FRM Early View - December 2018
- Large parts of the hedge fund industry held up despite the S&P 500 Index suffering the worst December since 1931
- Longer term expectations for growth may be limited as bond investors are continuing to accept negative real yields
- The outlook for alpha driven alternatives looks more attractive in our view as we enter the increasing uncertainty of 2019
Christmas and the New Year tend to bring out the extremes of people’s behaviour. Overindulgence on food and drink over the festive period is offset by the purgative resolutions of exercise and sobriety in early January, before we all abandon such hope of change and revert to our normal selves a couple of weeks into the year. Equity markets had a rather longer window of binging on loose monetary policy, before the fourth quarter of 2018 provided some ‘P/E Multiple’ cleansing, culminating in the worst December return for the S&P 500 Index since 1931.
For all the bluster in October and November, US equities were only down 5% through the quarter coming into last month. With cyclically-adjusted valuations still close to record highs and a higher level of ambient volatility to price into the risk premium, it appeared that the rational direction for markets to travel into the end of the year was surely down. The only thing seemingly stopping the bears was history, since December is historically the best month for equity market returns over the last 50 years. Well, so much for precedent. After the feast and famine, where do risk assets go from here, and is there a ‘normal’ pattern to resume?
As ever, a good place to start is the bond market. On the first trading day back in the office after the New Year, the German 30yr bond was trading at a yield of 79bps. While not quite plumbing the depths seen in 2016, European investors are starting 2019 willing to accept a negative real yield on their ‘risk-free’ assets for the next three decades. The situation is the same in the UK, with 50yr bonds trading at a yield of 169bps, and even US 30yr bond yields have fallen back to around 3%, only marginally higher than where they started 2018 despite four rate hikes in the interim. Negative real yields are certainly not new, but in our view they are much more interesting than the gyrations in the equity market.
We’ve talked at length previously about our worries that inflationary behaviour causes a sell-off in both equities and bonds at the same time, which would be problematic for most investment portfolios built around those two asset classes and predicated on some form of negative correlation between the two. As such a more orthodox ‘risk off’ move such as the one seen in December is somewhat reassuring. Active managers appear to be having a similar experience – returns to fundamental valuation metrics in most equity markets in December were positive (i.e. high-quality cheap stocks outperformed low-quality expensive ones), and the overall shape of returns from market neutral equity participants was more benign than the index returns might suggest.
Given the willingness for investors to accept such low long term rates, one has to conclude that longer term expectations for growth are limited. The secular stagnation thesis generally focuses on such a long-term horizon as to be unfalsifiable, but we feel there is little in the current situation to suggest that the new normal isn’t characterized by low inflation and low growth. So maybe we are back to the tug-of-war on equity valuations that arises from low bond yields – why pay 30x earnings for stocks in a low growth world vs why not pay 30x earnings for stocks when bonds pay much less. Trying to predict the future path for equities from here, particularly following a decent sized drawdown, is as impossible as ever. As the market tries to ascertain which of these narratives will dominate, in our view a slightly more confident prediction is that equity market volatility could, at least, be higher in the post-QE world than during QE.
Taken to its logical (and possibly wrong) conclusion, we think it is worth revisiting the worries around the ‘Japanification’ of the global developed economies. Given the difficulties in tightening monetary policy in a low growth world, the world could feasibly drift into a prolonged situation with ever-rising government debt-to-GDP levels (as fiscal alternatives to stimulus are sought) supported by ever-lower financing costs and sideways equity markets. Such an environment has arguably been emerging in many European markets for the last 10-20 years already. Whether the US follows suit may hinge on whether new digital technology is inherently deflationary due to increased efficiency or the key to solving the productivity puzzle and therefore a boost to growth in the same way as previous technological revolutions.
All of which leaves the investor in something of a predicament as we start the New Year. Should they accept potentially miserly returns from fixed income or tolerate the more volatile world in equities and hope that longer term growth surprises on the upside. Against such a backdrop, the outlook for alpha-driven alternatives looks more attractive in our view, in particular those who are historically genuinely uncorrelated to market returns (the most recent quarter has helped to separate the wheat from the chaff in this regard). In particular, the most basic weapon in the hedge fund arsenal – shorting – might be a valuable addition to many investors’ portfolios as we enter the increasingly uncertain waters of 2019.
Hedge funds have clearly not covered themselves in glory during 2018, experiencing their worst year since 2008 and disappointing investors for the second time in three years following a poor 2016. However, the behaviour in December gives us more hope. In the face of significant equity market declines, large parts of the industry held up, with declines in hedge fund indices being driven by long exposure to equities and high yield credit rather than alpha. As we noted last month, the industry appears to have deleveraged significantly in October and November, leading to losses from Market Neutral strategies, but we didn’t see further waves of deleveraging in mid to late December as the worst of the market sell-off took hold. In fact, returns to Valuation metrics turned positive and remained subdued during the worst of the volatility at the index level, leading to better returns from Quantitative Equity managers than we have seen for a while.
Equity Long-Short managers had generally reduced both net and gross exposure aggressively in October and November, and as such were generally able to trade the volatility seen through December. As expected, longer biased managers struggled to overcome the headwind of significant equity market declines during the month, but lower net and Market Neutral managers performed better. Asian markets continued to be among the more difficult regions to trade, whereas European alpha seemed to be higher than in other regions. Managers with a Value bias also tended to outperform, although risk factor returns were noisy over different regions and time-periods.
December was another challenging month for the corporate credit markets on continued geopolitical uncertainty, declines in equities and crude oil, and heavy outflows from US high yield and loan funds. US high yield spreads widened to levels last seen two plus years ago with lower-rated credits (CCCs) on average trading at distressed levels. Leveraged loans were also hard hit with expectations of a slower pace of US rate hikes in 2019 leading to heavy retail outflows from the floating rate asset class. A noteworthy rally in treasuries helped the investment grade markets post a positive month. All US high yield sectors were negative in December. Energy and Retail were the worst performers while the defensive Utility sector outperformed. Primary markets were pretty much shut in the month given the volatility and the meaningful weakness in both loans and bonds.
Corporate Credit managers mostly posted negative returns in December as there were very few if any places to hide given the market backdrop. As one may expect, Credit Long-Short managers with single-name and market hedges outperformed the longer-biased Distressed managers with the latter most impacted by the equity exposure. US financial preferreds were once again particularly hard hit. Most securitised product sectors also saw spread widening in the month. Longer spread duration assets including lower-rated tranches of CLOs and credit risk transfer deals underperformed while spreads for legacy assets held up comparatively. December returns for Structured Credit managers were on either side of the flat line with carry offsetting most of the losses from mark-to-market.
December was a positive month for CTAs, concluding a generally negative year for the strategy as a whole. December was interesting due to the dispersion between manager positioning and performance across asset classes. Nonetheless, in aggregate by asset class, Commodity and Fixed Income trading was generally positive, while Equity and FX were detractors.
In commodities, crude oil and products was the largest driver of gains, with managers almost all positioned short. Natural gas was the largest detractor, suffering a large reversal following the strong rally in November. Most managers generated positive returns in Fixed Income, due to long positions across a range of geographies – US treasuries were the one detractor, with short positions working against managers. Equities were close to flat in a month that had large moves in headline indices. Short positions in Europe were positive and generally offset losses from small long positions in the US.
FX was also close to flat. Managers remain short FX against the USD (JPY is the only major currency that managers are long). Statistical Arbitrage managers had some respite in December following a negative run of performance through October and November, and in aggregate the strategy was close to flat.
Fundamental strategies generally benefitted from a notable month across regions for both Price momentum and quality based factors (though value continued to do poorly). As there always seems to be during poor periods, there were rumours of risk reduction going on in the space in October and November, with the theory that this was impacting the technical reversion players. Whether true or not, this clearly wasn’t the case in December, with many technical managers positive.
Other Relative Value strategies also saw positive performance, particularly in the light of the size of equity market drawdowns which can sometimes lead to material widening of risk spreads. The best performing strategy was Volatility Arbitrage, particularly those strategies with a long volatility profile.
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