“We should also be wary of moving too gradually”.
Janet Yellen, 26th September 2017
After many false starts in shrinking the collective central bank balance sheet, there was, in September, perhaps the strongest sense that the move to tighten monetary policy was starting again, but this time in concert across the developed world. When the Fed had begun to tighten in December 2016, the European Central Bank (‘ECB’) felt a long way from comfortable with inflation and growth in Europe and the Bank of Japan was positively accelerating their levels of intervention. We then spent the next eight months watching yield curves flatten as central bankers kept the rhetoric on a very tight leash.
In September, everything has loosened up. 10yr yields across developed markets have risen materially (the trough to peak move through the last three weeks of the month was around 35bps in the US, 24bps in Germany and 48bps in the UK). Yellen gave the clearest indication yet that the markets may now be underestimating the pace of hike; Draghi effectively pencilled-in the end of Quantitative Easing (‘QE’) for October and Carney moved Sterling 4c higher vs the Dollar over two days with his most aggressive inflation and growth commentary of the year.
If we are now really at the point of shrinking the balance sheet, then there is no guarantee that this is an easy path. We have previously been wary of central bank missteps – tightening too quickly or too slowly. This is still a risk, but perhaps the bigger risk is the collateral damage of tightening regardless of timing. In Europe, the disparity between the potential impact on Germany and Italy caused by a tighter ECB is stark: this would not be the first time in the Eurozone’s short history that the healing process started too late and it is not inconceivable that we could potentially have a rerun of the sovereign crisis of 2011 in Italy for 2018.
Tremors have also been felt in the Equity markets this month. Tighter monetary regimes threaten to upset the current factor biases that have been baked into the market through most of 2017. Two areas of the market to rally this year have been Tech (low discount rates are historically good for Growth stocks) and Bond substitutes (stable dividend potential is attractive in an era of low interest rates). We believe Valuations in both of these areas of the market are high.
To complicate these issues, the Trump trade is back in focus. The Administration’s credibility took another bath in August, so the sharply increased probability of genuine headway on tax reform has wrong footed the market. There therefore seems to be a perfect storm around Tech stocks: tax reform could be bad for them (since they generally make fewer profits and pay less tax than other sectors of the market). Add the problems of potential overvaluation and higher rates to the mix, and you have a very unstable situation in our view.
We had the first sniff of this problem on Monday 25th September. On the surface, the S&P 500 finished down slightly, but within Equity markets the factor rotation from Growth to Value was marked – this resolved itself over the following days, but not without damaging hedge fund performance across a number of strategies. We remain particularly concerned by how easily small market dislocations can lead to fairly widespread losses in the hedge fund community.
In the big picture, we feel the potential reversal of global monetary easing over nearly a decade could be destructive at some point. After twenty years of broadly negative correlations between Bonds and Equities, we question - are we about to see bear markets in both? And if a rise in the cost of funding doesn’t pose questions about the integrity of sovereign credit after all this, what will?
But to front-run this threat has been expensive. There have been so many false alarms that ennui rather than panic is the prevailing response (look at the level of implied volatility). The last of these, at the end of June, was curiously like this one, in the last week of the quarter. Is it just another symptom of investors crowding into similar trades?
Inside the US, investor flows into passive and ETF products are potentially sitting on large profits. There is a natural reluctance to crystallise a taxable profit inside the year, so only a significant slide in prices seems likely to trigger a turning of this tide.
Outside of the US, a number of our European Equity Long-Short managers have commented that despite the hawkish sentiment around central banks, the macro data remains encouraging and positioning in the region is sufficiently light that the path of least resistance is potentially up from here. Even our most bearish managers struggle to make a convincing case for a European Equity market sell-off between now and year-end (save perhaps war with North Korea).
So here we are again, confronted by the familiar dilemma: we are living in an earthquake zone with all the bumps and rumbles of a potentially large impending quake, but the politics and the practicalities of a pre-emptive evacuation are unpalatable.
September was a mixed month for hedge funds as the sell-off in Bonds through most of the month led to losses for CTA managers and the repricing of valuations in Equity markets. Event strategies generally did better, as did Value focused Equity Long-Short and Credit, but Statistical Arbitrage suffered.
CTA managers primarily saw losses in their long Fixed Income positions, but sideways markets in other asset classes meant that there were few contributors across many managers’ portfolios. Managers continue to watch for positive correlation between Equities and Bonds, which has historically been a negative sign for CTAs as managers reduce risk in concert, in similar trades.
Equity Long-Short managers experienced a month of two halves, with Momentum trades in Growth stocks continuing to perform through the start of the month, before Value recovered through the second half of the month. European managers generally fared better than other regions, as the rise in 10yr rates from close to zero in Germany led to more rational pricing behaviour (and there hasn’t been the same level increase in Tech valuations in Europe as we have seen in the US).
Statistical Arbitrage had a difficult month in September, ending what has been a favourable run over the summer. Fundamental strategies had a poor month across regions, with a mini factor rotation seemingly occurring – there have been encouraging returns from Value, while Quality, Earnings growth and price Momentum all seemed to have reversed during the month. Technical Equity strategies performed marginally better, though there was quite a range of performance reported. Those managers with exposure to futures strategies also had a difficult month, in particular those that look more like Managed Futures strategies suffered in the Bond sell-off.
Corporate Credit managers were broadly positive driven by a rebound in long-biased positions in commodity-related Credits and reorganisation Equities as well as a recovery in a number of stub trade positions which had widened dramatically in August. Within the distressed space, Seadrill filed for bankruptcy after reaching a comprehensive restructuring agreement with their various stakeholders. Exposure to Puerto Rico was a detractor for some managers as the entire complex traded off following the destruction caused by Hurricane Maria.
Structured Credit markets were mixed in September with sector spreads generally flat to wider on the month. Retail weakness continued to weigh on commercial mortgage-backed securities indices (‘CMBX’) with high retail concentration, particularly in the lower-rated portion of the capital structure. Private student loans were also softer due to regulatory actions taken against certain student loan trusts due to alleged improper debt collection practices.
Overall September was a positive month for Discretionary Global Macro managers, which generally benefited from the global yield sell-off, as many still held shorts in Developed Markets Fixed Income. Some managers also gained from bullish Renminbi (‘RMB’) positions, though timing was crucial given the reversal in the RMB in September. The USD rebound also followed on the yield sell-off, though Emerging Markets FX positioning continues to be dynamic and varied. Emerging Markets risk appetite particularly in Equities remains robust.
Deal activity was slightly subdued in September though we saw a few sizeable deals being announced which is encouraging in our view. Anecdotally we are hearing from our managers that some corporates are slightly reticent to launch takeover offers ahead of a clearer understanding of Trump’s long touted tax reform. Even post the release of Trump’s tax proposals on the 27th of September, there remains uncertainty as to how they will impact Mergers and Acquisitions (‘M&A’). As the outcome of these proposals become clearer, we believe M&A activity could improve. While we are seeing a pick-up in Private Equity deal making activity this year, managers generally remain conservative and hold limited exposure to buyout deals given the increased risk characteristics of those.
Event strategies generally had positive performance in September. Risk Arbitrage was generally a positive strategy for managers. The main drivers were three deals which have experienced much volatility throughout the deal life. Softer catalyst situations (Equity and Credit) also contributed positively to performance. In Relative Value there is still a wide dispersion of spreads/discounts/stubs, etc. There were moves in both directions during September, maybe caused by below average liquidity. Overall, Relative Value strategies ended the month down. An internet services company was a notable contributor for several managers while a media company hit another record discount to its stake in an internet company in September.