FRM Early View - April 2018
- With a market environment that strongly characterizes the later-phase of an economic cycle, we see reasons to use active management to help navigate these markets.
- Hedge funds experienced a mixed month in April, with Global Macro and Relative Value strategies benefitting from higher levels of volatility to generate better returns.
- Company specific alpha was hard to generate for Equity Long-Short and Event Arbitrage managers.
How should investors unravel the inconsistency between the stubborn flatness of the US yield curve and an abundant growth and corporate earnings landscape?
By April 18, the US 2yr-10yr yield spread had dropped to 41bps, the lowest level since the global financial crisis. Market commentators had become significantly more vocal about the risks of a flat curve and the historical prescience of inverted yield curves to foreshadow a recession. 2yr rates have been rising relentlessly for the past year, in line with expectations of an ever-tighter interest rate policy from the Fed, whereas 10yr rates had been retreating from the highs seen earlier in the year on concerns that macro data was at risk of rolling over, not least in Europe where Purchasing Managers Index data had begun to disappoint.
Then, in the space of three days from 18-20 of April, we saw a 15bps jump in the US 10yr yield. The US earnings season was stronger than expected and with a broad based commodity rally, a more positive read on global growth and longer term inflation took hold. Economic commentary turned more positive, despite the fact that much of the commodity rally was a reaction to noise around trade tariffs and that the short end of the curve was also pricing in better economic sentiment and as such the yield curve remained pretty flat.
This tension between flat yield curves, but stronger growth and inflation expectations is historically symptomatic of the late-stage of the economic cycle. As in any system under tension, we expect the process to be resolved in fits and starts, with short periods of repricing interspersed with periods of relative calm.
Let us be clear, over the longer term this is clearly a problem for financial markets. If the yield curve is broadly correct, then we are perhaps 12-18 months away from the end of the tightening cycle in US rates. The rest of the world is still a few years behind the US in their monetary positioning, but in aggregate we continue to move towards a world with less liquidity. This problem is exacerbated by a stronger dollar (and there is plenty of room to go for the dollar to revalue back to the interest rate differential vs the euro or the yen), and new regulation for the Banking sector means it is likely that they either can’t or won’t step in to fill the liquidity void left by the central banks. Significantly steeper yield curves would solve the problem, but would also require expectations of inflation that quickly become unpalatable for most risk assets in our view. And if we do enter a recession in the next 1-2 years, the risk of further complications from weak sovereign balance sheets (which have barely healed since the Global Financial Crisis) should not be underestimated.
In the shorter term, it is tricky to say at what level the overall yield curve starts to, once again, cause a rebalancing of asset-mixes in investors’ portfolios and change the valuation of risk assets across the board. With the pull-back of prices in February and the improvement in earnings globally, equities no longer look as expensive on a P/E basis, so it is not surprising that the reaction to a sharp rise in long rates was much more subdued than it was in February. But we believe positioning remains full enough to support further legs down in the equity market if either the growth outlook dims or inflation concerns become too much.
Provided that the macro data doesn’t deteriorate materially, we could see the rest of the year characterized by the dynamics seen in April, namely i) an outperformance of cyclical stocks and commodities versus an underperformance of defensive, yield-sensitive stocks, and other spread assets; ii) continued high levels of M&A activity, and iii) USD appreciation on the back of a widening interest-rate differential to other developed market currencies.
At least the political landscape gives some reason for optimism. In last month’s Early View we wrongly thought that all of the good news from North Korea was in the price. Recent developments appear to be more tangible than we expected, and the market has found room to price more optimism. As ever, these things can unravel quickly (and there are risks around the renegotiation of the Iranian nuclear deal which are likely to come to a head this month), but for the time being, markets appear to be grateful for the improvement in the political narrative.
If we are right about the uncertainties of the next year or so, then hedge funds have a potential opportunity to show their worth. The managers that we speak to are mostly of the opinion that higher volatility in all asset classes could be positive for their strategy. This makes sense, since most strategies have the potential to profit from a dislocation between market price and some form of fair value or arbitrage. Higher volatility (and fixed transaction costs) means opportunities to add value are both larger and more numerous. The difficulty in reading late-cycle developments means that there is now a plurality of views at the macro level too, which could provide additional reward for being ‘right’ on market positioning.
However, the transmission mechanism between a better overall opportunity set and higher hedge fund returns can be noisy. In April, hedge funds in Equity Long-Short strategies generally lost money despite the equity market rising on the whole, whereas CTA managers had a noteworthy month of performance despite what appeared to be range-bound trading in most asset classes. Nonetheless, with a market environment that strongly characterizes the later-phase of an economic cycle, and the associated erratic changes in asset class positioning and pricing, we see reasons to use active management to help navigate these markets.
Hedge funds experienced a mixed month in April, with Global Macro and Relative Value strategies benefitting from higher levels of volatility to generate better returns, while company specific alpha was hard to generate for Equity Long-Short and Event Arbitrage managers. Credit strategies generally had a quiet month despite volatility in fixed income markets.
Much of the difficulty in Equity Long-Short strategies stemmed from a series of factor rotations and general investor de-risking through the first part of the month. Managers reported specific losses from exposure to Momentum factors, whereas Value exposure recovered from a difficult first quarter, particularly in Japan. As might be expected in a month with positive equity market returns, managers with higher net exposure generally performed better.
On the whole the developed market earnings season was generally positive and a source of alpha for hedge fund managers. Stocks are now exhibiting larger moves on earnings beats and misses, as investors move into stocks that are expected to perform better in the new monetary regime. Crowded longs/shorts that miss/beat earnings respectively were a source of significant negative alpha.
Event driven strategies remained under pressure in April as risk arbitrage performance continued to be a headwind for a number of managers and resulted in negative to flat performance for the month. Risk arbitrage losses were driven by further negative developments in deals requiring Chinese regulatory approval. A semiconductor manufacturing company and a telecommunications equipment company deal was one of the largest negative contributors across the strategy as the companies had to withdraw and refile their application for approval with Chinese regulators as US and China trade tensions persisted.
On the positive side, other core risk arbitrage positions benefitted from idiosyncratic company specific developments that led to tighter spreads. Deal activity was quiet in early April but picked up in the last few days of the month. Highlights for April included an increased offer of USD 64bn for Shire from Takeda Pharmaceuticals and Comcast’s USD 31bn offer for Sky PLC, topping a prior offer from 21st Century Fox.
It was a fairly uneventful month in the credit markets despite the late-month volatility in equities and a backup in treasury yields. US high yield spreads hit multi-year lows intra-month but retreated off those levels as rates increased later in the month. US leveraged loans and high yield were positive for the month while investment grade continues to underperform driven by longer duration. Within US high yield, lower-rated credits have held up relative to higher-rated parts of the market, again driven by interest rate risk. Telecom, Retail and Energy (driven by continued strength in the crude oil market) are the best performing sectors while the Automotive sector is a notable laggard.
US high yield saw the largest weekly inflow in April since December 2016 after seeing noteworthy outflows over the prior several weeks. Loan funds continued to see investor interest. Primary market activity in April was below average across both loans and bonds. Securitized products were once again largely immune from the late-month selloff in US equities and treasuries. Collateralized loan obligation mezzanine debt (due to increased supply and other fundamental factors) and lower-rated credit risk transfer a deal saw some widening but otherwise credit spreads were stable across most sectors.
April returns across Corporate Credit managers were mostly positive but there was a lack of idiosyncratic P&L drivers. Structured Credit managers were also positive for the month primarily driven by principal and interest income. Relative Value trading (structured credit vs. corporate credit, relative value rates and volatility trades, etc.) was a source of alpha generation for some managers.
Macro performance was mixed in April, with positions in US rates generally working, alongside long crude oil which is gradually finding its place in managers’ portfolios. Emerging Markets underperformed, particularly on the equity side, with higher US rates finally appearing to be reaching a tipping point where they start to hurt spread assets (though High Yield remains very resilient) and higher beta plays.
Trend following had a generally positive month from short US rates and long energy commodities, while suffering from currency exposures, in particular long EUR and GBP. USD remains stable with a weak undercurrent in the face of widening interest rate differentials, but managers have adjusted positions and largely abandoned the long USD trade.
It was a positive month for Statistical Arbitrage strategies. Fundamental strategies bounced back from a weak period in March and posted positive returns. This included a bounce in some of the Asian valuation based strategies which had appeared stretched over the first quarter of the year. Europe continues to be a strong region for these strategies. Technical strategies were more muted but still positive. There was quite large divergence in performance of the more technical managers, but performance from diversifying and futures based statistical strategies was positive.
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