FRM Early View - September 2018
- US growth remains robust as third Fed rate hike for 2018 is announced.
- US inflation creeps upwards.
- Deal activity still strong despite US China trade war, quantitative strategies struggled with reverting markets.
Quantitative easing was never an exercise in finesse – just look at the phrases used by policy makers, “helicopter money,” “whatever it takes,” “turning on the tap.” It’s the sledgehammer approach to cracking the particularly hard nut of the global financial crisis.
Exiting the process is more of a tightrope act. Policy makers are, of course, focused on the real economy more than the financial economy. Just as financial markets were the largely unintended beneficiaries of QE; it is very possible that they suffer inadvertent collateral damage of quantitative tightening.
We talked at length last month about the surprising smoothness with which the US has been able to slide into a quantitative tightening regime (albeit leaving some other parts of the world floundering in their wake), but we feel it is prudent to question whether we should expect this plain sailing to continue. As expected, the Fed announced their third rate hike for 2018 at the end of September, a few days after the US jobless claims data hit the lowest level since 1969. But US growth data remains robust and US equity markets have continued to see gains. Most importantly, the 5yr and 10yr breakeven inflation rates in the US have been creeping upwards, but in a controlled fashion. Thus far, the acrobat remains on the rope.
To us, inflation is the most important barometer of risk. If ‘demand-pull’ inflation (from higher wages in a full-employment economy) seems to be under control, at least for the time being, then ‘cost-push’ inflation is another (and a newer) beast. Brent Oil spot prices reached $82/bbl in September, up more than 40% over the last 12 months. After the damage that the last boom and bust in the oil sector did to companies tapping unconventional sources of oil, the industry seems unlikely to want (or be able) to bring additional production on line quickly. The hedge funds that we talk to therefore expect high oil prices to persist for some time yet.
So we have 1) plenty of reasons to worry about inflation surprising on the upside and 2) a US bond market that has once again topped 3% at 10yr yields. These were precisely the factors that played into the market sell-off in February. If anything, the landscape today is worse than it was at the end of January – we are three more steps into the tighter monetary regime, input costs are higher, we have a simmering trade war well underway, and (at the risk of sounding like a broken record) US equities are more expensive again.
We had a brief respite from worrying about equity market valuations through Q2, but the Shiller PE ratio on the S&P 500 climbed back to 29x at the end of September. The average 10yr return of US equities following Shiller PE valuations higher than 30x is -43% (since it has only breached this level twice, in 1929 before the Great Depression and in the dot-com bubble). Is it any surprise that long term investors have been ‘diversifying’ into bonds, even at just 3% yields? And is it likely to do any good?
Ay, there’s the rub. Inflation and asset diversification are inextricably linked in our view. Long term analysis of the correlation between bonds and equities suggests that correlation is only low or negative in periods of low inflation (the Napoleonic Wars, the late Victorian deflation, the Great Depression, the Oil Crisis, and following the GFC). For most of recorded financial history, equities and bonds have exhibited positive correlation. So if inflation does rear its ugly head over the next year or so, the reaction could be an increase in equity and bond correlation due to both selling off at the same time. For the vast majority of investors in the long-only world with a strategic asset allocation made up of a blend of bonds and equities, this is a particularly problematic potential scenario.
Hedge fund investors have a different potential problem. These strategies are able to take less direct market exposure, and as such worry less about bear markets per se, but have generally moved towards a world of higher gross exposure as market volatilities have fallen due to QE. These managers tend to have exposure to risk factors that are more subtle than explicit market exposure, but can be just as painful in periods of market turbulence. Our analysis of returns from risk factors across asset classes has shown that monthly returns in 2018 are frequently sitting in the tails of the distribution (on both sides), perhaps alluding to tremors in the stability of these measures. Of course, the ‘smartest’ hedge fund managers also make sure they have reduced their exposure to known risk factors too, but this just put more reliance on risk models that perhaps aren’t calibrated for a world of quantitative tightening. The data for this year shows that many of the purest quantitative strategies have struggled just as much as their less sophisticated peers.
Furthermore, reversing QE is going to tighten liquidity in the system. Hedge fund managers tell us of multiple concerns about liquidity across different asset classes in the current markets, let alone when central banks start to try to shrink their balance sheets. In equities, some smaller capitalization stocks are trading with a negative liquidity premium – i.e. more expensive than comparable larger companies due to risk premia and quant programs overbidding for the limited liquidity available in these stocks. In Credit, managers are bemoaning the lack of depth to even investment grade Credit markets, and there remain long-held concerns about the fate of daily liquidity products holding less liquid securities during a liquidity crisis.
At the risk of being alarmist, for the US market at least, this all feels a little bit like 2007. Back then we had central banks tightening in the face of low unemployment and rising wage inflation, rapidly rising oil prices, concerns about liquidity, and losses from over-levered quantitative equity strategies. We have no reason to suspect a crisis of the magnitude of 2008 is on the horizon, but we have every reason to be vigilant.
On the whole in September, hedge funds continued to struggle to make much headway in terms of performance for the year to date, with quantitative strategies, both CTAs and Statistical Arbitrage, struggling again with reverting markets, and mixed performance from Equity, Credit and Macro strategies, and more positive returns from Event strategies.
Discretionary Equity Long-Short managers continued their mixed performance for 2018 in September, with generally better alpha than we have seen for the past few months. There is a sense that valuation discrepancies in equity markets are starting to narrow, although they remain wide relative to historical data. On the whole, September was somewhat reversionary, with managers who produced better performance in August struggling in September and vice versa, largely due to the outperformance of European and Asian markets over US markets through the majority of the month.
Quantitative Equity Strategies had a more difficult month in September. In keeping with the reversionary theme, Technical Statistical Arbitrage managers had a weak September after a noteworthy month in August. There was clearly a sell-off in the momentum factor in the third week of the month which disappointingly seemed to impact returns. Additionally, the much anticipated triple witching (when quarterly futures, quarterly index options, and quarterly single stock options all rolled on the same day as a GICS sector and MSCI country rebalance) was a non-event for these strategies. More Fundamental managers also had a poor month, with some impact clearly coming from the momentum factor.
The biggest tension in the Event Driven space continues to be focused on the ongoing trade war between the US and China. However, that did not hinder merger deal flow in September. 2018 continues to be on track to be one of the strongest years in recent history for deal activity and there were multiple potential opportunities for managers in this space. Exposures rolled off managers portfolios as deals closed, such as the two year competition for the Broadcaster Sky. Comcast prevailed with the highest offer for the company in a London auction during the month. Comcast outbid 21st Century Fox and Disney bringing the bidding saga to an end.
Other merger transactions progressed, such as two eyewear companies, a chemical company/industrial gasses company, and two food companies. A high conviction view across the sector in a biotechnology company/a pharmaceutical company deal also progressed with regulatory approvals even though there remains some shareholder skepticism over the transaction. Further, a computer company’s pending acquisition of its tracking stock had new developments with reports that the CEO is said to be exploring the possibility of an IPO in lieu of the transaction and news that he plans to delay the investor roadshow.
Leveraged credit markets generally took the higher yields in stride and generated positive total returns with outperformance of lower-rated credit vs. BB-rated HY and investment grade credit markets. Emerging markets credit also stabilised during the month and rallied over the latter weeks of September. By sector, the HY sectors of Retail and Telecommunications outperformed and remained two of the best performers year to date in the US high yield market.
Corporate Credit managers were broadly positive on the month. Some managers benefitted from additional gains in a number of idiosyncratic positions that have driven performance this year including Puerto Rico (additional progress in discussions between bondholders, the Oversight Board, and the Government), long positions in energy credit and reorg equities (sector strength with the rally in oil prices), and equity stub trades (an investment company discount narrowed further following the tender in August).
Structured Credit spread performance was fairly muted in September as spreads were largely stable. Structured Credit managers’ performance was primarily driven by carry with equity and credit hedges generally a drag on performance but overall performance was generally slightly positive for the month.
September was a poor month for CTAs, giving back most of the gains from a notable August. This was particularly true for those with a shorter average lookback. Rather than a particular asset class, the poor performance was a combination of losses across an unusually large portion of sectors. By asset class, commodities was perhaps the strongest but in aggregate were close to flat. This was driven by gains in the Energy sector, offset by large losses in Copper. All other asset classes detracted.
In equities it was the fastest managers who were most negative, caught by the moves up toward month end in European equities. Japan was the one strongly positive region, where long exposure was positive. In Fixed Income, long positions in Europe (and Germany in particular) offset the gains from short exposure in the US. The reversal of the dollar in the first half of the month hurt managers’ long dollar bias. Alternative market managers fared slightly better, isolated from some of the difficult trades in developed markets. In our view the main risk in the strategy remains the net short FX against the dollar, with net equity exposure also creeping up.
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