FRM Early View - July 2018
- Markets return to an uneasy calm in July with rising equity markets and falling volatility.
- Commentators continue to watch the shape of the US yield curve for clues.
- Hedge funds generate mixed, but broadly positive performance on the month.
Every other month we are unpicking increased volatility in one market or other to find signs of the end of the economic cycle. In February it was equities; in April foreign exchange; and last month we wrote at length about the chaos in the quantitative market neutral strategies. And each time, thus far, investors have steadied themselves and markets have calmed, like a house falling apart brick by brick rather than as a sudden collapse.
Looking at the environment in which we started July, it would have been easier for concerns around Chinese debt levels or a stronger dollar to have escalated, potentially plunging EM economies again into another wave of difficulty. Or we could have seen a continuation of the pain in quantitative strategies as managers and investors reacted to the losses in June by taking down gross exposure or exiting strategies altogether, exacerbating issues caused by deleveraging. Neither of these appears to have happened, but with each mini-crisis the list of concerns with financial markets grows. So what’s next?
Rates tend to be the driver of each chapter in this story. The US yield curve spent much of July trying (and failing) to steepen. It’s hard to know what to make of this curve shape – we haven’t ever experienced tightening from such a low base, in a global fashion, after such an extended period of printing money. Larry Summers, Thomas Piketty and others have long argued that a period of lower growth should follow the higher growth rates of the second half of the 20th century. Regardless of how much weight you give to the secular stagnation thesis, it seems reasonable to us to conclude that the ‘new-normal’ for interest rates in the post-QE world is lower than before – after all, it has taken most developed economies the best part of a decade (and the best part of the whole economic cycle) to prise their rates away from zero.
The US was always going to be the first mover in the rate normalization game. So perhaps the flattening curve just tells us that the Fed has overcooked its rate rises – to fight the phantom of inflation that was never going to materialize anyway? Not so fast. All of that printed money has bought the long end of the curve. Until the Fed starts to unwind their balance sheet we believe the long end to be anchored somewhat lower regardless of demographics or economics. The old adage that flat yield curves predict recessions seems to lack credibility – if we only have a flat curve because of QE, then this time really is different. Most of the hedge fund managers that we speak to seem to agree.
But what if the Fed has raised rates too quickly and Chairman Powell is too proud to reverse course? This is still speculation at this stage, since the yield curve pretty much exactly matches the dot plot, so it would appear that investors and policy makers agree for the time being. But we should watch the Fed’s behaviour if the market starts to price rates significantly below the dot plot – will a relatively new Fed chairman have the mettle to change course, particularly if it risks giving some credibility to the rather obtuse recent attacks from President Trump? And even if he is wrong, maybe he doesn’t have to change course – the latest macro data suggests that the US economy might be strong enough to survive tightening too quickly as the pain would be felt elsewhere in the world. However, the stronger dollar that comes from this path risks inflaming the other Trump bugbear – the trade deficit.
We believe one way out of the flat yield curve dilemma may come from an unlikely source. There are increasing expectations that the Bank of Japan could make changes to its current monetary policy framework, expanding the band around its rate target. This could be bearish for bonds and is important beyond Japan, as anchored Yen rates have been a force that has kept global core rates from moving higher too far too fast. Some macro hedge fund managers are developing new products to bet on US yield curve steepening for precisely this reason, but we believe we need to see more evidence before betting too strongly on this thesis – after all, what difference is an extra 10-20bps on the Japanese 10yr bond really going to make to anyone except Japanese bond investors with a global remit?
For what it’s worth the equity market seems less interested in the recessionary implications of this curve shape than we are. The S&P rallied 3.6% in July, helped by around 90% of companies reporting earnings beats in one of the best earnings seasons in recent times (thus far). ELS managers have been reducing net exposure through the first half of the year, but more as a reaction to a more volatile world, not so much as a call on the market direction. When pressed, the managers that we speak to both a) talk a more bullish story than they have been for a while, but also b) act less sure of their forecasts. For many of them, a market squeeze up into the end of the year is, if not quite the ‘pain trade’, then perhaps the slightly uncomfortable trade from here.
If balance sheet management is one possible source of return for which the managers appear in need of a little more courage, then the other may be from idiosyncratic stock returns. Here too there is some evidence of nerves. If share prices are punished more severely for earnings misses (or even beats that are somehow underwhelming) the higher and later the cycle, then Facebook and Twitter just issued us a wakeup call. For what it’s worth, this type of fat tailed single stock behaviour has been an increasingly evident characteristic of the European market since mid-May. Our rough sense is that though the losses of the last six weeks have abated, managers are taking less gross risk. So what to conclude? Perhaps the most undervalued component of the active manager’s armoury relative to a passive competitor is the ability to reduce risk in face of increased uncertainty. They won’t always get it right (and there have been plenty of false starts over the last couple of years) but that may be a small price to pay for getting it right when it matters.
July continued the difficult year for hedge fund performance, with mixed performance across strategies (as has so often been the case in 2018). On the whole, risk asset strategies in equities and credit performed better, helped by a strong earnings season and generally rising markets. Relative Value struggled, due to a hangover from the quantitative market neutral sell-off in late June and the underperformance of Event Arbitrage strategies around high profile deal breaks. Macro strategies were generally mixed, as markets reversed some of their June moves which hurt some trend following strategies.
Starting with equities, as expected, managers with higher equity market net exposure generally did better in July as markets rose, with US exposure proving to be the most fruitful. Managers are generally slightly more bullish than they have been for some time, supported by the apparent resilience of macro data and corporate earnings twinned with the fact that the general risk reduction environment of the first six months of the year means that some of the ‘fast money’ from markets may have been flushed out already. Alpha generation in non-directional managers was muted but generally positive, again supported by the earnings season. A notable detractor on the month was a social network company, which is well held by the hedge fund community and whose shares plunged after missing top-line estimates.
In a risk on month supported by improved sentiment, global credit markets rallied alongside of equities while US treasury yields were higher. Notably, after lagging for the past two months, EM and European credit markets posted healthy returns. US investment grade credit also showed some strength after underperforming for most part of the year. New issuance in US high yield continued to be driven by a decline in refinancing activity leading to one of the slowest months in the last five years. Corporate Credit managers were generally positive in the month but returns were more modest compared to June with few meaningful single name performance drivers. Several distressed credits and equity reorg names that had positive idiosyncratic news in June continued to see positive momentum. Managers with larger reorg/value equities exposure outperformed. Credit shorts were a drag on performance.
In Structured Credit, it was another month of relatively muted price moves with spreads stable across most securitized products sectors. Private student loans saw some renewed interest as there was a large block that traded on a bid list and there were a number of other secondary trades. Otherwise trading activity was light in the month. Corporate and CMBX hedges were a drag on performance for some managers. Overall, it was another month that was largely driven by principal and interest income.
During the month, risk arbitrage had mixed performance. Overall, deals are progressing at a healthy pace towards completion and the pipeline of new deals remains robust. Vertical integrated deals and cross border deals remained the focus of attention during the month. In vertical integrated deals, the bidding war for a media company ended with one bidder (a telecommunications company) dropping its offer and focusing on purchasing a newscaster company instead. Sector focus has now shifted on whether another bidder (a media company) will top the telecomm company’s offer for the newscaster especially after the company reported attractive sales and subscription numbers during the last week of July.
A telecommunications equipment company/a global semiconductor manufacturer deal break was a notable detractor across the sector during the month of June. The former walked away from its bid to acquire the latter as the Chinese regulators failed to give their sign off given the mounting trade tensions between the US and China. As a result, the semiconductor company sold off and managers across the sector reduced exposure.
In Statistical Arbitrage, returns have stabilized after a difficult June, but haven’t rebounded as strongly as we have seen in previous dislocations. However, there was a danger that the poor performance in June might have led to a run on the more liquid products trading quantitative equity market neutral strategies, which in turn could have led to deleveraging, which it appears has not happened. More broadly managers in this strategy continue to find it difficult to add value while stock specific volatility remains so low. It may be a natural output of the fact that investors are increasingly accessing markets through passive or factor based products, rather than active managers, therefore most of the flow impact on markets is leading to market or factor volatility, rather than single stock volatility (as would be the case with higher volumes of active management).
CTA managers saw gains in equities as they tend to still hold long exposure to the asset class. Most other asset classes lost money in July. The main differentiator between the better and worse performing managers was the speed that they were able to re-enter and build up US equity positions into the rally. Across the board managers are still close to maximum levels of short FX exposure (versus a long dollar position), which detracted from performance during the last third of the month as the dollar softened.
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