Man FRM Early View - June 2020

June saw generally positive returns from discretionary equity and credit strategies, with mixed performance from relative value and quantitative strategies.

Markets

It’s been a while since the human race met such an obdurate obstacle. For the last few hundred years we have mostly made our own trouble: even the looming confrontation with climate change is largely of our own making. There was the ‘flu’ a hundred-odd years ago, but mankind had just been so utterly crushed by its own hand in The Great War that the cultural response seems to have been muted; repressed even. This thing we have now is a true affront on a scale for which nothing in living memory has prepared us.

The weapons of Anglo-American modern political warfare – corruption, lying, spinning, falsifying, bullying, institutional subversion – which have proved devastating in the fields for which they were developed, are of course nothing to the virus. You can’t just say “it ain’t so” to this one, and the blank cluelessness about what to do next would be comic if it wasn’t tragic.

Much of what we do in the finance industry assumes that markets reflect a truth, objectively and independently, about the state of the world, or at least as much of a shared truth as you can find anywhere. As such they appeared to offer a saner perspective… for a time. Maybe that phrase ‘the market is never wrong’ is actually only a truism (to a trader, the price is the only truth that matters) but it has long been wise to square what the market seems to think of things with the way we perceive them ourselves. This type of approach provides some part of the philosophical foundation for such key investment concepts as value, risk and return and most of us around now know nothing else anyway.

It is true, that over the last 40 years, there have been some prices which appear to be administered, rather than determined by the balance of supply and demand established in a ‘free’ market. But when the bigger picture investment decisions often felt like baffling simultaneous equations, these relatively few administered prices actually got us started in solving the other unknowns. The managed exchange rate systems prevalent in the 1980s and 90s in Europe and Asia come to mind: if the authorities wanted to fix an exchange rate, then movements in the interest rates become that more predictable. But while all that had largely ended by the turn of the century, the dependence on administered prices through Quantitative Easing, Bond repression and yield curve management has been increasing again since 2008. It’s a slippery and convex slope.

Is it alarmist to suggest that the balance has now tilted against the whole philosophical, political and historical free markets framework and taken us back to a distant and unfamiliar past? At the macro level, short term interest rates were always officially determined, but now prices are controlled all the way down the yield curve. The decision to support Credit prices establishes a precedent that no one much doubts will extend to higher risk categories of investment if the need arises. And though outright Equity purchases are still out, it does feel as if any weakness in Equities has triggered new support measures at least somewhere in the markets. With inflation at bay, many countries seem to quietly engineer a weak currency. Perhaps FX volatility is so low only because each is constrained in this objective by the others with a similar ambition. Oil is of course hugely manipulated by the producers. At the micro level, the fate of many companies appears to be in the hands of law makers now, and one can only imagine there is more to come here.

Is this why macro price discovery has felt so despairing this month? Markets in June have been loose, flaky and lacking in conviction. The S&P 500 managed to round trip 8% in the first half of the month, and then repeat the trick to the tune of 6% in the second half. (There was a sustained attempt to blame it all on retail investors which is never meant as a compliment.) Some individual stocks rallied 50% or 100% only to collapse again. Cross-sectional momentum had a crazy, precipitous sell off (hopes of a value recovery revived) only to get it all back and more; crazy and precipitous in the other direction (hopes for value dashed...again). Oil? Don’t talk about oil these last few months. Most institutional investors seem just to have looked on, bemused. Why would you commit capital to what looks like a wrong price when you have no confidence in the framework to restore the right one?

Inside the financial world itself the story is more nuanced than this. There are some cracks that can’t be papered over: A German payment processor was finally exposed as a fraud and there were a series of unusual hiccups in raising new money in both Equity and Credit (it’s not on the way up that problems of this kind tend to emerge). Pricing spreads are gradually normalising (though bid-offer spreads on index Credit indices for example are still twice what they were in January), but market making is still shallow and skittish. Indications of crisis damage to the capitalisation of some market makers is still trickling out, and this will take time to repair. And on the positive side, there has been some reasonable alpha generation again across a range of hedge funds.

In the big world outside, true to form, the virus isn’t doing politics. The case count goes on rising in defiance of the political will to re-open the economies. Perhaps re-opening is the right way to go, but in this country at least, we are living with a government narrative that has been repeatedly and painfully detached from reality. With this all-encompassing extension of official intervention, markets can no longer be expected to offer a read on how the world actually is. Instead prices have become more a part of the narrative than the reality. What hope then for the efficient allocation of capital in the global economy and the billions who depend on it?

Hedge Funds

Hedge funds continued to exhibit volatility of returns across different strategies in June, with generally positive returns from discretionary Equity and Credit strategies, and mixed performance from Relative Value and Quantitative Strategies.

Equity Long-Short managers generally saw positive returns to alpha during June, with managers keeping risk levels low and turning their portfolios over more frequently to navigate the gyrations in both market level and market factors. The re-emergence of ‘stay-at-home’ winners through the second half of the month was generally positive for managers (after the sharp, but brief, recovery in value names during the first week). The hedge fund universe is now split between those managers who believe in a continuation of the stay-at-home theme, possibly in light of a ‘second-peak’ and new lockdown restrictions, and those who are positioning for more of an economic recovery theme as economies normalise.

Quantitative Equity Strategies performance was mixed in June. There were strong results from faster and more technically driven strategies, such as Statistical Arbitrage and Machine Learning, however extreme factor volatility left managers trading longer term effects with fewer places to hide. Momentum factors experienced pain early in the month before rallying, whilst value factors rose alongside yields. The S&P 500 soared to February 2020 levels on a surprisingly positive job report, before a dovish Fed and rise in COVID-19 cases in many states saw a sharp reversal and a 13-point rise in the VIX on June 11.

Managed Futures managers struggled in June. Those managers who continued to operate with significant risk, were heavily impacted by the moves in oil early in June but recaptured these losses with gains in Equities over the middle part of the month. For the most part, the primary source of loss by month end was FX (Commodities were flat across managers despite the oil moves as shorts in Natural Gas added to performance), USD weakness early in the month hurt trend-followers despite other safe haven currencies strengthening as the month went on. A new surge in cases in Latin America and the shutting of schools in Beijing saw fears of a second wave of COVID-19 become more significant, threatening a generally positive risk attitude in June. Despite increased volatility, Equity markets in general were slightly positive for the month and most trend followers are now positioned to capture these gains.

Positive Q2 momentum continued in the Credit markets despite some pressure on risk assets towards the end of June on rising COVID-19 cases in several US states, which remains a key near term risk. In many areas Credit has outperformed Equities with HY, IG, leveraged loans all positive for the month. The rally in US HY was once again led by lower-rated Credits. The majority of US HY industry groups were positive for the month with a strong rebound for the Transportation and Retail sectors. It was a record month for US HY new issuance, led by strong refinancing activity. Corporate Credit managers had generally positive returns in the month led by capital structure arbitrage and Convertible Arbitrage strategies. Convertible Arbitrage in particular benefitted from strong primary markets as well as exchanges and tenders.

Most Structured Credit sectors also posted positive returns in the month. While delinquencies rose across all non-agency subsectors, the forbearance rates seemed to have stabilised. Supply remained low in most sectors including ABS and new issuance saw strong demand, supportive of spread tightening. The CMBS sector continues to be a laggard so far YTD.

In Event Arbitrage managers generally endured mixed performance in June. While median merger spreads retreated slightly from an uptick at the end of May, average spreads widened due to some large outliers, including some challenged transactions, e.g. an LBO of a software company or a merger of shopping mall operators, as well as situations with anti-trust risk, e.g. an acquisition of a technology firm by a global internet service provider. After the news that the EU had launched an in-depth anti-trust probe into the USD 50bn deal between two European car manufacturers, spreads initially widened but reversed again on the consensus that this probe shouldn’t change the timeline (January 2021) and the actual anti-trust issues are quite specific to commercial vehicles/vans.

A number of deals have closed or have progressed significantly, e.g. shareholders approved the separation of an online dating website firm from its controlling shareholder, and a provider of sensor solutions is poised to get approval from EU anti-trust regulators on its bid for a German multinational lighting manufacturer. In selected new deal news, three PE firms have made a joint offer to take full control of a Spanish mobile Telcom company, and a Dutch food ordering company has announced an all-stock deal to buy a US based food ordering company, after significant interest had been shown by other industry peers.