Navigating the Rorschach Test of Current Markets

There is a meme doing the rounds in finance circles that the three largest VIX volatility spikes of most of our careers were caused by the Global Financial Crisis, the COVID-19 pandemic, and by the Bank of Japan (BoJ) raising interest rates by 25bps at the end of July.

While this conveniently ignores the fact that the peak of the VIX Spot price was calculated from a very small number of contracts and probably overstates the level of panic in markets, the front month contract from the VIX curve traded higher than 37 in early August, comparable to levels seen during the major market events of the last 20 years.

The disinterested traditional investor may wonder what the fuss was all about; after all, most equity and bond indices finished the month in positive territory. But these sharply ‘V-shaped’ months are particularly interesting in the context of changes of market paradigm.

The first three trading days of August were the crescendo of the selling pressure seen for much of July. Active investors talk of ‘position-clearance’; the flushing-out of fast money, particularly from overextended trends such as foreign exchange carry, but also from short-term holders of equity indices. This position-clearance can be a harbinger of further market stress.

But in most instances, particularly when the catalyst for the sell-off was relatively benign, markets can rebound quickly once the selling pressure subsides. For the most part, this leaves active investors (and many systematic macro hedge funds) nursing losses for the month, as positions in aggregate were exited at the nadir of the market path.

However, as we move into a cutting cycle for most developed market central banks (outside of Japan at least), markets remain something of a Rorschach test for investors: you can see pretty much anything you want to see.

Optimists will see the stimulative effect of lower rates on an economy that has largely avoided recession. Whereas the pessimists will note that data is weakening, earnings have started to roll over and many assets remain priced to perfection. It is worth reminding oneself that central banks should not automatically cut rates if inflation and employment data are broadly on target.

Talk of a 50 basis points cut from the Fed in September feels premature to us. This is partly because we expect chairman Jerome Powell to exercise caution so close to the election, lest their decision looks politically motivated, but mainly because a 50 basis points rate cut is rare outside of market crises. There is little in the fundamental data to support such drastic action in our view.

So, we remain at an inflection point with markets in search of a new narrative. The sell-off, particularly in equities, during the second half of July and early August was more technical than fundamental, but arguably so was the rally back to the highs seen through the rest of last month.

The fundamental data remains unclear; small deviations from expectations still carry disproportionate heft, and investors disagree on the long-term expectations of inflation and interest rates.

For hedge fund managers, this calls for being nimbler and looking to capitalise on smaller discrepancies as a more robust way to extract alpha, rather than making big economic calls which can be quickly confounded by these fickle markets.

Key Drivers of Hedge Funds Performance: An Early August Snapshot

Equity Long/Short:

• August started out with a bang – Japanese equities notched their largest three-day decline ever and US stocks also took a nosedive early in the month on slowing economic data.
• Performance for Equity Long/Short followed a similar tune, with managers struggling over the first few trading days of the month. Outside of Asia, downside mitigation was stronger, but funds still incurred losses as exposure to beta and volatility proved costly.
• Performance for most global equity markets and equity hedge strategies rebounded following the first week of August, though Asia-focused strategies still trail on the month due to their larger drawdowns.
• The de-grossing which started in July carried into the first few trading days of August. We then started to see equity funds become net buyers of the dip, especially adding to their long positioning, before short selling picked up mid-month.
• Given expectations for a lower rate environment, managers have continued to sell info tech and consumer stocks, favouring higher dividend ones instead.

Credit:

• Corporate Credit managers largely saw another month of positive returns. After some early month volatility, risk assets including credit mostly shrugged off any growth-related concerns, with US high yield spreads once again close to recent lows. US leveraged loans, investment grade and high yield strategies are all in positive territory at the time of writing, with lower treasury yields supporting absolute returns.
• Convertible bonds held up reasonably well throughout the month, benefitting from the pick-up in equity volatility (particularly tech and utility names) as well as lower treasury yields as credit spreads were stable on a month-over-month basis. Managers did actively trade portfolio level credit hedges early in the month when spreads widened, locking in gains before the markets reversed.
• From a returns perspective, high yield long/short, capital structure arbitrage, and stressed/distressed/reorg. equities were generally positive contributors, with few idiosyncratic detractors. Debt of a privately held popular messaging app sold off after the CEO’s arrest, negatively impacting some managers, but it was viewed as a buying opportunity.
• August saw modest, mostly carry-driven returns for structured credit managers.

Event Driven:

• August saw most event arbitrage strategies modestly positive, with minimal impact from the early volatility in the month and a general narrowing of spreads.
• Positive updates include the takeover of Network International by Brookfield finally receiving all remaining regulatory approvals, Abu Dhabi's Adnoc completing due diligence on chemical company Covestro with a bid expected for September, and a competitive takeover situation for Taiwan’s Shin Kong Financial
• New deal activity is headlined by the $36bn acquisition of Kellanova by Mars; other notables include a private equity take-private of the healthcare tech firm R1 RCM for $8.9bn, convenience store giant 7-Eleven was approached by the Canadian retailer Alimentation Couche-Tard, and UK investment platform Hargreaves Lansdown agreed to a $6.9bn bid by CVC.
• Sidara surprised markets by not extending a firm offer for Wood Group, and the Hess/Chevron spread widened after the arbitration date was scheduled for May 2025.
• German battery maker Varta reached a restructuring agreement with its creditors with the help of capital from Porsche.
• Regulatory focus remains on the Hawaiian Airlines deal and the Capri/Tapestry litigation by the Federal Trade Commission.

Systematic Macro:

• August was a difficult month for the broad universe of managers. The acceleration of the unwind in the carry trade coupled with some managers being caught up in equity market volatility has led to some disappointing performances.
• Within trend following, most managers are posting negative numbers. In currencies, short-Japanese yen and long-USD positions held against a host of currencies have detracted, while long-equity positions also detracted at the beginning of the month – causing managers to rapidly reduce risk. Fixed income was also painful for those strategies that retained short-bond positions from July.
• Systematic macro strategies have felt the pain more acutely with carry trades – long USD and shorts across the US yield curve proved most costly. Some managers also suffered in equities depending on the mix of index positioning, as long-Japanese and US tech-heavy indices sold off most aggressively. Elsewhere, long commodity positions struggled with gas and heating oil selling off at the beginning of the month.

Discretionary Macro:

• Discretionary macro strategies are broadly flat at the time of writing, having given back most positive performance made earlier in the month.
• The spike in cross-asset volatility at the start of August was largely conducive for discretionary macro strategies. Unlike their systematic counterparts, they had significantly reduced exposure to carry trades earlier in the summer as hawkish policy expectations developed in Japan and signs of slowing growth tempered optimism for a soft landing in the US.
• Thus, discretionary macro funds avoided some of the pain as risk-on and carry trades were unwound and instead gained from defensive positioning in equity indices, longs in front-end rates and yield curve steepeners (largely in the US). Themes in EM fixed income also held up well with long-biased positions benefitting from the global rally in fixed income. However, short positions in Japanese government bonds struggled despite the hawkish shift by the BoJ. Since then, though, it’s proven difficult to retain those gains as markets have by-and-large recovered from the volatility, helped by encouraging inflation and activity data.
• With much of the price action now being attributed to systematic macro de-grossing, the idea that market positioning is now much cleaner has tempted some managers to start adding risk again. We’ve seen some tactical fading of the aggressive amount of easing currently priced into the US yield curve, as well as short duration positions in Japan being re-entered.

On the Radar:

• In the short term, the next Fed rate decision on 18 September will likely be a market catalyst. In the middle of August, market pricing suggested a 50 basis points rate cut as the most likely path. This has since softened, and currently stands at a 70% likelihood of a 25 basis points cut and a 30% likelihood of a 50 basis points cut. From these probabilities, either decision is likely to send a message to markets.
• The main event of Q4 from a market perspective is likely to be the US election on the 7 November. Uncertainty remains high around the event, not least since betting markets are pricing a near 50% probability of success for either candidate, and that markets seem unsure of the likely risks and opportunities from a sector perspective even once the victor is known. There is a real chance of a repeat of 2016, when markets waited for the result before deciding over the next 48 hours whether this was beneficial or detrimental to risk assets.

All data Bloomberg unless otherwise stated.