Entry Points | Inflation Risks & Long/Short Equity

Long/Short Equities Emerge as a Potential Inflation Hedge 

Inflation Worries Percolate | After a decade plus in which investors haven’t had to really consider hedging their portfolios, emerging questions about the prospects for inflation have many considering hedging strategies to help offset the risk. The caveat, however, is that thanks to historically low interest rates, what worked in the past won’t necessarily have the same effect going forward.

Fixed Income “Stability” Eroding | Many fixed income portfolios, for instance, reflect a tilt toward long-duration exposures, a response to the historically low interest rates. As a result, many fixed income allocations – rather than providing their traditional ballast function – are susceptible to any move higher in interest rates. This would likely be true in both a less-transient inflationary scenario as well as a Fed reaction to improving economic growth.

Traditional Hedges at Risk | More customary inflation hedges – namely precious metals and stocks – have their own shortcomings. A very large swath of the equity market, for instance, has benefitted for an extended period of time as rates fell or held steady at historically low levels. And growth stocks, in particular, are trading at multiples that assume uninterrupted, long free-cash flow streams for the foreseeable future.

Entry Points: Long/Short Opportunity Emerges | A value-oriented Long/Short equity strategy, alternatively, is uniquely positioned to provide investors with an inflation hedge. The most expensive areas of the market, which make up a large proportion of short books today, are also segments that would be disproportionately affected in a rising rate environment, whereas the undervalued corners of the market, in the long exposures of value strategies, could benefit from a tailwind.

Obstacles Confronting Growth | Looking at the top quintile of stocks whose price appreciation has been most correlated with the downward trajectory of treasury yields, the names in this in this cohort are trading at a roughly 70% premium to the overall market. Not surprisingly, the top industries in this grouping consist of software and internet services, medical technology, and biotech.

Value’s Tailwind |Conversely, the bottom quintile of equities showing the least correlation revolve around cyclical industries, including banking names and companies in the consumer finance, insurance, industrial equipment and machinery sectors. This grouping currently trades at its all-time largest discount compared its long-term average – reflecting a gap of approximately 40%. 

A Bottom-Up Determination | At Boston Partners, we’ve been utilizing a disciplined three-circle approach since our founding to identify and select undervalued stocks characterized by high-quality fundamentals and improving business momentum. Based on this analysis – versus any kind of top-down projection – many of the traditional growth industries that have benefitted from low rates are more likely to be found on the short side of our portfolios, while the cyclical, value-oriented stocks with room to grow are positioned to further benefit should rates begin to climb.

Active Strategy: Boston Partners has managed long/short value strategies for nearly 25 years, and currently manages multiple domestic long/short funds as well as strategies targeting global and emerging markets. Boston Partners’ long/short strategies seek long-term capital appreciation while reducing exposure to general equity market risk and volatility.

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Boston Partners Global Investors, Inc. (“Boston Partners”) is an investment adviser registered with the SEC under the Investment Advisers Act of 1940. Registration does not imply a certain level of skill or training. The views expressed in this commentary reflect those of the author as of the date of this commentary. Any such views are subject to change at any time based on market and other conditions and Boston Partners disclaims any responsibility to update such views. Past performance is not an indication of future results. Discussions of securities, market returns, and trends are not intended to be a forecast of future events or returns.