FRM Early View - October 2016
- The HFRX Global Hedge Fund Index returned -0.57% for the month
- Best performing strategies were Discretionary Macro and Credit, while CTA managers struggled
- Financial markets remain stable despite increased uncertainty in monetary policy and political outlook
Most of the time, the most rational approach to markets is to admit that one doesn’t know how things will develop. Right now we really don’t know how things will develop.
There is, of course, substantial political uncertainty on the immediate horizon. The increased possibility of a Trump victory in the US election has weighed on Equity markets in recent days, and it is difficult to untangle investors’ short term concerns over the election with their medium to longer term concerns over the economy. It is safe to admit that we don’t know who will win the election. In the absence of anything better, polling and betting markets are the best guide to the probabilities, but of course the rest of the market can see just as clearly as we can. While we have learned a few simple rules about how, for example, the Mexican Peso will trade, broader forecasting is not straightforward at all. We believe even hedging is hard – it is possible that Trump wins the election and Equity markets finish November in positive territory.
Elsewhere we have feared (rather than expected) a bursting of the ‘Bond bubble’ for some time, and although the sell-off in October was moderate in historical terms, the move in Government Bonds for most Developed Markets represents the biggest monthly move in more than a year. Yields on 10 Year US Treasury Notes and German Bunds rose by more than 20 basis points and 10 Year UK Gilts rose by more than 50 basis points. For now, it remains reassuring that Equity markets adjusted to higher borrowing costs in a rational way, in particular the ‘correct’ repricing of yield-substitutes lower and Banks higher. But it is very much too early to tell whether the growing volatility in all asset classes will dissipate, as it has over the past five years, or whether this represents the first step to a more uncertain post-quantitative easing world of higher Bond yields, lower Equity prices and more volatile FX. This call is particularly material with respect to a view on CTAs which suffered another grim month. We know they don’t like trading ranges and sharp reversals, but unfortunately it doesn’t make the call any easier to make.
One could make a positive case for October’s market moves. Few people really believe that zero yields are a long term solution or that higher rates shouldn’t be a prerequisite of a better functioning global economy. Inflation has been moving in the right direction and with the current consensus that the Federal Reserve (Fed) will raise rates in December and better than expected US GDP data for the third quarter, the moves in Government Bonds in October might be seen as a benign preparation of the ground for the rate rise (duration adjusted, a 25 basis point increase in the long end of the curve is more significant than a 25 basis point increase in the short end).
The negative case is that the US is at risk of rolling over into recession. Investment Banks’ models of macro data are starting to suggest a downturn in Developed Market growth expectations. In October, US consumer data came in below expectations and unemployment data has flatlined and is starting to creep up. We have already seen a growing reliance of Equities markets on corporate activity to support price levels and a weakening of earnings growth, and the announcement of mega-mergers (AT&T/Time Warner; Monsanto/Bayer) have historically been a good sign that we are late in the economic cycle. The reality is in our view some blend of the two cases.
We suspect, however, that the average market participant fears the impact of a US recession more than perhaps they should. One of the biggest sources of overconfidence is to assign too much weight to recent events. The US recessions of 2000-2001 and 2008-2009 were coincident (and accelerated by) the bursting of the dot-com bubble and the global financial crisis respectively. As a result, market participants with less than 25 years’ experience in financial markets associate a recession with a large Equity market sell-off. However, the three recessions prior to that, in 1980, 1981-1982, and 1990-1991 were all coincident with rising Equity markets despite a combined contraction in GDP greater than that of the two most recent recessions.
Given that they help to inform our views, it will come as no surprise that the hedge funds we speak to on a regular basis are similarly unsure. There is a mix of opinions on the outlook for the global economy from here, but a common theme is that risk levels are slightly lower than average, perhaps showing a collective uncertainty (or perhaps betraying the wounded pride of many managers nursing losses on year-to-date performance). There are, however, no hedge funds that have identified something on the horizon of the scale of the dot-com bubble or the sub-prime crisis (and we definitely heard, at length, theses around both of these in the years before those events).
In particular, European Equity hedge funds are struggling to read the current environment. One might think that the partial resolution of issues in the Italian banking system that led the Eurostoxx Banks Index to rally 13% in October, and the better-than-expected Purchasing Managers’ Index (PMI) data across the continent would be positive for market pricing. But some of the managers that we speak to had one of their worst months of the year in October.
If the fundamentals are hard to read, then we believe the technicals are doubly so. In our view, two potentially destabilizing forces are the substantial flows of assets into quantitative ‘risk parity’ funds and into ‘low volatility’ Equity ETFs. The former risks increasing the correlation between asset classes in periods of deleveraging and the latter presents the risk of a bubble in certain segments of the Equity market. We find it hard to forecast whether flows to these products will reverse or how markets will react if the flows reverse.
If we were forced to get off the fence, we would note that by December the amount of time since the last US recession will already be the third longest inter-recession period of the last 200 years. If economic cycles and macro data suggest that a recession at some point is inevitable, then the Fed might tolerate a mild US recession while increasing rates, particularly if inflationary risks emerge. Under such a scenario, Equities could reprice relative to Bonds as yields rise, but we believe widespread panic selling is unlikely. October would seem to represent a first step in this direction.
In general, October was a positive month for Discretionary Macro and Credit strategies, and a poor month for CTAs. Relative Value and Equity Long-Short strategies had mixed performance. The HFRX Global Hedge Fund Index returned -0.57% for the month.
The best performing strategy during October was Discretionary Macro. The larger than average moves in Fixed Income, FX and Commodities were all important drivers of return, as managers pressed their short Bond and long Dollar positions. Another driver of return was dispersion in EM FX, particularly the large divergence in Latin American EM FX versus Asia EM FX. Managers have held a short Asian, long Latin American bias for some time, and this thesis began to play out in October.
October returns for leveraged Credit strategies were positive (HY and leveraged loans) while more rate sensitive assets (IG corporates and Broad IG indices) were down. The underperformance of higher rated credits was also apparent across the HY ratings spectrum as lower rated credits outperformed with larger gains in CCCs and distressed paper. New issue markets in the US were fairly soft for high yield but remained elevated for leveraged loans.
Almost every high yield sector had positive total returns for the month. Metals & Mining and Energy performed the best while Healthcare and Broadcasting lagged and were the only sectors posting negative total returns. Retail and Telecom were also laggards (but were positive month to date).
Credit Long-Short and Credit Value managers were mostly flat to positive on the month. Returns were generally driven by stressed/distressed and bankruptcy names in Commodity related sectors as well as cap structure arbitrage trades. Securitized Products’ performance was fairly steady in October. Down in the capital structure, CMBX (synthetic commercial mortgage-backed securities (CMBS)) was higher on the month. Structured Credit managers generally posted positive returns driven by carry and hedges. In Convertible Arbitrage, returns were generally positive as convertibles benefitted from narrower credit spreads while underlying Equities performed in line with the broader equity markets.
In Equity Long-Short, October was a tough month with most major Developed Markets falling in value during the month. Interestingly, US Equity Long-Short returns were reasonably uncorrelated with markets, potentially set to record modestly positive performance for the month. The US market was moved by a combination of the commencement of the Q3 earnings season, as well as fluctuating outlooks for the US presidential election. These factors combined helped create large single stock moves and decent sector dispersion which we believe is a constructive environment for the strategy.
European managers fared less well. The stand-out positive Equity market sector performance was Financials, which is generally a smaller part of managers’ portfolios now given the volatility of this sector in recent months. In particular, Banks performed strongly and hedge funds generally have little exposure to the most volatile Italian banks in the sector. As a result, the market ex-Financials saw a substantial decline and high single stock volatility that was hard for managers to navigate.
Statistical Arbitrage had a weak period over the summer, with both notably poor returns and high correlation between seemingly unrelated strategies. October was therefore somewhat a recovery, not due to returns, but due to a lack of correlation between managers and strategies. A number of more fundamentally driven managers were the strongest performing, in particular in Asia where unusually both momentum and value signals ended the month stronger. Technical strategies were more mixed, but seem to have ended the month flat in aggregate. Futures strategies were also mixed, with those managers trading a greater portion of momentum strategies again the weakest performing.
Managed Futures managers saw losses in October, with positive performance in FX partially offsetting the negative contribution of Fixed Income and Commodities; Equities have had little net impact overall. Despite starting the month roughly neutral to the Dollar, managers drifted gradually to a net long USD bias which resulted in meaningful gains as the Greenback rallied across the board through the month.
Rates were the biggest source of losses for CTAs last month. Managers continued to hold a receiver bias which resulted in losses across virtually every region as Fixed Income sold off globally and heavily through the month. Such receiver bias has been scaled back through the month. Commodities were one other meaningful source of losses in October, with these being primarily driven by precious metals and energies and, to a lesser extent, grains and base metals. In precious metals, losses were roughly evenly distributed across long gold and long silver, both of which moved down meaningfully in the month. In energies, managers were hurt by ongoing choppiness in crude oil and natural gas, where they were mostly long. In grains, short corn and short wheat were the biggest drivers for the losses while long zinc was the biggest detractor in base metals. In Equities, CTA managers were positioned net long (including in Japan where they had held a flat-to-bearish bias for some time) and accumulated gains in Asia ex-Japan and Japan, and losses in the US.
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