Highland Associates’ 2019 Conference focused on “Changing Tides.” No, we are not talking about the Alabama Crimson Tide or the tides of the mighty Potomac, which flows through Washington, D.C., where we gathered in early April. We are focused instead on the changing tides in the marketplace.
At Highland, we cautiously observe a move toward more moderate economic growth going forward. Our speakers highlighted many of the challenges and opportunities these changes have on a moderating economy. Significant changes can be difficult to decipher. This is why we focus on a framework for decision-making to help us discern the big picture from the noise, making better allocation decisions for our clients. We also choose to focus on informational and strategic advantages when allocating long-term capital to take advantage of the opportunities created by changing tides. For more detail on these important changes, please see a summary below highlighting our conference discussions.
A View from Washington: The Good, the Bad & the Ugly
Libby Cantrill, Managing Director and Head of Public Policy for PIMCO
- President Trump has delivered pro-growth, pro-market policies over the last two years, including the Tax Cuts and Jobs Act as well as the 2018-2019 spending bill. However, companies are using tax savings more for share buybacks than productivity-enhancing investments. Fiscal stimulus will therefore have a short-term, “sugar high” effect on the U.S. economy.
- The Trump administration has delivered on a market-friendly regulatory environment by not issuing new regulations rather than wholesale repeal of existing regulation. This has created more business certainty in regards to the regulatory environment.
- Late-stage fiscal policy is unusual and potentially limits future counter-cyclical stimulus. Large budget deficits make it harder for Congress to respond with large fiscal stimulus measures in a recession. This will likely result in a longer recession and lower interest rates for longer.
- The market underestimated Trump’s resolve on trade. The administration’s actions on trade are rooted in Trump’s long-standing, deeply held opposition to the North American Free Trade Agreement (NAFTA) and China’s ascension to the World Trade Organization (WTO). Trump has almost succeeded in replacing NAFTA with the United States-Mexico-Canada Agreement (USMCA), but it still needs to be ratified by the Democratic-led House. Trump is faced with balancing his dislike for China with his need for a trade resolution with China before the midterm elections, which could force agreement on a deal with China.
- Infrastructure is the least divisive congressional issue, but the lack of political will from Democrats and worry over the deficit from Republicans will likely hold back this otherwise bipartisan legislation from advancing.
- Increasing partisanship and polarization will likely result in more congressional investigations, leaving the Trump administration on the defensive rather than offensive when it comes to policy-making.
Outlook for Fixed Income
Rick Rieder, Managing Director of Blackrock, Global Chief Investment Officer of Fixed Income, and Co-head of Blackrock’s Global Fixed Income Platform
- The probability that the Fed raises rates in the next year is 50/50. The Fed is unlikely to continue raising because inflation expectations are the lowest in the University of Michigan’s survey history, and the volatility of inflation is also at an all time low. Based on potential GDP growth, credit yields, and the current Fed Funds Rate, we are likely at or around neutral.
- It is unlikely that the economy is going into a recession. Rather the economy is moderating. Manufacturing no longer creates the booms and busts of the U.S. market cycle since we are now a service-based economy.
- The European Central Bank (ECB) must set policy to the weakest link. Due to economic weakness in Greece and Italy, it will be a long time before the ECB can raise rates. The ECB is currently providing 19% of global liquidity to stimulate growth and may need to do more in the future since interest rates in Europe are already negative.
- The growth in the BBB sector of the credit market is offset by corporate deleveraging and stable cash flows. Another area of concern is the stretch for yield in the leverage loan and MLP markets, which will likely experience losses in an economic slowdown.
- Blackrock is emphasizing quality rather than reducing risk and prefers shorter duration CMBS, residential MBS, and ABS to focus on carry and income.
Artificial Intelligence: Implications and Applications
Panelists: Brian Barbetta, Global Industry Analyst, Wellington; and Adil Abdulali, President and Chief Science Officer, MOV37
- Computer coding has evolved from a rules-based system that is both time-intensive and human-dependent to deep-learning/artificial intelligence systems that are faster and self-improving.
- There has been significant growth in unstructured, non-financial data that requires data science to analyze. Companies with the data and ways to process and use it will benefit from the information edge.
- Quantitative investing now includes strategies based on machine learning. These groups feed data to the computer system to create a model based on the machine learning the relationships among data series, and it requires fewer humans. The old method of quantitative investing was based on human hypothesis and model creation, and the computer system tested the data against the model and calculated the output.
- Shift to machine-based learning (i.e., artificial intelligence) will likely shrink the investment management industry and shift hiring from MBAs to data scientists.
- There are other powerful applications for AI that are transforming industries like retail, media, and healthcare. In healthcare, the combination of humans and machines has superior outcomes and advantages in treatment and correct diagnosis.
Evolution of Hedge Fund Investing
Panelists: Hugh Edmundson, Co-Founder and Managing Partner, Theorem, and Matthew Reeder, Partner and Director of Investor Relations, Theorem;Basil Qunibi, CEO, CIO, Atom Investors, LP
- Hedge funds broadly have increased the number of positions held, increased hedging, and increased the number of positioning changes resulting in declining manager value add.
- At Highland, we look for managers with strategic and informational advantages. Many of these managers are emerging hedge fund managers like Theorem and Atom (two managers we have allocated assets to in the past year).
- Emerging managers tend to outperform midsize and large funds and often offer lower fees. We define emerging managers as managers with a track record of less than three years and assets less than $300 million under management. These managers are held to the same due diligence standards as all midsize and larger funds.
- Atom’s fund of funds and Theorem’s credit strategy are unique in that they have carved out a niche in their respective areas with informational advantages. This edge allows them to be nimble with their investment decisions.
- Atom creates value by analyzing trades of top-performing hedge funds to evaluate where value comes from. They then execute the manager’s trades that are determined to be value-enhancing. The goal is to construct the next generation multi-manager hedge fund that achieves consistent and persistent alpha.
- Theorem applies data science and machine learning to consumer lending. Their proprietary system of information on consumer loans gives them an informational advantage over the market in pricing these securities. They look at 2,000 data points on every borrower compared to the 2 data points used by underwriters.
- Both managers emphasized the importance they place on investing in the company’s infrastructure as they’ve grown. Reinvestment into technology and human capital have been key to their successful business expansion. By hiring talented people who can support business functions as well as investment strategy, both managers have had great success in growing the business while staying focused on investment decisions.
China in Transition: The Divorce of Globalization
Panelists: Jordi Visser, President and Chief Investment Officer, Weiss Multi-Strategy; Ben Hunt, Founder, Epsilon Theory, Second Foundation
- The issues with China are a more systemic issue and reflect a breakdown in trust among governments. This marks a shift in cooperative to competitive institutions. This has far-reaching implications, especially in regard to global trade.
- The trade deal is a story promulgated by the administrations of the U.S. and China to maintain institutional power and use as a tool to influence the markets.
- The unwinding of globalization is going to impact institutions that made a bet on globalization and free trade many years ago. These are the companies that will be most impacted by disruptors and will have the highest default rates.
- China is unlikely to depreciate their currency because they want to achieve reserve status in the global economy like the U.S. China will continue to open its financial markets to outside investors to achieve this status.
- China has shifted from a deflationary to inflationary economy. This has massive repercussions on quantitative models that are predicated on the stock/bond relationships that have run the last 40 years. Market cycles will be sharper and shorter in the new regime. Expect higher volatility going forward within both equity sectors and different asset classes.
Breakout Session #1: State of Nonprofit Healthcare
Panelists: Olga Beck, Senior Director, Fitch Ratings; Lisa Goldstein, Associate Managing Director, Healthcare Ratings Group, Moody’s Investors Service
- Fitch and Moody’s continue to have a negative outlook on NFP healthcare. Margin compression continues to be a concern with competition from nontraditional providers, payer mix deterioration, and upward trending expenses.
- M&A activity is expected to be strong. However, expect increased scrutiny at the federal and state level going forward with conditions on pricing/margins.
- NFP healthcare has always been a resilient space, but systems can no longer operate as business as usual. Increased capex will be required to establish a seamless patient experience and combat new entrants. Future capex will likely differ from traditional expenditures on beds and towers and focus more on technological needs and smaller outpatient facilities.
- Both rating agencies commented that liquidity and asset allocation should complement each organization’s demands. There is no “one size fits all.”
- Lower margins and increased capex will require NFP healthcare systems to rely heavily on balance sheets and investment portfolio returns. This increased reliance on returns must be weighed against the need to preserve the important days cash on hand (DCOH) metric of portfolio liquidity and volatility. Stability of returns will be key for many organizations.
Breakout Session #2: ESG in Practice
Panelists: Mozaffar Khan, PhD, Senior Quantitative Research Analyst, Causeway Capital; Carl Balit, Executive Director, 57 Stars
- For many investors, ESG is an important step in the investment process. It is not a replacement but rather an important addition to the due diligence process.
- Using off-the-shelf ESG factors from mainstream data providers does not give a full picture of where ESG adds value. Rather, ESG factors that directly affect a company’s business model add value. Managers who show skill in ESG get more specific and use more knowledge of markets, institutions, and firms to outperform.
- Opportunities for ESG investment span public and private markets. Interest is growing mainly in Europe, Japan, and Australia with flows lagging interest in the U.S. as investors assess portfolio implementation.