THE confluence of the global economy re-opening, ongoing accommodative monetary policy and incremental fiscal stimulus brought about inflation concerns in Q1 this year.
It also compressed an entire year's worth of price movements into just three months, as investors rapidly adjusted portfolios to position for a new economic cycle. Market participants have had to consider inflation risk for arguably the first time in 20 years, and determine whether to make the associated portfolio adjustments.
We are benefiting from having a significant amount of our capital aligned with several structural alpha opportunities, driven by six mega-trends.
While we see each of these trends likely lasting for several years and will have capital allocated to them consistently, the specific opportunity set and available returns will ebb and flow at different points in time, presenting unique opportunities and meriting more of our attention.
Mega-trend #1
The first is the growth and drive towards efficiency in the Chinese equity markets.
While everyone understands the size, growth and dynamism of the Chinese economy, far fewer appreciate the magnitude of global investors' underweight exposure to China and the dramatic steps that regulators are taking to attract international capital.
Specifically, the recent QFII and RQFII will enable direct trading with local broker/dealers and create an onshore stock borrowing market in A-shares.
We believe this will spark a golden age of sorts in relative value equity investing in China over the next several years, as hedge fund managers will be able to implement the full complement of equity strategies, deriving alpha on both the long and short side, and dynamically managing beta, sector, factor, thematic and idiosyncratic risk.
Mega-trend #2
The second is environmentally focused investing. Climate change has taken centre stage in public-policy debates globally, and environmental issues have become top-of-mind for many investors. Changing consumer preferences, rapidly evolving regulatory policy and required shifts and increases in capex will drive sustained dispersion in performances of companies involved in the energy transition economy.
Our view is that investors are underestimating the complexity of this transition and overlooking many of the materials, processes and technologies that will enable this transition. We believe that investors who focus on this theme, and employ deep industry experience, policy and technological expertise, in coordination with a robust corporate finance framework, can look forward to a sustained alpha opportunity for the next decade.
Mega-trend #3
While it has become fashionable to critique Special Purpose Acquisition Companies (SPACs) as a capital markets distortion and dismiss them as a passing fad, they will continue to play a significant role in the capital markets.
In 2020, 237 SPACs were launched, raising almost US$80 billion in capital and surpassing traditional IPOs at US$67 billion. While almost every investor usually tries to invest in IPOs, only a fraction of global investors have the capacity or willingness to invest in a SPAC or in the Private Investment in Public Equity (PIPE) offering that often accompanies a SPAC merger announcement. Investors who have the ability to invest up and down the SPAC ecosystem may capitalise on sustained inefficiencies in the SPAC market.
Despite the growth and secular winner risk unwind of the first quarter, our SPAC strategy has delivered positive returns thus far in 2021, and we continue to see attractive valuations and compelling investment opportunities available.
While we think that security selection is more important now than ever to derive returns from the SPAC market, we are heartened by the very modest level of embedded optionality being priced into the market right now, with the 411 SPACs looking for acquisitions as of quarter-end, trading at only a 1.1 and 1.7 per cent discount.
For investors who think the market will inevitably move past the SPAC phenomenon, we would caution that both companies and investors are seeing substantial advantages in the SPAC market relative to the traditional IPO process.
Mega-trend #4
The fourth mega-trend is the asymmetry in the size of the US credit markets relative to the amount of dynamic capital deployed by banks and hedge funds. While investors know that US corporate credit issuance in 2020 increased by 56, 42, and 91 per cent in investment grade, high yield, and convertibles respectively, relative to 2019, fewer are aware that there has not been a commensurate increase in dynamic risk capital in credit from banks and hedge funds, creating ample relative value opportunities.
The broader economic backdrop makes these opportunities even more compelling. The severity of economic conditions during Covid-19, coupled with the vaccine outlook and potential economic acceleration out of the crisis, is causing companies to actively manage their businesses and capital structures, which often is the catalyst for convergence in relative value positions.
The actions emanating from this active management ranging from issuance to optimisation and to liability management are rooted in fundamental corporate financial discipline and securities valuations, which are the core tenets of our credit relative value approach.
Mega-trend #5
The fifth is the disintermediation of banks as hedge funds and asset managers extend credit directly to borrowers.
Particularly in the case of riskier and more complex loans, banks are not willing and able lenders in many cases. This offers one of the most attractive, risk-adjusted yield and total return profiles available in the financial markets for private credit investors.
With limitations on banks' structured lending emanating from statutory regulation, central bank supervision and shareholder preferences, we believe this disintermediation will continue, making private credit one of the most compelling capital allocation opportunities for investors who can manage lower liquidity.
Mega-trend #6
The final mega-trend is the migration of supply chain finance from bank and corporate balance sheets to investors. With estimates of financing needs at US$7.5 trillion globally and the operational and accounting complexities of investing in trade finance, a persistent supply-demand imbalance makes the risk-reward profile of investing in corporate credit via this asset class compelling.
We see better yields, shorter durations, lower default probabilities and higher recoveries in trade finance than for corporate bonds, leading to a compelling relative value opportunity on a sustained basis. While we see this market ultimately developing a comprehensive securitisation solution as we have seen in the asset-backed and mortgage-backed securities markets, the time between now and that eventuality provides a window of opportunity for investors.
Now, more so than any other time in our recent history, we believe that capital allocated to strategies that leverage not just the traditional forms of investment and cyclical alpha, but also structural alpha emanating from the trends discussed above, will provide both stability and significant uncorrelated returns for investor portfolios.
- The writer is chief investment officer of UBS O'Connor
Keyword added to your list