“When US rates go up, something blows up.” Or is it rather “when the US dollar goes up, something blows up”? Perhaps it doesn’t matter because for much of May we’ve had both. Throw in the odd emerging market crisis, and surely now it would be merely obtuse to overlook the risk of a general widening in global risk premia? The proverbial wisdom has it: sell in May and go away (especially if you get a warning from the volatility markets like the one we got in February). In matters regarding Italy and Spain, it is of course unhelpful to point out it was early May that one needed to sell to save the (current) drawdowns of 12% and 7% (as of 5.31.2018) respectively, but still, what is in the gnome?
Italy is its own weary story. In equities, we are indeed below the levels of the election two months ago but it was the optimism behind the 9% post-election rally that looks wrong: when is it ever right to be optimistic about Italian politics? Ten year bonds have sold off 150bps quickly (as of 5.31.2018), but then they did that in Q4 of 2016 and Q2 of 2015 also. Going back to the late 1980s, the European project (or should that be dream) has demanded a politically unachievable level of fiscal austerity from a number of Southern European countries. Every now and again, reality breaks in on the dream. While, in the end, reality may win out, we believe that it’s a poor investment strategy to bet on it, especially as the politics in Italy now doesn’t actually seem to be particularly anti-Europe (it’s more anti-immigrant and anti-poverty). Of course it’s not good for the European project and equity markets across the region are weaker. In short, though, this has nothing directly to do with a change in global liquidity conditions.
On the other hand, the EM sell-off is geographically broad. But this is less about multi-asset risk premia than it is about FX, or more precisely, it is about US appreciation rather than EM weakness, as many EM currencies had actually strengthened against the euro even before the worst of the Italy concerns. The move up in US rates and widening differential against other countries (see the record high number of countries with 10-year yields below US for evidence) finally reached a tipping point when it started to move FX markets and challenged the narrative of a structurally weak USD. Initially, the USD rally was said to be triggered by higher US inflation prints, but in general it is higher US real rates that drive USD strength and this time looks no different.
Local capital markets in many EM countries have come a long way since boom / bust cycles such as the one that ended so traumatically in 1997, and the resilient stock markets this time round speak to the higher share of domestic currency borrowing rather than a self-fueling liquidity squeeze in which higher USD prices only force in more buyers. With a few exceptions there is little incentive for EM economies to intervene meaningfully when the exchange rates are doing what they are meant to do (i.e. weaken) and making exporters more competitive. Only serious inflation offenders with twin deficits and higher risks of a ‘sudden stop’ in external financing (like Argentina and Turkey) need to act more decisively and raise rates to fend off a speculative attack.
Overall, as long as the pressure originates from a strong US economy which leads to higher real rates, we believe the shock to EM is more likely to be contained through currency adjustments which may be painful, but are more benign when compared to a deflationary recession in developed markets leading to deleveraging and a USD squeeze of a different kind. Nonetheless, market liquidity in EM assets may be put to the test and price discovery could remain noisy with little buffering from traditional market makers.
Broader credit liquidity could be a more structural concern. This environment with record tight credit spreads and an increasing risk free rate feels counterintuitive. While some hedge fund managers have been generating ‘alpha’ from more esoteric parts of the debt landscape, the returns from the others have been flattered by this rather suspicious looking free-lunch. The bulk assets seeking ‘yield at any price’ across various credit instruments is increasingly worrying to us. Sentiment in less liquid asset classes can change quickly, and with central banks no longer the backstop buyer of debt, it’s not clear who will be, particularly if data around default rates start to pick up into the end of the cycle. After ten years of cheap money it isn’t obvious where the most dangerous leverage is hiding…but we believe there must surely be some companies out there that can survive only when capital is at the historically cheap levels we’ve seen over the last decade?
So, in summary, we believe market instability now is from higher US real rates and strong relative US growth, while the more telling risk to bigger picture stability comes from ‘end of cycle’ type economic weakness. The challenge, as ever, comes back to timing. While the immediate economic data for most of the developed world remains robust, commentators are increasingly talking about a potential recession in the US for 2019 or 2020 (Hasn’t the end of this cycle been ‘a year or two out’ for quite a few years now?). Whether the data starts to weaken tomorrow or twelve months from now is impossible to say, as is the path and efficacy of any central bank response.
Investors risk getting caught between a rock and a hard place. Try to protect capital and you risk missing the last leg of risk taking from, say, equity markets climbing the final wall of worry or from merger arbitrage opportunities. Try to keep squeezing alpha from strategies with negatively skewed distributions and risk getting poleaxed by the next big volatility shock. We believe the best answer, as we’ve said before, is to be in a position to react quickly.
Hedge funds generally produced a positive return during May, with the best returns coming in the first half of the month (where all strategies performed positively) and a more mixed second half of the month. The best performing strategies were in the Relative Value complex, where some managers were able to trade both the mean reversion of risk spreads in the first half of the month and the pick-up in volatility during the second half of the month.
Equity Long-Short strategies enjoyed a positive month for most of May, but gave back some of their gains on increased market turbulence during the last few days of the month around concerns on the sell-off in Italian government debt. Regional performance was mixed, with noteworthy returns to single stock momentum in Europe and Asia for most of the month (albeit curtailed towards the end of the month), whereas returns from US managers were driven more by valuation.
May was a positive month for the majority of Statistical Arbitrage managers. After a tough period for performance, one of the most notable areas was in Asia-centric fundamental strategies; China, Japan and Korea all appeared to perform positively for factor based models. In other regions, performance was more muted, with European strategies roughly flat, and US strategies detracting. Technical strategies also had a positive month, but as ever had some divergence in performance. Diversifying and Futures strategies were typically detractors, with those managers trading Futures hurt alongside managed futures, and shorter term FX strategies also detracting.
Event Driven strategies also rebounded in May driven by merger spreads tightening and notably a rebound in the stock of a global semiconductor manufacturer due to increased optimism for deal approval by Chinese regulators. In addition, spreads for vertical mergers also performed positively following the completion of the cable television company/telecommunications company trial as the market viewed the trial developments as indicating a higher probability the Judge would rule in favor of the companies. The Judge is expected to rule on the case in mid-June. This led to tightening spreads for mergers such as an insurance company/retail pharmacy company and two mass media companies.
Given this backdrop, most Event managers performed positively in May, particularly those with larger merger arbitrage allocations. Global deal activity increased month-over-month with over USD 340bn of announced mergers (Source: Bloomberg, as of 5.30.2018).
Credit underperformed equities in May. Returns were modest for US high yield and loans and the markets traded in a relatively tight range with light secondary market activity. The European high yield market was soft with Retail and Transportation leading on the way down. Within US high yield, sector performance was mixed with no meaningful outliers. Energy and Healthcare names mostly performed positively while performance was mixed in the Retail sector, driven by earnings (which were a mixed bag). US high yield issuance remained below historical averages and there continued to be outflows from high yield funds and inflows into loan funds. It was another month of outperformance for lower-rated credits resulting in the spread between CCCs and BBs compressing towards historical tights.
Corporate Credit managers generally posted positive returns in the month helped by gains in financials, several stressed and distressed commodity credits, gaming and media reorg equities, and Puerto Rico muni bonds. Single-name credit shorts and market hedges were detractors. Most securitized products sectors saw tightening in May helping support the positive performance for Structured Credit managers.
May was a weak month for CTAs on the whole, with all major asset classes detracting from performance, but returns for individual managers were more dispersed than usual throughout the month. For the first half of the month, performance had held up, with long exposure to equities the primary positive driver of returns. However, in the final few days of the month, both crude oil, then equity markets suffered a sharp sell-off around Italian political instability, and both ended up detracting from performance. That period seemed to hit exposure across asset classes, with the short US, long European bond position also detracting in a flight to quality style move. Performance in FX was much more varied by manager, and seemed to be dependent on positioning in the Euro and CAD.
Discretionary Macro managers experienced more mixed, but generally positive performance, on higher levels of volatility across asset classes, in particular in FX, Fixed Income and Commodities. Perhaps unsurprisingly long volatility strategies and mean reversion strategies were generally positive, but more directional strategies also managed to finish the month flat to positive despite giving back gains in the second half of the month.