A taper tantrum-type shock caused by rising inflation, a correction in expensive mid-caps and a market backlash against heavily indebted business are some of the pain trades that could batter markets this year, according to FE Alpha Manager Luke Newman, who plans to take advantage of these using his short book.
Newman, who runs the five FE Crown-rated Henderson UK Absolute Return fund with fellow FE Alpha Manager Ben Wallace, has a great deal of experience of successfully shorting companies – he and Wallace prefer to use their short book to generate alpha rather than to simply hedge risk, as is the case with many absolute return funds.
This explains why the £1bn fund has a track record of making money in flat or down markets, as it made 7.68 per cent in 2015 when the FTSE All Share was made a total return of just 0.98 per cent and was up 0.09 per cent in 2011 when the index dropped 3.46 per cent.
In all, this means Henderson UK Absolute Return has made a 57.30 per cent gain since launch in April 2009. Although it is below the rise of the FTSE All Share, the fund’s annualised volatility has been 3.97 per cent (against the FTSE All Share’s 12.68 per cent) while its maximum drawdown has been less than a third of the index’s at 3.42 per cent.
Performance of fund vs sector and index since launch
Source: FE Analytics
In the following article, Newman reveals four pain trades that he believes could be on the horizon for markets – and how he and Wallace are reflecting this within their portfolio.
Inflation shock causes taper tantrum rerun
The manager points out that the main deflationary pressures that have affected the US economy – low oil prices and the strong dollar – will be “annualised out” of the official numbers by the end of the first quarter, assuming oil doesn’t fall materially further.
“What could that mean? It will mean that the print on your Bloomberg screen for core inflation in the US as we come to the end of the Q1 will optically go up. I can see a big inflation print being 100 or 200 basis points higher. Yellen is trying to trying to tell the market to be careful of this,” Newman said.
“However, this is such a skittish reactive market that I think there's a risk of taper tantrum-type event as we go into April. The bond market will effectively back up, sell off at the long end and you could start to see the market accusing the central bank of policy error.”
He adds that this will create opportunities in companies that benefit from a steepening of the yield curve, such as financials. Meanwhile, Henderson UK Absolute Return would put back on its short positions in bond proxy stocks such as utilities and consumer goods, as they would be expected to fall along with the bond market.
Fall in UK mid-caps
One of the standout areas of the UK equity market over recent years has been mid-caps, which have been one of the driving force behind the returns of many active managers.
FE Analytics shows the FTSE 250 has posted a 54.65 per cent total return over the past five years, far outpacing the 14.47 per cent advance in the FTSE 100. However, Newman thinks this outperformance is set to come undone, given the wide divergence between the two areas of the market.
Performance of indices over 5yrs
Source: FE Analytics
“The mid-cap space is very expensive and with good reason. There have been a lot of interesting investment cases and stories there. It's probably where most of the leverage has been as well. It's been exactly the right place to be as you've had consistent outperformance versus the large-cap areas of the market,” he said.
“Outside the US, mid-caps have decoupled from large-caps and now look very expensive fundamentally. We're just looking for the trigger. It's starting to feel like the elastic is so stretched that bad news for the mid-cap favourites will start to hurt. That is what you'd expect to see happen when the yield curve steepens.”
Newman and Wallace are hunting for names to add to their short book. However, Newman points out that although they attempt to fill their short book with individual positions – reflecting their stock picking approach – they are shorting the whole FTSE 250 through index futures.
“We're taking a very active view that there's pain to come for the mid 250,” he said.
Cost shock to low wage payers
The managers brought in this theme after chancellor George Osborne unveiled plans to lift the minimum wage and introduce a national living wage. This is likely to affect companies whose business models depend on keeping labour costs as low as possible.
“This is a theme that came in response to George Osborne's plans for the minimum wage. We're going to see a 10 per cent increase in the minimum wage over the next few years,” Newman said.
“What frustrated us last year is that the obvious companies that are going to feel the pain there – restaurants, pubs, food retailers, general retailers, low wage government outsourcing contracts – maintained a uniform line about the lack of impact. I think we're at the point now where they have to confess the extent of the pain.”
Performance of indices over 3yrs
Source: FE Analytics
The manager adds that while this does not mean low wage payers are going to go out of business, meeting the new wage requirements will be a major project and not one that can be easily navigated.
“There's going to be big cost shock - not just this year, but for another five years to come,” he said. “That cost shock won't go any and comes at a time when it's very hard for firms to put prices up, so I think the jaws will compress there.”
The end of ignoring financial leverage
Newman says that the theme of financial leverage and what happens when markets turn against firms with high debt levels is a new and important one for Henderson UK Absolute Return.
Recent years have seen the market ignore the high levels of debt that some businesses have built, as there was a general feeling that rates will remain low forever.
“If you were long duration and had lots of debt, actually you were in good stead and re-rated in P/E terms. But look at how expensive those companies are on an EV measure, factoring in the debt. I think people in the market generally thought it doesn't matter because all you do is roll over that cheap debt and get some more cheap debt,” he said.
“But that game is finished. We've seen that easy money go away, regardless of what the rate cycle is doing. We doing the basic things: running the most basic net debt EBITA screens, putting in the pensions and finding the most egregious debt number we can - because that's what the market is going to do.”
“The clue here was the US, when you stopped seeing the market re-rate the US companies with the debt raised to buy back shares or do a special dividend. That has been a one-way street since 2011 but the equity market has now worked out this can't go on forever.”