Second quarter 2021 O'Connor CIO Letter

Having witnessed three of the highest monthly CPI prints in over 40 years, the Fed has acknowledged that inflation pressures may be more persistent and could require policy action longer-term.

23 Jul 2021

Now trending: The inflation debate

In this short video, listen as Kevin Russell discusses this central debate for 2021 and what it means for investors.

Investors are captivated by inflation

As we wrote in our last quarterly letter, we believed investors were becoming too anchored to the idea of increasing inflation, and this played out over the second quarter as positioning for reflation became crowded and consensus for many market participants, especially in the equity markets. The long-held overweight to growth stocks and long-duration fixed income had been largely eliminated in favor of long cyclical and value stocks as well as short-duration fixed income. But anxiety about new virus variants, lower inflation expectations and most importantly recent Fed commentary have forced a rethinking of this consensus reflation positioning, bringing the market into more balance from an equity factor and interest rate outlook perspective.

While the first half of 2021 has been characterized by a broad trading range in Treasury yields and extreme equity factor volatility and rotations, the environment as we move into the second half of the year seems to be trending towards normalcy as economic growth and inflation remain the central story, but the related positioning and risk is likely to be more balanced and two-sided.

We expect an environment characterized by elevated but not extreme volatility in both the interest rate and equity markets, an environment that favors relative value investing disciplines and idiosyncratic and thematic performance drivers within financial markets.

Figure 1: Core CPI month-over-month

Core CPI month-over-month. Chart tracks the United States Consumer Price Index from January 1920 through June 2021.

And while the bond market seems to have settled after its rapid, inflation-risk adjustment late in the first quarter, as measured by interest rate volatility, the equity market continues to be laser-focused on inflation, creating some unusual trading dynamics.

Figure 2: MOVE Index one-week moving average

Move Index (1-week moving average). Chart tracks the Merrill Lynch Option Volatility Estimate (MOVE) Index one-week moving average from January 2021 through 13 July 2021.

Most notably, we have seen the correlation between the bond market and equity markets turn positive over the past month. While it’s too early to determine whether this is a lasting and structural shift in this key risk relationship, it speaks volumes about how important the topic of inflation has become to the psychology of the equity markets.

Figure 3a: Short-term correlation has turned positive

S&P 500 vs. US 10y Bond 3 month correlation of daily returns

Short-term correlation has turned positive S&P 500 vs. US 10y Bond 3 month correlation of daily returns. Charts the S&P 500 Index against the US 10-year bond 3-month correlation of daily returns.

Figure 3b: Long-term correlation has turned positive

S&P 500 vs. US 10y Bond 12m correlation of monthly returns

Long-term correlation has turned positive S&P 500 vs. US 10y Bond 12m correlation of monthly returns. Charts the S&P 500 Index vs. US 10y Bond 12-month correlation of monthly returns from 1962 to 29 June 2021.

Equity factor rotations create trading opportunities

Nowhere has this focus on inflation been more acute than in the extreme equity factor volatility and rotations that have occurred in the first half of the year. The debate between growth and value stocks has been polarizing at times, and the relative valuation premium on a price to earnings growth basis between growth and value has moved dramatically, going from a high of 130% premium in 2020 to a modest 10% by the late second quarter of 2021.

Figure 4: Growth vs. value has de-rated since the peak last year

PEG ratio is 12 month forward PE/ 1y ahead 1y EPS growth. Bottom-up aggregation of MSCI AC World Industries*

Growth vs. value has de-rated since the peak last year PEG ratio is 12 month forward PE/ 1y ahead 1y EPS frowth. Bottom-up aggregation of MSCI AC World Industries. Charts the 12 month forward PEG ratio premium from 1999 through 29 June 2021.

And just a few weeks into the third quarter, we are already starting to see a significant expansion of that growth premium again as positioning has become more balanced. While we always work hard to be disciplined with the overall factor exposures in our equity strategies, the frenetic back and forth between growth and value in 2021 has reminded us of the importance of this vigilance.

In fact, our equity teams increasingly find themselves steering clear of this binary factor choice and are seeing opportunities in stocks with a Growth at a Reasonable Price (GARP) profile. We expect that investors will inevitably come to this same realization and the omnipresent debate on growth vs. value will fade in the second half of the year. Again, this is an environment that should favor idiosyncratic and thematic performance drivers across our equity strategies.

Credit markets are more sanguine

While we are optimistic that the macro landscape should improve substantially for relative value investment strategies in the second half, we continue to align a significant amount of our capital with the structural alpha opportunities being driven by mega trends within the financial markets.

The corporate credit markets stand out to us as a bastion of corporate finance rationality and tradeable supply-demand dynamics, creating compelling opportunities across our credit relative value strategies. It is not that the credit markets are not impacted by the inflation debate but we suspect that the credit markets are just more sanguine on the risk than equities, given the health of the global economy and the ample liquidity of corporate balance sheets.

Figure 5: Spreads tightening in corporate bond markets

Spreads tightening in corporate bond markets. Charts US Investment Grade All Sectors OAS, and US High Yield All Sectors OAS, spreads from December 2019 through 13 July 2021.

An important nuance of the corporate credit markets in the US this year though is the asymmetry in issuance as we come out of the record issuance of 2020. While it is probably no surprise that US investment grade bond issuance is trending down more than 32% from the record issuance of USD 1.9trn+ in 2020, US high yield issuance is trending up 48% from 2020 levels.

This increased activity in the high yield market has created an environment conducive to relative value trades within corporate capital structures, which continues to be a core focus for O’Connor. As we have often written, active issuance and liability management transactions are often catalysts for relative value convergence as corporate treasurers are mindful of corporate finance tenets as they manage their capital structures.

Alongside our traditional focus on corporate bonds, we are starting to see our pipeline of opportunities in working capital finance build, and this segment continues to represent a tremendous value in corporate credit. The yield pick-up, shorter duration, lower default probabilities, and higher recoveries available in this segment of the financial markets continue to surprise us.

Importantly, several banks seem to be waking up to the opportunity for investors, and we are beginning to see some leverage and financing efficiency emerge for this market segment. We continue to believe that capital deployed in working capital finance is amongst the best risk-adjusted uses of capital right now as the market slowly but surely marches toward the efficiency of securitization over the next several years.

Figure 6: High yield and Investment grade issuance 2020 and 2021

Investment grade and high yield issuance is down from 2021. Charts the daily issuance in millions of investment grade and high yield credit, from Jan 2020 through 14 July 2021.

Private credit offers structural alpha

We have also seen some encouraging developments in our private credit strategies managed by the O’Connor Capital Solutions team, as counterparty and risk management challenges at several banks and broker-dealers over the past year seems to have reinvigorated their collective desire to recycle risk and partner with us on lending opportunities.

While this will always be a relatively modest allocation for the multi-strategy given the lower liquidity profile of these risks relative to the liquidity terms we offer to investors, we have been able to deploy incremental capital to some of these risk opportunities that would have historically stayed on bank balance sheets. We continue to see this as a structural alpha opportunity for investors over the coming years, and view some of these positions as the most compelling risk/reward profiles in the market.

Interest rate volatility continues to be key

We are encouraged by our performance in the first half of the year as we were able to navigate the polarizing debate and extreme positioning changes related to inflation well on a portfolio basis. Our continued focus on monitoring interest rate volatility as a barometer for overall risk appetite amongst relative value investors led us to bring down gross risk at the end of the first quarter and slowly gross back up in the second quarter as we see more balance in both investor positioning and the economic outlook for the second half of the year.

While 2021 has brought more factor and interest rate volatility than many investors expected, we do believe that the frenetic repositioning and bouts of risk aversion associated with inflation is beginning to fade. Vigilance managing risks in equity factors, interest rates and credit beta will continue to be our focus as we think our relative value investing approach across long/short equity, global event-driven and credit relative values can provide consistent and uncorrelated returns for investor portfolios.

Although we expect to be back in our offices more consistently in September, our technology and support functions continue to allow us to operate very effectively from a mixture of our offices around the world and in our home offices. Having been able to start visiting investors in person over the past month, we are very much looking forward to reconnecting with you in person as travel and work arrangements continue to normalize.