“How do we know when irrational exuberance has unduly escalated asset values?”
Alan Greenspan, December 1996
Greenspan’s comment seems apt for the current market environment. Then, as now, the S&P 500 had been in a bull market for around nine years and had a cyclically-adjusted price-earnings (‘P/E’) ratio of around 30x. While he felt that markets were being ‘irrational’ about the valuation of technology stocks, the current concern is whether similar market valuations can withstand the withdrawal of central bank liquidity and the higher discount rates caused by the end of Quantitative Easing (‘QE’).
The events of October 2017 did nothing to dissuade us of the fundamental case that central banks are now committed to tighter monetary policy across the Developed Markets. The response from Equity markets has been, if not exuberant, then at least firmly positive. For many investors, this is a welcome return to a more ‘normal’ economic regime. When the European Central Bank (‘ECB’) announced the broadly-expected level of tapering to QE, the market reaction suggested that they could have delivered more without spooking investors. In the US, the threat of higher discount rates appeared to be hampering the performance of the larger tech stocks in the market, only for Amazon and Google to noticeably beat their earnings estimates towards the end of the month, propelling the higher P/E sections of the market even further. In Japan, helped by the stronger-than-expected performance of Shinzo Abe’s ruling coalition in the general election, we saw the Nikkei 225 Index finish up on 17 of the 22 trading days in October – one of the most consistent monthly rallies of the past few years.
It is of course very early days, the US 10yr yield remains about 20bps lower than where we started the year, but the constructive reading of these events is that markets have navigated the first few steps towards a post-QE world without any of the issues we outlined in last month’s Early View. Our central fear had been that the end of QE could lead to a shock in either Equities or Bonds, which in turn could lead to deleveraging across all asset classes, and that losses to Equities and Bonds at the same time could be catastrophic for most risk-management regimes. However, Halloween has come and gone and we still do not see any sign of phantoms in the correlation matrix.
Hedge funds are generally enjoying this environment. Low correlation between and within asset classes has historically been beneficial for active management, since managers can potentially diversify more effectively and take more risk if necessary. In our view, there generally appears to be more alpha potential in the market, particularly in Equity stock valuations around earnings announcements. And as ever, we believe when things are good, momentum may start to emerge as a factor in hedge fund performance as managers add to contributing positions and themes.
Our cautious instincts lead us to be more careful after periods of positive performance. For hedge funds, we know that momentum at the single security level can lead to crowding, which then risks a sharp correction in alpha. For markets, the recent switch from Bonds to Equities is one of the clearer ‘risk-on’ shifts of asset allocation we have seen in recent periods. In the summer we felt that the short term pain-trade in Equities was upwards; we are less sure now since so much of the short term news-flow (particularly around the US tax-reform) is in the price. Remember, the S&P 500 is up more than 25% since the election of Trump less than a year ago. If the tax-reform package fails, we could give back a lot of Equity market gains in short-order.
It is harder to identify a catalyst for the next leg upwards in Equities if the tax-reform passes as expected. Nevertheless, the bulls are growing more confident that we can take away the support of QE, and absorb all the benefits of the Trump agenda, and that Equities can keep going up fuelled by an endogenous and mutually beneficial mix of their own earnings and GDP growth. Yes, valuations are high, but we have stable inflation and decent growth, so what is there to worry about? Momentum tends to work like that.
Of course, in the short term they may be right - historically the P/E multiple expands in reaction to robust earnings (i.e. the increase in the numerator, price, outpaces the increase in the denominator, earnings). This brings us back to Greenspan. His ‘irrational exuberance’ quote was made at the end of 1996, fully three years before the next bear market. The S&P 500 peak in 1999 was >100% higher than the level when he warned of overvaluation, and the dot-com crash from 2000-2002 only wiped out the Equity gains made by the market after Greenspan had spoken. Selling all of your risk assets on his warning would have been a terrible mistake. As ever, trying to time markets is a mug’s game. We focus on trying to avoid both irrational exuberance and premature paralysis, and instead aim to build portfolios capable of producing alpha in varying market environments.
Hedge funds generally demonstrated positive performance across all strategies in October, as slightly higher volatility in Equities and Bonds helped the price-discovery process, and low correlation between assets and asset classes meant that managers could take more risk exposure to the benign environment.
Equity Long-Short saw gains during the month, helped by rising Equity markets and a positive reaction to the start of the Q3 earnings season. In general, earnings beats and misses matched hedge fund managers’ views on corporate health, and stock prices reacted rationally to the news. European managers generally outperformed their US counterparts. One area of weaker performance was low-net Japanese managers, who commented that the strength of the index rally was largely indiscriminating between better and worse companies and therefore not a good environment for generating alpha.
Corporate Credit managers mostly posted modest positive returns in the month, driven by small idiosyncratic P&L drivers with Puerto Rico being one of the largest detractors for managers with that exposure. The Puerto Rico municipal Bond sector continued to see heavy markdowns across the complex as investors assess the near- and long-term impacts from Hurricane Maria on the economy and recovery prospects for the debt. Puerto Rico general obligation Bonds are down by more than 50% in less than two months in a sign of potential capitulation by mutual fund and hedge fund holders alike.
Also in Credit, Caesars’ long-awaited bankruptcy emergence happened in October but it was mostly a non-event in terms of P&L contribution given the already notable YTD performance. Credit and reorg-Equity longs generally performed positively given the supportive markets. Structured Credit manager performance was also positive but muted in October, driven mostly by principal and interest income.
It was a positive month overall for Global Macro managers. Fixed Income remains the biggest area of risk, particularly shorts in US rates, so the sustained selloff in Developed Markets Fixed Income contributed to gains. Interest rate volatility rose during the month and monetary policy divergence extended from the Developed Markets vs Emerging Markets arena into G4, as the ECB announced a more cautious taper of QE against a backdrop of more hawkish G4 central bank rhetoric. Relative Value Fixed Income strategies generally benefited from this dynamic as well, with managers short US and UK rates and long Brazil and Emerging Market Fixed Income.
Bullish sentiment within the Commodity complex continues to grow, particularly in crude oil and industrial metals, along with some protective views on gold. Theses around this range from increased electrical power and nickel use to the rising importance of non-fiat currencies, to persistent Emerging Market Commodity demand. Overall, these contributed to gains for Global Macro managers on the month.
Active trading in China markets has been a noteworthy driver of P&L for many Emerging Markets focused managers. Since the People's Bank of China relaxation of the reserve requirement on FX derivatives in early September, the RMB has reversed nearly 3% from the YTD highs, though long positions in CNH/USD are currently still favoured given the positive carry profile. This month’s 18th National Party Congress saw a consolidation of power by President Xi, and potentially paves the way for further rebalancing and market liberalisation. We believe the growth and opening up of China Fixed Income markets to be a potential area for trading opportunity.
For Managed Futures managers, Equity has generally been the main driver of performance as net exposure to the asset class remains long and Equities rallied across the globe during October. Additionally, Commodities also contributed positively for some managers, thanks to long positions in industrial metals, while Fixed Income trading was largely flat. FX detracted marginally from some managers’ returns thanks to the net short USD position.
In Event strategies, deal activity was quiet in October; only USD 200bn of confirmed deals were announced during the month, which is the lowest number that we have seen in a while. The only notable announcement was Hochtief’s counterbid for Abertis (topping Atlantia’s offer). Abertis rallied ~+8% on the news.
It was a favourable month for Relative Value strategies in general. The first week of October was particularly beneficial for arbitrage strategies around ETFs. As flows slowed it allowed the market to consolidate any over or under valued legs of common Relative Value trades. Risk arbitrage in existing M&A deals was positive as well, as deal spreads generally tightened.
Statistical Arbitrage saw another positive month in October. After a setback in September, fundamental strategies once again led performance across regions. It was a notable month for price momentum-based signals, while valuation-based metrics had a more difficult time. Futures strategies were positive, as one might expect given the robust month for Managed Futures. The more technical and faster strategies lagged the trend-following indices, but were still a positive contributor to Statistical Arbitrage as a whole.