As 2023 begins, it appears that the global economy is settling into a new regime which can be characterized by restrictive monetary policy to combat the most significant episode of inflation seen in 40 years, geopolitical instability on multiple fronts, and a sharp reversal towards de-globalization. These economic shifts, evolving over the last several years, have led to heightened market volatility and provided hedge fund managers with a renewed alpha-rich environment, following a decade of quantitative easing, relatively stable geopolitics, and highly efficient, just-in-time global trade markets.
The last three years of heightened equity volatility displayed in the charts below demonstrates how unusual a period we have gone through. The frequency of large daily swings in the S&P 500 is significant and often occurred as a result of news flow regarding COVID, geopolitical events, and monetary policy. In the last three years we have seen 97 days where the S&P moved +/-2%. Prior to COVID it took 9 years (2011 to 2019) to reach that same number.
The Bloomberg US Aggregate detracted 13.01% in 2022, the worst performance for US bonds in 97 years. With the S&P 500 losing 18.11% on the year, the traditional 60/40 portfolio experienced one of its worst performances on record. The correlation of stock and bond performance has left investors searching for diversification and alpha in unsettled markets.
Monetary Policy
As Central Banks around the world have adjusted policy with the intention of reducing inflation, equity and credit markets have traded in tandem to macro developments, exhibiting a correlation that has not been experienced in decades. Markets appear to hang onto every word from central bankers and react to each economic print with great intensity. Federal Reserve Chair Powell appears to be committed to his mission to continue raising rates and to hold them there for an extended period, however, market participants question his true intentions with the Fed Funds Futures currently pricing a rate cut by Q4 2023. Speculation around monetary policy has contributed to a highly volatile 2022 in rates, credit, and equity markets.
In essence, the central driver of macroeconomic uncertainty stems from the conflicting narrative of whether the economy is headed towards a “soft-landing” or “hard-landing”. To avoid oversimplifying the situation, it is important to note that there are many shades of gray here, and countless variables that play into potential outcomes. This same phenomenon is being played out in other developed markets around the globe. While we are hesitant to make a binary prediction, we do expect volatility and uncertainty to remain present across markets in the near future.
As we have said, inflation is a multi-faceted issue, and CPI is the Federal Reserve’s preferred method of measuring price increases. One of the more significant components of CPI is wage growth and it appears to be “sticky” making it more difficult to reduce through monetary policy action. If the Federal Reserve can successfully restrain the wage component of inflation by tightening monetary policy, all while avoiding a significant increase in unemployment, the US will likely be able to avoid a deep recession. The United States labor force participation rate has yet to recover from COVID, with 3 million people leaving the workforce since March of 2020. The US labor force participation since 2010 is displayed in Figure 3. 
It is estimated that as of the end of 2022, around 2 million workers retired early, and another 1 million people are dealing with Long COVID issues or living off inflated savings. Wage inflation should continue to face major headwinds with a large portion of citizens exiting the workforce unlikely to resume participation.
A recent shift in consumption from goods to services has the potential to put further pressure on wage growth from the demand side. Furthermore, an increase in the rate of immigration in the US is a factor that could help ease some of this pressure, however, this is unlikely to occur overnight and is politically untenable. If wage inflation remains persistent, the Fed will likely desire to hold rates elevated for an extended period, but it will have to also respond to the current outlook for economic growth which could create a mixed picture.
The combination of the Federal Reserve increasing rates at record pace and the often-overlooked pivot to quantitative tightening (“QT”), increases the risk of a policy mistake that would need to be reversed. Apollo Global Management’s Chief Economist recently noted research published by the San Francisco Fed that estimated the proxy effective Fed funds rate (including forward guidance and the Fed’s balance sheet/asset sales) is approximately 6% versus the current effective Fed Funds Rate of just over 4% as of December 31st, 2022. This illustrates tightness within the economic environment is more significant than is appreciated by looking simply at the Fed Fund Rate. Figure 4 displays historical representation of the effective Fed funds rate compared to the proxy effective Fed funds rate.
It is estimated that changes to the Fed Funds Rate take 12-18 months to work their way through the economy and demonstrate an economic impact. While equity valuations, mortgages, and debt issuance are generally the first to reflect changes in the interest rate environment, there is still a great deal of uncertainty regarding the effects of these rapid rate hikes combined with QT on the economic environment. Equity indices declined significantly in 2022, and it appears that a large portion of these declines were attributable to multiple compression, as earnings revisions have not been adjusted for the impact of tightening policy. This should be considered as we move into 2023.
Geopolitics
The last decade has seen a somewhat benign environment for geopolitics as a central focus for markets, but the Russian invasion of Ukraine in early 2022 created ripple effects across the globe. The war in Ukraine has wreaked havoc on energy, commodity, and grain markets, and does not appear to be nearing a resolution. The conflict’s ramifications continue to disrupt global markets with no clear end in sight. Currently, the US and EU continue to support Ukraine with billions of dollars in weapons and financial aid and we have observed a slow ratcheting up of support that is clearly unwelcome by Russia. Uncertainty persists as both sides have indicated they will not stop short of victory. We are hopeful that 2023 will see this conflict come to an end peacefully, but the likelihood of these events affecting markets is significant.
Energy
The Russia/Ukraine war caused a spike in oil and natural gas prices due to western sanctions and disruptions from the conflict. Western European and US policy has discouraged the fossil fuel industry from beginning new E&P projects over the last few years in the form of increased taxes and corporate incentives to move to “clean” energy. Recent fracking bans in the West have contributed to further production constraints in fossil fuels. This combination has resulted in a very volatile energy market. Furthermore, the transition to clean energy will not happen overnight and will ironically require significant amounts of fossil fuel to mine for the lithium, graphite, cobalt, and nickel necessary to for EVs and battery storage. The International Energy Agency published a report on October 26th, 2022 analyzing the growth in demand for minerals necessary to develop a sustainable energy transition. Below is an illustration of the expected increases in demand.
As the world continues its desire to reach carbon neutrality amidst geopolitical uncertainty, continued volatility related to energy in the near term seems inevitable.
Deglobalization
There is a growing desire in developed countries to onshore the production of a variety of essential goods with the goal to avoid the supply chain bottlenecks that occurred during COVID lockdowns which were then exacerbated by the Russia/Ukraine conflict and China’s “Zero-COVID” policies. While supply chains are beginning to normalize, developed countries have placed a higher importance on onshoring vital aspects of the supply chain. If the West continues its shift in the direction of deglobalization, this will likely be inflationary in nature, especially when considering much of the US, Canada, and Western Europe are operating near full employment. Following more than four decades of the growth of globalization, a swift pivot to restrictive measures on global trade has the potential to send shockwaves throughout asset classes. While we see a need to onshore certain products of vital importance like semiconductors, we are cautious in buying into the “end of globalization” due to the inflated cost of producing goods in developed countries.
As we move through 2023, it is nearly impossible to pinpoint the next significant dislocation, however, it is apparent that markets will continue to adjust to the new forces affecting the economic environment. If volatility persists and any additional technical breaks in the markets occur, liquidity and flexible capital will be rewarded.
Key Themes for 2023 and Beyond
We believe the current environment will provide ample opportunities for hedge fund managers to capitalize on dislocations as market developments play out. We have identified four hedge fund strategies that appear to have outsized opportunity sets over the next several years.
Credit
Credit hedge fund managers suggest that they are now seeing the best potential risk-adjusted and total returns in performing credit since the GFC. Over the last 10 years, bond and loan covenants have progressively become weaker as lenders tried to remain competitive in a low-rate environment. Monetary policy, until recently, has kept interest rates low, spreads tight, and total returns uninteresting.
Distressed bonds and loans currently sit near 2-year highs (over $300 billion outstanding), and distressed investors are hopeful this is the tip of the iceberg for the first sustained credit cycle since the GFC. The rising rate environment has the potential to lead to a “slow bleed” for companies struggling to service their debt obligations.
Distressed credit investors often invest in fulcrum securities of companies at a significant discount, with the assumption that the firm will be unable to meet financial obligations and file for chapter 11 bankruptcy. Through the restructuring, investors replace previous obligations with refinanced debt, equity, or a combination of negotiated securities. Distressed investors often obtain board seats, provide resources, and guide companies through exits, in order to drive additional value.
Following the unprecedented monetary and fiscal policy response to the COVID pandemic, many CFOs took the opportunity to refinance debt at historically low rates. Firms with floating rate debt are already beginning to feel the burden of interest expense squeezing cash flows, with technology, healthcare, and retail sectors under increasing pressure. With limited access to capital markets, costs of capital have increased substantially, weighing down more heavily on less mature businesses that were eager to grow at an unsustainable pace. While IG debt appears to begin a stable flow of maturities in fixed rate maturities in 2023, High Yield debt has a much higher proportion of floating rate debt outstanding. The longer monetary policy stays tight, the more issues companies will have servicing their HY floating debt.
High Yield corporate debt issuance is down 80% in 2022 compared to 2021, and many of these companies will have capital requirements soon, especially businesses with floating rate debt obligations weighing down on free cash flow.
Even if we see inflation come down and treasury yields ease, it may be difficult for these companies to refinance at manageable interest rates ahead of their maturities. Rate pressure has the potential to create a wave of rescue financing and restructuring opportunities as early as 2H 2023 but could last well into 2024-2026 dependent on macroeconomic developments. While it is hard to say whether we will experience a full-blown credit cycle, it seems probable that stressed/distressed opportunities will begin to present themselves idiosyncratically at the very least.
This landscape also sets up nicely for fundamental Long/Short credit pickers, following the worst IG bond returns since 1931 and the second worst return on record for HY bonds. Credits largely traded in line with technical and macroeconomic factors in 2022 opening the door for attractive entry points if we experience increased dispersion moving forward. On the long side, fundamentally stable companies that can weather an elevated rate and potentially recessionary environment provide upside optionality with a claw back to par. As credits begin to trade off, it should provide an attractive environment for credit managers to sell credits that will have difficulty withstanding pressures as earnings suffer and downgrades ensue.
In 2008 and 2020, credits traded down in tandem before the asset class began to take fundamental factors into consideration, ultimately resulting in dispersion among credits with varying credit quality. Today, credits continue to trade closely, regardless of credit quality. With the economy beginning to slow, Fundamental Long/Short Credit investors would welcome increased dispersion among companies with different credit ratings.
Activism
For the last decade, valuations of high growth businesses have increased significantly, both in the public and private markets. These valuations ballooned even further following the massive amounts of fiscal and monetary stimulus that flooded the economy following the COVID pandemic. With monetary policy tightening at a record pace in the US, the benefits of cheap, easy capital evaporated for many high growth companies early in 2022 which revealed inefficiencies masked by frothy markets.
Activist investors aim to generate alpha by taking a large stake in a company and encouraging strategic initiatives to generate value for shareholders. The alpha is generated by creating one’s own outcome, and the positions are often hedged to varying degrees to isolate relative performance and unwanted beta exposure. Activist investors can influence change in a business with or without board seats and can do so in a hostile or collaborative manner. Initiatives include, but are not limited to, improving operational efficiencies, cutting costs, implementing new business plans, making synergistic acquisitions, and pushing for value accretive divestitures or spinoffs. In some instances, investors with a controlling interest will take public companies private for easier implementation of these changes.
With public equity multiples compressing over the course of 2022, technology stocks have been discounted significantly providing attractive opportunities for entry. High growth software companies have recently drawn significant attention from activist investors. Sticky customer bases, growing percentage of market share, proprietary technology, and ample opportunities to cut costs are attributes that make some of these software businesses attractive at discounted valuations. Overall, the market has seen widespread multiple compression, with the SPX P/E Ratio valued below 20 as of 1/23/2023, significantly lower than its 2021 high of 35. With more attractive entry points and ample opportunities to trim the fat of inefficient business models, the environment is attractive for activist managers to drive value.
Some activist investors prefer to take a more cautious approach, seeking to ride out the economic storm in companies in defensive sectors with identified catalysts. Additionally, a manager can express a tactical secular bet by engaging in an activist position in a targeted sector, profiting from secular tailwinds while driving additional value. Other activists invest with a strict, bottoms-up fundamental lens.
Global Macro
During the majority of the 2010s, global macro strategies generally underperformed. The alpha opportunities in the strategy were limited due to central banks’ coordinated accommodative monetary policies, a highly efficient global economy and trade market, and limited geopolitical tension. With the onset of the COVID pandemic, a tidal wave of fiscal and monetary stimulus flooded the US and other developed economies. This unprecedented stimulus combined with COVID induced supply-chain disruptions spurred inflation to rise to levels not seen in decades.
Many global macro hedge fund managers trade a broad range of instruments across asset classes (rates, foreign exchange (“FX”), credit, equity and commodities) using top-down macro views to influence decision making. The instruments are used to express a view on inflation, interest rates, geopolitical events, and government policy. Many managers also utilize quantitative modeling to help inform their macroeconomic opinions and outlooks. Risk is often deployed directionally, and many macro managers utilize options to achieve asymmetric returns.
The rapidly shifting geopolitical landscape, accompanied by a high level of central bank involvement has led to increased volatility across the macro investment landscape, which has allowed global macro managers to take down leverage without diminishing target returns. Further volatility in rates could continue as central banks globally raise rates at varying paces Inflationary environments differ globally with minimal inflation in China, wage inflation continuing to be sticky in the US, and goods inflation lingering in Europe. Overall inflation will retreat at varying speeds across the world, providing opportunities for macro managers to take directional risk, trading the dispersion of central bank reactions. Relative value opportunities remain attractive, as increased volatility in the markets allow funds to profit from dislocations.
Short duration trades were profitable in 2022 with JPN/USD moves, and sharp volatility in Gilts and interest rates. This opportunity set may not be quite as robust moving forward from a short duration perspective once the markets settle down a bit, however, longer term opportunities are expected to become more plentiful. Disruptions in supply chains, global trade relations, commodities and energy are expected to continue to impact the overall global macro opportunity set in a positive way.
FX trading has seen a major resurgence in 2022, with large moves in USD, EUR, JPN, and GBP. An expansion of the BRICS alliance (Brazil, Russia, India, China, and South Africa) seems very possible, as Argentina, Saudi Arabia, Turkey, and Egypt have expressed interest to join the alliance. The current five countries in the alliance account for 40% of the global population and over a quarter of global GDP. As tensions continue to rise between the West and China & Russia in particular, one can only anticipate that further dislocations will ensue.
In addition, the impact of Japan’s policy regarding yield curve control could have major ramifications across rate and FX markets globally, as Japan is the largest global holder of foreign debt. Below is a graph of the dispersion seen in FX markets over the past 4 years. Notably, FX dispersion picked up substantially in 2022 following the war in Ukraine and central bank tightening efforts. The fruitful alpha environment in global macro strategies should remain attractive in the near future.
Crisis Alpha
The increased uncertainty and volatility in financial markets resulting from restrictive monetary policy and geopolitical turmoil lead us to believe that exposure to tail hedge strategies could be an appropriate addition to portfolios in the coming years. Tail hedge strategies seek to outperform during extreme market events, allowing for portfolio protection in circumstances of a volatility spike, widening of credit spreads, or sharp declines in equity markets.
Managers can take a variety of approaches when employing tail hedge strategies. Some funds focus on trading combinations of CDS, options, and futures, while others use varying degrees of index shorts as an overlay on their traditional strategies. Another approach is to employ more stringent stop-losses on traditional models to limit downside exposure. These all can be additive to portfolios with the right managers.
Tail hedge strategies outperformed in 2022, even in the absence of a major tail event. Many strategies are positioned long volatility and can better achieve attractive relative value positioning in volatile environments. Implied volatility in 2022 was expensive relative to realized volatility, which led to a more difficult hedging environment. Even after accounting for heightened hedging costs, the transition to a new economic regime of elevated rates, global conflict, and trade disruptions seems to be intensifying which leads us to believe the addition of downside protection in a portfolio remains attractive in our view.
Closing Thoughts
As we reflect on the shifting global economic and geopolitical environment, we remain hopeful that the opportunity set moving forward for hedge funds will be rich. We expect our managers to capitalize on dislocations and produce meaningful alpha in these types of environments. While we have identified credit, activism, global macro, and tail hedge strategies as having outsized opportunity sets due to market dynamics, we recognize that global markets never stay stagnant and there is potential for additional strategies to emerge as attractive.
Infinity Capital Partners, LLC
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