts for nearly 30% of the S&P 500.
With the expectation of continued interest rate increases, pressuring both bonds and growth stocks (which comprise a large portion of the S&P 500), we forecast that the traditional 60/40 stock and bond portfolio will likely underperform investor expectations.
The Bloomberg 60/40 portfolio index fell by -4.2% in January, caused by a -5.6% decline for large-cap stocks and a -2.2% loss for bond index. That was the worst performance of the 60/40 portfolio since a slump of -7.7% in March 2020.
Alternatives outperformed the 60/40 portfolio last month, further bolstering their case to be included in investor allocations. As a result, the 50/30/20 portfolio, as represented by a 50% allocation to stocks, a 30% allocation to fixed income, and a 20% sleeve of diversified alternative investments, may be justified as the default investor allocation.
Accelerate manages five 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): Buffered index
- Accelerate Carbon-Negative Bitcoin ETF (TSX: ABTC): Eco-friendly bitcoin
ARB declined -1.4% in January caused to a rise in arbitrage yields.
Specifically, SPAC arbitrage yields rose from 2.4% at year-end 2021 to 3.1% on January 31, 2022. Merger arbitrage yields increased from 8.3% to 10.5% over the same period. In addition, SPAC warrants declined by -29% on average in January. While ARB does not invest in SPAC warrants, it is assigned SPAC warrants for free when it acquires SPAC units below NAV in the IPO or in the secondary market. These SPAC warrants are attained for free but are monetized to generate returns for ARB investors.
There were no broken merger transactions, or even deals in jeopardy, in the ARB merger arbitrage portfolio.
SPAC arbitrage yields are now at their highest since March 2020, at the height of the Covid pandemic-related market panic. There are now 709 SPACs in the market, worth an aggregate $200 billion, and 98% of them are trading at a discount to NAV. The opportunity set for arbitrage currently is massive.
ARB is well-positioned to capitalize on rising interest rates, with a portfolio duration of just 5.7 months. This low duration, combined with a significant opportunity set with sizable yields, positions the strategy nicely for the remainder of 2022.
Once again, HDGE provided positive returns as equity markets declined.
Since its inception, HDGE has gained in the months when the S&P 500 dropped the most.
We believe that HDGE may act as an effective portfolio hedge (as its ticker suggests) given not only its negative correlation to the equity index but the fact that it has positive expected returns (unlike say, put options). It may be analogous to having insurance and getting paid for it.
ONEC fell -2.4% in January, led by the -16.1% decline in bitcoin and -6.1% fall in the real estate portfolio.
Three of the ten ONEC portfolio allocations were positive in the month, led by long-short equity’s 4.2% rise, with leveraged loans and enhanced equity providing slight gains.
In an inflationary environment, such as the one we are currently in, ONEC relies on its alternative currency allocation to help protect the portfolio from the scourge of inflation. While CPI was up 7.5%, bitcoin was up 15.5% year-over-year. Frustratingly, gold was flat over the same period. Nonetheless, we expect gold to contribute positively to the portfolio in 2022. The precious metal’s 3.3% gain YTD shows it is heading in the right direction.
ATSX was flat in January, outperforming the TSX 60 by 0.4%.
The overlay portfolio added 40 bps of outperformance, given it is long undervalued, high-quality stocks and short overvalued, low-quality equities.
The Canadian multi-factor long-short overlay portfolio‘s gains were led by a 19.0% surge in the momentum portfolio. Specifically, Canadian stocks with positive momentum rallied 6.5% while securities with negative momentum dropped -12.5%.
All five Canadian long-short factor portfolios produced positive returns in January.
ATSX remains one of Canada’s highest yielding alternative ETFs, with a distribution yield of 6.7%, well supported by its 11.3% since-inception annualized return.
Have questions about Accelerate’s investment strategies? Book a call with me.
-Julian
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.
