July 16, 2022 — If recession forecasting were a sport, it would be a national pastime relished by both professional economics and armchair amateurs alike.
Economic decline isn’t just the concern of market participants. An index of Google searches for “recession” now exceeds the 2008 reading and matches the level reached in March 2020. If everyone is concerned that we are in a recession, then we are likely to be experiencing a recession.
The recessions of 2008 and 2020 accompanied significant price declines in risk assets, particularly for equities. However, given that the prices of risk assets are forward-looking, risk assets have likely already bottomed by the time the leading indicators point to a recession. When a recession is declared official by the powers that be, the economy is likely back to growth and financial assets have typically recovered significantly from their lows.
Therefore, it is helpful for asset allocators to be on the lookout for leading indicators of a recession. In addition, it is beneficial to gauge where we are in the cycle with respect to a recession — at the start (before asset prices decline), middle (when financial assets bottom), or end (when risk assets have already recovered).
For that task, there are several useful datasets to track.
For example, an inverted yield curve has preceded every recession over the past 40 years.
The bad news: The yield curve is inverted.
However, the tricky part of a yield curve inversion is it does not point to the precise timing of a recession.
As we know, in investing, timing is everything. Unfortunately, we work in a field in which “too early” is synonymous with “wrong”.
An inverted yield curve points to a recession occurring in the next 0–18 months. So where are we in the economic cycle?
A recession is defined as two consecutive quarters of negative real GDP growth.
The US economy shrunk by -1.6% in the first quarter.
The Atlanta Fed now estimates that the U.S. economy shrunk by -2.1% in the second quarter of 2022.
With a -1.6% decline in Q1 and a -2.1% estimated drop in Q2, the U.S. economy suffered a recession in the first half of the year.
The economic conditions already priced into the market are what matters to investors. Are we in the middle of a recession or has it already ended?
Year-to-date, the S&P 500 index dropped -20.6%, marking its worst first six months since 1970. The Dow Jones Industrial Average’s first-half fall of -15.3% was its worst since 1962, while plunges of -29.5% for the Nasdaq Composite index and -23.9% for the small-cap Russell 2000 index produced each index’s worst first-half performance on record. Additionally, the bond index dropped -10.7%, its worst first-half year return based on data going back to 1975.
Canadian stocks fell -13.8% in the second quarter, their most significant quarterly decline since the first quarter of 2020.
Bitcoin just recorded its worst month on record while dropping -58% in the second quarter of 2022 (its worst quarter since 2011).
Adjusted for inflation, the performance figures for risk assets are even more daunting.
Over the first half of the year, the S&P 500 suffered its worst inflation-adjusted return since 1872.
Government bond returns are on track for their worst real annual return since 1865.
Given the “worst ever” year-to-date or monthly performances of several asset classes, it is not out of the question to believe perhaps that a recession is already fully priced in. We see it in financial markets, we see it in Google searches and we see it in the yield curve.
As Warren Buffett said about allocating capital through a recession and the subsequent asset price recovery, “if you wait for the robins, spring will be over.”
Accelerate manages five 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
- Accelerate Carbon-Negative Bitcoin ETF (TSX: ABTC): Eco-friendly bitcoin
Please see below for fund performance and manager commentary.
In a tough market for nearly all asset classes, ARB hung in there relatively well with a -0.3% decline while the benchmark S&P Merger Arbitrage Index fell -0.5%.
Year-to-date, ARB has declined -2.5% while its benchmark has fallen -3.3%. Arbitrage has outperformed nearly all fixed income alternatives this year given its consistency and low duration.
ARB produced 20bps of alpha last month and 80bps of outperformance year-to-date (ignoring that the arbitrage index excludes fees and costs to run the strategy including management fees, hedging costs, leverage costs, borrow fees, etc).
In a volatile economic environment, arbitrage has been relatively boring. In June, 12 M&A deals closed worth over $60 billion while 14 deals (worth $47 billion) were announced. No mergers failed. There were 3 SPAC IPOs, 11 SPAC business combinations announced, 10 SPAC mergers closed and 2 liquidations.
Arbitrage performance was negative due to spreads widening. Merger arbitrage yields below 14% at the start of June widened to more than 16% over the month (prices fall as yields rise). Last month, SPAC arbitrage yields rose from 4.6% to 5.5%.
No one knows when yields will peak, or if they already have. We know that SPAC arbitrage yields are their highest on record while merger arbitrage yields have only been higher between March 12th to April 15th of 2020.
HDGE fell -7.1% in June. The Fund is still up 6.4% year-to-date and 29.5% year-over-year.
It was a mixed month of performance for long-short factor portfolios. For example, Canadian long-short factor portfolios had negative performance while U.S. long-short factor portfolios were positive.
Nonetheless, all long and short factor portfolios fell in June. It was just a matter of magnitude of the drop. For instance, the U.S. long-short value portfolio gained 5.1% as its short portfolio (overvalued stocks) plunged -14.6% while its long portfolio (undervalued stocks) dropped -9.5%.
Given HDGE is 110% long and 50% short, its net long exposure led to a monthly loss, although the Fund’s short positions helped mitigate its downside participation.
ONEC fell -7.5% for the month in an environment which seemingly nothing worked. Over the short term, sometimes diversification does not help portfolios significantly.
For the first time since the Fund launched, all ten strategies within the ONEC portfolio had a negative monthly performance.
Arbitrage, mortgages, gold and leveraged loan allocations had modest losses of -0.3%, -1.0%, -1.2% and -2.7%.
The majority of alternative allocations fell mid-to-high single digits: real estate -5.8%, infrastructure -6.6%, risk parity -6.7%, long-short equity -7.1% and enhanced equity -9.0%. Bitcoin had its worst month on record with a -40.4% drop.
ATSX fell -9.0% for the month while its benchmark, the TSX 60, dropped -8.3%.
In June, the Fund’s long-short equity overlay portfolio declined 70 bps as Canadian long-short portfolios were down on average.
Specifically, the long-short trend portfolio fell -5.3% and the operating momentum long-short portfolio declined by -0.8%. The long-short quality, value and price momentum portfolios offset these losses.
ATSX’s year-to-date return of -7.1% remains 250bps ahead of its benchmark’s -9.6% decline.
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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.