Disease and Debt Now…Dispersion Later?

Navigating an Uncharted Deficit Future.

Deficits are rising across the developed world as governments aggressively loosen their purse strings in response to the COVID-19 pandemic. It is estimated global government debt will reach US$66 trillion by year end, and debt to gross domestic product (GDP) will rise from 105% to 122%, a bigger increase than any seen during the global financial crisis (GFC).1 In the United States, for example, the government borrowed a record US$3 trillion just in the second quarter of 2020, more than five times as much as it did in 2008 during the GFC.2 The US deficit could balloon even higher in the months ahead, as legislators seek to pass additional spending bills aimed at supporting state and local municipality budgets.

Debt levels create long-term uncertainty related to if or how countries will unwind their borrowing. However, the current environment presents opportunities for hedged strategies, such as long/short equity. Coming out of this crisis, we believe there will be clear winners and losers across almost every sector. In our view, this will create opportunities for idiosyncratic stock selection, long and short trading, and alpha capture.

THREE TAKEAWAYS

  • Globally, governments and central banks have responded quickly and aggressively to the COVID-19 pandemic with both fiscal stimulus and monetary easing. While most would argue these measures were a necessary action to avoid economic collapse, they come with an unfortunate byproduct—enormous debt.

  • Near term, we expect market volatility and increased security dispersion to persist as a result of the ongoing COVID-19 crisis and unprecedented interventionist policies. This may benefit certain hedged strategies poised to take advantage of increased price differentials across sectors, securities and geographies. Long/short equity, relative value and global macro strategies are particularly well suited to these environments.

  • There could be longer-term unintended and damaging consequences for governments that maintain massively leveraged balance sheets for an extended period. At some point, the economies of the world will need to unwind if they desire to maintain financial stability.

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GLOSSARY

  • Hedged strategy. A hedged strategy describes an investment approach designed to minimize the risk of adverse movements in the value of assets. Hedged strategies usually involve taking an offsetting position for the related asset. Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding—to hedge it, in other words—by taking out flood insurance. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policy holder receives no payout.

  • Long/short equity strategy. Long/short equity is an investing strategy that takes long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline. A long/short equity strategy seeks to minimize market exposure while profiting from stock gains in the long positions, along with price declines in the short positions. Although this may not always be the case, the strategy should be profitable on a net basis.

  • Relative value strategy. A relative value strategy seeks to exploit temporary differences in the prices of related securities. A common approach is called pairs trading, which consists of initiating a long and short position for a pair of assets that are highly correlated. In some cases, relative value strategies can generate risk-free profits through the process of buying and selling the two different securities at the same time, which is called arbitrage.

  • Global macro strategy. A global macro strategy makes investment decisions based on the overall economic and political views of various countries or their macroeconomic principles. Holdings may include long and short positions in various equity, fixed income, currency, commodities, and futures markets.

ENDNOTES

  1. Source: International Monetary Fund (IMF), Fiscal Monitor, April 2020.

  2. Source: Kiernan, P. “U.S. Budget Deficit Widened to $1.935 Trillion in 12 Months Through April,” Wall Street Journal, May 4, 2020.


What Are The Risks?

All investments involve risks, including possible loss of principal. Investments in alternative investment strategies and hedge funds (collectively, “Alternative Investments”) are complex and speculative investments, entail significant risk and should not be considered a complete investment program. Financial Derivative instruments are often used in alternative investment strategies and involve costs and can create economic leverage in the fund's portfolio which may result in significant volatility and cause the fund to participate in losses (as well as gains) in an amount that significantly exceeds the fund's initial investment. Depending on the product invested in, an investment in Alternative Investments may provide for only limited liquidity and is suitable only for persons who can afford to lose the entire amount of their investment. There can be no assurance that the investment strategies employed by K2 or the managers of the investment entities selected by K2 will be successful. The identification of attractive investment opportunities is difficult and involves a significant degree of uncertainty. Returns generated from Alternative Investments may not adequately compensate investors for the business and financial risks assumed. An investment in Alternative Investments is subject to those market risks common to entities investing in all types of securities, including market volatility. Also, certain trading techniques employed by Alternative Investments, such as leverage and hedging, may increase the adverse impact to which an investment portfolio may be subject. Depending on the structure of the product invested, Alternative Investments may not be required to provide investors with periodic pricing or valuation and there may be a lack of transparency as to the underlying assets. Investing in Alternative Investments may also involve tax consequences and a prospective investor should consult with a tax advisor before investing. In addition to direct asset based fees and expenses, certain Alternative Investments such as funds of hedge funds incur additional indirect fees, expenses and asset-based compensation of investment funds in which these Alternative Investments invest.