Man FRM Early View - June 2021

For investors, the most important thing currently seems to be not surging Delta variant Covid cases across many parts of the world, nor the vast swings in economic data from inflation to jobs to growth, nor the apparent tightening of financial conditions in China (which may or may not be the canary in the coal mine for the what comes after the normalisation trade). No, it is whether a small subset of the US central bankers now guess that there will be one more rate rise in 2023 versus their guesses from three months ago.

The attention with which markets are watching the controllers of monetary policy and measuring so precisely their shuffles towards a more hawkish regime feels out of kilter with actual economic data. Jobs and inflation numbers are subject to large spreads of economists’ estimates, and often post prints outside of the most extreme options, only for markets to collectively shrug in indifference.

Of course, in reality, interest rates rise of 25 or 50 basis points are neither here nor there in terms of market dynamics. Whether the S&P 500 Index trades on 20x or 25x expected earnings from 2024 has little to do with the discount rate, or even the relative attractiveness of equities over bonds, and much more to do with sentiment and exuberance around the stability of the economic and financial systems. So, the move in the Federal Reserve dot plot that caused the minor paroxysms in June is mostly symbolic as a change of sentiment over any kind of direct market impact.

The episode is though, as with other minor shocks seen in 2021 so far, representative of the fragility of financial markets in the current regime. The immediate reaction to the Fed meeting was a series of chunky repositioning moves in most asset classes. US 10-year breakevens dropped 20bp in two days; 5yr30yr US treasury curve steepness flattened by 30bp inside a trading session; precious metals gapped lower; and the US dollar snapped stronger against allcomers. The message was clear; the Fed is now in control of inflation.

In our opinion, none of these moves looks too dramatic on longer term charts, but they precipitated a fairly nasty few days of performance for the systematic macro hedge funds that we talk to. Some wiped out most of their healthy year-to-date performance in the matter of a few trading sessions (albeit to recover somewhat as some of these moves dissipated in the last week of the month). Equity markets took the reduced inflation outlook as a sign to reignite the Growth over Value trade that held sway for much of last year.

This does little to dissuade us of the view that there are enormous exposures of increasingly fast-to-react capital, seemingly balanced on the head of a pin across all asset classes. Gross and net exposures for several hedge fund strategies remain close to historic highs. As a result, it doesn’t feel like investors get a particularly good reward to risk ratio for trying to call the direction of markets from here – it’s just too technical and position-led in the short term. So even if you’re right in with the medium term call on economic recovery or inflation or whatever, it is possible that you’re stopped out of the trade due to short term noise in the interim. And we now move into the summer where liquidity is generally lighter anyway, which could only serve to exacerbate these air pockets in markets.

We believe it is easy to see why investors are increasingly moving toward less liquid assets, in the form of private equity and private credit, as a way of avoiding these positioning-led gyrations. Indeed, credit markets have barely noticed any of the volatility spikes in other asset classes seen this year. With credit spreads at the tightest level seen for a number of years, they remain arguably the best measure of whether market panic is justified or not.

All of this points to keeping risk levels low for the time being. It feels as if the easy money from the normalisation trade has been made, particularly by a hedge fund industry sitting on extremely strong 12 month returns. For the next few months protecting that P&L may be more important than adding to it, in our view.

Hedge Funds

Hedge funds had a mixed month in June, with noise around the slight change in tone from the Fed, leading to a change in market dynamics. The largest contribution to hedge fund performance came from the pick-up in FX volatility, which led to significant losses for several CTA managers, although some of these losses were recovered by month end. Other strategies benefited from what was a general ‘risk-on’ sentiment throughout the month, albeit with periods of turbulence in the middle of June.

Equity long-short managers benefitted from the strong month for global equity markets broadly, with many markets reaching new highs on the back of US consumer confidence hitting its highest level in 1.5 years, weaker than expected US inflation data, and a bipartisan infrastructure agreement. Outside the US, markets have strengthened but in a more measured tone as inflation and Covid variants remain a concern. Growth focused managers have benefited from a recovery in the factor during June, and there is still heavy long exposure to the growth factor based on a data released by prime brokers. For the most part, funds have reduced gross exposure throughout the month, with much of the movement in positioning for equity long-short managers coming from short covering.

Credit managers also benefitted from the good month for risk assets, and credit markets were less affected by the intra-month Fed driven volatility. Credit broadly outperformed loans, with high yield outperforming investment grade to finish the month close to multi-year tight spreads. Primary market activity in credit slowed in June following a hectic first five months of the year. Credit hedge funds saw modest positive returns in credit long-short and stronger returns for convertible arbitrage and distressed managers. There was some richening in convertible bonds and SPACs were generally up a little on the month. One of the more notable events in the credit space in June was the meaningful sell-off in GSE preferreds due to the adverse ruling from the Supreme Court as well as the removal of the head of FHFA (meaning little change now of any reform leading to privatization of these entities). Structured credit managers continued their good performance of recent months due to tighter spreads across sectors and reasonable carry.

In event arbitrage, deal activity levels continue to be good across all regions, with USD 335bn of deals announced in June. Managers commented that there were interesting opportunities from PE bids in UK and Italy, and that they are continuing to see a number of bid improvements. In a noteworthy antitrust development, the US DoJ is suing to block Aon’s USD 30-billion acquisition of Willis Towers Watson, claiming the deal to create the world’s largest insurance brokerage is anticompetitive. This had a broader knock on effect on some other large deals with regulatory risk in the market with spreads widening in response. As a result it was a more difficult month for hedge fund performance in the strategy, with the average performance a small negative.

Quantitative equity managers also saw a mixed month despite most major equity markets being positive on the month. The main driver of losses has been volatility in equity market factors around the Fed announcement, which saw investors sell reflationary cyclical assets and buy secular growth against tightening breakevens and a bull flattening treasury curve. The general tilt of quant strategies towards Value was detrimental in this environment.

Trend-following managers produced negative performance in June, following a strong run in recent months. Most of the losses were again centered around the mid-month Fed meeting, where the hawkish shift triggered reversals in key markets for CTAs. The US dollar was the biggest source of pain, rallying against well-held systematic currency exposures such as British pound, euro and Canadian dollar. Commodity markets were mixed against this backdrop, although the outperformance of oil was at odds with the otherwise cooler inflation picture in other assets. Trend strategies’ net long leverage in commodities is close to three year highs, based on data from prime brokers. CTA managers performance in equities was mixed, with faster strategies feeling more pain from volatility, while slower strategies maintained their long exposure through the noise and enjoyed small gains.