Jacob Mitchell,

Investors can expect continued market volatility in the coming months, according to leading investment boutique Antipodes Partners. Though there are several things they can do to reduce it within their portfolios.

“The start of the year saw investors initially grapple with concerns around accelerating inflation and rising interest rates,” noted Jacob Mitchell, Founder and Chief Investment Officer of Antipodes. “This was followed by unease around the US and China trade tiff and its potential to morph into a negative global growth. The quarter was also unusually challenging for some of the leading technology names.”

Mr Mitchell added: “Now, central banks have somewhat cornered themselves. Increasingly, political and economic pressure to normalise interest rates or withdraw stimulus is likely to further trigger volatility and lead to wider credit spreads. The European Central Bank and Bank of Japan still make up half of QE assets, making an exit a potentially bumpy ride. Our analysis suggests that US high yield or junk bond issuers are amongst the most vulnerable to this risk.

“The consensus is that we are in the later stages of the US corporate credit cycle.  However, higher leverage as a result of a significant loosening in credit standards is sustainable as base rates are low and a recession is not imminent.

“Though, in industries such as retail, media and telecommunications, the same forces that are underwriting the success of the mega-cap platform companies such as Amazon and Alphabet, are negatively impacting the smaller corporates increasingly caught in the cross-fire. Often, these smaller issuers are less likely to have access to fixed rate funding.

“The combination of US twin deficits and trade barrier rhetoric will clearly result in ongoing volatility,” Mr Mitchell forecasts.

“The key question for 2018 remains to what extent can the benign environment persist? Putting aside trade wars and policy missteps, the growth environment is unlikely to accelerate much further.

“However, thawing financial conditions and pending fiscal stimulus can sustain growth at current levels for longer.

“Easing financial conditions are a key pillar of growth and current US conditions remain the easiest since the global financial crisis and should support growth above trend for the remainder of the year.

“We believe the unusually favourable goldilocks combination of accelerating growth and tepid inflation experienced in 2017 will not repeat.

“Instead, normalisation of interest rate policy will likely upset the rhythm with more volatile and less forgiving markets.

“Last quarter, we warned of excessive investor crowding into structural growth winners and this quarter many technology names underperformed. In a higher interest rate environment, the market will become increasingly less tolerant of such biases.”

Looking forward, Antipodes observes several opportunities as well as some challenges:As the rally in Chinese growth sensitive equities has played out over the past two years, Materials and Industrials outperformed and, though Energy rallied late in the year, it remains very cheap by historical standards.
Though Financials significantly outperformed in the first half of 2017, the sector remains cheap by historical standards with sentiment and profitability expectations weighed down by macro-concerns, low rates and yield curve compression.
Domestic Cyclicals are also cheap by historical standards, especially strong incumbent retailers where the market is potentially underappreciating the brand equity and/or a successful adaptation to online reality.
Interestingly, in a market that until recently has paid up for yield – most intensely reflected in the North American Infrastructure sector – traditional yield sectors such as Telecommunications have de-rated, coinciding with the apparent value of good yield.
Consumer Staples were the ‘expensive defensives’, once enamoured for their perceived Profitability and Growth characteristics, that have now underperformed since the beginning of 2016. However, they still remain one of the most expensive sectors and in many cases structural pressures, such as substitution by private label, are intensifying.
Healthcare has underperformed to the point that relative value has appeared. However, healthcare related businesses will continue to be pressured by the public and governments grappling with affordability given decades of high cost inflation.
While Technology appears expensive on a more structural view of valuations, we guard against comparisons to the 1999/2000 tech bubble. Growth as a style is currently pervasively expensive across the global market, not just in Technology. While real structural change (cloud, social, virtual reality, media streaming, big data, autonomous driving, etc.) has underwritten the outperformance of the sector, due to their sheer size risks are building for the Titans of Tech, including:Tax and regulatory risk arising from increased scrutiny from governments around the world due to their influence and role in society, particularly around managing sensitive information.
Intensifying competition, whether it’s Amazon and Netflix competing on content streaming or Amazon’s Alexa threatening Google’s core search business with its voice search capabilities, the titans are bumping heads. Likewise, Google is encroaching on Apple by focusing on its own smartphone and Microsoft is attacking Amazon’s AWS cloud business with its successful Azure platform. Related to this is the growing capital intensity of many of these businesses as they make heavy infrastructure investments in compute capacity required to handle increasing artificial intelligence workloads and video streaming demands.

Mr Mitchell suggests that “if the current cyclical rebound in global growth continues, long-term global interest rates will be forced higher, triggering a rotation out of expensive longer-duration exposures into out of favour cyclical stocks”.

Conclusion

“The general uptrend in the broader equity market seems set to continue given economic data globally remains robust and central banks very accommodating. However, the blind assumption of unending low rates is a dangerous one,” said Mr Mitchell. “As a result, we simplistically see two likely scenarios:1 – Growth continues to surprise to the upside driving greater urgency from central banks to normalise policy. To minimise disruption to short-term funding markets, tapering would likely focus on the long-end of the yield curve leading to a potentially self-reinforcing pro-growth steepening, resulting in a significant increase in bond volatility and headwinds for the crowded/expensive low volatility, bond proxy and growth/quality equity exposures.

2 – Growth disappoints due to policy tightening by China or the US In this scenario, credit volatility would spike triggering a major sell-off in credit sensitive equities regardless of their duration, leading to a repeat of the 2015/16 commodity high yield melt-down which ended up spilling over into non-commodity exposures.
Conversely, the inevitable central bank response would extend the illusion of stability and amplify the imbalances with a continued melt-up in the low volatility, bond proxy and growth/quality equity exposures.

Antipodes Partners’ investment goal is to build portfolios with a capital preservation focus from non-correlated clusters of opportunity. “In our long investments we seek both attractively priced businesses (margin of safety) and investment resilience (characterised by multiple ways of winning), with the opposite logic applying to our shorts, i.e. no margin of safety and multiple ways of losing. While the investment case will always be predicated on idiosyncratic stock factors such as competitive dynamics, product cycles, management and regulatory outcomes, we seek to amplify the investment case by taking advantage of style biases and macroeconomic risks/opportunities.

“Given the divergent risks that the above two scenarios represent, investors should focus more than ever on uncovering sources of idiosyncratic alpha rather than relying on momentum or passive beta.

“In this sense, we’re encouraged by the high level of valuation dispersion within and across markets (region/sector/factor) as indicative of broad pragmatic value opportunities, both long and short.”

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