FRM Early View - June 2018
- Deleveraging contributes to market volatility.
- Signs of a global repricing are being driven by the emergence of catalysts rather than fundamental weaknesses.
- Hedge funds performance was mixed in June, with a good first half to the month tempered by rising volatility in the last two weeks.
Markets are behaving strangely, at least from the perspective of the hedge fund or the hedge fund allocator. Hedge funds tend to have little direct exposure to the turmoil in Emerging Markets, or political situation in Italy, or the volatility caused by Trump’s on-then-off-then-on-then-off Trade War rhetoric. And we have spent much of the last few years arguing that hedge funds need an environment of higher volatility (tick) and higher interest rates (also tick). So why do so many managers feel like they are wading through treacle rather than shooting the lights out?
There are rumours about deleveraging and redemptions, particularly in the arcane world of Quantitative Equity Market Neutral. One may be sceptical about explanations that hinge on flows because in the undignified scramble to make sense of market movement, we all tend to worry more about the intuitive appeal of the narrative than the evidence that supports it. Since ‘flows’ are often highly confidential, hard evidence can be hard to come by. There is also the small matter that for every seller there has to be a buyer, so the volume of activity only means anything when read together with the price moves we are trying to explain: and so, without more information, the argument quickly turns circular.
Managers who suspect deleveraging do so because they are observing the same evolution of losses each day: things are fine first thing in the morning and then as the day unfolds, normally uncorrelated positions move progressively against them to the close. The accounts are confused because the timeframes over which they see the market are variable. For example, some may be trading short term mean reversion so the first few days of the episode may work well for them, only for the more extended moves to draw them into the same misery as the longer term traders against whom the moves started in the first place. There is corroborating evidence in the squeeze on widely borrowed shorts, the apparent indifference to valuation, and from the sharp sell offs in Cross Sectional Momentum and the Goldman Sachs VIP index.
Of more general concern here is that over the last few years the hedge fund industry has been restructuring. In part, this reflects the movements of people and capital between funds where the news flow at the moment is particularly intense. This may only be short term, but there has also been a material move towards daily liquid, systematically managed, highly levered books (some of which are branded ‘alternative risk premia’) such that losses could theoretically trigger redemptions which force deleveraging which in turn may engender more losses… and so on. As the portion of the market still actively managing their books shrinks, the ability to find the liquidity provider for the more commonly held trades may be problematic. Perhaps something of this nature is going on now. We keep asking ourselves where the leverage is. Well, some of it is here no doubt.
One could, of course, argue that systematic traders might well struggle with the impact of the Trade War. There isn’t much in the historic data from which to learn about the Trump administration’s industry specific sensitivities. Perhaps the Dow feels the same way as it chalks up its longest ever continuous string of daily declines. Maybe this is a trigger, but interestingly, it is the flows, not the Trade War about which the managers have been talking.
So what? Is this a storm in our teacup or does it mean something larger? Is it just a quarter end phenomenon? Last month we were looking for bigger picture connections between higher volatility, Emerging Market stresses, the rising US dollar and the flattening yield curve in the US, all of which could be attributed to the Fed and their program of higher rates. We should add deleveraging to the list.
But list of what? The list of points that may suggest a premature end to an overlong cycle, of course; the ever pressing big question; the one that puts us in the inevitable narrative with a sense of an ending. A fast building consensus in the economics community is looking to 2020 for this ending. Indeed, some economists are even wondering if the consensus is now so well established that it will be self-defeating. But there are a bunch of potential reasons not to spend too much time on this. First, even economists know that their forecasts might not be worth much. Second, they are trying to forecast growth while we are interested in market conditions. If there is anything to know, the market conditions will get there first. Third, we’ve never seen a cycle quite like this, and we see little reason to believe that traditional (and flaky) predictors of cycle-end will work any better this time. Politics has confounded the political forecasters everywhere and as the news headlines attest now, politics could confound economic forecasters too, very easily.
But there is a fourth reason: when we come to unpick the structure of this rambling drama we suspect the apotheosis will be all about flows. For the last ten years, significant sums of money have been printed and stuffed into the market. Simple observations about the reversal of these flows could be far more telling than long chains of argument about economic causation. A punch in the face ends most arguments.
Equity Market Neutral is a tiny microcosm in the universe of asset management, but the underlying drivers of exposure in this space are not peculiar. We are confronting thin risk premia with growing risks everywhere. As they declined, leverage increased along with the risk and those flows supported wish fulfilment, but only up to a point. Since the beginning of this year, a whole series of metrics which went up in a straight line from the beginning of 2016 have been churning furiously. These market dynamics are fascinating. Not for the first time we conclude – follow the money.
Hedge fund performance was mixed in June, with Credit and Macro strategies performing positively and quantitative strategies such as Statistical Arbitrage and Alternative Risk Premia underperforming Equity strategies, both Equity Long-Short and more Relative Value focused strategies generally produced positive returns. The shape of returns during the month was somewhat similar to May, with a positive first half to the month tempered by rising volatility in the last two weeks.
It is perhaps illustrative of the uncertain nature of equity markets that the Equity Long-Short managers that we follow have been moving their risk allocations more frequently than usual. Managers who are comfortable with a variable market bias (i.e. who may run net long or net short depending on circumstances) have generally been switching from bullish to bearish through June, finishing with more pronounced net short exposure than we have seen for some time. Similarly, aggregate net long exposure to equity market for the Equity Long-Short universe has also been coming down, based on the data that we have. Factor attribution of Equity Long-Short managers was hard in June, as different periods saw different behaviour. The first half of the month was generally positive for Momentum and negative for Value and Quality, although Quality metrics recovered in the second half of the month as Momentum pulled back.
Event Arbitrage strategies experienced a generally positive June, helped by the closure of Relative Value spreads through the first part of the month, particularly Merger spreads and Holding Company Arbitrage spreads. Some of these spreads widened in what appears to be deleveraging activity toward the end of the month.
As discussed at length on the previous page, Statistical Arbitrage managers struggled during June, although aggregate losses don’t appear to be excessive to us. In our experience, it was the more traditional strategies that struggled, which we believe is indicative of negative flow dynamics in markets, whereas the most idiosyncratic strategies generally performed positively. For instance, Emerging Markets focused strategies produced positive performance despite the heightened volatility in those markets, with the biggest losses occurring in the comparatively sanguine US market.
Our managers in Discretionary Macro posted mixed returns with clear differentiation between defensive positioning that benefited from short exposure across Emerging Markets and selectively in developed markets as well as Fixed Income Relative Value positions in developed markets generating profits. On the negative side managers with pro-risk exposure in Emerging Markets, primarily in FX and interest rates suffered losses.
The general view held by our Macro managers is that the Fed reaction function doesn’t incorporate any substantial sensitivity to yield curve shape because they think the flatness is explained by technical factors, primarily global QE whose importance would recede in the coming quarters. Thus the Fed is expected to focus on real economy data and continue with the hikes regardless of the yield curve shape. Ditto the European Central Bank (‘ECB’), whose announcement to stop Bond purchases seemed to have little regard for timing, coming into the midst of Italian political turmoil.
There are signs that we could be witnessing a global repricing and the sequence may have more to do with the emergence of catalysts than with relative fundamental weakness. Emerging Markets was at the forefront of the sequence as its need for financing in hard currency (twin deficits) across several countries triggered the repricing across asset classes with an epicentre in FX. When other segments of the global market landscape face catalysts for repricing they may also suffer meaningful pressure.
June was a generally positive month for the CTA industry. Despite some volatility through the month, none of the major asset classes was a major contributor on either the positive or negative side. Generally, Fixed Income and FX were positive contributors, while Equities and Commodities were a detractor. In FX, almost all managers are short currencies versus the US dollar, and the stronger US dollar trend continued (albeit with less strength than in May). Short positions in US Fixed Income more than offset losses from long European Fixed Income. In equities, long positions in the US were a positive, but these were offset by losses in Asian equity markets. In commodities, long energy related products continue to be the main detractor. Short positons in Agricultural markets were the main positive driver in commodities.
Corporate Credit, with the exception of Investment Grade, held up despite renewed global trade tensions triggering market volatility heading into month end. US high yield outperformed leveraged loans and the European high yield market. Retail and Telecom were among the best performing US high yield sectors last month. Lower-rated credits were well bid. US high yield spreads remain within striking distance of multi-year lows as secondary valuations continue to be supported by below average issuance given the competition from the loan market.
Corporate Credit managers were mostly positive in June with returns driven by several positive idiosyncratic developments including an exchange, a restructuring deal and an ‘amend and extend’ transaction given the accommodative markets. The Puerto Rico Municipal Debt complex also did positively on news of an agreement in the dispute regarding priority issues between the General Obligation (GO) and sales tax (COFINA) bonds.
Structured Credit managers were also largely up in the month as spreads across most securitized products sectors were generally healthy with weakness only in some of the higher beta sectors like Credit Risk Transfer. Some managers selectively added risk seeking to take advantage of a large portfolio sale early in the month.
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