Man FRM Early View - July 2020

Hedge funds enjoyed positive performance during July, with returns supported by positive returns to equities, credit and government bonds.

Markets

What a curious world we currently inhabit. Just a few months after the fastest 30% decline in equities in recorded history and we have broker notes crossing our desks with the headline ‘can valuations become infinite?’ 1. One suspects that the author of that piece is being deliberately provocative, but it certainly feels like the right question to ask when looking at portions of the equity market recently. In intraday trading on 13th July an American manufacturer’s shares had briefly rallied over 70% in two weeks, on essentially no news. This is the sort of behaviour expected of micro-cap stocks caught up in a retail investor frenzy (and we’ve had plenty of those recently), not a USD 100-300bn company (the market capitalisation depends on which day of the last month you do the maths).

This is all becoming a serious headache for active investors who trade on fundamentals. Lest we forget that we are still in the sharpest and deepest recession of any of our careers. Of course, all the central bank stimuli were necessary (and necessarily enormous) to stave off a financial crisis, but if you clamp shut the main spigot of disaster, then the pressure seeps out elsewhere. The unprecedented magnitude of negative US real yields today reflects the Fed commitment to keep policy rates at zero for anything approaching a foreseeable future, and a consensus across the investment community that they will allow inflation to overshoot before they act.

But this version of ‘the Fed put’ is more narrow than previous incarnations, with a handful of stocks responsible for the bulk of the rally from the market bottom. The valuation spread between ‘cheap’ and ‘expensive’ stocks on forward-looking metrics keeps widening, and by some measures is now approaching dot-com bubble levels of stress. Yet, maybe, as the author of the broker note mentioned above implies, this time it really is different.

It’s almost rational to buy large tech stocks today at over 100x earnings. Will they be bigger companies in 10 years’ time? Possibly. Then why lend your money to Uncle Sam for a near guaranteed loss in real terms? After all, the discount rate used to justify such high valuations is much lower today than it was during the tech bubble of the late 90s.

And so, the stage is set for the next act in this market spectacle. The fingerprints of inflation have started to pop-up over the investment landscape. Breakevens and commodity prices are now creeping steadily higher (or, in the case of Gold, rocketing to new highs), yet still the long end of the yield curve stays anchored lower.

This cannot go on forever. There is of course great uncertainty over the speed of this path, and whether we take backwards steps before we eventually move forward, but some combination of a possible vaccine, improved treatment and increased societal acceptance of infection risks will lead to a time in the future when economies are free (or are at least recovering) from the economic impact of COVID-19.

It’s easy to draw wildly different conclusions of what this means for markets. Those of a more catastrophic disposition see the size of negative real yields and the associated expansion of the Value-Growth spread as an elastic band, which only stretches more and more as the central banks err on the side of caution by keeping rates lower for longer than needed. In their view, they see institutional investors blinking first and selling their bonds once the capital destruction reaches a certain pain threshold in real terms, which leads to a violent snap back of the tension in the system, and a sense that central banks have lost control of both inflation and the yield curve. Those of a more measured opinion might see us reach something of an equilibrium in terms of real rates, with any moves higher in inflation matched by a more gradual rise in nominal rates. Here the liability-driven buying pressure from pension funds desperate for duration at anything like a decent price acts as a dampener on excessive rate volatility, and central banks can inflate-away some of the debt in the system without market chaos.

And while the central banks feel somewhat united in their common purpose, the other cohort of economic policy makers – the politicians – are anything but. In July the EU leaders finally agreed on a EUR 750bn rescue package for the more beleaguered parts of the union. Despite rounds of tense negotiation and factionalism this pact is nothing but historic: it revitalized the French-German power axis in a way not seen since the eastward expansion of the EU and it has moved Germany from the austerity into the integration camp.

The trade-war rhetoric from several Western nations towards China continues to simmer along in the background, always threatening to reignite. And, of course, the US is quickly approaching what may turn out to be a messy presidential election, with risks that range beyond the usual binary market paths. What depths of electioneering will we see over the next few months? What if there is no clear winner or a legal challenge to the outcome? What if the election gets cancelled altogether? Surely none of the world leaders would sacrifice a nascent economic recovery on the altar of their own political ambitions?

Hedge Funds

Hedge funds enjoyed positive performance during July, with returns supported by positive returns to equities, credit and government bonds. Equity Long-Short managers benefited from a continuation of fertile opportunity set following the market dislocations in H1, whereas Credit and Convertible Bond managers benefited from narrowing credit spreads. Trend Following managers generally benefitted from trends in government bonds and FX, while Relative Value strategies experienced mixed performance during the month.

For security selection strategies in Equity and Credit Long-Short, there was positive sentiment for risk assets, driven by positive news flow on potential developments on the vaccine front, stimulus packages in Europe and US, with markets looking through increasing tensions with China and a steady increase in COVID-19 cases. The most notable returns were in US High Yield markets, leading the performance from leveraged loans and Investment Grade Credit. Primary US High Yield markets slowed after a record June, while positive inflows continued into High Yield bond funds.

The main performance drivers for Corporate Credit managers beyond the beta exposure came from large-cap financial preferreds and Convertible Bonds. Financial preferreds outperformed thanks to positive developments around banking stress tests, whereas Convertible Bonds had another positive month on spread compression. After a notable Q2 for new issues, Convertible Bonds was a similar drop-off to High Yield Credit, leading to an upward revaluation of the secondary market. Some name specific stories did well, including pharma-related names benefitting from COVID-19 research.

Structured Credit was also positive but lagged corporate credit. Legacy non-agency RMBS was tighter on the month while parts of the CRT sector saw some underperformance. Forbearance rates are generally well behaved and housing activity remains resilient. CMBS were tighter given the relatively higher yields vs. other sectors. Other sectors were also generally tighter on the month.

Performance in Quantitative Equity Strategies was mixed in July as markets in general were calmer than throughout much of H1 2020. There was some volatility across factors with Value being bought MTD and both Growth and Momentum selling off. The mid-month reversal, led by tech stocks being sold, saw Value favored over Growth and some commentators believe a rotation into Value could be imminent if tech underperformance persists, particularly in earnings season. Equity Momentum, though net sold, has retraced vs Value themes affecting many managers, most notably (and unusually) the Machine Learning cohort. There was generally better performance from technical-based models over fundamentals, which has been the case for most of 2020.

Managed Futures managers performed positively in July, led by FX and fixed income trading, as a more benign market environment suited trend-following strategies. Long exposure to global equity indices broadly helped performance with gains concentrated in US and Asian indices. Fixed Income also produced gains where UK 2-year and 5-year yields traded to record lows amid speculation of further easing from the Bank of England. Performance within Commodities was mixed; Gold rallied on the back of virus concerns and rising geopolitical tensions, passing USD 1900/oz for the first time since 2011, however energy markets were harder to navigate and saw some outsized losses for trend managers. In FX, the US dollar touched a two-year low in July as sharp increases in COVID-19 cases in the US weighed on investor confidence.

After a small uptick at the beginning of July, merger spreads have remained in a similar range as last month, except for a few outliers that have skewed average spread values. Amidst fairly wide dispersion Event / RV managers are generally small positive in July as several deals progressed or closed during the month, including a spinoff of an online dating company as well as a casino deal that just a few months ago was priced with a very low implied completion probability.

SPACs (special-purpose acquisition companies that raise money in an IPO for acquisitions) have again been a key positive contributor to hedge fund returns, and several managers also benefitted from exposure to deals with positive shareholder activist or competitive/bidding pressure on deal prices. The SPACs market has continued to accelerate as several high-profile dealmakers have raised new vehicles of record-breaking size, with especially electric car and truck companies generating a lot of interest.

In the US, regular new deal announcements have slightly exceeded deal closures, so the deal universe is growing. Managers also report new deals in the mining sector (especially gold) and a healthy deal flow in HK and Japan, as well as new privatizations of Chinese ADRs listed in the US as a result of stricter rules announced in the US.

1. Macquarie Research – 22 July 2020 ‘Value vs Growth debate: Can valuations become infinite?’