Man FRM Early View - August 2020

Hedge funds enjoyed their third straight month of positive returns as Relative Value spreads normalised and generally positive returns to equity markets continued.

Markets

+21%. That’s the 12-month price return on the S&P 500 showing on the screen at the time of writing1. It’s in the top quartile of all 12m rolling returns since 1970, and a good year in anyone’s book. The most popular way to rationalise such a move, while we sit in the greatest health crisis and deepest recession in living memory, is to point to the discount rate. With the drop and flattening of the government bond yield curves, one might roughly calculate from this that $76 today would be worth $100 of earnings 20 years from now. In that same calculation using the yield curve a year ago the present value of $100 in 20 years was only $62, which is about a 21% increase in 12 months. In other words, we can explain this phenomenal rise in the equity market as a consequence of the move in the bond market discounted over the next 20 years.

It's true, this explanation is a little glib as we can’t really see beyond the end of our noses and most of the rise in the equity market is driven by a small number of very large stocks. But the massive outperformance of Growth stocks versus Value stocks that we’ve seen for the last six months does fit this twisted narrative. The further out you are prepared to stretch the valuation model for the market as a whole, the more attractive Growth stocks look relative to Value. The flatness of the long end of the yield curve allows for such distant prescience… at least in a model. But the longer the view, the greater the sensitivity to any reversal in the yields of bonds, and the lower those yields, the greater asymmetry of the risks that attach to them: as the small print says, on a 20 year view, what goes up a lot can come down a lot…and fast.

So here’s a hostage to fortune: we think all this may be about to change. The 10yr US breakeven inflation rate has risen with an eerie steadiness since the depth of the market panic through until now. The central banks have decided they need to act. Jerome Powell’s much-anticipated announcement of more tolerance for higher inflation shows that, for now at least, central banks feel they need to reassure markets that higher inflation expectations don’t necessarily mean rate rises… yet. But that ‘yet’ isn’t infinite, and US government bond curves spent much of August steepening rather than flattening (the 30yr bond jumping a full 10bps in the hours after Powell).

But it isn’t just financial markets which are changing direction. Forecasts around the rate of change of Covid-19 cases remain highly uncertain: the US seems to be slowing, particularly in hotspots such as Texas while in Europe, new waves are popping up, accompanied by dark talk of the coming winter. But the mortality rate is dropping appreciably, and whether it is this, economic imperatives, or a new devil may care spirit that comes from the tedium of lockdown, government responses are progressively less draconian. Perhaps we are moving towards a greater political and societal acceptance of the situation; some people actually like going to the shops, the dentist, the cinema: a degree of normalcy creeps back.

And so, for the Value-Growth dynamic in equity markets, perhaps both sides of the equation have already changed direction. For Growth stocks, the discount rate is now rising, rather than continuing to fall. For Value stocks, there is a tentative return to some form of economic normality. And if we do see a narrowing of the Value-Growth spread, it’s probable, in our view, that we don’t see a prolonged equity bear market like that seen in the dot-com collapse. After all, no-one is expecting interest rates to get back to 5% in a hurry, and we’ve got 12 years of stimulus sloshing around the system to prop-up asset prices. It could feel more like a Value ‘catch-up’ than a Growth capitulation, or at least a healthier combination of the two.

This could all happen extremely quickly: there is a certain ennui in the air which we’ve all seen before in the dog days of the summer and liquidity is always thin at this time of year. There’s plenty of money that’s been waiting for the next great Value trade to unfold. And just as the sell-off in February and March was done, peak-to-enormous-trough, in just 28 days, there’s a risk that the Value catch-up, when it comes, is cataclysmically quick. Most of the fast money (i.e. hedge funds) is long Growth, long momentum, since they tend to either have held on to or be chasing higher the winners. These players tend to be computer driven, and faster to move, partly due to risk management, and so a technical liquidation element to the factor rotation can’t be ruled out. And timing this move will be near impossible – since by the time you’ve got enough data to know it’s real (and not just the head-fake we saw in early June) the trade will be done.

A factor rotation of this significance may have widespread repercussions (another of those hedge fund euphemisms for losses). A reversal of cross-sectional equity market momentum could hurt macro time series momentum…and off we go, with all the other causal arrows reversing too. Before you know it, Value stocks are up a lot, 10yr bond yields are more than 1% higher, Oil is at $60/bbl, and all this while you were working out how to position your portfolio for the US election.

 

Hedge Funds

Hedge funds enjoyed their third straight month of outsized positive returns during August, helped by generally positive returns to equity markets and a continued normalisation of capital structure spreads, which generally helped Credit and Relative Value managers. A reversal in bond prices through the second half of the month was generally a headwind for some Macro strategies, particularly Trend Following strategies, whereas equity market neutral factor strategies had a choppy month.

For Equity Long-Short managers, the new highs for some equity indices in August (including the S&P 500 and NASDAQ) meant that managers benefited from similar drivers as July; potential positive developments on Covid-19 vaccine including fast tracking of some in the US; continued hopes for another fiscal stimulus package in the US; some potential thaw in US/China trade tensions. Alpha generation continues to be relatively strong and the Q2 earnings season continued to be a source of differentiation between managers.

Tech stocks led the way as has been the case for most of this year – the top 5 companies now make up around 25% of total S&P 500 market cap2. Given the rally, broker reports suggest gross and net leverage is elevated for US Equity Long-Short funds, a fragile set up going in to the US election. In terms of positioning, buying of mid-caps in the US has outpaced large-caps, as managers have been moving down the ladder for alpha generation in the face of record market concentration and elevated valuations of popular long positions.

Credit markets generally underperformed equity during the month, particularly in the Investment Grade space given the backup in treasury yields. More risky securities in the leveraged loans and high yield universe were positive, however, given the general risk-on theme spilling over from equity markets. Lower-rated parts of the US Hight Yield market outperformed amongst an unseasonably heavy new issue calendar; supply was driven by close to record low yields for higher quality paper. High Yield fund flows, while positive, moderated from the strong pace over the past few months. Leveraged loan issuance also increased month-over-month and fund flows remained negative but less so relative to prior months.

Despite the varied backdrop it was generally a positive month for Credit hedge funds, but the size of gains was lower than the exceptionally strong month in July. Return drivers were somewhat similar though. Financial and non-financial preferreds enjoyed another good month of performance, with participation beyond just the largest US banks.

For another month Convertible Arbitrage was a top contributor for many managers. The Converts market continued to rally and there were gains from new issues as well as corporate activity including buybacks, and REITs with tech sector Convertibles performing positively.

In Structured Credit, it was a positive month driven mainly by carry, with spreads modestly tighter. The favourable trend towards stable/lower delinquencies continued in August, and the market was generally supported by data showing that existing home sales had returned to pre-Covid levels in the US. In Relative Value strategies, merger spreads remained largely unchanged at tight levels through August, and in these benign markets Event Driven managers posted small positive returns on the month. Gains have come mostly from large and mid-cap deals, while mega-caps have underperformed. The US has been the source of the larger deal-specific returns, and while individual Financials and Consumer transactions have been mixed, these two sectors have driven most of the positive net returns to date.

Deal activity continues to be robust, particularly in Technology and Healthcare/Pharma sectors. Special Purpose Acquisition Company (‘SPAC’) IPOs also continue to run hot, with high-profile sponsors announcing the launch of new investment vehicles. Pre-Covid deals continue to evolve in different directions, as some buyers are pushing for price cuts or even terminations of merger agreements, while in other cases shareholders are resisting deal terms, e.g. shareholders of a European diagnostics provider rejected a Board-supported acquisition offer, signaling expectations of higher valuations in the Covid-testing era.

Equity Market Neutral funds struggled with factor rotations in the middle of August, notably where momentum sold off aggressively before recovering some ground shortly after; Morgan Stanley suggest buying from Quant strategies drove the rebound. Machine Learning strategies look to be holding up better this month, adding modest returns MTD. Whilst Equity Long-Short and Macro strategies have been rotating within Asia, favouring Japan over China after strong buying throughout much of 2020, Statistical Arbitrage strategies have been net buyers of China.

August produced mixed results across the Trend-Following space, with most managers losing money during the month. The sustained rally in global equities added to performance, whilst rising Developed Market bond yields hurt Trend strategies. Commodities were a source of pain where the sharp rally in natural gas (on warmer weather forecasts in Europe) more than offset gains in Silver.

 

1. As of 27 August 2020.
2. Source: Bloomberg.