It is believed that the majority of hedge strategies in general, seek to capture gains from market inefficiencies by taking advantage of pricing differences and relative discrepancies between securities, technical market movements, deep fundamental valuation analysis, and other quantifiable trends and/or inconsistencies.
Ritchey explained, "As investors in hedge strategies through our liquid alternatives portfolios, we expect that inefficiency may provide us with better opportunities to generate excess returns, or positive alpha. In other words, volatility typically gives investors in hedge strategies a better chance at separating the winners from the losers. [That's not to say that hedge-strategy investors always try to avoid 'losers']"
According to K2 Advisors' current economic outlook, as financial markets comes to terms with, among other issues, China's slowing growth rate and uncertainty about global interest rates, the firm anticipates volatility to linger for quite some time-it also expects a possibility of escalation.
"Of the four common hedging strategies typically employed within our liquid alternatives portfolios--long-short equity, relative value, event driven and global macro--we believe global macro and long-short equity are best positioned in the near term to benefit from this anticipated increase in market volatility," he said.
Volatility and equity price spreads
Ritchey further explains that as volatility increases, the spreads between the share prices of companies that are considered healthy and those that are facing challenges typically widen. Long-short hedge strategies seek to take advantage of this widening by buying the good companies (going 'long') and shorting the weaker ones. According to him, hedge strategy managers are not soley focused solely on finding 'winners' but are able to fine-tune their hedges to identify the companies that may be negatively impacted by, for example, a collapse in oil prices, and capitalise on that negativity.
"We also believe long-short equity strategies are poised to benefit from a continued rise in interest rates in the US, and the rate moves do not have to be dramatic to have an impact. Even gradual increases may bring opportunities for long-short hedge strategy managers. In a low interest-rate environment, many mediocre companies can survive on cheap credit. When rates move higher, those mediocre companies tend to see their growth path limited because rising interest expense is a drag on their earnings," he explained.
Another factor that is seen to affect valuations has been the strong US dollar run over the last year. K2 Advisors expect this trend to continue throughout 2016, as US monetary policy has diverged from that of many other major countries and regions, and higher US interest rates will likely keep the dollar on its upward trajectory relative to other major currencies.
Middle East fairly resilient
Determining investment strategies in uncertain and volatile market conditions undoubtedly depends on an investor's portfolio interests. Although the first to be cautioned after, the GCC region appears to be viewed as a relatively stable market.
"I think the Middle East has certainly been through cycles before. So it is not the first time that oil is at a very low level; I think there are some institutional memory in the region on the cycle. They have built phenomenal reserves and rainy day funds for such situations which allows them to buy time. The question is not what happens immediately in the short term, it is what happens in the medium term once some of these funds have been either drawn down or exhausted in some countries. I think that it will take a few years to play out," said Hammoud.
Such global economic backdrop is believed to provide the region a platform to consider more structural reforms in their economies and invest in human capital and competitive companies that have the potential of becoming regional or global champions.
He further elaborated, "Low oil prices should be a huge benefit to the global economy, obviously not to the producers, but to the rest of the world as an importer of energy and the effect of that has not been as obvious as people expected. You would have expected Europe to do much better because the oil price has historically had a very significant impact on GDP and you are seeing a tiny bit of it, but not what you would expect. Oil prices remain acritical component of any economic conversation, but to a lesser degree than before I think."
China becoming more realistic
For the third time in less than a year, the International Monetary Fund (IMF) in January cut its global growth forecasts. It forecasted that the world economy would grow at 3.4 per cent in 2016 and 3.6 per cent in 2017, cutting 0.2 percentage points from its previous estimates in October 2015. Supporting its numbers, the IMF cited a sharp slowdown in China trade and weak commodity prices affecting Brazil and other emerging markets. Due to the wealth currency swings in the last couple of months, it is believed that there is less confidence in the global investor community, and the Chinese government's ability to control the narrative as well as the economic outcome of the country.
"I think that the negative narrative on China is not accurate, there is certainly challenges with China's economy but we have to remember that five or six per cent growth is still phenomenal for an economy that represents now probably one-fifths of the world's GDP with the US being a quarter. If you have one-fifths of the global economy growing at five or six per cent that is not too shabby. I think we just got used to numbers that are unrealistic. No one can grow over 10 per cent for a long time. China is in better shape than people give it credit for. There are real challenges, the state owned enterprises are a real concern. They also have competitive issues and a lot of companies that will require a lot of restructuring. I don't see China as being a huge negative, but will now be a story that has ups and downs like any other country," said Hammoud.
US-a consumer driven market
According to market estimations, the US was expected to grow two to three per cent, shying away from the four or five per cent rate. Companies in the US are generally seen to hold strong balance sheets due to the capitalist nature of the system. However confidence in its own domestic market is diminishing. Furthermore, political uncertainties due to the upcoming election cycle is believed to put more pressure on the government functionality.
"What worries me a little bit in the US is that the companies have by and large refused to reinvest in growth and in their businesses. They have preferred to return money to their shareholders and that is a sign that they don't have a strong set of beliefs about the future. Seeing the amounts of share buy backs in the US, it is the highest it has ever been and there has been a reinvestment cycle that has not be reignited at the corporate level in the US. I think the US consumer was the main driver of growth for many, many years, I think the US consumer has learned some lessons in the last crisis and while they are coming back and starting to spend money again, I don't think they will spend as liberally as they have before. But on a relative basis, the US is one of the strongest places and will continue to be one of the strongest places in the next few years," said Hammoud, providing his insight on the US.
Europe catching up
Having a rather negative track record over the past several years, Europe appears to be slow to improve. Limiting the prospects further is the rumoured exit of Britain from the European Union (EU). Nevertheless with relatively resilient economies such as Germany, the region is expected to fare well in the short term.
Hammoud elucidated, "Europe in many ways remains the sickest of the group of major economies, with limited positive prospects. The potential exit of Britain would be a total disaster for Europe and I think would send shivers down the global economies. However, I think generally people believe that at the end of the day Britain will do the rational economic things and stay in the EU. If Britain were to leave I think that is very negative on global economic growth. I think the countries that are able to reform will continue to muddle through, France, Italy to a lesser degree--and these are fairly large economies. Germany has been very resilient but has slowed down as well, but the whole German economic model based on exports obviously suffers a little bit if global economic growth is lower and China is sputtering. Europe will be mediocre at best over the next few years."
Irrespective of how ugly industry observers have painted the current market canvas, many market players have iterated that there will always be pockets of growth. Good investment opportunities are will always be present across the world. Some opine that global macro-economic conditions are almost irrelevant to whether there are good investment opportunities.
"I do think in an era like this one where there is a lot of volatility and significant potential headwinds, I think any investor has to double down on caution and quality assets, being fairly conservative in estimating the cash flows that they should expect from those assets over the next five or 10 years. Extra caution is the message I give to all of our investor clients. At the same time you have interest rates that are so low that there is plenty of good deals to be had when interest rates are this low. Most deals are creative when interest rates are zero," said Hammoud.
"Global macro strategies focus on top-down macroeconomic opportunities across numerous markets and numerous investments, including currencies and commodities. These strategies take into account many factors, which may include a country's or region's economic indicators, as well as central bank trends and divergences. Other developments that we believe could potentially enhance the opportunity set for long-short equities include so-called 'disruptive' technologies. Looking forward, we may see a similar shakeup in some areas as new technologies come to market and disrupt the status quo. Disruption--and volatility--are often thought of negatively, but as we've seen, both phenomena may provide positive investment opportunities for hedge strategies that seek to take advantage of the market inefficiencies they typically bring," concluded Ritchey.
© Banker Middle East 2016