Man FRM Early View - December 2022

The only real surprise for December was that a year which has seen such persistently high volatility across all asset classes finished with something of a whimper.

The only real surprise for December was that a year which has seen such persistently high volatility across all asset classes finished with something of a whimper. Even the decision from the Bank of Japan to step away from yield curve control was digested by the thin year-end markets in a relatively orderly fashion. The unseasonably warm spell in Europe assuaged many of the fears around gas shortages, and the precipitous fall in natural gas and energy prices across Europe helped to further soothe inflation fears. Despite this, equity markets had retraced some of their Q4 gains in the early part of December, and so many major indices recorded their worst year since 2008.

As we move into 2023, in our view markets are sending a message of ‘wait and see’. If the Eurodollar curve is to be believed, the Federal Reserve is close to the end of its hiking cycle, and rates should sit around 5% for much of the year. Excluding the brief dalliance at these levels in 2006/7, one must go back to the second half of the 1990s to see whole calendar years with rates at these levels. Wall Street’s equity analysts are acknowledging this relatively unknown territory with a surprisingly wide range of estimates for where the S&P 500 will finish the year (the highest, at 5000, nearly 50% higher than the lowest, at 3400).

While inflation remains above the central banks’ long-term targets, the response function from policy makers to a more difficult economic environment will be muted. The difficulty in forecasting the degree of economic pain is made harder by the protracted nature of the problem. For instance, higher rates will only tend to bite on the debt side of the corporate balance sheet when companies come to refinance. Similarly, consumers may feel the pinch more acutely when, for instance, re-mortgaging their house leads to less disposable income, and may lead to material house price declines which could lead to further consumer wariness. But these events will be spread over the year and beyond, and therefore won’t show-up immediately in corporate weakness. In the absence of a severe exogeneous shock, 2023 could turn out to be the year of a prolonged death-by-a-thousand-cuts recession, which makes forecasting more difficult than ever.

However, after such a disappointing 2022, positioning in equities remains light, particularly for the faster-money players such as hedge funds. Investors will be watching for signs of the economic landscape being less bad rather than outright good. With fewer rate rises on the horizon, each piece of less bad data (e.g., inflation coming under control and corporate earnings expectations/results that are not terrible) could see capital moving from the side-lines into equity markets. The higher rate environment could have other knock-on effects for market activity, such as a pickup in convertible bond issuance if equity prices are depressed and issuing traditional debt is too expensive, or a recovery of growth stocks vs value stocks if the headwind from rising rates normalises.

Perhaps one aspect of markets that feels slightly easier to forecast is a continuation of the higher volatility environment. Actively managed strategies have performed well over the last two years, benefiting from the increased variety of trading opportunities in markets over 2021 and 2022, and signs remain promising that 2023 may prove to be another year of alpha over beta in terms of investment returns.

Hedge Funds

Following two straight months of gains, global equity markets reversed and posted negative performance in December. Investors again struggled with mixed economic data and geopolitical tensions heading into the new year. Small capitalisation and tech stocks retreated the most. That said, the early indications of December equity long-short performance show muted losses, with market neutral funds in positive territory. As with November, China and Asia-focused funds outperformed their US and Europe-focused counterparts. Broadly speaking, positive alpha offset losses from beta. While crowded longs did not necessarily work in favour of funds – Goldman Sachs’ VIP Index was down -6.7%, worse off than MSCI World – stocks with the greatest short interest underperformed even more, an overall tailwind for equity-oriented long-short funds. Another tailwind was the cautious positioning that ELS funds maintained in December – both net and gross exposure levels for U.S.-based funds were barely above their 2022 lows.

Credit markets held up reasonably well in a month that saw a sell-off in equities and higher treasury yields. Floating rate leveraged loans outperformed the US investment grade and high yield markets. Performance across US high yield ratings categories and industry groups was mixed in December. Corporate Credit managers largely posted positive returns in the month. Portfolio level hedges were a source of gains. SPACs were positive contributors driven by early redemptions. Certain credit-sensitive convertible arbitrage positions were also a source of gains as credit spreads held firm while equities were lower. Similarly, certain stressed/distressed corporate/sovereign credit longs performed positively during the month while some equity stub trades were negative contributors as the discounts widened. Structured Credit managers also saw positive performance in December as spreads were firm and portfolio carry remained positive.

Despite a disappointing market backdrop, Event managers generally saw positive returns in December. A positive antitrust tribunal decision for the Shaws/Rogers telecoms deal, rejecting the Canadian regulator’s suit to block the deal, was a significant boost for managers positioned for that mostly expected outcome. However, an appeal seems likely. The large Activision/Microsoft transaction gained traction around encouraging UK CMA submissions and positive reactions to a proposed remedies package, amongst other developments. Pharma remained an active M&A area, with J&J closing its $17bn purchase of Abiomed, and Horizon Therapeutics finalising a sales process with Amgen emerging as the successful $20bn buyer. Thoma Bravo continued its active technology acquisition strategy with an $8bn buyout of Coupa Software. Overall, new deal announcements roughly offset deal closures. Merger spreads (net of rates) closed the month at similar levels to November, but while median spreads tightened slightly, average spreads widened marginally.

Macro performance was mixed. Discretionary managers who moved short duration positions out of the US and into Europe outperformed as hawkish ECB rhetoric led investors to increase their expectations for terminal rates in the bloc. Asia-focussed managers were mostly positive too, as markets reacted strongly to the BoJ’s decision to expand its yield-curve-control policy target range, seen by many as a step towards tighter monetary policy. Systematic macro performance was typically mixed, with some managers struggling to navigate the changing narrative as well as their discretionary peers did. Short positions in European fixed income markets worked well, while choppy energy markets proved difficult amid the China reopening story, and variegated JPY positioning drove higher return dispersion within the space. Trend-followers were broadly flat. Short positions across fixed income markets, driven by longer-term momentum models, helped performance on the positive side, however equities generally hampered performance with slower strategies faring worse. In currencies, the rally in JPY cause pain for traditional trend-following strategies that their alternative counterparts managed to avoid.

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