Risky Signals

It's becoming increasingly difficult to keep track of the near-daily market-sensitive policy announcements.

Over the past month alone, we've seen the Federal Reserve lower interest rates by 50 basis points, initiating an expected series of cuts from the world's largest economy. Then China announced a large stimulus package resulting in the biggest five-day move in Chinese stocks on record. Saudi officials announced a more relaxed approach to oil quotas that could see significantly more oil pumped per day than under previous agreements. All the while, tensions have escalated in the Middle East, following Israeli attacks on Lebanon and a retaliatory strike by Iran on Israel.

The market's broader response to these events has been muted so far. The 50 basis points cut initially triggered a positive equity market reaction, anticipating more accommodative monetary policy. This briefly flipped to fears that the Fed might have access to worse data than is publicly available. It eventually settled into an equilibrium of uncertainty about whether the cut is beneficial or detrimental, so let’s keep buying equities anyway.

We find ourselves in one of those curious periods (which feel more frequent in the last five years than in the prior ten), where relatively low levels of market volatility and an S&P 500 scraping up against new highs are at odds with the long list of of uncertainties that most investors can happily reel off.

Trying to run active strategies in this landscape is a situation that is susceptible to sharp changes in market narratives. These are difficult to predict, and their impact is hard to gauge even if one is right. The forthcoming US election means that this state should persist until mid-November at the earliest.

The general expectation, aside from ongoing global conflicts, is that 'active policy' will remain the norm for the time being. We expect more stimulus in China. The ‘Fed put’ is back in play; it took little more than a whiff of slowdown for Chair Jerome Powell to come riding to rescue of traditional asset holders.

When viewed through the lens of such supportive policy, it’s easier to understand why assets continue to rise in value despite increasing uncertainties – whatever happens, those in charge will have investors’ backs.

Except, of course, this largely follows the main playbook of the last 16 years – kicking the can down the road. Maybe government debt piles can keep growing indefinitely without a material default risk ever showing up in the price of long- dated bonds, but 2022 showed us how loose monetary policy can have more painful short-term implications in the shape of inflation.

While that particular genie appears to have been successfully re-bottled, the stopper is only loosely fitted. The next few years may be an interplay between generally quite accommodative policy and a fear that inflation will rear its head again in the short to medium term.

Navigating this successfully calls for skill and experience from both central banks and politicians. One finds relative comfort in the former, and considerable uncertainty in the latter.

Key drivers of hedge funds' performance: An early September snapshot

Equity long/short:

• September was a mixed month for broad equity markets. The month started weakly with many major markets posting losses. However, US (post-interest rate decrease) and Chinese (post-policy easing) equities recovered and moved into positive territory in the days leading up to month-end. Conversely, Japanese and European equities are posted modest losses
• It was a stronger month for fundamental long/short managers, who were generally able to navigate the turbulence well and post positive alpha across regions. On the heels of a strong resurgence in Chinese equities in the last week of the month, Asia equity long/short led the way
• While alpha generation on longs and shorts was tracking closely through most of the year, it diverged back in in July. Since then, longs have continued to generate strong positive alpha while shorts have given back gains. This trend continued in September
• Hedge fund positioning suggests a 'risk-on' mentality, but equity long/short funds are more cautious, with smaller increases in leverage compared to other strategies

Credit:

• It was another strong month for credit markets and most corporate and structured credit managers
• Convertible bonds delivered positive returns, including from primary markets as well as some idiosyncratic credit situations, certain volatility-oriented names, and exchange/buyback activity. China-related American depositary receipts also contributed positively, driven by the strong equity rally
• High-yield long/short and capital structure arbitrage strategies also performed well, with the debt instruments from a privately held messaging app rebounding from last month’s losses. The capital structure of a widely held stressed/distressed media company also rallied on positive fundamental developments
• Fixed rate financial preferred securities saw ongoing demand as the Fed cut rates. Some managers also profited from a stub trade that had been a meaningful detractor so far this year. This position performed well after the original thesis behind the trade played out. Portfolio hedges detracted due to the credit market rally and rising U.S. Treasury prices
• Structured credit managers benefitted from carry, mark-to-market gains, and active secondary markets

Event Driven:

• Merger arbitrage had a busy month with mixed returns from idiosyncratic drivers across strategies. Notable new deals include Frontier Communications / Verizon ($20 billion) and Smartsheet / Vista & Blackstone ($20 billion)
• Several transactions received regulatory approval: Kindred (French antitrust), Stericycle (HSR clearance), Hawaiian Airlines (Dept of Transport) and PSC Insurance
• The Revance Therapeutics/Crown Labs merger was set back by a delay in Crown’s tender offer due to a dispute. McGrath RentCorp and WilScot mutually agreed to terminate their merger due to regulatory hurdles
• The US Steel national security review (CFIUS) has been delayed to after the US election. The Federal Trade Commission litigations to block the Albertsons/Kroger and Capri/Tapestry transactions continued in the courts
• In Asia, Special Situations trades performed well across regions, e.g. in Korea, Japan (particularly with short plays) and China (benefiting from the new stimulus measures)
• The largest equity listing in Hong Kong in over three years was successful, with Chinese home appliance maker Midea Group launching a $3.5 billion share offering. This could create opportunities to profit from price differences between shares traded in mainland China and those in Hong Kong

Systematic Macro:

• Trend-following strategies have posted positive returns, clawing back some of the losses experienced over the last few months. Returns have come from most asset classes with long equity, long bond and short dollar positioning all contributing healthily
• However, alternative trend-following strategies have struggled as short commodity positioning and short Chinese markets exposures detracted following bullish rhetoric from Beijing
• Broader systematic macro manager performance is mixed. Those with more momentum/trend exposure have benefitted from general risk-on dynamics, while currency positioning has been painful for some

Discretionary Macro:

• September looks to be a positive month across discretionary macro strategies
• The rally in bond yields has boosted performance, particularly in curve steepening strategies, rather than directional positions where, in fact, there has been more of a bias to fade recent price action in front-end rates
• Japanese themes continued to profit through long JPY structures and JGB curve flatteners, though there was some volatility around the Liberal Democratic Party leadership election
• In Europe, longs in core fixed income and GBP broadly worked well, as did shorts in French OATS (long-term government bonds)
• Gold longs have contributed to gains, while long positions in emerging markets fixed income worked well outside of Brazil. Thematic exposure in, or related to, China has been limited over the past few years, however we expect this to change given the extent of the stimulus package announced in September

On the Radar:

• In the short term, the US election will dominate the headlines, but even as we are in the final stretch it is hard for investors to either identify or position for risks that may emerge from the event. We see hedge fund managers approaching the date with caution, looking to capitalise on opportunities after the event
• Regardless of what happens in the election, the path of US interest rates over the next six months will be watched closely for evidence of policy makers’ concerns around both the risk of economic slowdown (shown as faster than expected rate cuts) or the re-emergence of inflation (shown as slower than expected cuts). For us, the latter is a bigger risk to markets than the former

All data Bloomberg unless otherwise stated.