August 16, 2021 – The dog days of summer have brought calm to the markets, concealing an underbelly full of action and excitement.
Don’t let the flood of out of office replies fool you, there are many things going on in the markets!
There are a record amount of M&A deals outstanding, with the current 102 live transactions in the U.S. worth more than $530 billion, a new all-time high amount.
Additionally, there are a record amount of SPACs outstanding, with the current 583 blank checks in the U.S. worth nearly $200 billion, a new all-time high amount.
While the approximately 800 arbitrage opportunities in the U.S. worth nearly three-quarters of a trillion dollars present a record-setting bounty for investors seeking arbitrage investment opportunities, it does not allow one to enjoy the finer things in life during this hot market summer.
The record supply of arbitrage opportunities has not come with a commensurate increase in demand. This lack of demand to soak up the dramatic increase in the supply of arbitrage investments has led to a widening of spreads, representing an increase in yield across the spectrum of merger and SPAC arbitrage opportunities.
In fact, SPAC arbitrage yields are at a level matching that of March and April 2020, when most other asset classes were at a material discount to where they trade presently.
In contrast to the increasing prospective returns offered in arbitrage, equity beta continues to work favourably for investors as multiples expand, leading to lowered expectations for future stock market performance.
There are a couple of data points that investors should keep in mind when making asset allocation decisions in the current market environment:
1. The U.S. 10-year Treasury yields 1.3%. However, this interest rate is not compelling for investors when inflation, by way of the consumer price index, is rising at a rate of 5.4%.
2. U.S. equities are trading at record high valuations on several measures, including EV / forecast EBITDA and EV / forecast revenue. Canadian equities face a similar, although less extreme, high valuation dynamic.
The S&P 500 currently trades at 13.8x forecast EBITDA (green line below), more than double its valuation ten years ago. The TSX Composite sits at 11.1x forecast EBITDA (purple line below) – not as extreme, but also a record high valuation for the index.
Source: Bloomberg
Based on forecast sales of the index constituents, the S&P 500’s valuation now exceeds the peak of the dot-com bubble in 2000. Note that from 2000, when the S&P 500’s valuation reached these levels, the index produced negative returns over the subsequent decade.
This appears to be a market environment welcoming of diversification.
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): Buffered index
It was the best of times, it was the worst of times.While arbitrage returns have been challenged over the past six months, arbitrage spreads have widened such that they are the most attractive that we have seen since March of 2020 (when world markets were in flux). Wide arbitrage spreads typically lead to attractive returns on a go-forward basis. For example, the average merger arbitrage yield exceeds 8%, comparing favourably to high yield bonds, while the average SPAC arbitrage yield exceeds 2%, comparing positively with short-term Treasury yields.
Despite the challenging environment, ARB’s 6.6% year-to-date return continues to exceed the benchmark S&P Merger Arbitrage Total Return Index’s 4.3% return YTD.
HDGE declined -1.7% in July, as the short portfolio’s loss exceeded the gain of the long portfolio.
We believe that the normalization of monetary policy is likely, given that headline CPI far exceeds the Fed’s target. As monetary policy normalizes, we believe that certain fundamental factors, such as value and quality, will revert to their historical track record of outperforming.
Specifically, we expect undervalued stocks to outperform overvalued equities, and high-quality stocks to outperform low-quality equities. HDGE’s long portfolio is made up of high-quality stocks at attractive valuations with good price momentum, solid operating momentum and a positive share price trend. In contrast, its short portfolio consists of the opposite (junk stocks expected to underperform). As extreme distortions in the market continue to mean-revert, we anticipate HDGE’s long-short approach to benefit.
Positive contributors to ONEC’s 2.2% gain in July mostly came from the inflation-fighting alternative currencies, including bitcoin’s 14.8% surge and gold’s 3.5% rally.
Further positive contributors include a 4.8% increase from real estate and a 2.2% return from global macro. The infrastructure, mortgage and alternative equity portfolios registered small gains while long-short equity, arbitrage and leverage loan allocations fell slightly during the month.
After six months since its launch, ONEC’s 5.5% YTD return puts it within the range of positive expected outcomes.
ATSX’s long-short buffer portfolio did not contribute much to the Fund’s performance in July, providing less than 10 bps of ATSX’s positive performance.
Beta led to the majority of ATSX’s 0.9% increase for the month, as record fund flows continue to buoy the equity markets.
Suppose we see a sustained rise in bond yields for the back half of the year, which is a rational expectation given the reopening economy and higher than expected inflation prints. In that case, we could see the financial sector outperform. Moreover, a sustained rally in financials could cause the Canadian benchmark to outperform that of its U.S. brethren, given the former’s sizable allocation to interest-rate sensitive banks.
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.
