FRM Early View - November 2016
- The HFRX Global Hedge Fund Index returned 0.87% for the month
- The recovery in Equities following the US election has been positive for the hedge fund industry as a whole
- Financial markets continue to digest higher Bond yields and a stronger US Dollar
The most striking development in financial markets in November was not the surprise election of Donald Trump. It was the certainty of what a Trump victory would mean for markets, and how much this narrative changed from one week before the election to one week after the election. Remember that the initial reaction on November 9 was a sharp sell-off in Equities and a greatly reduced likelihood of a Federal Reserve (‘Fed’) Interest Rate rise in December. Some banks issued research pieces in the early hours (no doubt prepared before the election ‘just in case’) stating that this was bad for Equities, good for Bonds, bad for the US Dollar.
Within hours, the market had confounded expectations. Time for a quick about-face; Trump, and the Republican clean sweep, is reflationary. The new narrative had to fit the market data - good for Equities, bad for Bonds, good for the US Dollar. By the end of the month the initial scepticism was a distant memory. The S&P 500 Index reached new highs, US 10 Year Treasury Bond yields and the Dollar-Yen exchange rate saw their biggest moves since 2009.
And therein lays the quandary. Ask anyone to list the possible sources of uncertainty in financial markets next year and the list in our view is longer than in any year since 2008 (and from a geo-political angle, since much earlier). And yet the VIX Index remains at 12, the chance of a Fed Interest Rate rise in a few days’ time is 100%, and FX and Bond markets have quickly priced the new regime with a surprising degree of certainty. Perhaps, since Trump represents one of the most uncertain political developments of the past few decades, we all cling more tightly to the comforting certainty of the new narrative. Just look at how much markets reacted to the fact that he said nothing too controversial in his short victory speech.
Former US Ambassador Dennis Ross said of Trump’s foreign policy, that “anybody who feels they have a definitive answer should be viewed with a high degree of caution.” We feel the same way about his impact on markets. In a post-quantitative easing world full of excess cash, markets in our view are primarily driven by changes in positioning rather than changes in fundamental data. Positioning in Equities was light coming into the election and Bonds have arguably been overbought for the past year; even with the recent moves, the 10 Year US Treasury Bond yield is only back to roughly where we started in 2016. The change in Bond yields has mirrored the change in long positioning in Bonds held by our CTA managers – in particular, the sell-off in Bonds seemed to stabilize at the same time as the CTAs had finished selling their long position.
In the summer we noted that the US Equity market was expensive relative to history and cheap relative to Bonds. It is now expensive relative to both in our view. When increasing numbers of passive investors buy at stretched valuations on the expectation of super-normal future returns, it has historically been indicative of the last hurrah at the end of a bull market. And remember that while hedge funds can reduce net exposure, passive managers have no such option. To buy at these levels, we feel rational Equity investors need Trump’s policies on corporation tax and fiscal spending to deliver as expected, while ignoring i) the earnings impact of a much stronger Dollar on exports and wage inflation on an already at-capacity US workforce; and ii) that expected volatility in Equities remains close to record lows despite the many sources of uncertainty easily identified for next year.
The most benign outcome for Equities that we can see thus far is that Trump broadly delivers his agenda and the total picture of fiscal stimulus, higher Interest Rates and a higher Dollar may mean that pockets of the market do well and pockets of the market do poorly. This scenario could be beneficial for Equity hedge funds and might see markets grind, rather than soar, higher.
Away from the US election, another source of market volatility in November was the OPEC decision to cut oil production on the last day of the month leading to a rally in oil into month-end. While the S&P 500 Index traded flat on the day, the intra-market moves on November 30 were some of the most extreme daily moves seen in recent years. Some of the Commodity specialists that we speak to believe that oil could be an interesting story in 2017 as OPEC begins to lose control of the ability to set the price due to their own supply constraints and that medium-term bullishness around oil might be a sensible reaction to global growth and inflation. Add oil to the list of sources of uncertainty in 2017.
As we go to press markets are digesting the result of the expected no vote in the Italian referendum. Forecasting the impact of these things is a shorter route to humiliation than ever, so we will discuss the market implications of this result in next month’s piece, when the next iteration of the narrative has had time to emerge.
Last but not least, Man FRM celebrated our 25-year anniversary in November. We would like to thank the readers of Early View for their support over the past quarter-century, and look forward to navigating the next 25 years, however uncertain they may be.
The recovery in Equities seen following the Trump victory in the US election has been positive for the hedge fund industry as a whole. The HFRX Global Hedge Fund Index returned 0.87% in November. At the margin, most strategies saw slightly better pricing of fundamental themes driven by a normalization of the Bond market and increased expectations of higher inflation in 2017.
It was a positive month for US Equity Long-Short managers. Cautious positioning going into the election did however limit the extent of their participation on the upside and a few managers posted negative returns as hedges and shorts offset positive performance in the long book. There are a variety of views on the impact of the Trump victory, with some managers seeing the possibly more business-friendly outcome as a positive and a potential to increase exposure, while others think it is too soon to have any strong view and see this month’s rally as an over-reaction.
The US election also helped drive returns in Event Driven strategies. Managers focused on soft catalysts and special situations led the charge, although M&A managers also saw gains in the month as spreads generally tightened. For example, two mortgage loan company stocks were up sharply mid-month in anticipation of a new Administration more sympathetic to shareholders, while a drugstore chain stock rebounded on expectations of a friendlier antitrust environment, followed by news of new competition to purchase stores to be sold as an antitrust remedy related to the companies’ merger.
A high level of corporate activity also helped Event hedge funds in November, with $298 billion of announced deals month to date1, including $97 billion of proposed deals. Notable signed deals included ETP/Sunoco Logistics ($20 billion stock), Harman/Samsung ($8 billion cash), and Brocade/Broadcom ($5.5 billion cash).
Statistical Arbitrage managers also had a positive month in November, ending a long streak of negative returns for the strategy. There was a healthy degree of dispersion across the strategy as a whole, but also within sub-strategies. Fundamental managers with a bias towards valuation metrics were among the strongest performing, with the move in Bond yields seemingly helping the strategies, while momentum was weak. Technical strategies performed well overall across regions, while fast futures strategies outperformed CTA indices and ended the month flat.
European Equity Long-Short managers did less well than their US counterparts. The market euphoria following the Trump victory didn’t affect European markets to the same extent, and concerns over the Italian referendum and the related impact on the Italian banking system continue to weigh on markets. Hedge funds were close to flat on average over the month.
After a stretch of positive monthly returns, Credit Long-Short managers posted more muted returns in the month and underperformed the longer-biased Credit Value managers. This is not surprising, since Credit in general underperformed Equities. After a fair amount of intra-month post-election volatility, US leveraged credit markets saw fairly muted performance in November (leveraged loans up slightly, high yield down slightly). Longer duration assets such as US and EM investment grade fared poorly given the increase in Treasury yields. Similarly, higher rated high yield credits tended to underperform lower-rated/distressed bonds.
Most high yield sectors posted negative total returns for the month with the outliers being Metals & Mining to the upside and Healthcare and Transportation the worst performers of the month. Fixed Income flows have been decidedly negative in November across the board while leveraged loan funds, given the floating Rate nature, continued to see healthy inflows.
Structured Credit managers were flat to positive on the month, with the exception of managers with exposure to Rate-sensitive sectors such as municipal Bonds. Carry continued to be positive with rate hedges helping offset any month-to-month impact from the backup in Treasury yields. Performance for Convertible Arbitrage managers was also muted and mixed in the month.
CTA managers saw losses in November, with the biggest losses in Fixed Income and Commodities. Elsewhere, managers have accumulated gains and losses of smaller scale in Equities and FX respectively. In Fixed Income, managers held a decreasing but still notable receiver bias for most of the month and exhibited losses as global yields continued moving higher, primarily in the US. The steepest losses were seen in the first half of the month.
Commodities have been another area of loss for CTAs in November, primarily driven by energies and, to a lesser extent, precious metals while base metals contributed positively and helped mitigate such losses. By market, short crude oil (and related assets), short natural gas, gold and silver (mixed positioning through the month), and long sugar were the biggest detractors amid choppiness in those markets. Long zinc and long copper were the biggest contributors.
Systematic positioning in FX was a detractor in the month with losses in long AUD, short GBP and long JPY more than offsetting gains in short EUR and short CAD, to name a few meaningful drivers. Macro Equities have been a contributor so far this month with gains in North America and Japan outweighing losses in the Eurozone, Asia Ex-Japan and the UK. By market, long S&P 500 and long Russell 2000 were consistently among the biggest contributors across managers while long FTSE 100, long Eurostoxx and long DAX were some of the biggest detractors.
In terms of positioning, CTA managers have flattened the rates portfolio almost entirely and hold a minimal net receiver bias with small net exposure in all regions. In Equities, managers exhibit a net long bias across the board where the US is the primary driver. In Commodities, managers are approaching the end of the month net short energies, net long base metals, net long softs and net short livestock; net exposure to grains and precious metals is small on a consolidated basis. In FX, the biggest areas of positioning are net short EUR, net short GBP and net short CAD as managers continue scaling up bullish Dollar positions while reducing long positions in the JPY and AUD.
USD-JPY continues to be one of the larger movers in DM FX, as yield differentials widen (e.g. 10 Year JGBs did cross above 0% in November but real yields remain low) and the reflation theme continues. Our Asian Macro managers added to this position in November and traded their long USD bias versus weaker Asian currencies.
Looking ahead, managers across most strategies are ready for the difficult 2016 to end. We believe the dominance of political and macroeconomic factors over idiosyncratic stories has made the environment particularly hard for hedge funds to generate alpha and uncorrelated returns. While the outlook for 2017 is hardly spectacular, managers are hopeful that more normal levels of Bond yields and increased breadth of market drivers might result in a more fertile ground for potential alpha generation than this year.
1As of November 28, 2016. Source: Bloomberg
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