The Gray Rhinos: The Long-Term Investment that Hedges Tactical Volatility Opportunities

Last week inflation reached its highest level since 1981 (CPI MoM = 8.5%), aligning with the whirlwind of macro, policy, geopolitical, and social uncertainty, putting downside pressure across asset classes throughout 2022. With inflation stubbornly high (amid a stagflation environment), consumer sentiment and demand appear to be vulnerable to pockets of uncertainty and structural weakness. Plateauing demand trends (amid inflation and a weaker purchasing power) due to 2020’s excess capital artificially “inflating” consumer spending habits throughout the V-shaped recovery (trickling into a strong 2021) may structurally cause cross-asset underperformance in 2022. This dynamic may partially illustrate why retail sales only increased 0.3% in March. The uncertain trajectory of demand trends coupled with the persistent supply bottlenecks may keep equity and bond markets volatile as the polarizing forces of supply and demand economics battle for equilibrium. This dynamic ignited by the ongoing Russia-Ukraine war and China’s COVID-19 lockdowns (amid the new variant) may continue to intensify the commodity market supercycle (specifically soft commodities, wheat, industrial metals, and crude). Monetary policy also remains strictly scrutinized as the Federal Reserve’s hawkish policy attempts to employ its quantitative tightening (reduction of balance sheet assets) and increasing interest rates to balance inflation but not cause a recession or slow down economic growth (aiming for a soft landing). However, the Fed’s velocity of their interest rate hikes remains most important (the number of rate hikes —expected six more, the ideal Fed Funds Rate, and if a 25 bps or 50 bps hike per meeting is necessary).

The current environment has significantly put the borrowing/financing markets in a difficult situation, specifically homebuilders, autos, and home appliance companies. With the 30-year mortgage rate at 5%, the refinancing wave and the “hot” housing market appear to be drying up, positioning for a steep slowdown. With mortgage rates at 2011 levels, a housing market crisis remains a tantalizing possibility within the next 12-18 months as mortgage rates appear to have bottomed for good amid the post-Covid rate environment. Thus, investors should remain cautious, but asset classes such as legacy mortgage-backed securities with opportunity bias, survivorship bias, and lower interest payments outstanding (and LTVs) remain a glimpse of the investment opportunity beyond the shade of the current market uncertainties.

The recent bear market rally (or a sharp, short-term price increase in the market amid a longer-term bear market period) gave investors a false sense of a potential market rebound despite the slowly unraveling certainty of current markets: volatility. Though recessionary fears have risen due to the 2/10-year yield curve inverting, not all the warning signals have been triggered that usually preface a recession (yet). Therefore, investors should be less concerned about predicting the next recession and more concerned with weathering the market’s current volatility and preparing portfolios for the next gray rhino events.

Before I continue, let me define a “Gray Rhino” event.

A “Gray Rhino” (based on the book “The Gray Rhino” by Michele Wucker) is a highly probable, high impact yet neglected threat: kin to both the elephant in the room and the improbable and unforeseeable black swan event.

How can investors weather current market volatility?

During uncertainty and looming risk, the mirage of catalysts plaguing asset performance remains challenging to mitigate. However, understanding the pockets of opportunity of supply and demand economics and the thematic fundamentals to uncover the best asset classes, sectors, and exposures may help investors mitigate risks while also providing investments that generate uncorrelated outperformance.

Given market conditions, the following are where we see potential attractive and unattractive opportunities:

What We Like

What We’re Avoiding

Commodities:
– Specialized energy exposure
– Soft commodities (coffee, sugar, corn, soybeans)
– Gold

– Industrial metals (Copper, aluminum, steel, etc.)

– Fertilizers & agricultural chemicals

– Farmland (and other hard assets)

– Orange Juice

Equities:

– Insurance/reinsurance companies

– Health care

– Food Retail

– Financial (banks or institutions that benefit from higher interest rates)

– Small-Cap Domestic Equities

Currency:

– US Dollar

Fixed Income

– Legacy NARMBS

– Short Duration Corporate Bonds

– Floating Rate Bonds (Bank Loans)

Commodities:
– Nickel
– Cattle (Livestock)
Equities

– Real Estate

– Industrials (homebuilders, auto parts & equipment, building products, home furnishings)

– Large Cap technology stocks

– Logistic and trucking

– Casinos and Gaming

Currency

– Russian Ruple

– Euro

– Eastern Europe currencies (Hungarian Forint, Polish Zloty, Bulgarian Lev, Czech Koruna, Romanian New Leu)

Fixed Income

– 20+ Year Us Treasuries

– Emerging Market Bonds

– International Bonds

As of April 19, 2022

What is a “Gray Rhino Investment”?

As we saw last quarter (Q1 2022), the earnings season remains highly anticipated as stock-picking continues to be crucial to equity outperformance. With that said, investors remain in sensitive territory. Investors’ diminishing sensitivity to asset volatility and gains remains a troubling dichotomy that may signal the potential for a sustained steep market reversal (which we have started to experience so far in 2022). The psychology of investors appears to have a distorted value function when factoring in the “utility” of performance. Investors have started to discount their expectations of an investment hyperbolically. In 2020 and into 2021, the “Gray Rhino” risks appeared to have fallen to the wayside as gains throughout many asset classes (amid the liquidity capital injections) overshadowed apparent concerns. However, 2022 is a much different story, and the “Gray Rhino” lurking in the background must be brought to light.

Many believe that COVID-19 was a “Gray Rhino” event due to the number of warnings, statistical probability, and related academic research. However, COVID-19 is not the only “Gray Rhino” we have been ignoring. It appears that there are a few more “Gray Rhinos” littered throughout the current thematic backdrop, including a real estate slowdown, climate change, disruptive (or radical) innovation (as discussed in: “The Disequilibrium of Innovation“, The Next Stage of Disruptors: Part 1“, and
“The Next Stage of Disruptors: Part 2”),
and cybersecurity dilemmas. Therefore, instead of ignoring the obvious and remaining too exposed to market drawdowns, investors should augment their portfolio’s tactical exposures/opportunities (to weather the current volatility- listed above) with long-term “Gray Rhino” investments as the potential for significant, outsized gains remain on the investable table. Therefore, during the current market pullback, it appears to be an opportunistic time for investors to add exposure to strategically oriented “Gray Rhino Investments,”, especially regarding climate change and disruptive innovation.

In short, investors can weather the current market volatility with tactical investments within equities, commodities, currencies, or fixed income asset classes. However, now appears to be the best and most opportune time for investors to increase their exposure to high probability events that are regularly ignored. Gray Rhinos such as climate change and disruptive innovation should shift from a subconscious notion to proactive action. If so, investors may be able to accelerate their long-term performance profile, while volatility mitigation in the short-term can aggregate a smoother return stream. “Gray Rhinos” are not all extinct, so start making them elephants.

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Hunter Frey, Analyst
Hunter Frey, Analyst
Hunter Frey is an Analyst at Catalyst Capital Advisors, LLC and Rational Advisors Inc. covering all in-house equity strategies and an insider buying income-oriented strategy at Catalyst Funds. Mr. Frey received a Bachelor of Science degree in International Business with a focus in Spanish from Gardner-Webb University, Godbold School of Business, and is in pursuit of a Master of Business Administration in Economics and Finance from New York University, Stern School of Business.

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