“Bond bear market confirmed today”
Bill Gross/Janus Advisors tweet 10 January 2018
The last two months have seen a material repricing of global assets. The melt-up in equities over the second half of December and for the large part of January was arguably the fastest since the tech bubble of the late 1990s. By 26 January, the S&P 500 was up more than 10% from the intraday lows in early December. In the last 20 years, we have only seen a similar move in such a short time as a bounce from a previous sell-off, not as a process of printing daily new highs. It is not surprising that we saw a bit of profit-taking through the last few days of the month.
In government bonds, global yield curves saw a smooth parallel shift upwards of around 30-40bps during December and January, leading to the proclamation of a bear market by Bill Gross on 10 January. As hedge fund investors, this is a welcome development for us. We’ve long felt that more normal yield curves are necessary for rational pricing across a range of assets. Since hedge funds by and large spend their time buying securities that they feel are under-priced and selling securities that they believe are overpriced, then more rational pricing is clearly welcome in our view.
If we are now in a bear market for bonds, then this potentially gives the CTA industry the chance to answer the concerns over their ability to profit in periods of rising bond yields (since the industry has only really existed during a 30yr bond bull market). With January being a positive month for many hedge fund strategies, but particularly for CTAs, does it suggest we were worrying unnecessarily?
Not so fast.
The one jigsaw piece yet to fall into place is that yield curves remain stubbornly flat, at least outside of the very short end of the curve. The US 10yr-2yr yield differential remains at around 60bps, well below the historical average. Forward pricing suggests the average US interest rate from 2020 to 2028 will be around 2.8%. Considering the market has three or four rate-hikes priced in for this year (to get us to 2.25%-2.5% by the end of 2018), then there is very little priced in after that. So while the era of super-easy money may appear to be over, bond prices are suggesting that monetary policy could remain easier than pretty much all of recorded history for at least the next 10 years – hardly the worst environment to try to generate return on capital. And of course, the US is further along this path than other developed market economies.
So while the Fed has been effective in using forward guidance to shift the short end of the curve, the long end has only moved grudgingly, and by as little as necessary. We feel a ‘true’ bear market in bonds would see investors selling their longer-dated bonds on fundamental grounds, rather than reacting to short term expectations of the Fed. But why would long-term investors sell bonds to buy riskier assets when in January we saw the carry from bonds overtake the dividend yield of equities in the US for the first time in 10 years? At least in the US, equities are now more expensive relative to bonds not just versus historical norms, but in absolute terms.
It could come down to inflation and the timing of the Fed rate rises. We know that inflation has historically lagged GDP growth, so it is possible that 2017, in hindsight, was the year we had the growth before inflation caught up.
Perhaps the Fed has got it right. The rate rises seen in 2017 (and expected in 2018) might be sufficient to keep inflation on target. If that happens, then this could only be the start of the melt-up – higher equities on the back of continued strength of the global economy and higher yields at the long end of the curve. Global earnings growth remains robust which may support the P/E multiple for some time yet. In our view, this is very much the benign scenario for 2018.
To complicate matters we have the Trump tax cuts, which have pushed equities higher on a ‘one-off’ repricing and may have wider implications for the economic cycle. Depending on the company, they are proposing to pass the tax benefits either onto customers, or onto the workforce, or onto shareholders. Whichever way, it’s an injection of cash into a market that was already at risk of overheating. We also have rising commodity prices, a devaluation of the dollar, and an economy at full employment.
Therefore the volatile scenario for 2018 is, in our view, that inflation surprises consistently on the upside which leads to deleveraging. In our view, it is not hard to envisage an overleveraged financial system selling its overvalued bonds and equities in the face of more negative real returns from both asset classes.
It seems to us, as hedge fund allocators, that a potentially prudent way of helping to protect against the volatile scenario while seeking to benefit from the benign scenario is to ensure investments remain very liquid and to be fast to react to changes in the market landscape. In either scenario, Bill Gross may be correct – and we may be at the start of a bond bear market. But what kind of bear market could make all the difference.
Overall hedge funds had a positive month in January, with losses in the last few days partly blunting what was still a notable month across nearly all strategies. The best performing themes were beta and single stock momentum exposure in equities, trend-following in FX and rates and a convergence of Event Arbitrage spreads. Credit managers were more muted, but still produced positive returns on average.
Given the strength of the S&P 500 through January US ELS managers generally benefited from any bullish positioning they held and so performance has mostly been a function of net exposure. The commencement of the Q4 earnings season has introduced some dispersion into the market but generally longer-biased managers have performed the best. While net exposures remain elevated, bolstered by a surge of earnings revisions, managers are remaining alert to any events that could lead the rally to unwind or to a factor or sector rotation. Sentiment is therefore cautious despite high exposure levels and the ebullience in the market.
European ELS managers also performed positively in January despite more muted stock index returns. The main driver of returns for these managers was single stock momentum, which continued its notable run of the previous month.
Many Macro managers are buying into the synchronized global growth theme and are concerned about rising inflation risk, which is broadly reflected in positioning long inflation breakevens, and short nominal fixed income. These trades generally benefited managers in January, along with longer-term macro trends which have extended further.
CTAs were generally positive in January driven by two overriding themes – short dollar (which correlated with the long equities and commodity themes), and short rates. Equity has contributed around half of the gains. Futures managers trading more diversified books by strategy have underperformed peers.
Regarding the outlook for Macro managers, 2018 has the potential to be driven by a confluence of themes, including potential inflation overshooting, extended USD weakness and continued removal of Developed Markets’ central bank accommodation. A key consideration for the USD outlook is the continuing breakdown in the long-standing correlation between yield differentials and FX levels. One interpretation of this is that USD inflows to purchase US assets are being overshadowed by USD outflows for funding purposes, which could be reflective of strong global capital demand in a risk-seeking economic environment. Another negative catalyst for the USD is the significant amount of domestic and international USD bond issuance that is expected in 2018, on the back of a 44% rise in Emerging Markets USD-denominated issuance in 2017. As such a weaker USD may provide positive support for global financial conditions and risk assets.
January was a mixed month for credit markets as flat to positive performance for US high yield and leveraged loan markets outperformed the rate sensitive investment grade markets which sold off in conjunction with sovereign yields globally. High yield spreads tightened and loans benefitted from floating rate coupons. Within high yield, lower rated paper (B and CCC) outperformed as did a handful of higher spread sectors (Retail, Telecom) and energy credits, buoyed by rising oil prices. Corporate credit managers were mostly flat to positive in January. Managers continued to benefit from more gains in a distressed energy name that had positive idiosyncratic developments the prior month. Other areas that generated gains included stressed telecom and healthcare names and Puerto Rico exposure which rebounded in January.
Structured credit managers generally reported positive performance driven by carry and spread tightening. Specifically, non-agency RMBS contributed as credit risk transfer remittance reports showed better than expected delinquency rates for hurricane affected areas and a number of legacy RMBS deals were called without trustee reserves. Private student loans also benefited against a favourable fundamental backdrop, while short positions generally detracted from performance.
January was a positive month for Event Driven strategies. Strong equity markets, fallout from the tax reforms and increased confidence in global growth boosted returns from Special Situations. It also led to a broad tightening in merger spreads. Returns were generally diversified across many positions, with little on the detracting side. While Relative Value situations generally performed positively throughout the month, one well owned position in particular detracted towards month end as rumours circulated that the parent company might be considering an IPO or a deal to buy the subsidiary’s stocks that it does not already owned. Theoretically this should not be negative for the relative value trade, but uncertainty and crowding have contributed to make this a significant deleveraging event and offset some positive gains accrued during the month.
Global deal activity has made a notable start this year with USD 400bn of transactions announced, including USD 130bn proposed (Bloomberg as of 30 January). While the sustainability of deal making may be questionable given current valuation levels, the recent pick up in announced transactions (Q4 2017 and January 2018) has provided managers with potentially fertile ground for the coming months.
In Statistical Arbitrage, it was an encouraging month for most factor based strategies, in large part driven by returns from cross sectional momentum. Technical strategies have been positive as well, but this is not an environment (strong cross sectional momentum and low volatility) in which we would usually expect these strategies to thrive.