FRM Early View - December 2016
- The HFRX Global Hedge Fund Index returned 0.86% for the month
- The hedge fund industry finished 2016 with positive performance across most strategies in December
- In our view, markets in 2017 may exhibit lower correlation between asset classes which could potentially benefit hedge funds
A large number of people in ‘forecasting’ professions spent the holiday season licking their wounds after one of their worst years in recent memory. Psephologists face an existential crisis after so spectacularly failing to call Brexit and the Trump election victory. Economist predictions of a possible U.S. recession, Eurozone weakness and Chinese hard-landing were all wide off the mark (or at least premature). In addition, hedge funds and long-only active managers generally got it wrong more often than right all year on both security selection and macro positioning.
It is therefore with some trepidation that we publish the first Early View of 2017. These pieces are designed to distil the opinions and outlook of both ourselves and the hedge fund managers in which we invest. It is therefore timely to point out that an ‘outlook’ is often no more than a benchmark against which we measure the degree to which we should be surprised by subsequent events. With that caveat in place, and lest we leave the rest of this page blank, our thoughts from this year’s early vantage point are outlined below.
Equity markets finished 2016 on a positive note and macroeconomic data continues to be better than expected, particularly in Europe. It is therefore hard in our opinion to bet against the current upswing in momentum while the fundamental backdrop remains credible. Longer term, we still think that market participants are too optimistic about the prospect of a Trump presidency and Republican clean sweep. The eventual impact of his policies is much too multifaceted to be understood in advance, and the confidence with which markets have embraced the fiscal inflationary narrative leaves plenty of room for concern. This rally can push valuations, with the ‘P’ of price outpacing the realized ‘E’ of earnings in the traditional P/E method of market valuation, but we believe this relationship will revert to lower than current levels with a force that continues to grow as the current rally stretches on. Justifying the multiple in the last leg of a bull market is the venerable game being played out now.
In Europe, the Eurostoxx 600 Banks Index has risen over 50% in the last six months, with the December rally spurred on by a partial resolution of issues in the Italian Popolare banks. Despite the significant move, the data suggest to us that the sector remains cheap on a number of valuation metrics. Hedge fund managers are eyeing the sector with interest, but remain wary that the issues remain far from fixed – and that there have been many false dawns for the sector over the past six years. On a broader note, the Italian FTSE MIB Index gained 13% in December, continuing the 2016 theme of an Equity market rally after an apparently market-negative election result, but in our view the country remains a significant risk to the Eurozone. The growing debt-to-GDP ratio is higher than all of the other major economies in the currency bloc and the longer term impact of the referendum remains to be seen.
While we think the market is overly optimistic about the Trump reflation story, our outlook on inflation is also uneasy. If we are to see inflation, then we believe Commodity prices are a likelier source than the more benign fiscal expansion, and it is as hard to see this as a victory for Central Bank policy as it is to see any real economic benefits that might flow from it. The Bond yields we saw pre-Trump were not the natural market level, but rather a level repressed by extraordinary Central Bank policy. As such, the move back to more ‘normal’ levels was as much in response to the expected (and delivered) rate rise from the Federal Reserve (‘Fed’) as it was about increased inflation expectations. We should note that Bond yields could rise much further in the potentially inflationary worlds than they could fall in the deflationary ones. Furthermore, the investment community remains overweight Bonds even after the recent moves and we believe there is a lot of speculative money to move out of the asset class should panic start to take hold. If Trump really does look like he is going to cut taxes and increase spending while potentially upsetting China relations then there might be another - rather large - seller of Bonds to add to this consideration. All of which leads us to the conclusion that even without the Trumpian Kool Aid we could expect higher Bond yields at some point in 2017, though they needn’t stay up there in our view.
From a political angle the world feels more insecure than it has for a long time, and the risk of an exogenous shock to financial markets is higher than average in our opinion. If the more pessimistic commentators are right, then Trump and Brexit are the first indicators of a downswing of global economic integration (see the recent decision by Ford to scrap plans for a new plant in Mexico as a possible guide to business under Trump). The unwinding of global trade could be fast – and who knows how that might play out? Elsewhere, it is much harder in our view to envisage a market-positive response to a Le Pen victory in the French general election than it was for Brexit or for Trump.
In conclusion: In our view, Equities look expensive, Bonds aren’t cheap, and the risk of a major shock is higher than average. Are there any reasons to be cheerful? From a hedge fund perspective, absolutely. Much of the frustration in 2016 was due to the high correlation of macroeconomic factors and low volatility of risk assets. We expect both of these to change in 2017. The Fed, the European Central Bank and the Bank of Japan are now on the most clearly divergent paths for at least a decade and the normalization of the discount rate should, we think, lead to more rational and individually differentiated pricing of risk assets. This is not calling the turn – we are already there. Hedge fund returns have been improving for the past few months, which gives us a bit more confidence for 2017.
The hedge fund industry finished 2016 with positive performance across most strategies in December. The HFRX Global Hedge Fund Index returned +0.86% in December, as increases in the value of risk assets helped managers with net long exposure. The best performing managers were in the Managed Futures and Global Macro strategies, although Relative Value, Equity Long-Short and Credit strategies also produced positive returns.
Managed Futures managers accumulated gains in December that were primarily driven by positive performance in Equities and partially offset by losses in Commodities. FX and Fixed Income were minor contributors overall. In Equities, Managed Futures managers entered the month net long across the board and capitalized on the move higher in developed markets. The majority of the gains were generated in the first half of the month. By region, gains were most notable in the Eurozone. In Commodities, their losses were mainly driven by industrial metals and grains and partially offset by gains in energies. Long copper, long soybeans and short corn were among the biggest detractors while long fuels generated gains.
Discretionary managers overall had another positive month as most benefited from monetary policy divergence. Managers saw gains from the continued USD rally, notably versus Asian currencies. USD/JPY has been particularly susceptible to widening yield differentials, and long USD/CNH has been a prevalent position for discretionary managers. Fixed Income exhibited greater dispersion in December, and managers with more diverse regional positioning (including longs in emerging markets rates) outperformed managers with uniformly short developed markets rates positions. Several managers also gained on the rally in European and Japanese Equities, on the view of further policy accommodation in these regions. Long crude oil positions contributed on the month as several managers increased their holdings on the OPEC reduction announcements.
In Event strategies, managers focused on special situations and M&A were positive overall in the context of supportive Equity markets and the VIX in a fairly low and tight range month relative to other intra-month moves in 2016. Deal spreads tightened slightly, as St. Jude/Abbott received Federal Trade Commission (‘FTC’) approval following prior MOFCOM (Ministry of Commerce, People’s Republic of China) approval and the LinkedIn/Microsoft deal closed. An exception was Cabela’s/Bass Pro, which widened at month end on news of facing further FTC scrutiny and delays in its separate sale of the credit card business to Capital One. Deal flow in December was about $300bn, plus over $200 billion of “proposed” or more speculative potential deals. Notable signed deals included Linde/Praxair ($35bn stock) and Sky/Fox ($15bn cash). More speculative situations included reports involving Mondelez and Heinz, and reported talks between Actelion and potentially competitive bidders Johnson & Johnson and Sanofi.
December performance was positive across all Credit strategies. Corporate credit managers (Credit Long-Short and Credit Value) benefited from positive returns from outright as well as hedged trades (cap structure arbitrage; primarily long Credit versus short Equity), especially in Commodity-related sectors. Financials, primarily driven by floating rate securities, were once again a bright spot in December. Equities, in particular post-reorganization, were generally a positive contributor while portfolio hedges were a drag on performance.
It was a solid finish for the year for U.S. and European levered Credit markets. U.S. High Yield outperformed the European High Yield market in December. U.S. and European High Yield markets outperformed the respective investment grade markets and leveraged loans for the month. For U.S. High Yields and loans, performance was driven by higher oil prices and positive inflows into both High Yield and loans. Similarly to the Equity markets, there is optimism with regards to potential policy changes regarding less regulation, tax reform, etc., from the incoming U.S. administration.
Lower-rated and distressed credits (U.S. High Yield) generally posted positive returns in December and outperformed higher-quality Bonds. Not surprisingly, given the rally in crude oil, the Energy sector was the best performing U.S. High Yield sector. All U.S. High Yield sectors posted positive total returns for the month of December. Net new issuance in the U.S. High Yield market hit a year-to-date low in December while it was a healthy month for U.S. institutional loan volume.
Convertible Arbitrage managers also saw positive returns driven by improved valuations on tighter Credit spreads. Positive performance for Structured Credit managers was primarily driven by portfolio carry with positive mark-to-market across most sectors generally offsetting the drag from portfolio hedges (Equity, Corporate Credit, CMBX, etc.).
Equity Long-Short managers also generated positive returns in December, with the best returns coming in from European managers with more fundamental exposures. This region had lagged other regions throughout 2016 in terms of alpha, but recovered as the Italian referendum passed and Equity markets rallied.
For Statistical Arbitrage managers, December was a negative month to conclude their worst year post 2008. Futures strategies in particular seemed to suffer from the extended rally in Equity markets over the month, particularly in some European markets. Fundamental strategy performance was mixed, but the broad pattern of outperformance of those managers tilted towards valuation based metrics continued. The performance over the year as a whole has been desperately disappointing, with a number of potential causes frequently cited. Our view is that investors should distinguish between transient causes and those of a more structural nature. Certain areas of fundamental strategies have undoubtedly become more commoditised, and are therefore likely to exhibit lower Sharpe Ratios. Overall, we remain optimistic about the potential longer term performance of the strategy, however the selection between managers becomes increasingly important as the size of the space grows.
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