August 10, 2024 – With the prevalence of recession predictions, and their host of corresponding recession indicators, it would seem like forecasting the next economic downturn is a national pastime.

The reasoning behind the widespread desire to foretell a downturn is straightforward. Recessions bring downward volatility in risk assets, and all else equal, most allocators would prefer to sidestep mark-to-market portfolio losses that most-often accompany a recession by aiming to sell before the bear market occurs (We’ll save predicting when to buy back in for another memo).

Historically, investors have used a myriad of technical indicators to judge where we are in an economic cycle in order to predict whether the next bear market will happen in the near term. Whether it be weakness in corporate earnings, housing starts, building permits, retail sales, industrial production, the Economic Surprise Index, or the Consumer Confidence Index, there are a multitude of leading or coincident economic indicators that investors follow to gauge the probability that the next move is down.

Moreover, one of the most popular recession indicators, the inverted yield curve, just completed its longest and deepest inversion in history. An inverted yield curve, which occurs when short-term Government T-bills yield more than long-term Treasury bonds, has been a harbinger of a recession in nine out of ten instances over the last seventy years.

During the current business cycle, a recession of significance did not occur during this yield curve inversion (at least not yet). However, what is debated amongst market prognosticators is whether the initial inversion of the yield curve portends an economic downturn or whether the conclusion of the inversion (and corresponding upward-sloping yield curve steepening) counts as the trigger.

Notably, in the past four recessions (2020, 2007-2009, 2001, and 1990-1991), the yield curve had turned positive by the time a recession occurred. While there is no shortage of critics citing “it’s different this time”, there is skepticism about whether the yield curve has lost its predictive capability regarding the direction of the economy.

In any event, there is a new recession indicator in town, the Sahm Rule, and it is flashing a big, red warning sign to investors.

The Sahm Rule (note: not an actual rule) is an economic indicator developed by economist Claudia Sahm to identify the onset of recessions. It is designed to signal when a recession is likely happening based on changes in the unemployment rate.

The Sahm Rule triggers a recession signal when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more above its low during the previous 12 months.

Unfortunately for investors, with the U.S. unemployment rate rising to 4.3% in July, up 60 bps from its low at the start of the year, the Sahm Rule has been officially triggered.

 

The leading indicator has a good track record of success. Each of the last eleven Sahm Rule triggers has coincided with a recession.

In ten of those eleven examples, the economy was already in a recession by the time the Sahm rule was triggered.

Along with the inverted yield curve and other leading economic indicators, the Sahm Rule is no panacea. Skepticism abounds regarding the effectiveness of these forecasting tools, and justifiably so, as they are just observations. With respect to the Sahm Rule specifically, the indicator has only once signalled a recession from an unemployment level so low. Even the signal’s creator has her doubts, stating “A recession is not imminent, even though the Sahm rule is close to triggering. The Sahm rule is likely overstating the labor market’s weakening due to unusual shifts in labor supply caused by the pandemic and immigration. The risk of a substantial weakening or a recession in the next several months is elevated, adding to the case for the Fed to begin cutting rates.”

While the jury is still out on whether we are on the precipice of a recession or are already in one, our foremost economic indicators foreshadow a potential downturn. First, it was the inverted yield curve. Now, it’s the Sahm Rule. Investors should consider the implications and prepare accordingly.

In order to prepare for the potential upcoming recession, we do not advocate “going to cash”. Even if one sidesteps an equity bear market, the challenge of knowing when to buy back in, along with the negative tax ramifications of crystallizing capital gains, makes selling everything generally not a good idea. We have never met anyone who has been able to successfully sell the top and buy the subsequent bottom. Usually, if one is lucky enough to sell at the right time before the downturn, they typically end up “fighting the last war”, remaining bearish and not buying back in until risk assets are priced higher than where they previously sold.

That being said, we outlined our approach to risk management in the context of economic downturns in our 2019 memo, Risk Management, Before it’s Too Late:

Risk management is an important aspect of investment portfolio construction. However, this much-needed protection against adversity is rarely implemented before it’s too late.

Unfortunately, instead of a well-thought-out and implemented risk management plan, many investors are stuck panicking after a large market drawdown and some even end up capitulating and selling their investments at the lows, realizing significant losses and interrupting their long-term investment goals. These spooked investors remain out of the market, unable to capitalize on the bounce back in asset values.

Instead of worrying about risk management when it’s too late, the best approach is to plan ahead. And the best way to manage risk before the turbulence hits is through diversification.

Diversification is a risk management technique that combines a wide variety of investments within a portfolio. The purpose of true diversification is to hold a myriad of asset classes which don’t move in the same direction as each other (ie. uncorrelated assets).

As we often say, the only free lunch in investing is diversification. Through exposure to a portfolio of uncorrelated, or negatively correlated, investments that can hold up or even do well during a recession, one can fortify their investment portfolio to stand up against any economic weakness. Asset allocation that focuses on diversification allows an investor to remain fully allocated throughout the cycle.

Accelerate manages five alternative investment solutions, each with a specific mandate:

  • Accelerate Arbitrage Fund (TSX: ARB): Merger Arbitrage
  • Accelerate Absolute Return Fund (TSX: HDGE): Absolute Return
  • Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Multi-strategy
  • Accelerate Canadian Long Short Equity Fund (TSX: ATSX): Long Short Equity
  • Accelerate Diversified Credit Income Fund (TSX: INCM): Private Credit
Please see below for fund performance and manager commentary.

ARB gained 0.7% in July compared to the benchmark S&P Merger Arbitrage Index’s 1.5% increase.

Performance of the Fund was driven by the successful closing of several merger arbitrage investments, including AbbVie’s acquisition of Cerevel, Sababa Holdings’ buyout of Whole Earth Brands, JD Sports’ acquisition of Hibbett, Thoma Bravo’s buyout of Everbridge, Alamos Gold’s merger with Argonaut Gold, and Silvercorp’s merger with Adventus Mining. Some of these merger spreads were more volatile than others, but ultimately all ended up closing as expected.

The ARB portfolio management team remained busy adding new investments to the Fund throughout the month, including three Canadian and two U.S. merger arbitrage investments. In addition, three new SPAC IPOs (out of five new issues during July) were added to the portfolio.

In terms of allocations, the ARB remains fully deployed, with 141.2% long and -8.1% short exposure (149.3% gross), with 58% allocated to SPAC arbitrage and 42% to merger arbitrage.

HDGE added 1.6% in July, bringing its year-to-date return to 18.6%.

It was a mixed month for factor performance, particularly for U.S. equities. The long-short value factor was the sole driver of positive multi-factor returns, generating 3.5% of alpha. Meanwhile, the long-short price momentum, operating momentum, and trend portfolios experienced drawdowns of -2.4% to -4.6%.

Moreover, all long and short portfolios were positive for the month. Short sellers and hedgers had some difficulty, as the GS Most Shorted basket surged 10.5%. Nonetheless, HDGE’s beta neutrality, along with tight risk controls around individual short positions and the aggregate short portfolio, helped the Fund buck the trend and generate positive P&L.

ONEC’s NAV increased by 2.9% in July. The real asset bucket was the largest contributor, as real estate surged 6.8% and infrastructure rallied 7.0%.

Other allocations that contributed positively include gold, gaining 4.1%, long short equity, up 3.9%, and risk parity, which increased by 2.4%. The absolute return and arbitrage allocations chipped in for gains of 1.6% and 0.7%, respectively.

The credit portfolio, consisting of leveraged loans and private credit allocations, generated a modest positive total return over the month.

Negative contributors for the Fund include managed futures, which fell -3.5%, and commodities, which dropped -0.5%.

ATSX gained 3.9%, bringing its year-to-date performance to 12.6%. In comparison, the benchmark TSX 60 surged 6.1% in July and is up 11.3% year-to-date.

Canadian long-short factor portfolios experienced variable results for the month. All major long-short factor portfolios, including value, quality, operating momentum, and price momentum, fell by modest amounts, while the long-short trend portfolio was one of the only drivers of return to generate alpha. Nonetheless, ATSX’s 150 long / 50 short structure allowed it to continue its rally this year, however, with relatively muted performance compared to the Canadian benchmark.

The credit market remained calm in July, with yields staying relatively constant. However, with the bout of volatility in early August, private credit yields have increased, and NAV discounts have widened. After the recent volatility spike, INCM has traded from in line with the net asset value (NAV) of its underlying loan portfolios to an approximate -7.4% discount to NAV currently.

In addition, most private credit funds reported their second quarter results over the first week of August. While most private credit funds performed adequately in Q2 (flat NAV), some funds did have some loan write-downs accounting for 5-10% of their NAVs (specifically Oaktree, Goldman Sachs, and BlackRock). These write-downs caused the underlying NAV of INCM’s private credit funds to drop approximately -1.5%, taking INCM’s “fundamental NAV” from $20.15 per unit at the end of July to $19.88 per unit as of August 8th.

Currently, the INCM portfolio provides exposure to 4,639 underlying loans and investments, of which 85.7% are secured, yielding 11.9% on average.

Have questions about Accelerate’s investment strategies? Click below to 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.

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