AIF 2022 - Interview #2: Diversification key to hedging against inflation

The alternative investment industry has witnessed the resurgence of global macro strategies and CTAs off the back of rising inflation – in the first quarter alone, CTAs generated performance-based gains of $27.8 billion, attracting $3.3 billion in net new capital, according to data from HFR. But with the current trajectory far from guaranteed, investors are advised to maintain a diversified portfolio in the hope of lessening the impact of future shocks.

“The old adage in economics is that diversification is the only free lunch in finance, and keeping a diversified portfolio might help one navigate a variety of different environments,” says Erik Norland, Executive Director and Senior Economist of CME Group, discussing the uncertainty around the current inflationary scenario. “A diversified portfolio can stand a better chance of delivering stable performance in changing economic environments – maybe less well than the perfect portfolio for a given environment, but much better than a poorly position portfolio of undiversified assets."

Of course, market uncertainty also gives rise to increased volatility, which can be beneficial for alternatives. Howard Siow, CEO of Taaffeite Capital Management, which runs a systematic Global Macro house, uses his fund as an example of this relationship: “Some level of volatility drives positive returns in the TCM strategy. However, the returns are not a smooth upward trend as periods of stronger and weaker performance are to be expected”. Industry data shows macro hedge funds posted record quarterly gains in the first quarter of 2022. The HFRI 500 Macro Index returned more than 9% in the first quarter, while the HFRI 500 Macro: Systematic Diversified Index was up by almost 12%.

Inflation is a key topic due to be discussed in the first panel session of the Amsterdam Investor Forum, organized by ABN AMRO, to be held on 21 September. The debate entitled Global economic outlook: is there a light at the end of the tunnel? will also cover other dominant macro-economic themes, alongside inflation.

Deciding factors

According to CME Group’s Norland, understanding whether the current inflationary environment is temporary or persistent is going to be a long-drawn-out process. “Investors really should focus on month-to-month inflation numbers,” he suggests. “They're a little bit choppy but, essentially, if the month-on-month inflation numbers continue to come in stronger than, say, two tenths of 1% per month, then that implies that you're going to have inflation of well above 2%, maybe about 3% per year.”

Even numbers of 0.3% each month would multiply out to an inflation rate of about 3.5% to 4% per year, which is still high.

However, some market commentators believe inflation will moderate, due to a reduction in government spending, as Norland explains: “For example, government spending in the US before the pandemic was 21% of gross domestic product. Then it rose to 35% of GDP which was a huge increase. In the past 12 months, this has actually decreased to 25% and appears likely to reduce further to around 22% of GDP.”

Siow agrees that the inflation spike could be short-lived. “Recent inflation is driven by a supply shock, not because of the printing of money over the last 14 years. There are currently no signs of permanent changes in demand or supply, productivity or workforce participation, but really it is market (buyers and sellers) trying to find the new equilibrium amidst the noise. Supply shocks often result in overproduction so it would not surprise if the recent inflation dissipated faster than expected.”

Reducing exposure

Even if the rise in inflation is transitory, investors still need to seek to hedge against it, in case it continues longer than expected.

“Many investors believe this is a temporary problem,” says Norland. If they’re right, then they don’t really need much protection. The issue is if they’re wrong. If inflation turns out to be more persistent, this poses enormous problems for almost every kind of investor imaginable. Among the most vulnerable investors would be invested in fixed income but investors in other asset classes including equities could suffer as well,” he adds. Norland will sit on the panel due to discuss the global economic outlook at this year’s AIF.

Siow outlines his firm’s expected action should inflation endure: “The TCM system rotated to less volatile equity and fixed-income positions over the last 12 months to allow the healthy gains in the commodity portfolio to have more meaningful impact.

“If inflation continues, we expect the portfolio to continue to be rebalanced to reduce inflation exposure. With inflation being a significant headwind to these long-biased portfolios, it is akin to flying with only two out of four engines performing. This is likely the first economic downturn in 40 years that the powerful Fed Reserve is seemingly unable to step in to blast away with a monetary bazooka, as almost any intervention could add fuel to an already spiralling fire. It has investors justifiably nervous, as the risk of spiralling hyperinflation and even currency collapse is a devastating scenario to consider however unlikely.”

Within this scenario, Norland points out the positive outlook for inflation-linked bonds: “Outside of an inflationary environment, these instruments usually have negative yields now. Now however, the US inflation linker has a positive yield in real terms, which is a big shift since this had been negative for quite a long time. Therefore, for investors looking for yield, inflation linked bonds are an alternative to the standard treasuries in the US and government bonds in other European countries.”

Should inflation normalise, however, Siow says fixed income and equities will be significant drivers of returns again.

“TCM will likely miss the first leg of gains, but the gains from subsequent legs could be significant. For many, it's time to keep heads low and let inflation- led volatility ride out. There will be significant opportunities when the dust begins to settle, but we suspect we are still far from the bottom.” he notes. Siow is a panel member within the AIF’s second session, where speakers will outline their outlook for the changing markets.

Finding a balance

Whichever inflation trajectory plays out, investors will benefit from having a diversified approach to their portfolios. Says Siow: “TCM is well diversified globally providing investors with good exposure to opportunities across global markets and is also a well-balanced portfolio with the objective to take advantage of niche and less expected opportunities, and protection against unexpected negative events.

“The portfolio has high-quality assets distributed across global equities, sovereign debt bonds, commodities, and currencies. We expect the strategy to continue to perform well.”

Norland agrees with the suggestion that the environment is bound to increase the appeal of alternative investment strategies. He discusses approaches which have done well in the recent past: “Those which have been performing very well are global macro and CTAs. They had a very difficult decade during the 2010s but, given the divergent macroeconomic trends, these approaches have been doing well.” He caveats his observation by noting it does not necessarily mean these strategies will continue to perform at the same level.

Siow and Norland will both be speaking at the AIF in September where they will delve deeper into these themes of inflation and the performance of various hedge fund strategies through the recent market storms.

To register or for more information please visit: https://www.amsterdaminvestorforum.com/

This article was originally featured in Hedgeweek