FRM Early View - March 2018
- Markets spent most of March on the back foot, as discussions around inflation and higher rates were replaced by new concerns of a potential trade war between the US and China.
- Despite continued volatility in equity markets, most hedge fund strategies performed better in March than they did in February.
- The accumulation of technical, isolated and contained market disruptions could be the proverbial canary in the coal mine that presages a more substantial regime change.
Markets spent most of March on the back foot, as discussions around inflation and higher rates were replaced by new concerns of a potential trade war between the US and China. At least some of the actions from President Trump can be written off as purely posturing, not least certain tariffs which are expected to hurt US business more than help them and the flip-flopping between an aggressive stance one-day and a host of exemptions and a more conciliatory stance the next. But on the broader message of protecting America’s interests, he has been, at least for him, remarkably consistent. Either way, markets are sufficiently jittery following the sell-off in February to not react well to developments that might hamper growth and risk stoking the already-smoldering fire of inflation.
At least a talk of a trade war makes a refreshing change from talk of a nuclear war. The de-escalation of tension around North Korea and announcements of dialogue between Kim Jong Un and (separately) South Korea, the US and China, means that most of the ‘good news’ around the easing of geopolitical tension in the region is probably now in the equity market price. In our view, it is hard to see how the US/North Korea talks can lead to anything material – since Kim is unlikely to give up his only bargaining chip, his nuclear program – and the risks of this unravelling in the face of more jittery markets should not be underestimated.
All of which means that capital markets could continue to be more volatile this year than they have been in recent history. In 2017, the Vix Index closed above 15 on only a handful of occasions. In the two months since the equity market sell-off in early February, it has closed below 15 only once. Those who heeded the advice of many commentators and ‘bought-the-dip’ in early February are looking less confident now. Most Developed Markets finished March close to, or below, their lowest levels in February, and there is much less talk of buying the dip this time than there was six weeks ago. One only has to look at the record outflows seen on some large cap equity ETFs to see how much the bid has evaporated.
Perhaps the most interesting part of all is the US yield curve. The 2yr-10yr spread in the US remains stubbornly low, at around 50-55bps, since the latest wave of equity market selling has been a risk-off move with people buying back into treasuries. One of the highlights of the first Fed meeting under Chairman Powell was the increase in the dot plot for 2019 and 2020, which means that the middle of the curve is underpricing the actual policy makers’ expectations. Assuming the policy makers are right, then there is significantly more pressure to be placed on both credit funding and equity discount rates as we move through 2018.
For hedge funds, this world feels a bit more interesting. They have become increasingly cautious on taking equity beta, in particular, CTAs have much more risk averse positioning now than they did at the start of the year, and managers are generally quite excited about the potential opportunities arising from higher volatility and more areas of distress in both credit and equities. After close to a decade of watching the S&P 500 print the kind of Sharpe ratio that most hedge fund managers could only dream of, there are a few strategies sitting on gains for the year in the face of equity market losses, and a fair few more that are protecting capital through the worst of the market noise.
So where do we go from here? If this is an inflection point, we are probably still nearer the start than the end. Despite faster market participants reducing their equity exposure in February and March, broader market positioning still feels quite full, in our view. The aggregate holdings that build up over 10 years of flows into passive and risk-parity programs could take some shaking out. Thus far, talk of systemic risk has been muted, but investment grade CDS spreads have risen steadily throughout the year, from around 35bps at the start of January to around 120bps at the end of March (with a more marked increase in March rather than during the initial signs of equity market panic in February) and the Libor-OIS spread continues to widen.
This seems odd since the consensus view is that there is no real stress in the financial system. Banks are stronger and have healthier balance sheets than any time in the last ten years, while other market indicators of stress are certainly not flashing red or even yellow. For example cross-currency basis markets are telling us that there are plenty of US dollars around, with JPY and EUR basis tightening over the last few weeks (i.e. becoming less negative). Nonetheless, it feels reasonable to be suspicious about ‘technical’ market disruptions in equities, investment grade credit and cash funding spreads. These appear unrelated, but are conspicuously correlated at the same time as we are transitioning from an era of low rates, low volatility and easy financial conditions to something that looks and feels less comfortable. The accumulation of technical, isolated and contained market disruptions could be the proverbial canary in the coal mine that presages a more substantial regime change. One suspects that Goldilocks will not go away quietly.
Despite continued volatility in equity markets, most hedge fund strategies performed better in March than they did in February. Given the higher levels of asset volatility, there was greater variation in individual manager returns, but several strategies eked out flattish or small positive returns for the month.
In Equity Long-Short, European managers generally performed better than their US peers due to a lower aggregate net exposure and less reliance on Technology stocks on the long side of their books. The tail end of the Q1 earnings season was broadly positive for managers as stocks continue to behave more rationally in the face of good/bad news, and managers are seeing short alpha in March (which was harder to achieve in February despite the market sell-off). There were a number of days in the month that witnessed outsized returns (both positive and negative) for cross-sectional momentum. Our own opinion was that these represented rotations within the equity market rather than a deleveraging event, but these are always hard to pin-point.
March returns for Corporate Credit managers had a negative bias with a few exceptions. Managers focused on (floating rate) financial preferreds and hybrid debt outperformed. A disappointing bankruptcy asset sale of an E&P company negatively impacted returns for several credit managers while a few managers saw gains on some idiosyncratic credit shorts (e.g. healthcare names). Puerto Rico exposure was also a meaningful contributor for some while reorg. equities were generally a detractor. Structured Credit managers outperformed in March with mostly positive (carry-driven) returns.
On the whole corporate credit markets tracked equities lower, especially during the volatile back half of the month (driven by a perceived hawkish Fed rate decision in the US and the potential for a US/China trade war as both countries announced tariffs). Leveraged loans once again outperformed high yield, supported by continued inflows into the asset class and the persistent rise in Libor. The investment grade market held up much better compared to February as rates were somewhat range bound. Within US high yield, lower-rated credits underperformed and returns were negative for a significant majority of the industry groups. Retail and Energy were among the worst performing sectors. The latter was a bit surprising given the rally in oil.
March performance for securitized products was mixed with mostly stable spreads across the legacy structured credit sectors with some of the newer and higher beta sectors like credit risk transfer (CRT) experiencing spread volatility alongside corporate credit. Floating rate risk once again outperformed. Puerto Rico bonds staged another rally in March as a revised fiscal plan projected a higher surplus in the coming years.
In Macro, the widening in funding spreads have so far only affected the strategies that are closely tied to funding markets, with a net positive effect on the opportunity set for Fixed Income Relative Value and other liquidity provision strategies. There have been meaningful moves in cross-currency basis markets and implied repos in derivatives which are relevant to managers’ positions and generally positive in March but noisy on a year-to-date basis. Emerging Markets remain resilient across asset classes on the face of Developed Market turbulence, with little beta expansion to report, primarily, in our view, due to the structural weakness of the USD which has puzzled many in the context of widening interest rate differentials.
CTA managers had a mixed month, with winning positions in Commodities and FX and a mixture of winners and losers in equities and bonds. In commodities, P&L was driven by long positions in energy commodities, particularly oil, while small long positions in gold were also positive. The largest FX positions were long euro and sterling versus the dollar, with smaller positions also long the yen versus the dollar. Equity positioning is now much more subdued than at the start of the year, with broadly short exposure to European indices (leading to positive returns in March), and still some long exposure to the US. Fixed income exposure broadly lost money during the month, as managers are short US government bonds, which rallied on the risk-off move through the second half of the month.
After a positive February, Risk Arbitrage gave back some gains. The spread widening felt broad-based and there were a few environmental concerns weighting on merger spreads such as i) fears around a potential trade war between the US and China leading to some widening in deals requiring the Ministry of Commerce of the People's Republic of China’s approval and ii) widening on deals requiring Department of Justices’ approval as the Time Warner/AT&T hearing started. Event RV did poorly during the first half of the month but bounced back in the second part of the month as volatility picked up.
In Merger Arbitrage, deal activity was again robust in March, with ~USD 300bn of new deals being announced so far this month (excluding proposed deals; source: Bloomberg). More generally, global M&A activity has started off strong for 2018; it has reached USD 1tr already, up more than 50% from a year ago. Also, a flurry of jumbo deals have been announced.
In Statistical Arbitrage, it was a relatively volatile month. Generally the increased volatility in markets has been a positive for technical strategies, while slower more factor driven strategies have struggled with more broader-based deleveraging and market rotations. By region, Europe continues to be a positive for the strategy, while Asia (and particularly Japan) was difficult again. In Asia, this appears to be at least partly driven by a continued struggle for Value metrics. The US was interesting, with more technical managers generally performing positively, while the slower more factor driven strategies suffered during the increased volatility in the first week of the month.
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