One of the most anticipated calls of our CIO Call series wrapping up this week (see schedule) was with Calamos Co-CIO, Head of Long/Short Strategies and Senior Co-Portfolio Manager Michael Grant. Contrary to most equity investments, Grant’s Calamos Phineus Long/Short Fund (CPLIX) has gotten off to a strong start this year (see this post for January’s performance)—demonstrating the contribution the equity alternative can make as a 5%-15% sleeve in a portfolio.
Grant started the call with a shift in his perspective about leaning into equity risk post-pandemic. Since the health care crisis began in March 2020 and through the end of last year, he had been bullish about the market’s extraordinary fundamentals and historic earnings (see this post). However, he has since tempered his view, while remaining in favor of risk assets. (Listen to the call in its entirety here.)
“This is not a case where one should immediately assume we roll into a bear market,” said Grant. “The support for equities is coming from a solid earnings picture for this year. It’s coming from a healthy economy led by robust employment conditions, and it’s coming from the reality that even though liquidity is peaking, in an absolute sense liquidity is still very robust. That leads us to the conclusion that the S&P 500 will probably trade within a range of 4200 on the downside to perhaps 5000 on the up side.”
But Grant emphasized that only profitable businesses are likely to win going forward. The recent, extraordinary period of “free money” had “disfigured the investment landscape," he said. "As a consequence, we had unusual performance in many of the unprofitable, negative cash flow-generative businesses.”
Declaring unprofitable businesses “done-and-dusted for this cycle,” he continued. “Over time, profitable businesses win in equity markets. In fact, over a decade, about 40% of the S&P eventually disappears. We think this is the world we’re now returning to, and it’s the distinction that clients should very carefully make when they look at their portfolios today. Obviously, rising interest rates affect all equities, but we equally believe that the profitable, high quality, cash flow-generative businesses are within 10% to 15% of the point where valuation is no longer the primary determinant of the stock outcome.”
In 2022 Grant and team expect “solid” earnings from businesses that can generate operating leverage, which he described as a classic mid-cycle differentiation.
“The good news is that much of the excess of the free money era was concentrated in the equity derivatives of long duration, in the long-duration growth and technology stocks in particular, and we’re beginning to see that unfold before us.
“On the other hand,” he said, ”if we look at industries like Financials, like Industrials, like Energy and Commodities, there was very little valuation premium excess built up in any of those industries in the past decade. Therefore, if those companies can deliver on the operating leverage that we anticipate over the next 12 months, we think the stocks can move higher in line with that.”
As in December (see post), Grant commented on the importance of rising interest rates and inflation unfolding “in glacial fashion.” He now expects this is what will happen.
“The Fed is stepping back and not targeting a specific level of inflation that it must meet,” said Grant. “In a sense, this is a narrative that we saw from [previous Fed Chairman] Alan Greenspan. In the 1990s, Greenspan refused to target a certain level of inflation. His view was that in a healthy economy, 3%, 4% inflation is actually a good thing. He stepped back and said, ‘Let’s let events, unexpected events come and shock the system and allow windows where inflation would ultimately prove tame.’”
Grant parts ways with some on the scope of today’s inflation. “We don’t really have broad inflation. What we have is a handful of important prices that are all going up right now at the same time,” he said.
Today’s prices are higher as a result of the non-traditional COVID recession, according to Grant. He predicted that the supply shock in the goods sector will ease in the next few months, and headline inflation with it.
“Ultimately,” he said, “the real problem for inflation is going to be in employment markets because we are transitioning to a much tighter era of employment conditions. In that sense, I think inflation will plateau at a much higher level than at any time in the post-2008 period. The key is what that level is. More importantly, if you look at expectations of inflation, they are still anchored in the 3%-4% range.
“As long as that holds true, I think the Fed can gradually raise interest rates over the next 12 months without it turning into a bear market for financial assets,” he concluded.
Even if the Fed raises rates multiple times this year—Grant predicted there would be at least five hikes—"liquidity is too robust for that to materially create an economic downturn.”
He said, “Up until December of last year, the Fed’s balance sheet was still growing at a 20% rate year over year. Most money supply aggregates have grown 40%-plus over the last two years. If we think of monetary policy and if we think about liquidity as a leading ingredient for the economic cycle, it’s very hard to anticipate economic weakness for the next 18 months.”
The team forecasts the economy will grow 4% real, 7%-8% nominal with the 10-year Treasury yield between 2%-2.5%.
When the discussion turned to CPLIX’s performance, Grant was asked what he expected to be different about the next two years.
“What’s going to be different for all of us on this call is the possibility that the dominance of mega caps is over,” Grant replied. “Over the last five years, those mega caps have delivered uniformly amongst them extraordinary fundamentals. In the next couple of years, I don’t believe that’s going to be the case. In fact, it’s possible that one or two of those mega caps goes into structural decline as the market will be more discriminating concerning corporate profitability.”.
“…We’re not going to get the extraordinary, absolute returns in the benchmarks or at least the S&P. An actively managed portfolio, both long and short, in my opinion has a much greater chance of now beating those benchmarks,” he said.
The mega cap dominance over the last five years was challenging for CPLIX, Grant acknowledged. “When you have such a small, concentrated part of the market driving the benchmark returns, that makes it very challenging for a portfolio that’s diversified and active, non-benchmark in its intent to keep up with that.
“…The fund is a global product,” he said, “and it still managed to beat most other global equity markets with the exception of the S&P, again because of this concentrated performance in the mega caps.”
CPLIX’s performance year to date—what call moderator and Calamos Senior Vice President Robert Bush described as "firing on all cylinders," as shown in the chart on the right—demonstrates the diversification benefits of using an equity sleeve with a low correlation to equities.
Bush described the fund as “very high conviction, where Grant and team have a lot of flexibility as to how much of the market they want to embrace, where they want to go, what types of sectors they want to be in and the reasons they have for being in them.”
The fund enjoys more latitude than its peers in the Morningstar Long/Short Category, added Grant.
“We do not have limits in terms of how quickly we can move. We do have strategic ranges, which is from minus 20 to plus 80. Now, that’s a very wide range, and it makes us almost unique within the long/short category. Since inception, the average net exposure for the fund is slightly below 30%. That’s since inception in 2002.
“Now, we do tend to move those net exposures relatively slowly because the driver of those exposures is our view of where we are in the business cycle. Those fundamentals rarely change with much rapidity,” he said.
Investment professionals, for more on Grant’s outlook or CPLIX, please reach out to your Calamos Investment Consultant at 888-571-2567 or firstname.lastname@example.org.
Click here to view CPLIX's standardized performance.
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