Caution advised

The return of volatility and risk aversion when euphoric markets retreat

We were surprised at the magnitude of the move in risk markets following the U.S. election. Betting markets had shown that Trump was a clear favorite to win. The usual uncertainty and market volatility that occurs in September and October of a presidential election year did not transpire this year. We believe this was due to Trump’s increased probability of winning and the market’s assumption that lower taxes and less regulation would improve earnings and multiples going forward.

While we agree with the market’s assessment of regulation and tax policy under Trump as being supportive to valuations, there are some negative aspects to his policy playbook that the market does not seem to be focused on, namely mass deportations and increased tariffs. Both of Trump’s likely immigration and trade policies are clearly inflationary, which was evident in the reaction from bond markets both in the lead-up to the election and once the outcome was known. The market appeared to reflexively go back to the 2016 playbook, when the reality is that the set-up is quite different this time.

Relative to the conditions when Trump won in 2016, risk premiums are much lower, monetary policy is more restrictive, while both the debt and the deficit offer less room for fiscal stimulus. We believe at some point the U.S. Treasury market will show serious concerns about the fiscal position of the U.S. government, but do not have a strong view of when that will occur. The U.S is already running the largest deficit relative to GDP among developed countries, suggesting limited room to manoeuvre.

As of the time of writing, the bottom for high-yield spreads in the immediate euphoria of the election was 261 basis points (bp), which is 40bp through the 2008-2023 low and just 20bp above the 2007 bottom of 241bp. Much like the move lower in spreads over the past two months, in 2007, the bottom in spreads was accompanied by a significant selloff in U.S. Treasuries.

The November low in spreads occurred with the 5-year Treasury yield of 4.31%, while the 2007 bottom coincided with a 5-year yield of 4.97%. So, although spreads are slightly higher than 2007, the all-in yields are worse for the high-yield market now than they were then. While spreads could continue to tighten in the short-term, the chances of a material spread widening event in the next six months has increased in our view.

History has shown that euphoric markets and expensive valuations do not last, and often create conditions for material repricing events. While it has been a challenging year to be defensively positioned, we believe we are well structured to capture opportunities when volatility and increased risk aversion inevitably return.

Justin Jacobsen, CFA, is the Portfolio Manager of the Pender Alternative Absolute Return Fund. PenderFund Capital Management. Excerpted from the Pender Alternative Absolute Return Fund Manager’s Commentary, October 2024. Used with permission.

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