Why structural returns are thriving amid inflationary gloom

By Toby Hayes, portfolio manager, Trium Capital

Unprecedented inflation has unleashed a wave of volatility that may have ended the longenshrined 60-40 portfolio model. And despite the optimistic assertions of most economists, prices are not cooling – in fact, they are running away. This may have serious implications for allocators who have an asset class split designed for a world of monetary easing.

The signs are everywhere, but some metrics underline the inflation problem more than others. In the US, for the year ended May 2022, the Consumer Price Index for All Urban Consumers increased 8.3%. Over that period, prices for food at home increased 11.9%, the largest 12-month percentage increase since the period ending April 1979.

The energy index within CPI rose 34.6% over the last year, and the food index increased 10.1%, the first increase of 10% or more since the period ending March 1981.

Meanwhile, in Europe, Germany posted its highest inflation figures in half a century, while Spain’s recent numbers will have horrified the ECB.

After the party, the hangover

Hammered by the removal of the easy money Fed punchbowl, the bond market is waking up to a sobering reality. Fixed-income investors have already suffered eye-watering losses on a scale last seen in the 1980s. The bad news is there may be more pain to come.

Despite recent volatility, the market may not yet have priced in a persistent inflationary regime. Some 60-40 allocators may expect inflation to fall back – but, as we all know, predictions are hard to make. For investors caught flat-footed by inflation, these are worrying times. History has shown that balanced portfolios with bias are most vulnerable in an inflationary regime where CPI is above 3%.

There simply is not enough exposure to truly uncorrelated returns. This is something underlined by the recent acute volatility; as the tide has been drawn, the asset classes without real diversification have been found, as Warren Buffett famously said, to be swimming naked.

Fortunately, many allocators have been building their exposure to liquid alternatives that can act as fixed income replacements and provide sources of uncorrelated returns. For example, structural returns are not only unique, but their idiosyncratic nature and fundamental underpinnings make them one of the purest forms of diversification.

Their defining characteristic is that their return profile is independent of traditional risk factors such as Federal Reserve policy, macroeconomics, the pandemic response, or corporate earnings. Instead, they are driven by quite esoteric factors, such as the weather, taxation policy, regulation, seasonality, index rebalancing, congestion, and credit rating slippage.

These factors are specific and unique to the market in question. The steepness of curves, the volatility regime, and the inflationary regime can amplify or
dampen the magnitude of structural returns.

Some structural returns require volatility and inflation to perform, while others prefer calm environments. Certain structural premia exhibit long periods of performance, followed by periods of dormancy. We map structural premia against their preferred environment and the prevailing economic conditions – be it inflation, deflation, or high and low volatility.

Capitalising on the curve

Across the spectrum of the structural market, we are rolling up or down to monetise the slope of the curve and extract premia. The steepness of curves is particularly interesting in an inflationary environment.

Moreover, this asset class has a fundamentally and structurally negative correlation with fixed income and equity markets.

For example, commodity curves are now the steepest on record due to real-world physical reasons. War and the pandemic have created havoc and supply chain chaos that has led to the hoarding of physical commodities and a structural steepening of curves.

Within commodity markets, you can now generate a far higher internal rate of return for the same level of volatility. Backwardation has increased across commodity exports – including energy and industrial metals – and simple backwardation curve roll strategies are annualising between 5-25%.

It is crucial to understand that we are not trading the oil price bouncing around, but rather monetising on the changing of the shape of the curve due to reasons completely uncorrelated to the macro shifts that are roiling bond and equity markets.

There is no one ‘event’, pandemic, global depression nor Federal Reserve policy pivot that hurts structural returns at the same time. Their ability to diversify is fundamental, not just statistical. In this regard, they are unique in finance and should have an essential place within a balanced portfolio.

Not only are they truly uncorrelated, but structural return strategies can be geared towards the prevailing economic outlook. Whether deflationary or inflationary, high or low volatility conditions, structural returns offer the rare quality of certainty in an uncertain environment

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