Man FRM Early View - May 2022

The market narrative around inflation continues to evolve. While much of this year has seen investors and policymakers finally accepting the magnitude of the problem, not least via mind-boggling CPI data prints, the month of May felt like something of a new chapter. Talk is now of inflation peaking – according to US Federal Reserve, US 10-year breakeven inflation fell from over 3% at the start of the month to less than 2.5% intraday on 26 May - and focus has turned to ‘what next?’.

This may of course be seriously premature, but empirical evidence suggests that when inflation is high but falling, then risk assets typically perform well. Given that positioning has been comprehensively flushed out over the last few months, it was unsurprising to see a sharp bounce in equity markets during the second half of the month, and so determining whether this is just a bear market rally or a more sustained recovery as markets normalise is a question that has rightly concentrated investors’ minds.

There are plenty of unknowns in the current path. The prolonged impact on commodity prices from Putin’s war in Ukraine has at least two dimensions of uncertainty; the first is the continuation of the war itself, both in terms of longevity and severity, as a longer or more intense war is likely to increase supply tightness in energy and agricultural commodity sectors beyond that currently priced into forward curves. The second dimension is around seasonality – the impact of higher energy prices on inflation will likely be felt more acutely in the Northern Hemisphere winter when the implications of Russian sanctions could start to show in real scarcity, particularly in subsectors such as European natural gas. Similarly, the impact of the war on Ukraine’s wheat harvest for 2022 will only be known with certainty in August or September of this year.

Beyond the supply constraints themselves, the pricing behaviour of retailers and intermediaries remains unclear. One suspects that it is more palatable to pass on increases in raw material costs than decreases, and the temptation to increase costs regardless of necessity may slow any normalisation of price indices. For employers, wage demands are likely to lag price increases as the cost-of-living debate takes time to achieve political traction. But announcements such as the UK government’s decision to give all households GBP400 to help with fuel costs will likely only add fiscal stimulus fuel to the inflationary fire. As with previous severe inflationary episodes, once the genie is out of the bottle, it can be harder than expected to put back in.

This uncertainty is prevalent within markets too. Credit spreads have widened significantly this year, while bank estimates of default rates for 2023 remain low. Either the banks are too bullish on the economic outlook, or shorter-dated corporate bonds offer an unusually high loss-adjusted yield. Similarly, merger spreads in announced M&A deals are significantly wider than usual right now, but the flow of new deals being announced shows little sign of slowing, suggesting that those providing liquidity into these situations may be handsomely rewarded for it.

Risk premia such as these can fatten due to widespread investor caution and uncertainty over both geopolitical and economic tensions. Institutional equity positioning is light, and retail investors have been scared off by losses in commonly held tech names and fragility in other retail hotspots such as cryptocurrencies. Indeed, the usually high correlation between the performance of Bitcoin and the NASDAQ index over the last few months (and when both have been losing money) suggests that a chunk of the fast money has been burned, and history suggests that retail investor confidence can take time to return, regardless of fundamentals.

So once again we feel markets are balanced between risk and return. If one believes in a gradual normalisation of the inflation landscape with modest economic growth (or even a mild recession), then the opportunity to benefit from traditional risk-on assets and particularly from liquidity provision in active strategies looks attractive right now. However, further severe stagflationary stresses are sufficiently possible (if not yet, by consensus estimate, probable) to keep risk-aversion high. One is reminded of the gradual recovery from the Global Financial Crisis, through the stuttered recoveries, the Eurozone crisis, and the difficulties of exiting quantitative easing. While the current inflation episode is a very different kind of economic shock, the sense of uncertainty over the possible exit paths is somewhat similar. A bumpy road with many false dawns feels like a sensible roadmap for the rest of 2022.

Hedge Funds

Hedge fund managers generally posted losses in a choppy month for traditional risk assets. Equity and credit hedge funds endured a difficult start to the month before a small recovery as markets geared toward a softer Fed policy path. CTAs had been on track to extend their recent run of positive performance; however, a number of trends reversing in fixed income and currency markets proved difficult to navigate.

Equity long-short managers struggled to recover early-month losses despite more positive equity market performance in the last week of May. Disappointing earnings from “Big Tech” companies alongside existing concerns around the war in Ukraine and Covid-19 lockdowns in China weighed on sentiment, and several factor unwinds challenged hedge funds early in the month. The trend lower in aggregate net exposure continued in the US; despite this, managers struggled to protect themselves from falling alongside the market with more growth-oriented strategies, and those with heavy TMT and consumer discretionary exposure struggled the most. Outside the US, Europe-focused funds have not experienced losses as harsh. However, Asia funds – particularly China-dedicated ones – saw continued losses and did not benefit from modest performance bounce-backs late in the month like their Europe and US counterparts.

Credit markets showed similar weakness in the early stages of May before a strong rally into month end. The US investment-grade market outperformed US high yield, helped by longer duration and higher interest rate sensitivity. Performance for high yield credits was mixed with the retail sector underperforming. Credit-focused hedge funds generally posted negative returns against this backdrop. Convertible Arbitrage managers suffered as credit-sensitive convertible bonds were particularly weak, driven by the sell-off in growth/tech names. Financial preferreds and SPACs were also soft on the month, while credit long-short managers saw some gains from portfolio hedges and select high yield shorts. Structured credit managers saw gains from carry and hedges which helped offset negative mark-to-market losses from spread widening across many securitised products sectors.

In event driven, merger arbitrage spreads widened materially mid-month due to a combination of markets moving lower, de-risking, possibly more leveraged Event traders capitulating, as well as adverse, idiosyncratic developments in several transactions (a popular social media firm widened to a 50% gross spread). Several deals have been impacted by regulator reviews, resulting in extensions to the timelines and stoking completion concerns. However, managers seized the opportunity to add to higher conviction trades as spreads tightened in the second half of the month. Index rebalance trades have been challenged in the volatile environment, whilst softer catalyst investments with longer durations and higher beta have had a difficult month, particularly in the US.

Discretionary macro strategies broadly suffered from shorts in US rates. Rising recession risks drove saw a fall in 10-year U.S. Treasury yields, whilst the potential for a less aggressive Fed policy path led investors to take out some of the tightening priced in this year, working against popular macro themes in short-term interest rates. Macro managers are generally running less risk in rates following recent gain taking, given the extent of the sell-off this year, whilst recent market behaviour has encouraged a more tactical trading approach. This has generally resulted in more risk being allocated to currencies, where improving terms of trade prompted gainful long positions in the likes of BRL and MXN during May.

We saw some of the best performances within the hedge fund asset class coming from quantitative strategies. In equities, low-net managers were broadly flat-to-positive through the factor deleveraging at the start of the month, whilst machine learning strategies continued to show little sensitivity to dispersion amongst style factors. In terms of macro, defensive strategies such as CTAs were broadly flat after giving back gains accrued in the first half of the month. Both trend-followers and systematic macro managers were caught out as the US dollar retraced slightly, notably against euro and Japanese yen where considerable short exposure had manifested. Sovereign bond trading was also difficult as the surge in global yields took a pause; however longs in the crude oil complex continued to bolster returns. Equity shorts were mostly additive despite the recovery in global markets into the close – faster strategies in particular enjoyed the largely uninterrupted direction of travel in the US as the S&P 500 index fell for the seventh consecutive week during May.