FRM Early View - March 2019
- March was generally a positive month for hedge funds, albeit with significant variation in individual managers’ returns
- A large drop in bond yields generally benefitted Trend following strategies
- Hedge funds may look to shift their exposures to react to the changing environment
If you only listened to the central banks, then you might conclude that the world economy is in serious trouble. Over the last two Fed meetings the US central bank has significantly changed course, leading to a big drop in bond yields (30bps off the 10yr yield over the month of March) and expectations of rate cuts this year. The ECB has announced TLTRO III and says ‘it stands ready to adjust all of its instruments as appropriate.’ And the appetite of Chinese policy makers for economic support appears to be growing stronger rather than tapering off. Since monetary interventions follow a law of diminishing efficacy, markets didn’t take long to take the recent stimulus as a sign that recession is on the horizon.
However, it’s hard to square what the bond market (taking its lead from the central banks) is saying about inflation expectations with the fundamental data. In most developed markets unemployment remains historically low, wage inflation is good and commodity prices are recovering from the pull-back seen in the fourth quarter. In fact, US financial conditions indices show the loosest environment for a number of years. We know that the Phillips Curve has been ignored by global markets for some time now, but it appears to be completely dead and buried in Germany. The March Manufacturing PMI print was sufficiently poor as to push 10yr bunds back into negative yields, but on the last day of the month German unemployment reached the lowest level since reunification. Record low bond yields and record low unemployment? Go figure.
It’s not surprising to us that CTAs had one of their best months in a long time in March – most computers don’t stop to scratch their heads when the world seems to make little sense and their long bond positioning that has built up over the last few months paid off. But the rest of the hedge fund industry that we speak to seem to think that things may have gone too far. They seem to be taking their lead from the fundamentals (as humans tend to do) and think that inflation is more likely to surprise on the upside in the second half of this year than the downside, which could mean, at some point, a reversal in this bond move.
The challenge from here, if inflation expectations do pick up through the summer, is whether the Fed has done enough to stimulate growth with the recent change of direction and confound the ‘yield curve inversion equals recession’ thesis. At their February meeting, the Fed made it clear that they would tolerate higher breakeven inflation, which some of the more sceptical commentators translated as targeting a higher equity market. It’s hard to see this path as anything other than one of inflating an asset bubble for short term gain in exchange for long term pain, but still, one that might feel quite benign for some time (and is arguably a continuation of central bank thinking of the last decade – act to avoid recession and hope that inflation doesn’t become a problem).
But what if monetary stimulus is largely exhausted, at least for this cycle? The empirical evidence suggests that an inverted yield curve doesn’t predict recessions quite as accurately as some commentators would have us believe, but what if this time it does? It is possible that for the rest of 2019 we have a moderate pick-up in inflation expectations without a commensurate improvement in GDP growth, anchoring real yields in developed markets ever lower. As we have said before, forecasting the path for risk assets in such an environment is hard, since the relative attractiveness of various assets in a world with negative real yields is inherently unstable. Perhaps the only thing one could say with any confidence is that asset volatility could be higher in this environment, but we’ve been wrong about that enough times before too.
Perhaps the ‘whatever it takes’ attitude to avoid negative economic environments is now too entrenched to give up without a fight. Monetary stimulus may become less effective, but the proponents of fiscal stimulus are becoming ever more vocal – on the right of the political spectrum we have already seen corporate tax cuts in the US, whereas on the left not a day seems to pass without a discussion of Modern Monetary Theory on the financial news channels. Printing more money for government spending (and ignoring the fiscal deficit) may have some theoretical appeal, but the risk of unintended consequences could be disastrous.
Either way, the last few weeks feel like a significant milestone in the post-2008 financial era. Policy makers may be forced to confront the upshot of their actions of the last decade. As we’ve said many times before, exiting QE was never going to be straightforward, and the behaviour of the equity and bond markets over the last six months show how difficult it is for investors to read the roadmap. Against such a confusing backdrop, we are relieved to be investors in those much-maligned hedge funds, who have the ability to shift their exposures to react to the changing environment.
March was generally a positive month for hedge fund performance, but characterized by significant variation in individual managers’ returns. Trend-following strategies enjoyed a notable month, and some Relative Value strategies did well against a more muted backdrop. Credit and Equity Long-Short managers had mixed months, with pockets of difficulty in both strategies.
It was a positive month for Trend Following strategies such as CTAs, with only one story worth mentioning – the performance was driven almost entirely by long bond positions. The US was the largest contributor, but Germany was also noteworthy thanks to the sharp drop in bond yields in reaction to the Manufacturing PMI print in the middle of the month. Positions remain sizeable in bonds, but several managers have actually started to reduce the overall exposure toward month end. Elsewhere, FX was generally positive, but varied through the month. The dominant exposure is short FX against the dollar, with short Euro one of the largest positions. Equity was close to flat, and while it moved around through the month, it was never a material contributor in either direction. Commodities were a detractor, largely due to the fall in crude oil.
Other Macro strategies followed a similar pattern. Those with long bond exposure generated the most notable returns, although few of the Discretionary community had the risk tolerance to take such large long bond exposures as their Systematic counterparts. Return contributions from other asset classes were generally muted, although there was significant variation in FX trading strategies depending on region and FX pairs traded.
For Equity Long-Short managers, March was a curious month. The more dovish tone from central banks was seen as a positive sign for some sectors, leading to significant short covering. This short covering has largely supported equity markets through the month, despite the weakening growth outlook in Developed Markets and rally in government bonds. This meant that alpha generation within markets was more difficult to come by than in previous months. We have seen before that a reduction in the long bond yield is typically unhelpful for closing valuation discrepancies within equity markets (since higher bond yields can be a catalyst for more rational pricing under most discount models), and March was no different. Similarly, managers with a small/mid-cap bias struggled during the month.
It was a muted and mixed finish to the quarter for the credit markets after two strong months. The rally in US treasuries resulted in positive returns for the investment grade market. Performance in US high yield and leveraged loans was mixed, with the higher-rated parts of the former outperforming in March. It was a good month for primary issuance in the US high yield market while leveraged loan new issuance lagged given the receding focus on rate risks. Loan funds also continued to see heavy outflows while there were inflows into US high yield bonds funds.
March returns for corporate and structured credit managers were modest and largely positive with a few outliers. Unlike February, there were few meaningful idiosyncratic return drivers. Carry was once again the dominant performance driver across securitized products sectors, with secondary market spreads largely stable to modestly tighter across most sectors.
The Relative Value landscape was generally more muted than previous months across all strategies. In Event strategies, median merger spreads had reached fairly tight levels following the completion of a number of larger deals earlier in the year, leading to quieter returns from Merger Arbitrage strategies in March. Other types of Event Arbitrage, such as softer catalyst and Relative Value trades were generally positive in March.
Statistical Arbitrage returns averaged around flat, but unlike other strategies, they saw relatively little dispersion between managers and sub-strategies. The lack of obvious factor support (such as strong return to Value or Quality) meant that Fundamental strategies were largely treading-water for the month, whereas the more Technical strategies struggled with relatively benign levels of equity market volatility. Simpler forms of Statistical Arbitrage, such as those seen in Alternative Risk Premia programs also had a mixed month. The shift in the yield curve meant that lower beta, higher dividend stocks tended to outperform, leading to positive returns for Low Beta and Low Volatility programs, and negative returns from Small Cap vs Large Cap strategies. Value and Quality factors as stand-alone programs also struggled during the month.
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