Man FRM Early View - July 2022

How quickly expectations change. If say a year ago, you’d been told that US inflation would hit a 40 year high of 9.1%, and that this print would be sandwiched between two rate rises by the Federal Reserve of 75bps (themselves unprecedented since 1994), you might not have also predicted that the S&P 500 would have recorded one of its stronger months on record, up almost 8%. This equity market strength is comparable in recent history only to the rallies in April 2020, when central banks reacted aggressively to the threat from Covid-19, and in November 2020, when the promise of a Covid vaccine materially changed the forward path of corporate earnings around the world.

Neither such ground-breaking developments occurred last month, which should raise suspicions that recent market behaviour has more of a technical then a fundamental basis. Indeed, there appears to be phenomena at play in the short-term market behaviour. Short squeezes have been more common in July than earlier in the year, with faster market participants looking to cover shorts in the face of lower market liquidity, leading to something of a snap-back in the worst performers year-to-date. The correlation structure between factors in markets has also shifted, with Value stocks and Momentum stocks now seeing greater commonality after years of negative correlation between these two factors. The repositioning of quantitative models and risk management of factor-neutral hedge funds may account for some of the sharp change in market leadership. Finally, the most mundane explanation of the market recovery is large institutional investors rebalancing their portfolios after a quarter of significant equity losses (Q2 was the second-worst quarter for the S&P 500 since 2008, only exceeded by the Covid crisis in Q1 2020).

But before we dismiss the market behaviour last month as nothing more than a bear market rally, it is worth examining whether reasons for fundamental strength could be starting to emerge. It seems unlikely to us that such fundamental reasons for recovery would come from the Federal Reserve. This would involve Jerome Powell backing off from rate rises for fear of excess damage to the economy, which seems unlikely given that a) the economy seems to be dealing with the rate rises better than markets and b) this critically undermines the confidence in the Fed to do the right thing in the next inflationary period. A second source of fundamental strength could come from corporate earnings, with some commentators theorising that high inflation means that nominal earnings should hold up very well even in recession, and therefore why should a nominal index such as the S&P 500 decline? This theory doesn’t tend to be backed up by history, as markets have generally fallen significantly during and following periods of high inflation and poor real growth expectations, but there are relatively few instances of this over the last 50 years (and even fewer over the last 30 years), therefore empirical analysis is of limited inference. The third, and most compelling fundamental argument in our view, is that investors are starting to take a longer-term view. We discussed this at length in last month’s Early View, but if one believes breakeven inflation rates or the US government bond yield curve or the Eurodollar markets, then one should conclude that inflation comes under control relatively quickly and that, at some point in the next year, the US economy will be looking substantially rosier than it does today on all fronts. For those investors who can bear to wait, buying and holding the S&P 500 after such a significant decline in H1 may be proven a wise decision in a few years’ time.

For negative fundamental concerns, one may wish to look further afield. Europe is facing a significant headwind in the shape of reduced natural gas imports from Russia, which is set to become a growing challenge to industry as H2 progresses and the domestic demand for gas rises as we move into winter. Europe was already struggling with weaker growth than the US post-Covid anyway, and in July the German IFO Business Confidence Index dropped to a level close to the nadirs seen in March 2020 and in September 2008. This should be worrying for European economies, given the high degree of correlation this Index has to forward-looking GDP growth in the region. With the euro already reaching parity with the dollar and widening government bond spreads between peripheral and core European economies (despite the best efforts of policymakers’ new anti-fragmentation tools), there seems to be plenty of reasons to fear continued fundamental pain in Europe for some time yet.

Another global source of economic risk continues to be the Chinese housing sector, where the slow-moving collapse of the last year seems to have picked up pace in July. Chinese High Yield Credit indices dropped 10% through the first three weeks of the month and shares in the Chinese Banking sector followed with a similarly sized fall. With property developers’ larger debt maturities approaching and anecdotal evidence of homebuyers defaulting on mortgages for unfinished properties, one can see why policy makers have sped up their attempts to solve the problem. But ideas such as bailout funds, backed by the Chinese Central Bank, to allow developers to continue operating, seems to us to only ease short-term concerns while magnifying the key problem of excess leverage in the development industry. We may therefore be moving into a new phase of the post-Covid landscape, where US markets manage to contain the inflationary risks and move, albeit noisily, into a more benign environment in 2023, whereas Europe and Asia continue to face tangible obstacles to a quicker recovery.

Hedge Funds

Hedge funds overall posted slightly positive performance in July, but with a range of results across strategies. Equity Long-Short and Specialist Credit managers benefited from the risk-on behaviour across markets, as did spread-based strategies such as Merger Arbitrage. However, the reversal in market leadership across asset classes meant that systematic strategies focused on momentum (both time-series and cross-sectional momentum) struggled during the month.

Equity market performance reversed in July, providing a tailwind for Equity Long-Short strategies. Indices across most regions advanced, with Chinese equities proving to be a negative outlier. Gross leverage increased, driven by price movement rather than active risk-taking by funds; beneath the surface, there was modest de-grossing in the week of 18 July. Funds continued to keep their net exposures low ahead of FOMC and a crucial week of earnings announcements. On the short side, beta hedges have been cut down, but managers have maintained or added to single names. Unsurprisingly, ELS performance has largely been commensurate with the levels of net exposure held by funds. US and global funds have displayed positive returns while Asia funds have lagged in July, in line with regional indices. Low quality assets outperformed in July – largely reversionary – and were consequently a headwind to short portfolios. However, a rebound in tech assets boosted the performance of crowded hedge fund longs.

For Credit managers, modest primary market supply and good demand for corporate credit risk led to tighter US high yield credit spreads and higher leveraged loan prices. A rally in treasuries supported the outperformance of higher-rated US high yield credits. All the US high yield industry groups were up in the month, with the housing sector leading the gains after meaningful underperformance in June. Corporate credit managers posted mixed returns during the month. Portfolio credit and rates hedges were a meaningful drag for some managers. Financial preferreds saw a strong rebound after a challenging first half of the year as there was some stability in the rates market and outflows from mutual funds and ETFs moderated. Idiosyncratic long credit vs. short equity cap structure arb trades led to losses for some while certain stub trades were profitable in July. Certain credit-sensitive convertible bonds rallied along with the rebound in underlying stocks. A buyout and earnings-related stock volatility also drove gains for some positions. SPACs were small positive contributors for some managers. Structured Credit managers posted modest, largely carry-driven returns, with a drag from portfolio hedges and modest mark-to-market PnL across sectors.

July looks set to deliver mixed performance in quantitative strategies. In Macro Quant we are expecting weaker results from trend-followers (SG CTA Index off about 1%) with losses driven by a combination of rallying equity indices when managers are caught short, curve flattening in rates and a drop in crude. Alternative-trend managers are likely to enjoy rising EU gas prices. For the Micro Quant and Diversified space, we see solid performance in market neutral equities and machine learning equities. Regionally, US factor bets were mixed, EU and Asia were negative on value but positive on growth. Meanwhile it was another negative month for quant credit.

For Event managers, the market stability in July brought merger spreads in a bit narrower from June, however there is large dispersion between shorter dated deals versus longer dated and more complex deals. Deal flow has been slow, not unexpectedly for summer, but developments around deals were predominantly positive, with several deals receiving regulatory approvals and/or closing. Twitter was a headline negative outlier mid-month, rerating down after Elon Musk announced that he was walking away from the $44 billion deal, however Twitter is seeking to enforce in court, and news of an expedited trial already in October and Twitter’s contractual advantages buoyed the stock. Uniper announced a bail-out by the German government, resulting in a dilution and an obstacle for the expected minority squeeze-out. Equity special situations have seen a lot of value to growth rotation, with selling pressure on previous outperformers and a squeeze on shorts. Event managers have rotated into mergers and shorter-dated credit opportunities. Equity RV arbitrage trading in Asia has been positive and capital market events had mixed performance across geographies.