Man FRM Early View - December 2021

2021 was a year of tension in markets between the disruptive effects of ‘minicrises’ throughout the year (the storming of the Capitol, the Gamestop saga, the Archegos blow-up, the Delta variant, tapering talk, bond market liquidity issues, Evergrande, the Omicron variant…) and the fairly remarkable resilience of investors in the face of these events. Equities kept going up for most of the year, and bond investors seemed preternaturally unperturbed by talk of the necessity of tighter policy in the face of rather startling inflation data.

This resilience is best explained by the persistence of the accommodative policy environment. For all the talk of tapering, most companies (and especially governments) were able to borrow for much of the year at negative real rates of interest. In many areas of the economy, profitability was buoyant, supported by an inflationary backdrop that meant (in the short term at least) companies could either benefit from increased costs of raw materials or pass these costs on to the consumer. After the speed of events in 2020 around the emergence of Covid, lockdowns, the market crash, the policy response, and the market recovery, it feels like we have had to recalibrate our timescales in 2021 for a slower development of economic pressures.

Furthermore, we perhaps became too focused on the ‘taper tantrum’ of 2013 as a risk to markets when central banks switch from a looser to a tighter monetary policy, which never materialised. It is hard to say whether this was due to better signposting from policy makers this time around or just the fact that one data point is not great evidence on which to build predictions for the next iteration of a similar environment.

But it is hard to get away from a sense that markets didn’t quite behave in 2021, and nowhere is this truer than in the return to hedge funds. The year can be characterised by one where quantitative-driven strategies fared significantly better than discretionary strategies. Computers generally try not to make specific predictions about how events will resolve, and instead we believe wellworn strategies such as trend-following and factor investing performed well during the year. In the discretionary space, discretionary macro managers were amongst the worst performers on an absolute basis, whereas stock pickers in the discretionary equity long-short strategy had their worst year for alpha generation in a decade (source: Morgan Stanley ‘2021 Hedge Fund Year End Recap’).

Looking forward the 2022, the key questions remain like those posed a year ago, albeit with what feels like a few degrees more precision than before. Firstly, how do markets react to the end of Covid as a systemic issue? We are going out on a bit of a limb here but increasing numbers of scientists are now expecting Covid-19 to move from a pandemic situation to an endemic one in 2022, due to the improvements made in vaccines and treatment, as well as the fact that dominant mutations have tended to show decreased severity.

Secondly, how persistent are bond investors in keeping yield curves under control? Inflation only becomes a problem if bond investors make it a problem. The fear for much of the last year has been the central banks losing control of the curve in the face of increased inflation pressures. In our view, whether bond investors remain as steadfast and tolerant of negative real rates in 2022 as they were in 2021 will be an important factor for the overall economic environment.

Thirdly, can corporate growth and profitability continue to surprise on the upside? Many firms managed to benefit from imbalances in the inflation landscape in 2021, but with full employment and increasing cost pressures on firms, when does the end consumer’s limited tolerance for higher prices start to meaningfully impact earnings?

And fourthly, as Covid risks recede, how quickly do concerns shift to other global tensions? With geopolitical issues around possible military action in Ukraine, Taiwan and other regions, overvalued markets should always be wary of the next exogenous shock.

We don’t pretend to have the answers to any of these questions, and the last year has shown that generally market forecasting is as difficult as ever, but we do believe that investors benefit from active risk management in the face of uncertainty. Just as very few commentators believed that the S&P 500 total return index would return +28.7% in 2021 despite the multiple inflationary risks, we remain humbly agnostic about the expected returns of traditional assets for the year ahead. Happy New Year.

Hedge Funds

Hedge fund managers generally ended 2021 with a positive month, as risk assets rallied and quantitative strategies enjoyed positive returns.

In equity long-short, managers benefited from positive returns to equity markets as US stocks hit record highs towards the end of the month. Reports of strong retail sales around the festive period overshadowed worries over the spread of the Omicron variant of Covid-19. Notably, 2021 was the first year that the S&P 500 Index outperformed the Nasdaq since 2016, showing the stronger returns to more value driven stocks over the year. From a valuation perspective, the S&P finished the year at around 21.3x forward EPS, above the 20-year average of 19.1x, but not excessively so. Chinese markets were the laggard in December, as tech shares continued to be pressured by government regulation, and concerns over the Evergrande situation continued to weigh on risk appetite.

Equity long-short funds underperformed in the early part of December due to general overweight exposure to IT and consumer sectors, although the more crowded names in these sectors outperformed in the second half of the month and stabilized overall performance. Aggregate net and gross positioning remained stable throughout December, with both measures lower than the highs seen earlier in the year.

Quantitative equity strategies generally enjoyed a very strong December. Volatility levels reduced through the month, and managers were able to capitalize on the normalization of dislocations that occurred in the more volatile period at the end of November. In particular, managers profited from trading patterns in small cap and highly levered stocks. From a factor perspective, it was a strong month for Value, particularly more traditional measures of deep value such as book-to-price ratios, and a weak month for market-neutral momentum.

Macro quant strategies such as CTAs had a small positive month, albeit one with considerable volatility throughout the month and dispersion from manager to manager. The pick-up in volatility across most asset classes in late November meant that managers came into December with different positioning to one another. The strongest contributor to performance has been net long equity positioning, as global equities recovered throughout the month. Commodities were the biggest detractor, particularly the extreme whipsawing seen in natural gas markets during the month, and the unexpected rally in gold into year end. Rates and FX contributions were mixed, with long bonds losing money on a pullback, and currencies generally rangebound for much of December.

Credit markets followed a similar pattern to equity markets, with risk-on behaviour as concerns over the severity of the Omicron variant waned. US high yield bonds recorded their best month of the year, up almost 2%, with the strongest returns to bonds issued by companies in the energy and transportation sectors. Investment grade bonds were flattish on a weaker return to rates. December was a very light month in terms of primary market activity, which provided further support to secondary market pricing. Also, in keeping with equity markets, those credit hedge fund managers with more net exposure benefited the most in December, although credit hedges and sovereign shorts were costly.

In other areas of the credit landscape performance was mixed. Convertible arbitrage managers performed positively, although those with larger exposure to SPACs were weaker on the month as these securities generally failed to keep up with the broader risk-on moves in markets. Financial preferred were also muted but slightly positive on the month, as were structured credit exposures.