Growth and inflation around the world remain subdued despite central bank actions and rhetoric in favor of the contrary. These two economic data points are often looked at as drivers of market and currency performance particularly where we see large differentials around the world.
Given the tepid rates as well as infrequency of these data, investors are looking elsewhere to get a view on the direction of growth.
So far this year, it appears that commodity prices are being used as a real-time proxy for the direction of global growth and inflation. This has the dual (and we believe somewhat temporary) effect of turning the commodity super cycle theme into a kind of Super Theme, and also causing correlations of assets and currencies to move higher.
As a result, we’re seeing more correlated risks and a narrower breadth of opportunities across the investment universe—both in capital markets and in currencies.
We believe exposures that have a negative correlation to a macro theme help reduce our concentrated risk to these factors.
The fundamental opportunities are still relatively large, but they are riskier, more concentrated, and less differentiated. We focus on navigating these risks in the portfolio, and we’re doing so in three ways.
#1: Haircut Fundamental Opportunities
One way to navigate this environment is to own less of the fundamentally attractive, but riskier assets. Across our strategies, we’ve set exposures to be smaller than what fundamental valuation signals alone would otherwise justify.
The opportunities are less compelling because they are more risky and more correlated by a common risk factor. We’re simply not being compensated for the higher risk that narrow investment breadth provides us.
#2: Increase Use of Options
Another way that we are navigating this environment is by seeking downside protection in the portfolio. That means using long option positions in an attempt to protect on the downside while maintaining the ability to participate on the upside.
Of course, options cost money. Today’s environment is one where we are more willing to pay a bit more for this protection than we normally would be. This helps us partially bridge the gap between the fairly wide opportunity set and the narrower investment breadth.
Optionality in the portfolio does not completely eliminate the risks that we need to navigate, but it does enable us to make allocation decisions based more on fundamental valuation opportunities vs. shorter-term macro risks.
#3: Introduce Negatively Correlated Exposures
The third way we are navigating this environment is by allocating to exposures that may not necessarily present a large fundamental opportunity, but do provide a negative correlation to the commodity super cycle theme. We believe exposures that have a negative correlation to a macro theme help reduce our concentrated risk to these factors.
One example of this approach is a recent strategy change we made. We sold Canadian dollars (CAD) and bought euros (EUR), reducing our EUR short position and moving our previously flat CAD exposure to a short exposure.
Again, the EUR/CAD exchange rate does not necessarily present an overwhelmingly compelling valuation story, but this exchange rate is currently exhibiting a significant negative correlation to commodity prices, especially oil. For this reason, we believe this exposure may help reduce portfolio volatility without detracting from return potential.
The combination of these three strategies—de-risking, buying options, and adding exposures that are negatively correlated to risk themes—helps us navigate the current environment where fundamental opportunities are riskier and more concentrated.