FRM Viewpoint - July 2017
- The HFRX Global Hedge Fund Index rose +0.93% in July, increasing its YTD return to +3.51%.
- The month was characterized by a notably hawkish shift in the stance by the Bank of England (BoE), Bank of Canada (BoC), and European Central Bank (ECB).
- Earnings seasons in major markets were a positive tailwind for most Equity Long-Short managers in July.
July was a favorable month across the board for hedge fund strategies. Many managers suffered losses in the last week of June as the correlation structure between Equities and Bonds turned positive and most risk exposures struggled. However, this phenomenon eased during July leading to a snap-back in returns across pretty much all strategies, with the exception of Credit Long-Short which generally performed better in June and therefore had less to recover.
Earnings seasons in major markets were a positive tailwind for most Equity Long-Short managers in July. In the US, around 20% of the S&P 500 has reported so far and the level of positive surprises is in line with prior quarters with no major disappointments to challenge the market’s run. Hedge fund performance, while mostly positive, has lagged the market as a robust short book has become a critical focus for many managers given the current level of valuations - the market multiple is at the 89th percentile compared with the last 40 years and the typical stock is at the 99th percentile of historical valuation1. This has helped push gross exposure levels up notably and net has pulled back from recent highs though is still above 2016 levels.
One of the main stories for Global Macro managers has been the continued weakness YTD of the USD, which has fallen to its lowest level since September 2016. Positioning among Managed Futures programs is also the most bearish on USD in several years, mostly on account of bullish EUR price action. Discretionary Macro managers have also generally shifted positioning throughout the year, reducing Trump catalyst trades and shifting notably to a more bullish EUR stance. Expectations of fiscal policy progress in the US have continued to weaken, while US financial conditions remain loose.
The past month has been characterized by a notably hawkish shift in the stance by the Bank of England (BoE), Bank of Canada (BoC), and European Central Bank (ECB) with discussion of potential European Quantitative Easing tapering. US monetary policy expectations, on the other hand, have become less hawkish with the probability of a December Fed hike dropping from 60% two months prior to lower than 40% as at July 28, 2017.
One of the more notable shifts in the outlook has been in China, as the RMB has continued to appreciate (+3.2% YTD) and Bond yields have eased since Q1. China’s economic growth rate has accelerated over recent quarters and recent regulatory and policy measures implemented by Chinese officials and the People's Bank of China have afforded greater control of the exchange rate. In addition, the liquidity situation may improve further in the near term as the People's Bank of China is showing a clear bias toward maintaining liquidity stability while positive changes in capital flows are providing additional support.
Asian managers are citing the introduction of the China Bond Connect as a further catalyst for attracting foreign capital – particularly given low foreign ownership of outstanding Chinese Bonds of sub-5%, compared to the US which is nearly 50% foreign owned.
Elsewhere, many Global Macro managers cite a North Korea confrontation as the primary global geopolitical risk, which is highlighted by the increased frequency of recent missile launches (78 under Kim Jong Un vs 16 under Kim Jong Il)2, as well as the heightened tension in US-China relations in recent weeks.
In Credit, it was another favorable month for the broad Credit markets with loans, investment grade, and high yield all positive for the month. Not surprisingly given the risk on sentiment US High Yield was the outperformer with all industry groups posting positive returns in July. With the rebound in crude, US High Yield energy sector posted noteworthy returns in July. Metals and Mining and Healthcare sectors were also positive performers. The Telecoms sector was an underperformer.
Performance for Corporate Credit managers was mixed and fairly muted in July with a lack of meaningful idiosyncratic events in the month. Threat of US sanctions resulted in a further repricing of risk in Venezuela resulting in modest losses for some managers on their positions in a large oil and natural gas company. Otherwise Equity stub trades and reorganization Equities were positive performers offset by single-name and index Credit shorts. With US High Yield Credit spreads once again approaching post-crisis tights the risk/reward for owning outright plain vanilla Credit risk remains unfavorable in our view. Away from Corporate Credit, declining volatility and liquidity risk premium remained supportive for Structured Credit in July with many managers posting positive returns for the month. With the notable YTD spread compression we believe any potential returns in this space to be mostly carry-driven in the near-term.
July was generally a positive month for Event strategies. While Risk Arbitrage remains positive, its contribution was less meaningful than in previous months. Deal activity was relatively muted again, with ~ $220bn of deals announced (excluding proposed deals) as at July 28, 2017. Relative Value strategies which were generally negative last month were mostly positive in July. We saw that Softer Catalyst and Special Situations were generally the largest performance driver in July on the back of positive idiosyncratic events, as well as a strong market backdrop. While Credit remains a smaller allocation in many Event Driven portfolios, it helped in July that there was a rebound from High Yield Energy sector names, and Energy post reorganization Equities.
Summary of performance drivers by strategy
|Key:||+ Positive factors and/or drivers||<> Neutral factors and/or drivers||- Negative factors and/or drivers|
|Alternative risk premia||Trade examples1||Environmental factors|
Relative Value (RV)
|+ Event Driven strategies continued to post gains in July. The HFRI Event Driven Index was up +0.9% ...||+ Common contributing positions included two technology firms …||- Deal activity was relatively contained, with $260bn of new deals, not including $80bn of proposed deals (Bloomberg) …|
|+ Price Momentum was strong across most regions, with Australia the only negative region.||- One tobacco firm was a common detractor as the stock price fell following the FDA’s announcement around new regulations concerning nicotine.||+ The fundamentals of Merger Arbitrage appear to remain sound, and managers are able to find potential opportunities to populate their portfolios.|
Equity Long-Short (ELS)
|<> The month saw a generally good Q2 reporting season in the US, however manager performance was not as straightforward as it seemed given the reaction of stocks to the results …||- On July 28, the Tobacco sector saw a drop of almost 11% following news that the FDA is considering capping the amount of nicotine in cigarettes to an amount that is not addictive …||+ July was a good month for Equity Long-Short managers, as strong, calm markets provided a good backdrop for the release for Q2 earnings …|
|<> The month’s best performing managers in the strategy, when compared to their respective benchmarks, were in the US.||<> Much of the underperformance from positions in European stocks can be attributed to the stronger EUR weighing on exporters.||+ The Eurostoxx 50 Index returned +0.2% for the month as a whole, while the S&P 500 returned +1.9%.|
|+ Outright Convertible Bonds followed Equities higher and were positive across all regions …||- Commodity-related reorganization Equity positions continued to trade lower due to idiosyncratic events …||+ All 21 of the JPM US High Yield industries were positive in July. Utilities (+2.3%) were the best performer …|
|<> In Structured Credit, more modest, primarily Carry-driven returns are expected in the near-term given continued spread tightening.||<> Equity stub trades and reorganization Equities were positive performers offset by single-name and index Credit shorts.||- US High Yield new issuance in July ($16bn) was the lowest monthly total in 18 months.|
|+ Emerging Market assets continue their run on account of the weaker USD and relative Emerging Market vs Developed Market rate differentials …||<> Discretionary Macro Managers have shifted positioning throughout the year to a more bullish EUR and RMB stance …||<> Global Macro themes were dominated in July by the continued weakening dollar, which fueled a further rally in EUR/USD …|
|- Mean reverting price action has made Commodities a difficult sector, particularly for Managed Futures managers.||+ Crude oil exhibited a significant reversal in July with Brent finishing the month up nearly +10%.||<> The Bank of Canada hiked rates for the first time since 2010, and hawkish comments at the Bank’s meeting raised expectations of future hikes.|
1S&P 500 as at July 28, 2017
The above summary is based on FRM’s opinions on performance drivers across the hedge fund industry and is not representative of the investments made by FRM. 1. The herein mentioned examples are intended as illustrations of typical investment consideration and/or strategy implementation. It should not be construed as indicative of potential performance of the fund or strategy or any investment made by the fund. It does not constitute a recommendation or investment advice or solicitation to buy or sell any particular securities and should not be considered as any investment advice or research of any kind. There can be no guarantees that similar opportunities will be available in the future or that any opportunities identified will provide similar results.
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