Don't Blame it on the Sunshine

On the face of it, equity-market behaviour in July and early August suggested that investors sought to call US President Donald Trump’s bluff. Risk-on themes from the preceding two months persisted despite the looming deadline for the reintroduction of tariffs. Equities rose over the month with relatively low volatility, driven by strength in US markets, which were themselves led by the Nasdaq and tech stocks.

Which is why when tariffs were reintroduced, in line with the advertised timetable on 1 August, markets reacted with a degree of shock – surely Trump was going to postpone again?

It’s not quite clear which tariff world we inhabit. Are things worse or better now than, say, a month ago when the first ‘new’ deadline was originally set? Any optimism arising from the draft trade deal between the US and EU was quickly muted by criticism from France and Germany, who deemed the agreement unworkable and unsuitable.

Erosion of independent institutions

The situation around the US-China deal, easily the most important relationship for the global economy, continues to fluctuate daily, as the new self-imposed deadline of 12 August approaches.

However, fears that second-quarter earnings announcements would be disrupted by tariff-related impacts proved largely unfounded, shifting greater focus to next quarter.

Tariffs were not the only focus at the end of July; arguably more significant developments unfolded around key figures responsible for United States labour-market data and monetary policy. Weaker-than-expected job numbers tempered equity market gains in the final days of the month, prompting Donald Trump to label the numbers ‘rigged’ and dismiss Bureau of Labor Statistics chief Erika McEntarfer.

Meanwhile, the Federal Reserve’s decision to keep interest rates unchanged reignited tensions between Trump and Fed Chair Jerome Powell, exacerbated further by the resignation of Governor Adriana Kugler shortly after. These developments now give Trump the opportunity to appoint politically aligned candidates to both roles.

Slowly boiling frogs

Markets seem particularly sanguine about these developments. After all, the gradual erosion of independent authority across various branches of the US legislature has been going on for some time now (consider the increasingly partisan nature of Supreme Court Justices in the first Trump administration) and rarely serves as a material catalyst for an immediate revaluation of either equities or bonds. Slowly boiling frogs come to mind.

However, if markets do ever say enough is enough, we feel it is most likely to be seen in the long end of the US yield curve. Of course, if this particular Rubicon turns out to be the firing of the Fed’s Powell, the resulting erosion of confidence in the durability of US exceptionalism would likely be intertwined with an inflation shock that could ripple across all asset classes.

Thoughts on the performance of quantitative equity strategies in July:

Outside of US political drama, July brought notable developments in inter-market equity dynamics. Some quantitative equity strategies had a particularly difficult month, which may have gone unnoticed by those outside the hedge-fund industry. To understand this behaviour, it is worth briefly exploring the three types of risk inherent in quantitative equity strategies (experienced hedge-fund investors may wish to skip ahead three paragraphs).

Firstly, there is market risk. Most quantitative equity strategies these days run ‘market neutral’, which aims to eliminate market risk either at the index, sector or country level depending on the tightness of the strategy to the market-neutral mantra.

Secondly, there is factor risk. Here is where it gets a bit more complicated. Market factors, such as quality, value, or momentum describe the characteristics or behaviour of the underlying stocks in an index. Quantitative strategies will generally take one of two approaches: to explicitly target factor exposures, by being long stocks which look cheap, high quality, and/or exhibit upward momentum, and by being short those with the opposite characteristics. Alternatively, they will explicitly seek to avoid these exposures by also neutralising their strategy to these factors.

Thirdly, there is idiosyncratic risk. This is the residual risk remaining when market and factor risks have been discounted. For managers aiming to be factor neutral, this should represent most of their risk.

There are typically two types of environments in which quantitative equity strategies struggle. One, where market factors (typically momentum) underperform; and two, more rarely and somewhat paradoxically, when idiosyncratic risk exposures underperform.

Confusingly, both can and often do occur due to deleveraging, that is, when a cohort of market participants have similar positions and start to reduce risk, they lead to losses for other members of the cohort, which triggers to further risk reduction. In other words, crowding begets systemic risk.

July exemplified the latter. Hedge fund managers with less explicit factor risk were hit harder, with some experiencing one of their worst months in recent years.

We believe that while factors have become slightly more volatile this year, hedge funds aiming to avoid factor exposure are relying on similar risk models to achieve neutrality. This has increased the commonality between the supposedly ‘idiosyncratic’ exposures of different market participants.

Prolonged poor performance in certain traditional factor exposures, such as short interest, has triggered deleveraging among managers with both factor and idiosyncratic exposures. The critical observation is that when losses start to be attributed to the idiosyncratic part of a manager’s exposure, most risk managers will cut risk as the source of the losses is hard to pinpoint. The correlation between idiosyncratic exposures then escalates into a systemic event affecting similar managers.

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

Equity Long/Short (ELS):

• Fundamental Equity Long/Short performance in July remained resilient, albeit with notable dispersion. European managers lagged behind their peers focused on Asia and the US
• Beta was generally a larger component of returns versus alpha, meaning more directional managers generally outperformed
• Short alpha was overwhelmingly negative, with high short interest stocks and themes rallying on greater retail enthusiasm – bringing back references to meme-stock mania. The Quality factor underperformed as lower quality stocks gained increased bids, while the Momentum factor had a choppy month
• Prime brokers saw notable de-grossing in equities through July, though we note this was led primarily by systematic versus fundamental traders. Gross exposures in the global fundamental equity space have come down slightly, but not to the same degree as the wider hedge fund space

Credit:

• July was a marginally negative month for credit indices, driven by wider government bond yields and slightly wider spreads. Investment-grade credits marginally outperformed high-yield credits and leveraged loans
• While it was a quiet month on most fronts, credit hedge funds generally performed a little better than the broader market in July. Convertible strategies were positive contributors, with managers who lean more on credit selection outperforming those with a more purist arbitrage approach. Stressed/distressed credits were flat to slightly down, in line with the broader market environment. Portfolio level hedges added a small amount given the weaker rates picture
• Structured credit managers were slightly positive, supported by yield returns more than offsetting the slight pull-back in index values

Event Driven:

• July was a solid month for event driven strategies, particularly those with exposure to merger arbitrage or related transactions
• Deal activity defied the usual summer slow-down, especially in the US but to a lesser degree also in Europe. Notables included a US$60 billon market cap deal in the rail industry (Union Pacific buying Norfolk Southern) and Palo Alto buying Cyberark (cybersecurity firm valued at more than US$20 billion)
• Chevron won the long-standing arbitration case against ExxonMobil, clearing the way to proceed with the US$53 billion acquisition of Hess, which was announced in October 2023. The arbitration resolved a disputed right of first refusal on certain assets of Hess in Guyana
• A number of the pending Italian hostile banking deals saw clarifying developments, e.g. UniCredit withdrawing their offer for BPM
• The Mexican government issued bonds totalling $12 billion to support PEMEX as part of a broader initiative to reduce the company’s debt. Demand exceeded expectations
• Korea’s corporate governance theme was boosted by the Commercial Code revision that passed on July 3rd

Quantitative Strategies:

• As we noted at length above, July has been a difficult month for some quantitative strategies
• A ‘junk rally’ in equities has posed challenges for quant equity market-neutral funds to navigate amid signs of industry de-leveraging, though a bounce in momentum and quality factors looks to have supported performance later in the month. The worst performance was centred on managers with little traditional factor exposure, as deleveraging seems to have spread through idiosyncratic exposures
• Macro-quant strategies generally fared better for the first three weeks of the month but gave back performance in the last few days. Trend-following strategies benefited from long equity positions, though short positions in US dollar and copper weighed on performance over the past week. Positive performance from more diversified Quant Macro managers was driven by equities and energy

Discretionary Macro:

• It was a mixed month for discretionary macro strategies, with performance leaning negative at the time of writing
• We have started to see more thematic positioning form among the peer group, with curve steepeners in developed market rates becoming popular alongside broader US dollar aversion. Steepeners have continued to generate profit in the US, UK and Europe, however short US dollar trades against the euro, Japanese yen and Brazilian real all struggled in July
• Elsewhere, tactical long positions in front-end rates incurred losses, while long positions in digital assets delivered gains following the United States House approval of three cryptocurrency bills, including the GENIUS Act

On-the-radar:

• The 12 August deadline for the conclusion of any US-China trade deal feels sure to generate more market noise, unless (as is highly possible) the date gets postponed again
• Staying with the US administration, Trump feels closer to firing Powell than a month ago and therefore the weakening independence of US institutions remains a material long-term risk
• Elsewhere, we are watching to see if the pain in quantitative equity strategies continues into August, or whether the challenges of July mean that managers generally take less risk going forward