Man FRM Early View - August 2021

As we gradually return to the office-based working environment in the UK, it has provided this writer with the opportunities for the kind of serendipitous conversations that seldom happen over video conferencing software from home. Here’s a couple of examples:

Exhibit A: Bumping into a portfolio manager from another part of the business at the coffee machine, I remark that I can’t believe the S&P is hitting another all-time high. His reply? A shrug, he is market-neutral after all, and “What else are you going to buy when the US 10-year yield is 1.25%?”

Exhibit B: Meeting an old friend for our first face-to-face lunch in years, I ask when he is planning to retire. His reply “If you could guarantee me a 5% return on my savings then I’d retire tomorrow”.

Besides the level of tedium of the conversations (my small talk being one of the many casualties of the pandemic), the common theme is that low rates are the driver of events rather than the consequence of them. This is not a new phenomenon - central banks controlling yield curves rather than inflation has been happening for so long that it surely constitutes the normal state of things now. But, with general expectations for tapering of US central bank bond purchases either to happen sometime in the fourth quarter of this year or the first quarter of next, it is feasible that, within the next couple of years, bond markets will likely once again become the consequence of the macroeconomic landscape rather than its determinant.

Of course, bond buyers remain in relatively good supply. Since the end of the first quarter of 2021, yields have fallen steadily despite no acceleration of purchases from central banks and no let-up in future inflation expectations. The enthusiastic bid for bonds seems to be largely driven by liability-driven investors (defined benefit pension schemes and insurance companies) immunising their portfolios at improved levels of solvency. While this is an important systemic phenomenon, it is unlikely to sustain market pricing indefinitely – the defined benefit marketplace is finite and increasingly mature. We therefore face a situation for 2022 with gradually reduced central bank purchases and a possibly less fervent structural bid for bond yield ‘at-any-price’. In our opinion this should lead to healthier price discovery in government bonds and challenge the current extreme of negative real rates (after all, how many unconstrained investors are willing to buy a depreciating asset in real terms).

An era of structurally higher bond yields poses a challenge to the equity market. The trailing 12-month dividend yield for the S&P 500 index is now less than 1.3% (as of 26^th August 2021), approaching the lowest ever level of 1.1% seen in August 2000. If we see the negative real yield in bonds disappear over the next year or two, then there needs to be very significant and sustained earnings and dividend growth from US equities for them to stay relatively attractive on a yield basis given the current level of equity indices.

There are two challenges to this chain of events. The first is that the central bank ‘put’ doesn’t disappear just because tapering begins. Unstable equilibria such as the current relative pricing between equities and bonds typically require an external stimulus to topple them over, and in the event of a large, unknown shock to markets, policy makers can simply return to yield curve control whenever it suits them. Despite the eye-watering levels of stimulus pumped into markets since the Global Financial Crisis (‘GFC’), there doesn’t seem to be any tangible evidence that central banks have reached the level of running out of ammunition.

The second challenge is that maybe we have moved into an era of low interest rates forever. Secular deflationary forces (which we covered at length last month) might mean that inflation never really gets above 2-3% for very long, even with interest rates at, essentially, zero. In this world, the negative 10-year real yield makes perfect sense, since the 10-year yield should, theoretically, reflect the realised daily interest rate compounded for each day over the next ten years, plus a risk premium for interest rate uncertainty, plus a default risk premium. With zero rates forever, then the first two parts to this equation are close to zero, and in countries such as the US, one might argue the last part is also close to zero. In such an environment, the structural bid for long bonds comes from arbitrageurs rather than central banks or pension funds.

It should become apparent whether investors believe either of these challenges is feasible as we approach the start of tapering, with the extent of any taper tantrum in both bonds and equities calibrated relative to the experience in 2013. One suspects that policy makers will exhibit an abundance of caution due to lessons learned from the previous episode. However, if the general thrust of this argument is correct, that a reduced structural bid for bonds leads to lower equity indices on relative pricing grounds, then we expect this path to be bumpy. In the absence of high inflation (which could easily send both equities and bonds southwards at speed), then we might see a dampening effect of risk-on and risk-off episodes - bonds rallying in response to equity market falls, then equity rallies on relative attractiveness versus the lower bond yields, and so on, until both markets find their new equilibrium. After all, we have just been through two decades of bonds and equities both enjoying extremely strong periods of growth while still exhibiting negative correlation to one another, why should this not still be the case in the other direction?

Hedge Funds

Hedge funds had a more muted month of performance in August, more subdued markets and thinner summer volumes leading to a more difficult trading environment. Long-short managers in credit and equities struggled to gain much traction, whereas more quantitative approaches in traditional asset classes fared a little better. Systematic Macro was a source of pain for much of the month, with significant intra-month reversals in FX and Commodity markets leading to losses.

The equity market behaviour was difficult to navigate for discretionary equity long-short managers, with an overriding tone of increasing risk (both from geopolitical concerns around Afghanistan and growing Delta-variant Covid case numbers) but also record highs in equity indices. These difficulties were compounded by uncertainties over the likely path of tapering of US central bank bond purchases, leading to a mid-month sell-off, only for markets to rebound sharply on no apparent better news. Managers have generally reacted by reducing net and gross exposures and are looking to be more tactical in trade ideas while the economic landscape of the new-normal settles.

Credit markets were similarly perplexed by growing concerns over political and economic developments, leading to a widening in spreads in most parts of the credit complex. Loans outperformed credits on retail flows and generally slower loan supply in the summer months. As with equity markets, credit related to ‘reopening’ sectors, such as airlines, cruise ships etc. saw some underperformance given concerns over the growth of Covid case numbers. Faced with this backdrop, traditional credit managers in the space generally saw flat to negative returns for the month. The structured credit space was similar, although returns were slightly positive on coupon gains, with flat spread performance.

Managers focused on event strategies had a more volatile month, driven by several factors. The fallout from the break in the deal between Aon and Willis Towers Watson late in July, led to volatility across mergers in August. This then spilled-over into the SPAC space, where several names are now trading at a discount to trust value. Conversely, the supply of new deals was at odds to the usual summer lull, with early August seeing the fourth busiest two-week period for deal activity since 2008. In positive news for the merger space, there was Chinese regulatory approval for a significant deal in the semiconductor space, which helped to dampen the recent rise in regulatory risk fears and bodes well for other deals in the same sector. Merger spreads, however, remain volatile and relatively wide, with average annualised spreads over 8%.

Other relative value strategies had a mixed month, with some positive performance from convertible bond arbitrage, on largely idiosyncratic moves within specific names and sectors, despite a relatively quiet calendar of new issues in the convertible market. On the other hand, fixed income arbitrage managers generally posted negative returns.

Other relative value strategies had a mixed month, with some positive performance from convertible bond arbitrage, on largely idiosyncratic moves within specific names and sectors, despite a relatively quiet calendar of new issues in the convertible market. On the other hand, fixed income arbitrage managers generally posted negative returns.

Quantitative strategies also generally had a negative month in August, with losses for both technical statistical arbitrage strategies and systematic macro strategies. Factor driven equity market-neutral approaches generally fared better, thanks to positive returns from Value and Momentum factors in the first half of the month, although these gains also softened during the second half of the month.

For trend following managers it was a difficult month. The US dollar strength during the middle of the month saw sharp reversals across a range of FX trends that were held in size by many trend followers. In addition, there were further notable losses from commodity exposures, particularly in energies, although a rally in crude oil in the last few trading sessions helped to reduce the size of these losses. Trend following managers are generally long equities, and therefore the continued march higher for many developed market indices (despite the mid-month wobble) was generally positive for systematic managers.

Macro managers generally struggled during August, with difficulties stemming from the fixed income space. Trend exposures to fixed income had turned positive in recent months with falling yields seen through much of the second quarter, and therefore renewed concerns over tapering and higher fixed income volatility were generally negative for the space. Relative value strategies in fixed income were also negative, continuing a run of poor performance seen in recent months.

Dedicated hedging strategies, including short-biased equity managers, continue to struggle with the ever-higher levels of equity indices. Their troubles have been compounded by the relatively high level of implied volatility, meaning that hedging strategies are generally more expensive, while flare-ups of risk have tended to not lead to the kind of significant market falls required for these strategies to contribute meaningfully to return.