Man FRM Early View - April 2021

US government bond yields seem to remain the main determinant in how financial markets evolve as the global economy digests the impact of lockdowns and re-openings; of n^th waves and vaccinations; and of stimulus and (eventually) tapering. Fears of inflation inevitably accompanied the central bank stimulus during the first wave of the virus last spring and started to accelerate through the first quarter of this year. In reaction, US 10-year yields nearly doubled from 0.91% at the start of the year to an intraday high of 1.77% in late March, keeping track with increases in break-even inflation and high expectations of fundamental data prints for the first quarter on GDP, CPI and job creation.

So why have bond yields pulled back in April? The economic data delivered as expected – off-the-charts good news in almost all regards. Corporate earnings are strong, Joe Biden’s USD1.8 trillion stimulus package was delivered, and 10-year US breakeven inflation hit its highest level in over eight years. Almost every aspect of the inflation story has been verified yet the bond market has taken a breather.

One explanation is that this is just that, a breather. The extraordinary pace of recovery in the US was in the price already – a case of ‘buy the rumour, sell the news’. Now we might need to wait for expectations of further follow-through of recovery in the second quarter before bond yields step back to a higher level, and that the inflation story unfolds in chapters rather than a smooth narrative.

But this ignores the supply and demand of the situation. There has always been a structural bid for duration at the right price. A recent report from JP Morgan suggests that UK and US pension schemes are sitting on their healthiest funding ratios in over a decade, given the positive performance of risk assets over the last year. It would be unsurprising if these schemes were not seeking to take down risk and immunise liabilities at these levels. On the supply side of the equation, the fast money is probably already out – why should active bond holders sell in April if they hadn’t sold earlier in the year? From our perspective, we see the systematic positioning in duration assets at their lightest level in years. Trend-followers sold a lot of bonds in the first quarter, but most are now either neutral or net short government bonds.

Furthermore, as bond yields rise, it weakens the argument that bonds are no longer a hedge in an economic crisis, so the buyer of protection returns to the market.

A more complex explanation of the bond pause is that the Federal Reserve’s narrative is largely right – that once you look through the data there isn’t an inflation problem. Chairman Jerome Powell stuck firmly to this line in the Fed meeting at the end of April. Maybe we have a few quarters of great data while the pent-up demand pours back into the system, but then what? The premise that monetary and/or fiscal stimulus automatically leads to inflation has been something of a mirage since 2008. This argument quickly becomes circular, but if the extraordinary levels of stimulus seen over the last 12 months is not enough to cause excessive inflation, then this strengthens the case for secular stagnation over the longer term, and maybe we should all be worrying about deflation in five years’ time rather than inflation today.

Neither of these explanations fit well with equities at new record highs. If inflation is on its way, and this is just a breather with a structural bid for bonds outweighing a temporarily exhausted offer, then this points to a bear flattener for yield curves when policy makers eventually react. Historically, equity markets have struggled during yield curve bear flattening periods. If the Fed is right, and once you look through the data inflation is still under control, then we have to dust off the arguments of the mid-2010s for the correct relative price of equities to bonds in an era of structural deflationary pressures. One might argue that equity markets performed perfectly well during the 2015-2019 period, but the already-stretched valuations of today makes for a much harder starting point for a repeat of those moves.

In the short term, the equity market has been propelled higher by record buying activity. Bank of America released a much-quoted report in early April showing that net buying activity in global equity funds over the past five months had now exceeded the previous 12 years. Hedge funds remain close to record highs in terms of net and gross exposure to equities. With sentiment this close to a peak, we are wary that the equity market reaction to any shocks is likely to be amplified. As to what these shocks may turn out to be, the obvious culprits probably draw too much of the attention. It seems unlikely to us that central banks will announce a tightening of policy without a large amount of foreshadowing, while a re-emergence of a Covid variant in developed economies (large enough to materially affect markets) seems unlikely given the accelerating pace of vaccination programmes in most regions. It is, rather, the unforeseen events that trouble us most in these periods of renewed optimism.

Hedge Funds

Hedge funds continued their strong start to 2021 with another month of positive performance in April. Gains were shared across most strategies, with success for quantitative strategies and event arbitrage. Research driven strategies in equity and credit were also positive during the month, although returns were driven more by market exposure rather than alpha.

In equity long-short, managers performed well, helped by equity markets continuing to rise for most of the month, and positive returns to momentum factors. Positioning remains at extremes, with data from Morgan Stanley indicating that both net and gross exposures are at their 99^th and 98^th percentiles, respectively, since 2010. Managers are increasingly using index shorts to manage the market risk coming from conviction longs, rather than holding alpha shorts. The earnings season has been good for companies, but on-the-day reaction has been underwhelming, which has impacted hedge funds’ ability to generate returns from correct positioning around earning events.

Credit managers also benefited from the good month for risk assets. High yield (‘HY’) spreads were modestly tighter and loan prices were higher during April. The rally in US Treasuries helped investment grade bonds also perform well after three disappointing months in the first quarter. From a hedge fund perspective, primary markets cooled a little in April after a record month for US HY in March, and there were relatively few meaningful single-name drivers of return elsewhere on the secondary markets. Structured credit also saw spreads grinding tighter during the month across many sectors, but manager performance was again heavily carry-driven – similar to March.

Event strategies continued their strong year with further gains in April. Deal activity remains very high, across all categories and regions, but particularly in deals over USD5 billion in size. The high volume and size of deals means that there remains insufficient capital in the space to close merger spreads to levels that would be comparable with the risk-seeking behaviour seen in other parts of the market. ESG considerations are also acting as a further catalyst to increased M&A activity in sectors like real estate, energy and consumer. SPAC issuance has plummeted to near zero, and both pre-announced SPACs and SPACs in de-SPAC are absorbing the impacts of new regulatory scrutiny, namely around the accounting for warrants as well as whether liability protections qualify for forward-looking earnings growth projections.

Quantitative equity market neutral strategies performed well against a disperse backdrop, with broker reports suggesting that valuation dispersion increasing represents the later years of the tech bubble.

Factor-based strategies continued their positive performance in 2021, following the very disappointing performance in 2020. This suggests that markets are more conducive to return for these managers as Covid, and the policy response to Covid, stop being the sole drivers of share prices.

Correlations between stocks and bonds continued to rise through the month and remains difficult for systematic macro strategies to position around. Volatility in FX markets has also caused problems and has reportedly led to the closure of a well-known manager in the space. Trend-based strategies have enjoyed positive returns with the SG CTA index up almost 3% month-to-date. Our data suggests that gains have been driven by equities and commodities with losses in FX from long exposure to a falling US dollar.