Man FRM Early View - June 2022

The balance between inflationary pressures and central bank actions developed with increasing intensity during June. The above-expectation US inflation CPI year-on-year print of 8.6% early in June poured fuel on the fire of overheating concerns. Both equities and bonds fell sharply for a few trading days, before a new consensus emerged around expectations of a 75bps rate rise from the Federal Reserve, which became a reality on 15 June. Markets recovered somewhat after the Fed meeting, indicating that investors felt the central bank having a grip on the situation trumped any negative concerns over tighter financial conditions.

The clearest sense of this narrative can be seen in Eurodollar futures. At the start of June, Eurodollar futures were suggesting that US rate rises would continue until around the middle of 2023. At the end of June, the curve is now much more front-loaded, with more rate rises predicted for the second half of 2022, but then also a quicker normalisation in early 2023. If you believe the Eurodollar futures, investors are now expecting a rate cut in the first half of next year – a sign that the Fed has truly grasped the inflationary nettle.

This message also comes through in breakeven inflation rates, which for longer maturities (i.e., 5-year and 10-year) have been falling throughout June, and from government bond yield curves, with inverted curves visible in the US 2Y-10Y, 3Y-10Y and 5Y-10Y spreads at points in June (and for much of the month in the case of the more distant maturity spreads). The message is that investors believe inflation is a problem for the next year or so at most, and that by 2024 onwards, a more stable environment of low inflation and low interest rates will resume.

The big question for allocators right now is whether these longer-term expectations from markets are correct. If they are, then maybe we should be positioning for a more benign environment in 2023, since empirical data suggests that periods of high but falling inflation tends to be positive for both equities and bonds. The counter argument is that if markets are wrong, and inflation proves harder to tame even with chunky rate rises, then central banks will have to do more, and this would imply much higher risks of a stagflationary period with higher volatility and more economic damage. Watching the behaviour of 2023 Eurodollar contracts, 5-year breakeven inflation and the shape of the middle of government bond yield curves should be a good indicator of which of these paths will prevail.

As ever, however, the landscape is multi-dimensional. One of the more pernicious sources of possible shock is in the Eurozone government debt stability. The spread between, say, German and Italian 10-year government bond yields has been steadily widening throughout the year. This became sufficiently stark for the ECB to announce new ‘anti-fragmentation’ tools at their meeting on 24 June, with more information to follow in the July meeting. Italian debt to GDP currently sits above 150% (it was around 120% during the Eurozone crisis in 2011) and stopping this debt pile growing requires nominal GDP growth to exceed the cost of servicing the debt, which clearly becomes harder as yield rise. One could imagine a scenario where the ECB is focused on nominal growth and the Federal Reserve focused on real growth, to deal with the slightly different economic challenges of the two regions.

For allocators, these different paths forward raise several interesting questions. With US government bonds now offering a healthy real yield again (more than 0.5% for the 10-year bond at the time of writing, comparable to the average seen from 2013-2019), there is good reason to assume that bonds may return to being a defensive asset if inflation comes under control relatively quickly. By next year the Federal Reserve will have given themselves room to tighten in a crisis, and investors can hold the asset without destroying capital in real terms.

Elsewhere in the financial landscape there may be increased opportunities associated with concern over higher rates. Spreads in structured credit markets have widened on expectations of defaults across a range of asset classes, for example, BB-rated CLO tranches are now offering spreads of over 800bps – which would require significant defaults on the underlying loans to be impaired. If inflation in the US gets under control without a major recession, then these spreads could represent an attractive level for longer-term fixed income investors.

But perhaps the bigger question for the alternatives industry is whether a quick resolution of the inflation situation reduces the need for hedge funds in investors’ portfolios. Some areas of the hedge fund landscape have enjoyed strong returns in the most recent period of higher volatility since 2020 (such as Trend Following, Discretionary Macro, and strategies which are structurally long volatility such as Convertible Bond Arbitrage). These strategies have helped investors to weather the storm of both equities and bonds losing value concurrently. A return to more benign conditions may lead to such defensive allocations adding less value. Fortunately for the alternatives industry, there are plenty of uncertainties to be resolved before we get anywhere close to declaring the inflation shock as being over.

Hedge Funds

Hedge fund performance was mixed in June, both across strategies and across the different parts of the month. In the first half of the month there was strong performance from defensive strategies as equities fell and volatility spiked around inflation and recession fears. The second half of the month saw better performance from traditional strategies such as Equity Long Short and Credit, as markets recovered and volatility normalised.

Equity Long Short managers remain focused on worries about economic health and fears of recession. Indices across regions and sectors were in the red, with some more defensive sectors (i.e., Staples and Healthcare) serving as relative outperformers. Regionally, Chinese equities were the only positive outlier as the relaxation of lockdowns and signals that the government may ease up on both regulatory pressure and virus policies boosted Chinese equities from their April lows. Amidst a weak backdrop, Equity Long Short managers experienced more limited losses than major indices in June, a welcome reversal from May. Unlike May, funds were generally able to protect against losses early in June with short alpha especially pronounced. More conservative positioning by funds – i.e., lower net exposures – again meant that funds had more limited participation in the market rebounds during the week of 20 June. With equities bouncing around in the final few trading days of June, these themes have carried through in ELS performance. To briefly touch on positioning, there was pronounced net selling in the first two weeks of June and ELS funds added to beta hedges. However, funds quickly pivoted towards net buying while covering some of these hedges into month-end.

In Credit markets, the US high yield and investment grade markets were also sharply lower during the month. US leveraged loans also finished negative in June. All the US high yield industry groups finished in the red with the housing sector leading on the way down. Corporate credit managers largely posted negative returns during the month (though performance for most managers was better than in May) with losses across most asset classes and sub-strategies including convertibles, stressed/distressed credits, reorg. equities, financial preferreds, and SPACs. Portfolio hedges, not surprisingly, were a source of gains. Structured credit managers were flat to modestly positive in June as negative mark-to-market losses from spread widening across many sectors was offset by meaningful positive carry and gains from hedges.

For Event strategies, June was another month of two halves, with challenging markets ahead of the Fed’s rate decision and spread widening across the board in merger arbitrage, and managers were reluctant to add exposure. However, over the last week or so sentiment improved markedly, particularly in Europe and in the LBO space, and the previous large de-risking flows declined. Several transactions closed and some China antitrust approvals came through. Deal flow was lower in June, but a large LBO deal was announced, and several financings are lined up for early July. China ADR positions performed well, and news flow on privatisation bids continues to be encouraging. Equity RV arbitrage strategies had a good month, particularly cross-border spread trading.

Early signs point towards a mixed month for Discretionary Macro strategies. Popular themes in the space that that are positioned for central bank tightening worked well in the first half of the month, as the ECB signalled towards a July hike and the U.S. Federal Reserve delivered their first 75bps hike since 1994. However, investors became increasingly agitated around the possibility of a recession and cast doubt on how aggressive central banks will tighten in the event of a recession, causing some retracement in these themes as they sought safety. The USD benefitted from growth concerns whilst in-vogue commodity exporters weakened, such as the Brazilian real, although losses were somewhat offset by yen shorts as the Bank of Japan’s easy monetary stance sent the yen to new lows. Tactical positions remain an important feature in this choppy environment, with tactical shorts in equity indices contributing to performance in June.

Finally, the strong recent performance from quantitative strategies broadly continued in June. Defensive strategies such as CTAs remain well-positioned to benefit from rising interest rates, where shorts in US and European fixed income drove the SG CTA index to another positive return. Trend-followers generally entered the month with modest shorts in equities, however mounting concerns over the global growth outlook sent equities lower and short exposure across the trend space increased commensurately. A stronger USD helped Trend’s performance in currencies, similarly for Systematic Macro strategies which, due to risk management models, can significantly increase their allocation to ‘safe havens’ like the dollar. Reversals in agriculture markets and crude oil were generally difficult for macro-quantitative strategies to navigate. Elsewhere, machine learning strategies in equities have posted good returns, at the time of writing, whilst quant credit traders are nursing modest losses.