Accelerate Monthly: The Spring of Hope or the Winter of Despair?

December 10, 2023 — “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair.”

The famous opening line of Charles Dickens’s novel, “A Tale of Two Cities”, captured the paradoxes and contradictions of the era. On one hand, “the best of times” suggested a period of great advancement and prosperity, when new ideas about rights and democracy emerged. On the other hand, “the worst of times” indicated a period of great turmoil, inequality, and suffering, particularly seen in the brutal conditions leading up to and during the French Revolution.

Dickens’s dichotomy succinctly characterizes market sentiment heading into 2024. Are we heading in for a soft landing, with steadily declining inflation, a smooth path of rate cuts, and a speculative surge in the stock market? Or are we spiralling into a hard landing and recession, concurrent with a challenging equity market?

Market participants are forging ahead into the new year with uncertainty regarding two main paths for risk assets, interest rates, and the economy. These two diametrically opposing views were exemplified over the past several months.

During September through October, there was a general market malaise caused by consternation regarding a potential recession, concerns regarding the path of interest rates (higher for longer), and challenging conditions for both stocks and bonds, with three consecutive months of declines for traditional asset classes.

Those economic and market worries were flipped on their collective heads in November. Rate cut expectations surged, interest rates plunged, and stocks and bonds enjoyed their biggest rallies in years.

November saw the S&P 500 notch its best monthly performance in three years, surging +9.1%, while long-term Treasury bonds posted equity-like returns of +9.9% for their best month since 2008. Stock and bond performance has been nearly equivalent over the past several months, as the correlation between the asset classes has risen and their diversifying properties have ceased.

Other interest-rate-sensitive segments of the market also skyrocketed. Real estate’s double-digit gain was its best since 2011. Innovation ETFs jumped more than 30% as investors bid up speculative securities and piled into the lowest-quality issues.

Accordingly, November was the best of times for market bulls and holders of risk assets.

The riskiest segments of the capital markets led the charge for the month. Meme stonks skyrocketed more than 30.0%, while the most shorted issues squeezed nearly 27.0%.

Conversely, it was the worst of times for stock market bears, hedgers, and rational long-short investors.

However, it is no wonder that traders went wild betting on duration and going full tilt on risk assets: November saw the greatest easing of U.S. financial conditions of any month over the past forty years.

Source: Bloomberg

Six weeks ago, market participants were convinced that the Fed would keep rates high next year, with only two rate cuts priced in. Now, five to six rate cuts are priced in against a Fed forecast in September of just one cut from current levels.

Hope springs eternal. Risk assets surged last month on the back of rapidly easing financial conditions. The probability of a rate cut by March 2024 jumped from 10% to 60%.

The significant increase in both the cadence and magnitude of expected 2024 rate cuts was spurred by rising expectations of an economic soft landing, with a concurrent relatively pedestrian decline of inflation back to the Fed’s 2% target.

One potential hurdle facing these lofty market expectations is that inflation has been more stubborn than the market has given credit for. Over the past couple of months, Truflation’s high-frequency estimate of the U.S. inflation rate has come in persistently above 3.0%, rising steadily over the past several weeks.

Source: Truflation

An inflation rate consistently above 3.0% is not conducive to the commencement of a highly aggressive rate-cutting cycle from the Federal Reserve.

Ergo, the market may be over its skis regarding the expected decline in inflation to below 2.0%, a level that would facilitate rate cuts.

Notably, market participants have been hopelessly wrong regarding the cadence of rate cuts for the past two years, with devastating results in ‘22.

Source: Bianco Research

Since 2020, there have been five significant drops in the 10-year Treasury yield, signifying market expectations of near-term rate cuts and Fed easing. Each time, the market was disappointed as inflation and interest rates remained higher for longer.

Is the sixth time the charm?

Economists remain skeptical of market expectations around the speed of potential rate cuts next year. While market prognosticators ascribe a high probability of a rate cut in the first quarter, economists are slightly less bullish and believe we’ll see a decline in the Fed funds rate in the second or third quarter.

Source: Financial Times

In any event, expectations are elevated for an overzealous rate-cutting cycle to occur in 2024. If a hiccup occurs regarding inflation, or if strong economic growth continues in the U.S., stock and bond holders could be set up for disappointment next year. In the short term, the direction of interest rates is the key driver for the performance of both traditional asset classes.

In addition, a critical risk for owners of large-cap growth stocks in general, and the S&P 500 in particular, is the narrow breadth of leadership and the concerningly high valuations across the so-called Magnificent 7.

Valuation explains the majority of future stock market returns and current equity valuations do not paint a pretty picture concerning go-forward performance. With the S&P 500 trading north of 20x earnings, forward return expectations based on current valuations stand in the mid-single digits per annum. In addition, the lofty valuations priced into the Magnificent 7 offer a more challenging future return outlook, pricing in negative returns for the market’s most loved names. Investors are right to be cautious.

While by no means are we advocating taking all the chips off the table and cashing out of the casino after last month’s good fortune. However, it may be prudent to conduct a portfolio rebalancing in December, given the high expectations heading into the new year and the myriad of risks facing stock and bond holders.

Accelerate manages four alternative ETFs, each with a specific mandate:

• Accelerate Arbitrage Fund (TSX: ARB): Cash Plus
• Accelerate Absolute Return Hedge Fund (TSX: HDGE): Portfolio Protector
• Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Portfolio Stabilizer
• Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Canadian 150/50

Please see below for fund performance and manager commentary.

ARB gained 1.5% in November while its benchmark, the S&P Merger Arbitrage Index, ticked up 0.7%.

As discussed in last month’s monthly performance memo, the Fund declined in October mainly due to spread widening related to its VMWare / Broadcom merger arbitrage investment. Specifically, the consideration election date expired, and the VMWare market price adjusted to the highly-valued share consideration no longer available for investors to elect. Accordingly, the VMWare shares traded near the lower-valued default all-cash consideration. In addition, the merger spread blew out around last-minute concerns regarding Chinese approval. In November, the merger received all approvals and closed successfully, providing arbitrageurs a 25% return in a month.

Also adding to the positive monthly performance was the bidding war for Sculptor Capital Management concluding successfully. The acquiror, Rithm Capital, was forced to increase the consideration paid by 10.4% after a competing bidder came through.

The Fund remains active in the SPAC IPO market, allocating to two of the four new issues offered during the month. Merger activity was relatively subdued in November after a record month for M&A in October. Nonetheless, the Fund continues to find attractive merger arbitrage investments, allocating to four of the twelve new deals announced during the month.

ARB remains fully deployed, with gross exposure of 1.3x (consisting of 124.6% long and 7.1% short). The Fund is currently allocated 74% to SPAC arbitrage and 26% to merger arbitrage.

As beta-related strategies enjoyed a resurgence in November, HDGE suffered a -0.9% decline as overvalued, low-quality, and junk stocks rallied.

Nearly all long-short factor portfolios generated negative performance for the month. The long-short value, quality, price momentum, and trend portfolios fell as the short side of each portfolio surged double-digits while the long side failed to keep up. In Canada and the U.S., only the operating momentum factor produced positive returns for the month. As a reminder, the operating momentum factor includes return drivers such as increasing/decreasing earnings estimates, share repurchases/issuance, and quarterly beats/misses.

Since its inception, HDGE has maintained an uncorrelated and differentiated return stream for its investors, with a correlation to stocks of 0.11 and a correlation with bonds of -0.03.

ONEC generated a 2.2% return, led by its allocations to real assets. The Fund’s infrastructure allocation gained 7.6% while its real estate portfolio surged 9.2%. Its macro hedge fund allocation performance was mixed, as risk parity rallied 7.3% while managed futures fell -5.0%, whipsawed by the rapid change in trends. On the equity hedge fund side, ONEC’s long-short equity allocation added 5.2%.

The Fund’s private credit portfolio contributed positively during the month, with the mortgage allocation gaining 3.3% and the leveraged loan portfolio adding 1.4%.

Mixed performance came from both the absolute return and inflation protection buckets. From the absolute return allocation, arbitrage added 1.5% while beta-neutral equity fell -0.9%. The inflation protection segment was essentially flat as gold’s 1.9% gain was nearly negated by the -1.5% decline in the Fund’s commodity allocation.

ATSX rose 5.2% during November as its benchmark, the S&P/TSX 60 gained 7.9%.

The Fund’s 50 long/50 short equity overlay detracted -2.7% of the monthly performance, with Canadian long-short factor portfolios performing relatively poorly during November’s risk asset surge. For example, the long-short value portfolio fell -7.5% as overvalued stocks rallied 8.2% while undervalued securities gained just 0.7%. Similar relative performance between long and short portfolios is seen across the Fund’s other key factors.

In terms of expected performance, ATSX generally underperforms during swift market rallies but is likely to outperform during flat or down markets, mitigating drawdown and volatility risk for equity investors.

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-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.