Man FRM Early View - January 2022

One of the more frustrating characteristics of financial markets is not that they are unpredictable, but that they seem maddeningly predictable immediately after the event. Economic data has pointed to a problem with inflation for the best part of a year, while policymakers have been buttering us up for a tightening cycle for almost as long. And long-term empirical evidence tells us that the big risk for inflationary times is that both equities and bonds lose money at the same time. Cue ample facepalming on 24 January, with the S&P 500 Index down 10% and the US 10-year yield over 20 basis points wider since the start of the year.

But the idea this was just an inflation shock may be a little oversimplistic. To explain, we think it helps to split January into two parts; the turmoil under the surface in the first part of the month, as the Value-Growth performance spread widened precipitously (by some measures, at the fastest rate in over a decade), and the latter part of the month, as risk-off behaviour translated through into the indices themselves, with a spike in volatility and large intra-day performance swings.

Value stocks (that is, those that look relatively cheap based on current earnings, book value or cash flow) have outperformed Growth stocks for the last few months, but this circumstance was palpably amplified in the first two weeks of January. Here's the fingerprint of inflation since, when valuing stocks, higher rates make future cash flows less attractive compared to those in the present day. But the sudden acceleration of the value trade is more likely, we think, to be driven by the combination of investor positioning and new catalysts. In terms of positioning, many active investors have, in recent years, held a bias towards higher Growth companies (which helped to weather the storms in 2020), and the investor shift to ESG mandates has left less capital allocated to companies in the Oil & Gas sector. The catalysts were three-fold; firstly, energy commodities pushing even higher by the geopolitical tensions around Ukraine; secondly, the Federal Reserve committing to hold the course on tapering and rate rises; and thirdly, notable large tech companies reporting disappointing earnings and/or sales in their fourth-quarter reporting. The pain trade was, therefore, oil & gas companies higher, dragging Value stocks along for the ride, and long-end rates higher, bursting the valuation bubble of many high Growth names.

Many active investors, including some well-known hedge funds, suffered heavy losses in this period. Net long exposures concentrated in high Growth names were especially punished, with a large and high-profile technology innovation ETF suffering losses of more than 27% through 27 January. Markets then see another coincidence of positioning and catalysts in the second half of the month. The scale of these losses from the Value-Growth shenanigans led some investors to cut risk across their portfolios in the second half of the month, and this aligned with the growing risk-off sentiment around the worsening Ukraine situation, leading to material drops in equity indices.

Looking forward from here, we feel there remain several unanswered questions around the market dynamics. Overstretched positioning in equities appears to have been at least partially cleared out in January. When the dust has settled, investors may start to wonder how much the discount rate really is to blame for the underperformance of technology stocks (versus a simple crowding and deleveraging line of argument), since impact of present value of the next 10 years of earnings doesn't change that much whether rates are at 1% or 2%. And despite markets now pricing up to five rate rises from the US Federal Reserve in the next year, the long end of the yield curve seems a particularly stubborn beast. With no other information than a 25-year chart of 10-year US bond yields one would never guess that we were currently in the highest spike of realised inflation over that window. Breakeven inflation rates are slightly more elevated relative to long-term history, but still feel disconnected from the economic data, and at most tenors they fell during January (with longer-term breakevens falling significantly).

One must conclude that (at least for now) the Fed still has control of the curve, and that investors believe they will act sufficiently to control inflation looking over a multi-year period from here. This, if true, means that we may face a challenging period for equity market returns in the short term (which may act as a dampener on the demand side of the inflation equation in itself), but that the appetite for growth stocks may rebound quicker than expected if long-term 'risk free' rates remain so desultory.

Hedge Funds

There was an extremely wide range of outcomes for hedge fund managers in January, and therefore noting that the industry as a whole was negative in performance terms.

For equity long-short managers, anything with a net long bias or a Growth tilt suffered losses over the course of the month (and those with both suffered a double-helping of pain). Geopolitical worries around Ukraine and mixed earnings announcements also led managers to generally cut risk, leading to further noise throughout markets, particularly in crowded names. On the positive side, Value-based strategies have worked extremely well, in our view; specifically, exposure to energy names has been a significant source of gains for managers in those strategies. However, given the market volatility and the extreme rotation in the fortunes of Value and Growth stocks during the month, it has been entirely possible for two hedge funds running not too dissimilar equity long-short strategies to record returns for January of +10% and -10%, respectively.

European managers appear to have done better than their US counterparts in January, although this is explained by the relative performance of indices, and the comparative lack of large cap tech names. Looking forward, some managers are beginning to question whether the factor rotation is overdone, and whether the market sell-off has been too severe. Any moderately acceptable resolution to the Ukraine situation, combined with stronger earnings data in the latter part of this quarter's earnings season, and some of the stress in January could easily rebound.

Quantitative equity strategies saw performance also dominated by the Value-Growth dynamic, with alternative risk premia strategies generally performing positively, particularly those with a diversified set of traditional factor drivers. Brokers reported gross leverage in quant strategies rising during the month, but net exposure falling, suggesting that managers were adding shorts and tightening up hedges on parts of their books that were not working. The more volatile environment has generally been a negative for machine learning strategies, and quant credit strategies were also down on a lack of dispersion.

Credit markets largely followed equities into more of a risk-off territory, with high yield bonds selling off and outflows from credit retail funds. Investment grade credit also underperformed on moves in rates. Given the continued demand for floating rate risk, leveraged loans outperformed credit during the month. Despite losses, risk adjusted moves in credit have, thus far, been less severe than the sell-off in equities. Also, as with equity markets, energy credits have held up well given the strength of energy commodity pricing.

Credit managers are generally flat on the month in terms of performance. We believe hedges have worked well, particularly investment grade and rates hedges. Despite higher volatility than previous months, the view from our managers is that markets are orderly and pricing the changes in the risk and rate environment well. Structured credit markets have been somewhat less impacted so far, as higher interest rates in a strong economy are not necessarily a bad thing for this sector.

Event strategies were mixed in January. After deal spread tightening at the end of December, the weak and volatile equity markets have resulted in spread widening again in January. Managers are selectively taking advantage of these by adding to high-conviction positions, especially as the deal closure expectations for near-term deals remain largely unchanged. European deals have behaved better than the US & Asia, again perhaps reflecting the reduced systemic equity market pain in Europe versus the rest of the world. There have been several large deals announced across several sectors, with gaming a notable mention, with the USD75 billion acquisition of Activision by Microsoft, as well as the deal between Zynga and Take Two (around USD11 billion), and a PE consortium bid for Kohl's (USD9 billion). This suggests that thus far inflation concerns, and market volatility, have not impeded M&A activity.

Trend-following managers have ridden something of a rollercoaster in January. The early part of the month was largely positive, with long exposure to commodities and short exposure to bonds helping managers benefit from their pro-inflation positioning. However, the second half of the month saw losses mount from their long equity exposures at the same time as a slight check-back in bond yields, leading many managers to burn through most of their month-to-date gains. The last few days of the month appear to have been slightly positive, and we expect to see most trend-following managers finish in positive territory.