Man FRM Early View - July 2021

Those looking for a review of market behaviour in July would do as well to just re-read letters from the end of June. Continued positive surprises on data, in terms of jobs, growth and inflation, were met by expectations of faster central bank tapering, leading to flatter yield curves and ever more negative long-term real rates. We had another equity market wobble – a couple of days of questioning whether the spread of the Covid Delta variant might check the normalisation trade – only for the MSCI World Index to finish the month once again close to record highs. Equities higher, bonds higher. This investment game is easy.

If only. But after such an eventful 18 months, it feels like something of a luxury to be able to widen one's focus from the day-to-day concerns and try to pick up the line of argument from two years' ago, and ask what is the 'normality' into which we are slowly returning? In our view, none of the bigger macroeconomic questions posed at the end of 2019 have magically disappeared due to Covid.

The 2010s were characterised by enormous (monetary) stimulus leading to GDP growth and asset inflation; but sluggish productivity gains despite seemingly unstoppable technological 'disruption', widening inequality (particularly in developed market populations), weaker than expected retail and consumer price inflation, and difficulties for many central banks outside of the US to get away from a zero interest rate policy. Economic concerns, particularly when seen through the lens of winners and losers in a post-GFC environment, then spilt over into the political arena, with the increase of populist candidates and causes.

All of these remain pertinent for the post-Covid regime (in some cases, particularly those around policy responses, more so than ever). We feel that there are good reasons to believe that the current social and political landscape is moving away from prioritising growth, as with each year that passes since 2008, newer generations feel less and less convinced by the moral imperatives of global capitalism – that competition is good, that the invisible hand of the market is a driver of efficiency, that a richer world is a better world. With 30 years of rising GINI coefficients of inequality in almost all developed markets, who can blame them?

The growing epicentre of these concerns is the environment. The whole Covid episode served to cement the status of scientists in most right-minded citizens and has only added to the already significant energy behind support for environmental action. The financial sector (led by the largest pools on investor capital) has swung behind ESG, climate impact and responsible investing with increasing momentum. Most observers are expecting the political classes to set more ambitious targets for decarbonisation at the COP26 conference in Glasgow later this year. We think decarbonisation is, like any artificial constraint, a drag on growth, since it is folly to believe that any new green technology can be anywhere near as additive to growth and productivity as taking oil, coal or gas from the ground and burning it for energy. It is, however, a necessary constraint for the future of the planet (lest there be any doubt on this author's convictions).

This momentum has of course consequences on policy and politics. There is now a real chance that the Green party could win the most seats in the German Federal Elections in less than two months' time, or at least find themselves as a powerful junior member in a coalition. The horrendous flooding seen in parts of Germany in July is only likely to strengthen their cause. This could lead to a possible 'Green New Deal' type spending plan for Germany of the kind recently pushed for by political progressives in elections in the US and the UK. With Mario Draghi also promising 'whatever it takes' mark II for Italy, we may experience a level of fiscal laxity across Europe not seen for decades.

Add this to the record budget deficits planned by the current US administration, and we can start to see a possible game plan for the next few years. A populace frustrated by perceived inequalities in the global macroeconomic system pushes for progressive change, particularly on the environment but also across a range of other issues, leading to policy and fiscal stimulus to enact change. For the modern monetary theorists, this is the logical next step in an era of record low borrowing costs. But while government spending programmes, such as large infrastructure projects, might help to prop up total GDP, they risk doing little for productivity (since 'central planning' has been shown enough times in history to be an inefficient use of capital).

Of course, popular frustration emerging as political policy can result in even more dangerous threats to global growth. Protectionism and trade wars were a constant concern in the Trump and Brexit period from 2016 to 2020, and recent actions by the Chinese authorities to effectively nationalise all the successful private education businesses has sent shockwaves through the Chinese equity market. Investors must surely now assign a higher risk premium to any growth company in China for the risk of future political interference, making it harder for them to raise capital, and again this is negative for growth and productivity.

The political and economic balance for the next decade may therefore be between the desire to build a better world – one of reduced environmental strain, lower inequality, a higher quality of living for most citizens – and the tolerance for possible negative impacts to overall growth and productivity that come from these systemic constraints. Since higher productivity is a way to justify, and perhaps even propel further, the current valuation of equity market multiples, moving into an era where the nuances of global capitalism are more closely debated may have an impact on long-term risk asset expectations.

Hedge Funds

The hedge fund industry continues to go from strength to strength in 2021, with many managers chalking up year-to-date numbers for the first seven months that probably exceed an average full year's expectations. Performance continues to be positive for managers with exposure to risk assets, namely equities and credit as investors continue to bid both equities and bonds higher. In many markets, there was a wobble in the middle of the month as investors renewed concerns around the Delta variant of the coronavirus, but these concerns dissipated after a few trading sessions. A notable exception has been in China, where concerns over both the economic outlook and political moves to nationalise successful private companies in the education sector have weighed heavily on markets. Other strategies had mixed fortunes in July, with CTA managers seeing sharp reversals mid-month, particularly in FX, leading to losses in many cases. Arbitrage strategies were mixed, but generally positive.

For equity long-short managers, it was generally a positive month in US and European markets, driven by market beta and a strong second-quarter earnings season (88% of S&P 500 Index companies posting positive EPS surprise through 26 July). As noted above, this was sharply in contrast with Asian equity long-short strategies, who were on course for their worst month on record¹. From a factor perspective, the month started with a continued recovery for smaller, growthier companies, but this had shifted in favour of large-cap defensive names by month end. Managers have started to reflect the more uncertain outlook with tighter net and gross exposures, at least relative to some of the very stretched measures seen in the first half of the year.

Credit managers also felt some of the volatility in the middle of the month from the increased COVID concerns, but as with equities this reduced quickly. Credit spreads appeared to find it more difficult to tighten much from the current levels, leaving performance broadly flat for US high yield and leverage loans on the month. Investment Grade has outperformed due to the rally in long-term rates, and similarly higher-quality credits outperformed lower-quality throughout the rating spectrum due to the impact of the move in risk-free rates. Corporate debt primary markets have continued to slow through July following the high level of issuance in the first half of the year.

With a relatively quiet month from a credit index perspective, it is pleasing to see many credit hedge funds generating positive performance from security selection, although those managers with significant interest rate hedges saw more muted performance. It was also a mixed month for convertible bond arbitrage, as some popular names were negatively impacted by the China news around the tech/education sector. SPACs appear to have recovered some of their positive momentum following a retracement in valuation during the second quarter, and new issuance of SPACs has also picked up in July. For structured credit, it was a slower month for residential primary market activity, but there were more active markets in ABS during the month. Positive returns for managers were driven by both interest income and modest spread tightening across most sectors.

Relative value strategies also had something of a mixed month in July. Quant market neutral strategies generally did well, with factor-based fundamental strategies being (as ever) subject to the prevailing currents in equity markets, but generally finishing the month in positive territory. More technical and machine-learning based quant strategies were strong in the first half of the month with some give-back towards month end. Quant credit managers have enjoyed the pickup in volatility across the assets class. As with their discretionary counterparts, we expect quant strategies to have struggled in China, particularly around A/H arbitrage trades given the high degree of volatility in those markets.

Event arbitrage strategies were also mixed on the month, with the collapse of the Aon/Willis Towers Watson deal on monopolistic concerns leading to losses from direct exposure to the deal but also slightly wider deal spreads in the market on concerns that this could be a sign that regulators are assessing deals with greater scrutiny.

In CTAs, there were sharp losses in the middle of the month associated with FX reversals. The general strength of the dollar versus most currencies and the further strengthening of safe havens such as the Japanese yen and Swiss francs were negative contributors to performance. Positioning in FX was extremely full coming into the month, and therefore modest trend reversals led to significant negative contributions to P&L. Exposure to FX has generally now been scaled to significantly lower levels due to the higher volatility in the asset class and the weakness of trend characteristics. Managers generally offset some of their FX losses thanks to long exposure to equities and their growing long exposure to longer dated government bonds. Commodities were generally mixed contributors to performance throughout the month.

1. Source: Goldman Sachs Research; as of 27 July.