Man FRM Early View - May 2019

Generally positive returns from relative value and macro strategies with long fixed income bias.

  • Equity markets pull back on trade war concerns
  • Generally positive returns from relative value and macro strategies with long fixed income bias
  • Strategies with long risk-asset exposure suffer during risk-off sentiment in May

Markets

One of the sure-fire methods for eliciting amazement from those not-so-versed in financial mathematics is to point out the extraordinary power of compound interest on investments over multiple decades. In his annual letter to shareholders earlier this year, Warren Buffett highlighted that it had been 77 years since he made his first equity investment and that over that period a fee-free investment in the S&P 500 Index with dividends reinvested would have returned more than 5,000x your initial investment (gasp!).

It is hard to know what to do with this information. Numerous commentators have noted that the second half of the twentieth century coincided with relatively high-interest rates, inflation, global population growth and that the next 50 years won't see the same tailwind to global growth. Against such a background (and by picking arguably the best performing of the developed markets), the biases in the data become more apparent.

Of course, one seldom hears with such excitement about the returns achieved by Japanese equity investors over the last few decades. In fact, over the last 22 years, a fee-free investment in the Topix index with dividends reinvested would have made around 57% in total – a far cry from the 558% made from the S&P 500 over the same period. This time period is pertinent, since the Japanese 10yr government bond finished Q1 1997 with a yield of 2.28%, having dropped steadily over the prior decade. Sound familiar? Will US investors in June 2039 be telling their children about the 50% total return they've achieved from their S&P tracker over the previous two decades?

The usual riposte to such would-be Cassandras is that both population demographics and economic philosophies are more conducive to growth in the US than they ever have been in Japan, which is undoubtedly true. But as the US 10yr yield slips ever closer to 2% it is, we think, valid to question what this means for long term expected returns from traditional assets. Even if the flat yield curve doesn't necessarily predict a recession, it certainly suggests an environment in which interest rates don't get much above 2.5% for the next ten years. The government bond market has taken three months to get the message from the Fed – that unless growth surprises materially on the upside then this tightening cycle is done.

Which brings us onto the trade war. It is reasonable to read the negative long bond yields in Germany, Switzerland and Japan as a cue that large chunks of the developed world are not expected to contribute much at all to global growth over the next decade. Therefore the escalating tensions between the two overwhelming contributors to global growth are rightly centre-stage in any fundamental assessment of equity market valuation.

As the month of May progressed, it became harder to see where reconciliation between the US and China might come from. The leaked ‘red lines' from the US side of the negotiation would be very difficult to swallow for President Xi, and equity markets probably have to fall much further than their current pull-back to persuade President Trump to change course (c.f. the announcement of possible tariffs on Mexico announced on the last day of the month). Tellingly, commentators suggest that the Chinese leadership see the economist estimates of a 1.2% hit to GDP growth as a price worth paying for national pride – suggesting that further escalation of the situation is more likely than rapprochement. With such entrenched positions (and growing enmity between the central bank and the White House), it seems to us that a more likely first mover to support markets would be a Fed rate cut, albeit one aimed at the drop in growth expectations rather than the stock indices.

Where this all leaves us appears to be a slow grinding end to the economic cycle. One upshot of the move in equities and bonds over the last month is that the running yield on the two asset classes (in the US at least) have drawn much closer together. The Bloomberg estimate dividend yield on the S&P sat at around 2.05% at the end of May, only 10bps or so lower than long bond yields. This comes back to our central theme – ultra-low long rates combined with a flat yield curve is pretty much uncharted territory, and as such when determining the ‘right' PE multiple for the US equity market comparing to history is of little use. The bulls might argue that the relative attractiveness of equities at such a low discount rate means that the market could trade on 30, 40 or even 50x earnings provided that growth remains positive (if a little anaemic). The bears might point to areas such as Japan and Europe over the last 10 years as evidence that low rates and a relatively attractive yield are insufficient to propel equities to historically unpalatable valuations.

But a closer examination of the difficulties of value-based hedge fund strategies over the last few years suggests that both of these narratives can hold sway at the same time within different portions of the market. Low rates mean that ‘zombie' companies can stay alive for much longer then they would in previous interest rate regimes, trading as perpetual value-traps. Whereas companies that can show signs of real growth can trade at enormous multiples of earnings, or, in the case of the current excitement around Software names, multiples of sales.

The short term gyrations of the equity market as a whole are an expression of this balance between greater tolerance for multiple expansion (Q1 2019) and greater concern for long term growth expectations (Q2, so far). Over the longer term, however, it is hard to square the shape and level of the current US yield curve with the kind of US equity market returns to which we have become acclimatized over the last ten, twenty, or even 77 years.

Hedge Funds

May was another mixed month for hedge funds, with generally positive returns from relative value strategies and macro strategies with a long bonds bias, and negative returns from strategies with long risk-asset exposure.

Within the Equity Long-Short universe, a number of managers had tempered their net exposure during April following a strong first quarter, and as such generally fared better than might have been expected during the market sell-off in May. Hedging and balance sheet management were more prevalent during the first half of May which helped to insulate against the worst of the market losses in the second half of the month. As might be expected, managers with a short equity or long volatility bias performed better than their peers during the month, whereas Growth-biased managers with long net exposure gave back some of their Q1 gains.

It was a mixed month for Statistical Arbitrage managers. Those managers that report daily returns were close to flat on average and were relatively uniformly distributed around this with small winners and losers, but no particularly outsized returns either way. We know from brokers that certain momentum measures have had a very strong run in performance in May, and this strategy (in particular the fundamental sub-set) is generally exposed to the factor. Value looks like it had another poor month, so the relative weights to the two factors will have determined the relative performance. Technical managers seem to have performed better than fundamental managers. We have long thought that the technical managers are better placed to benefit from market volatility, and at least this month that seems to have played out.

In Credit, it was a negative month for global high yield markets on similar concerns to the equity market, but the rally in treasuries helped US investment grade credit outperform lower quality paper. US high yield markets also saw a pick-up in defaults and outflows, after strong inflows to the asset class in the first four months of the year. As a result, performance was mixed for Credit Long-Short managers, but some were able to take advantage of idiosyncratic capital structure arbitrage situations given the bifurcation in performance between safe and risky credits. Other winners included outright shorts in weak credits (including a few companies that filed for bankruptcy during the month), and long positions in GSE preferred and Puerto Rico COFINAs on positive fundamental news flow. Distressed managers generally underperformed due to their long risk-asset bias.

Securitized products outperformed in May given low direct exposure to trade-related risks. Lower mortgage rates have been supportive of legacy spreads while Credit risk Transfers and Collateralized Loan Obligations were modestly wider but still outperformed corporate credit. Returns for Structured Credit managers were once again dominated by carry, with help from equity and credit hedges and drag from rates hedging.

The landscape for Macro managers was more fertile in May than for much of the year, with increased volatility in equities, bonds and FX on the back of increased trade war tensions between the US and China and political upheaval in the UK. Manager performance was mixed, with some discretionary managers benefitting from long duration risk-off trades, and short Emerging Market FX such as China.

Managed Futures managers were negative in aggregate in May, with both the SG CTA and SG Sub Trend Index losing money on the month. The big risk-off move meant large losses in equities across all regions, which were offset by another month of large gains in fixed income. The relative position sizes in these two sectors largely determined how each manager performed. There were also some large moves in the commodity space, which was another source of losses – long positions in the energy and short positions in agricultural grains (corn, wheat and soy) the chief culprits. Managers have started to reduce their equity positions, both due to the volatility scaling, and for the faster managers, due to signal adjustments.

Concerns around the trade war also weighed on global corporate event activity. With M&A spreads remaining tight, this led to a muted opportunity set for the purer Risk Arbitrage strategies. Those managers focusing on softer catalyst situation generally lost money in line with the broader market sell-off. Other arbitrage strategies, focused on liquidity provision, had a mixed but generally positive month as the increase in volatility led to increased opportunities for short term trading.