The Art of a Measured Retreat?

We have delayed publication of this month's Early View by a week to give us time to assess the market implications of the US/Israel–Iran conflict. At the time of writing on 11 March, the situation is still very volatile, but here are a few initial conclusions that we have drawn.

Firstly, as each day passes it becomes increasingly unlikely that this can be viewed as a 'surgical strike' akin to the action taken in Venezuela. Some geopolitical strategists had believed that the US had picked a continuity candidate in advance (much like Delcy Rodriguez), and that once the senior leadership in Iran had been killed, a peace agreement would follow with a more US-friendly new administration. The developments over the weekend of 7-8 March, and the announcement of Mojtaba Khamenei as new supreme leader, suggest that these ideas are wide of the mark.

Secondly, many strategists took it as read that the primary reason for regime change in Iran was broader access to Iranian oil for global markets. US President Donald Trump's actions frequently betray his true motivations – to bring down the price of oil over the long term and reduce the cost of living in the US. His volte-face on Monday evening to talk down oil markets in the short term is further evidence of this.

Where does this leave us? Right now (although this will likely have changed by the time you read this), these two conclusions suggest the most likely path forward is another version of TACO (Trump Always Chickens Out), or at least a measured retreat. The US can present this as a win ('so much winning, quicker than expected' and so on) and given the level of destruction of Iran's military capabilities and senior leadership, there would be some truth in that position. Iran might also see a gradual de-escalation as a win given the weakness of its current position. Longer term, this solves relatively few of the structural geopolitical problems in the Middle East, although one would be forgiven for believing that war was the wrong approach to achieve this anyway, given the history of the region.

Market moves

Perhaps the most telling aspect of this conflict has been the market response. Equity markets are slightly lower, primarily driven by concerns over the cost of oil and gas and the knock-on risk of inflation. None of the equity moves in March so far have felt panicked. Bonds were also lower during the first week of March, before both equities and bonds rallied on news of a possible reduction of hostilities. Equities and bonds becoming correlated on daily moves is the usual inflation playbook.

This is also another example of the market being able to focus on only one concern at a time. Behind the geopolitical noise, the US had followed through on its threat to impose sweeping 15% tariffs following the Supreme Court judgement against specific tariffs earlier this year. And concerns around the weakness of private credit exposures through pooled structures such as business development companies (BDCs) appear to have quietened (although the share prices of companies affected, such as Blue Owl, have continued their slide).

Liquidity remains key

For hedge fund managers, these types of markets are frustrating. Even those with 'correct' positioning often find themselves reducing risk to right-size exposures to increased uncertainty, and the skittishness of intra-asset correlations can make portfolio management difficult. Add to this those who have lost money in the process of reducing risk and the net effect is deleveraging, which leads to further small losses across the active management industry. Crowded positions are typically the most painful, as witnessed this month with the outperformance of crowded short indices and the negative returns to cross-sectional momentum factors. Often one must wait for the dust to settle and for arbitrageurs to re-enter trades for these dislocations to close.

At the risk of sounding like a broken record, there is value in liquidity in markets such as these, both for managing risk and capitalising on opportunities. The overall picture so far in March is that while there are small losses across many areas of the hedge fund industry, everything is functioning in an orderly fashion and there is little sign of panic or capitulation. The situation in Iran is evolving rapidly, and while forecasting is difficult from here, we expect the situation to ease over the next few weeks as both sides seek to avoid a prolonged conflict.

Key drivers of hedge funds’ performance: an early February snapshot

Equity Long/Short:

• Equity Long/Short strategies continued to deliver mixed performance in February and have seen small losses in early March
• The worst affected strategies in February were market-neutral, with losses from some factor exposures continuing from the difficult environment in January. As we move into March, the pull-back in equity indices has weighed more heavily on traditional Equity Long/Short strategies
• While market exposure (beta) in Europe and Asia has been more affected by the war in Iran, managers were generally carrying lower net exposures to these regions and have been quick to cut risk

Credit:

• The more liquid end of credit markets remained stable through February, despite initial cracks in some private credit exposures. Convertible bond markets remain richly valued, forcing managers into primary issuance trading and gamma trading to generate returns
• During February, the US High Yield CDX (Credit Default Swap) index finished at a spread of 293 basis points (bps), tightening a further 3 bps since January and 23 bps since the start of the year
• Despite the Iran conflict, the spread has only widened 4 bps during the first six trading days of March
• Managers are largely continuing to 'wait and see' in liquid credit strategies, with modest gross exposures and few sizeable positions while default rates remain low

Event Driven:

• Several large M&A deals were announced in February, e.g. Coterra Energy (shale) acquired by Devon (US$23 billion), Masimo (med-tech) acquired by Danaher (US$9 billion), InPost (delivery) acquired by a private equity (PE) consortium (US$9 billion), and two financial deals: Schroders acquired by Nuveen (US$13 billion) and Webster acquired by Santander (US$12 billion). Netflix walked away from the Warner Bros. Discovery acquisition, deciding not to chase Paramount's increased bid to US$31 per share. The deal is now trading at 10% spread to close and is expected to close in September
• FountainVest (a China PE buyer) called off a deal to buy a major stake in EuroGroup Laminations (EGLA) after they failed to obtain a regulatory approval in India. Tullow Oil announced a restructuring, extending its senior bonds and putting the company up for sale. US PE group BasePoint Capital increased its bid for the UK’s International Personal Finance
• Spreads have widened in some bigger US deals, e.g. Norfolk Southern and Clearwater. There was a lot of pre-announced deal activity in Europe, especially in the UK, which bodes well for the pipeline of transactions

Macro:

• Systematic macro strategies, particularly trend following, had another strong month in February, with the SG CTA (Société Générale Commodity Trading Advisor) Index returning +3.0% for the month, bringing year-to-date returns to +7.9%. However, trend following has been one of the worst hit strategies in early March, with long equity and short US dollar positions triggering losses
• Discretionary macro managers have been more mixed in both February and early March. Larger returns (both positive and negative) have been registered by those managers with more exposure to commodities
• Managers with exposure to emerging market themes have been relatively muted over the first two months of the year, but saw modest losses in early March on the US dollar rally

On the radar:

• The immediate focus is, hopefully, on the resolution of the conflict in the Middle East and the impact on energy prices. Concerns over inflation are expected to feed through into the correlated behaviour of equities and bonds, with both likely to come under pressure if inflationary concerns persist
• Over the medium term, the focus returns to the health of the US economy and its knock-on effects on credit markets. Non-farm payrolls (NFPs) at the end of February were a significant miss, and the long-term chart of NFPs is now showing a worrying downward trend
• Looking towards the end of the year, we continue to focus on the US midterm elections, and any actions the current administration may take to shore up support as we approach the polls