Why we have a positive outlook on credit, equity long-short, statistical arbitrage and macro strategies.
In the wake of the Covid-19 outbreak, the path forward remains one marked by uncertainty in terms of both the pandemic itself and in the market reaction to its development. While markets have already priced in a substantial recovery despite mixed fundamental economic data, and even though uncertainty tends to manifest itself in volatility, we do believe downside risks are somewhat mitigated due to the apparent commitment of central banks to support asset prices. Notwithstanding this view, there are still several risks on the horizon outside of a strong second wave of infections that do have the potential to derail markets again and are therefore worth being cognizant of:
- The upcoming US Presidential election, especially in light of economic inequality being strengthened by Covid-19;
- Potential for renewed US-China tensions.
Despite the market rebound in the second quarter, we believe that there are still plenty of medium- and longer-term opportunities that are attractive:
- Credit, where markets still haven’t fully recovered from the deleveraging damage, and uncertainty around fundamentals has led to scarcity of capital;
- Equity long-short and statistical arbitrage managers could benefit from increased stock dispersion driven by the uncertainty underpinning financial markets;
- Macro managers should find opportunities from an abundance of potential catalysts on the horizon.
2. Financial and Economic Outlook
The current financial and economic outlook is defined by uncertainty. Coordinated global stimulus led to a fast recovery of financial markets from March lows. The trough in economic activity was reached in April, during the lockdowns in many countries, whilst the reopening of economies has initiated a nascent recovery. However, we believe the path of that recovery is difficult to predict from here, especially while the health crisis persists. Markets are anticipating that economies will continue to gain momentum. A new infection wave could again create disruptions, but the commitment of policymakers to provide further support to the economy and markets limits downside risk, in our view. Additional upside could be triggered by a breakthrough in the search for an effective coronavirus vaccine or treatment.
2.1. The Deepest Recession Since the Great Depression?
The world economy was in the late stages of a long-term business and debt cycle before the coronavirus black swan appeared. The shutdown of countries led to a collapse of economic activity by 20%-30%, the deepest recession since the Great Depression of the 1930s. The OECD estimates that world GDP will decline by 5% to 6% in 2020, followed by a projected recovery in 2021 of 5.0% to 5.5%. The bounce is lower than initially estimated in April due to persistent social distancing and the decline in productivity as a consequence of workplace safety measures.1
If infection rates are not brought under control, new lockdown measures and more cautious social behavior could cause additional pain to the economy, in our view. This downside scenario could result in another correction in markets.
But whatever the GDP decline will eventually be, it has been a historically deep recession. We believe even when the virus is defeated, the impact of the crisis will last, especially in the corporate sector. Unlike 2008, governments in developed countries reacted with a fast, coordinated and sufficiently sized fiscal policy reaction. Budgetary stimulus such as transfers to households and companies, health-care spending and tax cuts has so far reached 8.3% of GDP in developed market (‘DM’) economies – 660 basis points higher than during the Global Financial Crisis (‘GFC’). In the US and Australia, fiscal stimulus even exceeded 10% of GDP. This has been the key to stabilising economies and breaking the self-reinforcing collapse in spending and income. However, in emerging market (‘EM’) economies, the size of the fiscal stimulus is only 2% of GDP, even less than after the 2008 crisis, while the pandemic is still taking a terrible human and economic toll.2
The fiscal stimulus palliates the income hit from increased unemployment for households. In fact, the increase of the personal saving rate in the US from 7.7% of disposal personal income in February to 32.2% in April not only reflects reduced spending and risk aversion during the lockdown, but also the significant household stimulus. In contrast, the impact on the business sector has been very severe and could lead to lower economic growth for years. Business models trimmed for steady growth do not easily cope with a sudden 20-30% collapse of economies. Companies will reduce capital expenditures and distributions to shareholders to repair their damaged balance sheets.
2.2. Financial Conditions Have Eased
The uncertainty around the economic outlook contrasts with the optimism that is reflected in markets. Central banks’ medicine has been highly effective and the major factor in the recovery of risk assets, in our view. As a result of the unconventional and large monetary support, financial conditions have eased quickly (Figure 1). The risk that negative developments will trigger a correction increases with the difference between market prices and fundamentals being near historic peaks across most DM equity and bond markets.3
Figure 1. Financial Conditions in the US
Source: Federal Reserve Bank of Chicago, January 2005-July 2020. Shading indicates US recessions, the most recent one is ongoing.
Current equity market pricing appears to reflect a V-shaped recovery of the economy and is taking comfort from the bold actions taken by central banks in March. We noted with interest that the Federal Reserve appeared to react to a relatively modest sell-off in June with loosening of conditions for credit purchases. The signal to the market was that the strike of the Fed put is not far out of the money. Hence, the market has been somewhat immunised from the negative news of resurgent infections in the US. What is the price to pay for the monetary drug though?
Policymakers are again facing trade-offs between supporting the financial system and creating new bubbles. This time, both monetary and fiscal policy did the right thing and provided necessary support without the hesitations that we saw in the GFC and the Eurozone crises. More difficult, however, is the decision when the risk of creating the foundation for the next crisis becomes larger than the need of dealing with the consequences of the last one. If support is sustained for too long, it can create new financial bubbles and overheat economies. For example, as a result of slashing interest rates to zero and quantitative easing (‘QE’) in the wake of the GFC, the corporate debt-to-GDP ratio increased to record levels, as leverage was cheap and easy to access. This mountain of debt will have to be dealt with now – some in the form of defaults. This poses a risk for the banks which, together with lower interest rates, may negatively impact profitability of the sector.
2.3. Liquidity Risks in Markets Have Increased
The ease of monetary liquidity that has characterised the post-GFC era stands in contrast to the tighter regulation of the financial sector. As a result, risk has been shifted from the financial into the asset-management sector. Paradoxically, this has increased liquidity risk in markets.
At the heart of the most severe days of market stress in March was a near meltdown of intermediation in risk-free assets. Conflicting regulatory constraints and operational risks created this vulnerability. Constraints on banks’ leverage ratios has made access to balance sheet valuable. Large hedge funds have increasingly used the Treasury cash-futures trade as a way to reserve leverage for themselves which could be used otherwise when more attractive opportunities developed. This has led to a continuous build-up of exposure in the trade up to March 2020. Market volatility and deteriorating liquidity resulted in a richening of the futures versus deliverable cash bonds, causing mark-to-market losses for hedge funds. While the trade could in theory be held until delivery, risk management and operational risk concerns in the work-from-home environment triggered a deleveraging of positions.
Additional liquidity demand came from corporates that raised cash by drawing on bank lines. Due to post-GFC regulatory requirements, these draws further increased the demand for high-quality liquid assets by banks themselves, while their dealers needed more short-term funding to warehouse inventories that could not be cleared. This triggered a breakdown of the Treasury market that quickly spread to other markets and threatened to trigger a financial crisis. The Fed stepped in with a series of interventions that resulted in a significant increase in its balance sheet.4
2.4. Activist Monetary Policy Creates New Challenges
Regulation that was imposed as the consequence of the GFC has substituted a credit crisis with a liquidity crisis. It is arguably easier for central banks to deal with the latter, but it requires activist monetary policy – which relies on key actors to make fast and bold decisions.5 It also comes at the price of reducing the room to maneuver in pursuit of other policy goals; money supply has skyrocketed with M2 increasing by 85% annualised since March.6 With the Fed purchasing about 60% of the increase in US public debt since February, QE is the key determinant of the yield curve. Dealing with these issues is critical in the long-term to avoid another financial and economic crisis.
Figure 2. M2 Money Stock Has Risen Sharply Since March
Source: Board of Governance of the Federal Reserve System; January 2005 to June 2020. Shading indicates US recessions, the most recent one is ongoing.
For hedge funds, risk management rules may have to be reviewed. A market that cannot absorb private actors’ liquidity demands under duress will experience sharper evaporation of risk intermediation, which forces central banks to backstop markets. Therefore, a controversial conclusion could be that cutting exposures as liquidity disappears and mark-to-market losses increase may be a wrong decision. To be able to ride out the next storm, leverage headroom may not be used completely. Another question is if policymakers will widen their regulatory reach and limit leverage deployed in trades such as the Treasury cash-futures basis. This would reduce the return expectations for Fixed Income Arbitrage strategies.
2.5. Political Risks for Markets
Finally, Covid-19 has accelerated trends in the economy that may lead to a further increase in inequality and fuel populism: social distancing has boosted online merchants at the costs of brick and mortar retail; white collar workers have been able to work from home, while lower-wage sectors shut down. The market rally in the face of closed business and the record pace of unemployment growth is likely to feed the anti-establishment sentiment. A further rise in populism could strengthen the extreme wings in the political system, leading to further equity market volatility as we approach the Presidential elections in the US. With the background of the economic damage from Covid-19, the elections could also provide new fuel to the US-China tensions. The Trump administration may take a tough line on China to distinguish itself from the Democrats. However, even a change in the US government is unlikely to reverse the de-globalisation trend – with negative consequences for productivity.
In summary, the uncertainty for markets remains very high, in our view. Markets have recovered from the lows following the rollout of large monetary and fiscal policy measures. While uncertainty can translate into volatility, we believe that the commitment to provide further support for markets and economies is intact and limits downside risk. The inability to bring the pandemic under control, the upcoming US election, and possibly renewed US-China tensions may challenge this assessment.
In the long term, new market risks could build as a consequence of the stimulus as the track record of unwinding unorthodox monetary policy is mixed at best. The massive increase in sovereign debt could result in the temptation of using inflation to ‘solve’ the problem of unaffordable IOUs. This would have profound consequences for investors. After a decade of seemingly inimitable returns from passive exposures to equities and bonds, we now face a regime with far less certainty in the upwards trajectory of any traditional asset class. Given the enormous uncertainties that resulted from a crisis of historic proportions, we believe that active management, particularly active risk management, may finally receive its day in the sun.
So, given our market outlook, where do we see the best opportunities?
3. Strategy Outlook
We believe that investments with medium- and long-term horizons are still attractive, particularly those in strategies that haven’t fully recovered from the deleveraging damage and where uncertainty about fundamentals leads to scarcity of capital. We believe credit strategies have the highest return potential in the next 12-18 months. The picture has also improved for equity long-short, statistical arbitrage and macro strategies, while we see a more challenging environment for merger arbitrage.
3.1. Credit Strategies
We are positive on corporate and structured credit strategies based on the following drivers:
- Wider spreads and deleveraging in sectors such as energy lead to credit long-short opportunities;
- Convertible arbitrage benefits from cheapness of bonds, strong new issuance and elevated realised stock volatility;
- Bankruptcies, liquidations and balance sheet restructurings in sectors most impacted by the pandemic;
- Structured credit, in particular credit risk transfers (‘CRTs’), legacy residential mortgage-backed securities (‘RMBS’) and asset-backed securities (‘ABS’), sold off materially due to de-leveraging and implies overly pessimistic fundamental assumptions.
The widening of high yield spreads and the selloff in levered loans has led to an increase in the stressed universe across sectors, which couldset up a strong credit-picking environment (Figure 3).
Figure 3. US High Yield spreads
Source: Bloomberg; as of 30 June 2020.
We think credit long-short strategies offer the following specific near-term opportunities:
- Senior secured loans and bonds of companies that experience challenges due to the pandemic, such as those operating at low business capacity;
- Traditional capital structure arbitrage (long bonds, short equity) in sectors that need to de-lever such as energy;
- Technical capital structure arbitrage driven by index CDS flows. These allowed market participants to set up unfunded long credit risk. This has compressed single name CDS to tighter levels than cash, allowing for trades that will be profitable if the relationship normalises (risk-on environment) or if the company defaults, which would trigger a collapse of the spread;
- Fallen angels, which come under selling pressure as traditional bond holders are forced to sell;
- Financial preferreds which trade wide relative to pre-crisis levels as the sector has lagged during the market recovery.
Convertible arbitrage is attractive, in our view, as bond valuations remain cheaper than pre-crisis but are expected to normalise as capital flows back into the asset class in less volatile markets. An additional potential return source is new issuance, which is high as risky issuers can achieve substantial coupon savings versus the traditional bond market.
Distressed-debt managers may also benefit over the medium to long term. The damage to companies bottom lines from the shutdowns in the spring and the slow economic recovery is expected to result in a much higher number of corporate defaults than in the past (Figure 4).
Figure 4. Defaulted Bonds and Loans
Source: JPMorgan Chase & Co., © JPMorgan Chase & Co. 2020; as of 1 July 2020.
Industries that were most acutely impacted by Covid-19 such as travel, gaming, leisure and retail are likely to see bankruptcies, restructurings and liquidations, in our view. Energy is another sector that has already been under pressure given the collapse in demand for oil.
In the long term, we also expect that sovereigns, US states and municipalities will be subject to debt restructurings. Providing restructuring funding for troubled jurisdictions has been an area that distressed managers have been engaged in especially since the GFC. It requires specialist understanding of the legal and political complexities and long-term capital, which we find particularly in the larger, established credit managers.
Structured credit experienced a sharp dislocation and spread widening in March. This was triggered by volatility in rates markets, with around USD218 billion in outflows from bond funds in two weeks, strain on bank liquidity and tightening credit, as well as rapidly declining liquidity.
As a result, investors that deployed leverage were forced to raise cash at extraordinarily high costs. The selling occurred initially in more liquid, higher-quality securities, but to meet margin calls, investors were also forced to sell less liquid instruments at distressed levels. Entire portfolios traded over the weekend of 21-22 March – something that did not happen even during the GFC.
The Fed support helped stabilise even those structured credit markets which are outside of the program as it brought back the risk appetite. Prices have recovered but are still pricing in conservative assumptions, especially in light of the fiscal transfer payments to households. Yields adjusted for assumed losses from the pandemic are still materially higher than pre-coronavirus and the credit curves are generally steeper.
The structured credit opportunities we consider most interesting are residential mortgages such as legacy non-agency RMBS, where previous defaults have resulted in credit curing and home equity has been built up by remaining borrowers over the last 10 years (Figure 5). Furthermore, asset-backed securities such as subprime auto that are not eligible for the Fed’s Term Asset-Back Securities Loan Facility (‘TALF’) program are attractive, in our view.
Figure 5. Last Cash Flow Subprime Spread
Source: BAML; as of 30 June 2020.
Managers might also look at secondary market opportunities in mezzanine and equity collateralised loan obligation (‘CLO’) tranches as well as selectively in mezzanine collateralised mortgage backed securities (‘CMBS’) (Figure 6).
Figure 6. CMBX 6 BBs price (2012 vintage)
Source: Bloomberg; as of 30 June.
3.2. Equity Long-Short
Discretionary equity long-short managers fared relatively well during the crisis. Multi-portfolio manager platforms in particular were able to reduce and redeploy risk, often despite considerable gross notional values. Style factor exposure was an important contributor to returns; long Growth and Momentum were top performers. Factor volatility increased significantly in June, with a sudden sell-off of cross-sectional momentum and a rally of value – which faded away towards the end of the month – but managers’ returns were mostly immune from that.
Our view on equity long-short is more positive than it has been for a long time. Markets are exhibiting high (but not extreme) levels of volatility and dislocations between winners and losers, both in terms of the Covid-19 impact and the longer-term economic implications. We believe that a discretionary research approach is well suited to identify winners and losers that arise out of the coronavirus outbreak.
Our key concerns about equity long-short have been the low alpha generation and the inconsistency of returns. For the discussed environmental reasons, we think that at least in the medium term, the strategy will generate more alpha than previously. The return inconsistency remains a problem that can potentially be addressed by focusing on platforms and sector funds. Platform managers have shown to have the ability to manage risk effectively which has been a differentiating factor during March by being able to reduce and reallocate risk capital quickly.
One of the difficulties of investing inequity long-short in the second quarter of 2020 has been the emergence of volatility in equity factors as the quarter has progressed. While equity market index volatility generally declined through May and June, the level of volatility in factors such as Value, Momentum and Quality reached unprecedented levels (Figure 7). Some of this may be due to the reallocation of capital away from factor strategies as a rebalancing move after the events of March, but it may also be a symptom of the changing regime within the equity market as companies and investors react to the new environment. We saw a similar phenomenon in the GFC, where factor volatility peaked in the second quarter of 2009, around six months after the peak of equity index volatility.
Figure 7. Volatility of DJ Market Neutral Value index
Source: Refinitiv; as of 30 June 2020.
3.3. Relative Value
In relative value, we are:
- Positive on statistical arbitrage;
- Neutral on merger arbitrage; and positive on other equity arbitrage strategies;
- Neutral on fixed income arbitrage.
Statistical arbitrage managers had a challenging March. Many of the levered quant equity funds were forced to de-risk and thereby monetise mark-to-market losses. Causes for the de-leveraging were:
- Volatility targeting: rising market volatility meant that less gross exposure was necessary to reach a set expected volatility target for funds;
- Margin calls by banks which forced funds to raise cash;
- Risk management rules that kicked in as losses accumulated;
- Rising transaction costs;
- Operational market frictions such as short sale bans or the fear of market closures.
Of note in March was that even machine learning funds were equally as prone to losses as traditional statistical arbitrage managers. While these funds don’t run explicit factor exposures, the violent deleveraging that we saw in March made it difficult for most – but not all – new finance managers to isolate themselves from the carnage. Based on our observations, we believe that machine learning managers were less likely to de-lever and thereby monetise losses.
As we discussed above, we believe that the type of markets we saw in March have become more likely, but so has the probability that central bankers will intervene and restore order. Our view on discretionary de-leveraging decisions has therefore changed: we think that the threshold to trigger an intervention should be higher than in the past.
We are optimistic about the return outlook for statistical arbitrage as higher equity volatility and dispersion generate more trades opportunities. Similar to other strategies, the competition has been reduced. Alternative data sources may be a fruitful information source due to shifts in consumer behavior during the lockdown and the ability to indicate the degree of recovery and mobility as measures are rolled back.
We have a less positive outlook for merger arbitrage for the following reasons:
- Median spreads have compressed from the wide levels that were triggered by the deleveraging in March (Figure 8). Some managers expect that spreads will widen out further again and therefore are running relatively low exposures;
- Merger volumes have declined, particularly in the US, and are likely to remain subdued for the quarter, in our view;
- Deals have been breaking. While this is not unexpected following the economic shock, managers have had more difficulties navigating through this than they anticipated. In particular, the late break of the Forescout acquisition caused concern.
Figure 8. Median Non-Annualised Merger Spreads (US)
Source: UBS © UBS 2020. All rights reserved. Reproduced with permission. May not be forwarded or otherwise distributed; as of 30 June 2020.
Our rationale for not downgrading merger arbitrage further is that spreads remain wider than pre-coronacrisis levels and that there is less capital chasing deals.
We are positive on equity arbitrage, which includes transactions such as block trades, placements and rights issues. Activity is high and hedge funds report healthy deal pipelines, while capital has left the space. Barriers to entry are high as the strategy relies on long-term relationships between managers and bankers. Higher market volatility has led to an increase in the premium that managers can demand. This has made hedging of transactions more important, which requires experience in selecting the right instruments.
We are neutral on fixed income arbitrage as we believe that we are entering a period where the heavy hand of activist central bank rates management will limit opportunities in the near term.
3.4. Global Macro
Many macro managers delivered positive performance during March. Trend following generated positive returns especially on long interest rate exposure. Similarly, many discretionary macro managers reacted quickly in February when the virus took hold of northern Italy and accumulated large short-term rates positions and other protective exposures. While risk has been reduced by many global macro funds, we see many catalysts that could present new entry points for trades, such as a second wave of infections, the shape of the recovery, the form of Brexit, US-Chinese relationship, the US Presidential elections (and turmoil or crisis as we approach it), and EM defaults. We therefore believe that macro strategies should be represented in portfolios.
While markets have recovered from the lows following the rollout of large monetary and fiscal policy measures, uncertainty remains very high, in our view. While uncertainty can translate into volatility, we believe that the commitment to provide further support for markets and economies is intact and limits downside risk. The inability to bring the pandemic under control, the upcoming US election, and possibly renewed US-China tensions may challenge this assessment.
Given this outlook, we believe there are plenty of medium- and longer-term opportunities in three areas. First is credit, where markets still haven’t fully recovered from the deleveraging damage, and uncertainty around fundamentals has led to scarcity of capital. The second is equity long-short and statistical arbitrage, where managers could benefit from increased stock dispersion driven by the uncertainty underpinning financial markets. And last but not least, macro managers should find opportunities from an abundance of potential catalysts on the horizon.
1. IMF World Economic Outlook Update, June 2020; and OECD Economic Outlook, Volume 2020 Issue 1.
2. BIS Bulletin No 23: The fiscal response to the coronavirus crisis in advanced and emerging market economies.
3. Global Financial Stability Update, June 2020, International Monetary Fund.
4. Source: Bloomberg News.
5. The initial blunder by ECB President Christine Lagarde comes to mind when she declared that it is not the ECB’s role “to close spreads”.
6. Pantheon Macroeconomics, The United States in H2 2020, June 2020.