Spotting dispersion opportunities in 2016
Based on the divergence in growth prospects across regions and a decoupling of central bank policies, we expect equity markets to face increased volatility in 2016. We believe a corresponding pickup in dispersion, which has historically been correlated with alpha generation, or excess manager return relative to the benchmark, could benefit long short equity strategies. We think increased focus should be paid to differentiating factors between companies in 2016 as we believe such an environment should support long short managers’ stock-selection efforts. A key factor to monitor in 2016 will be the price of energy, in our view; new supply dynamics coupled with changes in demand have created what we see as an unprecedented market environment that has far-reaching implications for companies, countries and international money flows.
From a sector perspective in US equities, we remain particularly constructive on technology and health care. The technology sector has exhibited high dispersion of returns, low correlation at the stock level and elevated volatility, according to our analysis. In addition, innovation has continued to “disrupt” the sector in areas such as cloud computing and over-the-top content (meaning audio and video media delivered over the Internet without requiring users to subscribe to a traditional cable or satellite service). Health care stocks came under pressure in the third quarter of 2015 as fears relating to drug pricing sparked a pullback in the sector. However, we believe the pace of drug development, specifically in the immuno-oncology field, will provide a tailwind to the sector as companies have been developing treatments that should address unmet needs. Additionally, large players within the space could take advantage of market selloffs to enhance their pipelines through further acquisitions. Outside the United States, compelling opportunities exist in Europe, in our view. The decline in oil prices in 2015 and signs of an emerging-market slowdown disproportionately challenged certain industry groups within the region.
Corporate credit/relative value strategies: Niche areas and stressed issuers may offer opportunities
Within corporate credit strategies, we believe inefficiencies inherent in the non-agency residential and commercial mortgage-backed security markets should offer alpha trading and relative value opportunities. For example, niche areas such as asset-backed collateralized debt obligations, collateralized loan obligation mezzanine tranches, peer-to-peer securitizations and Puerto Rico municipal bonds insured by bond insurers appear to offer additional areas of opportunity.
Distressed managers in late 2015 were faced with a limited amount of restructuring activity, and we believe a manageable maturity wall will likely keep a lid on corporate default rates, at least in the first half of 2016. However, spread widening began to extend beyond energy into other sectors in late 2015, and this could potentially impact the refinancing market if risk aversion persists in 2016. In addition to the natural resources sectors, we believe stressed sovereign and municipal issuers such as Greece and Puerto Rico offer opportunities.
Event-driven strategies: Healthy opportunity set
For event-driven strategies, we expect the opportunity set to remain healthy in 2016 as many companies proactively pursue value-enhancing actions to avoid being targeted by activists. Companies have also been under pressure to meet earnings targets, and the slow growth environment could lead to further consolidation. The volatility of merger arbitrage returns will likely be higher than historical averages in 2016 due to the longer duration of current deals and heightened antitrust risks, especially during a US election cycle. Special situations disappointed investors in most of 2015 as market declines were a significant headwind, and many event names were becoming crowded, which hurt risk/reward profiles and increased volatility. We expect special situation returns going forward to be more equity-market dependent, while merger arbitrage returns look attractive to us and should be orthogonal to (or statistically independent from) equity markets.
Global macro strategies: Central bank actions likely to be crucial
Finally, from a global macro perspective, we are anticipating inflation will remain low globally in 2016, encouraging a liquidity environment that may benefit equities. In our view, global central banks are likely to maintain low short-term interest rates and continue record liquidity injections in select regions and countries outside the United States, such as the European Monetary Union and Japan, which could further cushion global economic expansion. With regard to the US Federal Reserve, the path for policy normalization could be lower for longer. Within emerging markets, we expect increasing central bank divergences and political risk to increase volatility and dispersion, thus underpinning what we believe should be fertile investment opportunities.
David Saunders (pictured at the InvestmentEurope Pan-European Fund Selector Summit in Lausanne in 2015) is founding managing director, and Robert Christian is head of Investment Research at K2 Advisors