Uncertainty Versus Volatility - The Different Kinds of Unknowns?

Reading the headline performance data in isolation would lead most observers to conclude we’re in the halcyon days of risk-on markets. The S&P 500 finished May up 6%, with the Nasdaq gaining nearly 10%, and the Morgan Stanley index of crowded hedge-fund long positions rising a whopping 14.9%. Bond yields widened slightly, with the US 10-year Treasury yield increasing by 24 basis points (bps) during May. Credit spreads returned to near-historic tight levels, with the CDX High Yield index tightening by 57 bps in May to close at a spread of 351 bps.

All of this sits abstrusely with the level of uncertainty that still prevails over the global economy, particularly vis-à-vis the outlook for trade dynamics and tariffs. In the final week of May alone, we saw 50% tariffs on the EU announced and then delayed within three days; the US Court of International Trade ruled that all country-specific tariffs, including the 10% baseline tariff, were illegal, only for an appeals court to suspend that judgement the following day; and a new announcement of 50% tariffs on all steel and aluminium imports.

How are companies expected to plan strategically for future investment in such an environment? While some investors have turned to the ‘TACO’ trade (a moniker for 'Trump Always Chickens Out') amid the back-and-forth, this uncertainty has undoubtedly hindered businesses’ ability to plan for future investment.

It’s an incongruity we’ve highlighted before, but it bears repeating. Many indices of risky assets have recovered to near all-time highs, and implied volatility remains no higher than long-term averages. In contrast, measures of uncertainty in the global economy are generally off the charts. Various commentators provide such measures, each using a relatively arcane methodology, but most agree that the current levels of economic and trade uncertainty are comfortably higher than anything seen over the last 20 years.

Potential for disruption remains high

To borrow heavily from Donald Rumsfeld, this is the difference between ‘known unknowns,’ in the case of implied volatility and the ‘unknown unknowns’ of uncertainty. Implied volatility measures are subdued because, at least for the next few months, there are few obvious catalysts for risks and relatively little new news to spook markets (even the tariff acrobatics are starting to feel like old news in today’s market).

The potential for the current US administration to do something new and potentially disruptive to global markets remains high. It would be a mistake, however, to assume that uncertainty is necessarily negative for risky assets. It feels natural to fall into this interpretation, but there are clearly paths where an unorthodox approach results in a positive catalyst for markets, such as an acceptable resolution to the situation in Ukraine; a change of focus from tariffs to useful deregulation; or breakthroughs in AI leading to material productivity gains.

From a hedge-fund perspective, the current environment remains largely fertile. As noted above, indices of crowded hedge-fund positions have performed well recently, and the second quarter has seen positive performance in cross-sectional momentum factors within equity markets (i.e. stocks that have been performing well continue to do so, and vice versa).

Stay humble, liquid and diversified

Most strategies have generated alpha this year, which represents a double-edged sword for investors. The positive spin is that it reflects the industry’s resilience in the face of market gyrations. However, those of us with a less optimistic disposition fear the risk of hubris, overleverage, and the pain of an inevitable give-back in some of these more crowded winners.

Our position as an allocator in these markets remains threefold: stay humble, as it is easy to become overly confident in one’s own interpretation of the macro environment; stay liquid, since it is simpler to adjust course if one is wrong, keep dry powder available to capitalise on dislocations; and stay diversified, because different strategies will excel at different times in this new era of uncertainty.

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

Equity Long/Short (ELS)

• Global equities posted strong gains in May. Top-down forces, such as tariff negotiations and economic data, continue to drive investor sentiment. Interestingly, Moody’s downgrade of the US credit rating had little impact on equity market sentiment. At the micro level, earnings season progressed, with Nvidia’s highly anticipated report towards the end of May providing strong momentum to tech and growth stocks
• Given the above, beta, growth, and momentum factors generally outperformed. However, it is worth noting that there was a brief wobble in the momentum of euro-denominated assets early in the month, which temporarily impacted managers with positions in European defence and banking names
• Performance across the ELS space was strong across regions in May with both beta and alpha serving as positive drivers. In general, longer-biased funds outperformed given the strength in equity markets, though we also saw market neutral players generate strong alpha off earnings
• Despite the rebound in equities, our view is that many ELS funds remained in 'wait-and-see' mode and have been slow to actively add back either net or gross exposures in meaningful amounts

Credit:

• Risk markets continued to build on gains since the early April sell-off supported by the ongoing easing of trade tensions. Credit spreads were tighter, and bond yields reversed course and were higher particularly at the long end, in part driven by Moody’s downgrade of the US credit rating. US high yield and leveraged loans outperformed US investment grade credits After a quiet April, primary markets became active, and fund flows turned positive in May
• Corporate credit managers were broadly positive in May. Convertibles were a source of gains as credit spreads were tighter while equity volatility remained somewhat elevated. Certain American depository receipts (ADRs) and crypto-related names outperformed. Stressed/distressed credits and certain issuers that announced a restructuring event were positive contributors. Government-Sponsored Enterprise (GSE) preferreds also posted strong gains, driven by heightened expectations of a potential privatisation. Overall, it was a month that saw outperformance of higher-beta, lower-rated names. Portfolio-level hedges, not surprisingly, were detractors for some managers given the strong market backdrop
• Most securitised product sectors saw spread tightening during the month, although the moves lagged behind the tightening in corporate credit. Structured credit managers posted positive returns, driven by a combination of carry and mark-to-market (MTM) gains

Event Driven:

• We’ve seen a positive month for event driven strategies, particularly in event credit names that bounced back from April’s losses following the postponement in tariffs, progress in trade negotiations, as well as higher oil prices and other idiosyncratic developments
• Deal activity picked up again, with some large acquisitions by US private equity (PE) firms, e.g. 3G buying Skechers (US$9.3 billion) or Blackstone acquiring TXNM Energy (US$5.2 billion). Other notable deals include Salesforce buying Informatica (US$7.3 billion) and Sunoco buying Parkland (US$4.9 billion). Activity in Europe was more muted, but pre-bids in the UK were a positive offset
• US President Donald Trump announced a partnership between US Steel and Nippon Steel, which augers well for the pending Committee on Foreign Investment in the United States (CFIUS) approval and has significantly improved the likelihood that this merger, that has been in the pipeline since 2023, will finally complete
• A number of corporate events were announced in Europe. For example, Norwegian Air Shuttle launched a convertible bond (CB) buyback programme, Altice France filed for a hardship clause to implement a restructuring, and DocMorris completed its rights issue
• In Japan, Nidec withdrew its hostile bid for Makino Milling in early May, but PE firm MBK has stepped in with an acquisition proposal

Systematic Macro:

• Trend-following strategies didn’t suffer as much as they did in April, even though they are running with lower risk given the high recent realised volatility. Nevertheless, they are still down for the month. Losses were driven by fixed income and commodities, with short Japanese government bond (JGB) positions and long US Treasury positions proving most painful for fixed income. In commodities, short energy positions and long coffee exposures struggled, as improved production prospects impacted returns
• Alternative trend strategies also appear to be down, with losses concentrated in commodities and fixed income. Within commodities, short power, short natural gas, and long carbon emissions positions were the most unprofitable. Meanwhile, fixed income returns were hindered by long positions in various sovereign credits as well as some mortgage-backed securities (MBS)
• Systematic macro appears to have had a more positive month. Here long exposures in commodities (coffee, gold and oil) and short US treasury positioning proved profitable. Those who rebuilt equity risk also benefited from returns in the US and Asia

Discretionary Macro:

• May was a mixed month for discretionary macro strategies. Tactical long positions in equity markets performed well as markets appeared to move past peak policy uncertainty. Long euro (EUR) trades also contributed positively, alongside curve steepeners, primarily expressed in Germany. However, long positions in front-end developed market (DM) rates gave back gains as yields rose on improved growth expectations
• Japanese macro trades generally worked well. Long Japanese yen (JPY) positions continued to perform, and managers used the April volatility to add to short JGB positions, though those who rotated into curve flatteners struggled
• Long Hong Kong dollar (HKD) positions delivered positive performance as it traded near the lower end of the Hong Kong Monetary Authority (HKMA) peg. However, short positions in currency crosses such as the Taiwanese dollar (TWD) and Singapore dollar (SGD) struggled earlier in May. Argentina-related themes performed well in emerging markets, although other popular trades in Ukraine and Venezuela gave back some year-to-date gains

On the radar:

• The less political angle: Fundamentals still matter, particularly inflation and the room this gives central banks to react to any economic weakness. Watch for inflation prints over the next few months and leading indicators on growth such as jobs, PMIs and consumer confidence
• The more political angle: Monitor the relationship between the Trump administration and the various checks-and-balances within the judiciary and legislative branches of the US government. Despite the bluster of the last two months, there are encouraging signs that the broader US establishment is finding ways to rein in some of the president’s excess. Any progress towards an environment where the rule of law is upheld is beneficial for market stability