In search of sustainable returns

THINK.CAPITAL‘s Elmien Wagenaar examines the global landscape, highlighting why hedge funds can help in an environment where returns market direction are hard to capture.

We have entered a new regime of greater macroeconomic and market volatility, BlackRock, the world’s largest asset manager, noted in its mid-year outlook, adding to a growing number of influential market participants highlighting significant long-term changes to the character of markets.

Some problems are hard to fix through adjusting interest rates

This new regime is the result of a range of supply constraints that is much harder for central banks to manage and will be a persistent feature going forward. A world shaped by supply constraints will bring more macroeconomic volatility. There is no way around this. When inflation is driven by demand, interest rates can be increased to manage the buying power of individuals. But supply-side inflation is harder to manage with interest rates. Therefore, policy cannot stabilise both inflation and growth at the same time – it has to choose between them. In other words, central banks have to either accept higher inflation or destroy demand to rein in inflation.

Whole industries were affected by COVID

The BlackRock view is that a new era of inflation was ushered in by the Covid-19 pandemic and the subsequent shutdowns and reopening of economies. When the pandemic began, economic activity was intentionally halted to control the spread of the virus. However, as restrictions were lifted and economies restarted, it proved challenging to quickly resume production.

Throughout 2021, there were specific supply issues in different sectors, driven by a sudden and significant shift in consumer spending from services to goods. This change in demand created bottlenecks in industries producing goods, as the supply struggled to catch up. On the other hand, service industries faced excess capacity due to reduced demand. Consequently, inflationary pressure has been highest in sectors experiencing supply bottlenecks, such as the automotive industry. This explains why there could be a significant level of inflation overall, even though economies have not yet reached full employment.

Geopolitical de-risking

They believe that even with the pandemic behind us, supply constraints in developed markets will become more prominent due to changes in globalisation and demographics. In the past, countries benefited from cheap imports from China, and it was a multi decade long trend to shift purchases from local suppliers to Chinese suppliers. But now countries are reorganising their supply chains to ensure greater security. This is partly due to supply bottlenecks during the economic restart post pandemic, but also due to increasing geopolitical tension and competition between the United States and China, especially in technology.

Aging populations

Additionally, the aging population in Europe and China will lead to a slower growth rate in the global workforce. In particular, China is shifting its focus from rapid growth to prioritising worker safety and well-being. As a result, labour costs are expected to rise.

Globalisation has seen its peak

In summary, they suggest that we may have reached the high watermark of globalisation as companies are now reducing their risk of being reliant on China only and procuring more local suppliers.

Global trends add to supply woes – the stark implications

If we have, indeed, moved from a regime where demand shocks dominated the macro environment to one where supply constraints dominate, it has two important effects:

A move away from the great relaxation of the past 30 years: Firstly, central banks will likely need to consistently adopt stricter policies to counter rising prices. This is different from the past 30 years when widespread price decreases led central banks to keep monetary policies relaxed. If interest-rate increases cause problems in the financial system or a slowdown in economic activity, central banks historically would have been quick to lower rates to boost activity. However, in the new situation, central banks may need to wait longer in order to support economic activity.

Economic relationships previously relied on for investments become less reliable: Secondly, under the new circumstances, the economic relationships that investors relied on to generate investment returns may become less reliable.

The new era does not bode well for broad investments across different asset classes, especially not in the way we were used to in the previous 30-year regime. Hence the need to pivot into new strategies to seek sustainable returns going forward, BlackRock notes.

As an allocator to hedge funds, we at THINK.CAPITAL believe investors should take note that the right combination of hedge funds can be perfectly tailored for an environment where returns from market direction are hard to capture.

  • Longs and shorts: Through their ability to take long and short positions, hedge funds can capitalise on the higher dispersions in share prices. The new regime of higher macroeconomic and market volatility has already been shown to create higher dispersions. Hedge funds are known for their ability to generate returns from one share price diverging from another, while not being exposed to the general direction of the market. They can, therefore, generate returns from dispersion during both rising and falling markets, making them well-suited to navigate this volatile regime.
  • Changing economic relationships: The shifting dynamics in globalisation and demographics can disrupt traditional economic relationships. Hedge funds can be both long and short fixed interest instruments, to capture fluctuations in their values.
  • Wider opportunities in security selection: To be less reliant on historic economic relationships means that security selection becomes even more crucial. Shorting allows hedge fund managers to be even more selective and identify specific securities or sectors that may be negatively affected. By shorting those assets, hedge funds can potentially profit from their relative underperformance compared to the broader market or other sectors.
  • Flexibility to hedge and manage risk: In an environment of increased market volatility, shorting can serve as a risk management tool. By taking short positions on certain assets or sectors, hedge fund managers can hedge their long positions and protect themselves from potential market downturns or adverse events. This flexibility to manage risk can help cushion portfolios during periods of heightened volatility.

Read the full BlackRock outlook here:

Elmien Wagenaar is the founder and investment manager of THINK.CAPITAL, a boutique asset manager focused on alternative investments. She has over 20 years’ experience in analysing and investing in hedge funds. She obtained both her BSc Hons and MSc in Applied Mathematics degrees (cum laude) at the University of Stellenbosch and became a Chartered Financial Analyst charterholder in 2005.