Man FRM Early View - May 2021

Once more around the holding pattern while markets and economies digest the return to whatever passes for post-Covid normality. Skirmishes continue in the battleground for the inflation narrative – the US CPI print struck a blow for the inflation bulls early in May, pushing 10-year breakevens to 2.55%, and triggering a swoon in equities, led lower by another mini-meltdown in tech stocks. But the anti-inflationist cause struck back, helped by the stubbornness of the yield curve, for which the bid for duration seems to make it progressively harder to steepen. With bond yields anchored deep in negative real terms, equities drew on the favourable relative valuation to return close to record highs by month-end.

One can't help but feel that something must give soon, but for the time being, policy-makers seem to be enjoying the breathing space. Hawkishness in Federal Reserve members is spreading, emboldened by the obstinacy of long-dated bond yields. At times in the first quarter, commentators were worried about the Fed losing control of the curve, but for now, the curve hasn't reacted much at all to the increased volume of taper talk.

Each data release represents another test. The shockingly low US non-farm payrolls number in the first week of May seriously muddied the waters for understanding the current economic landscape, and now feels like the missing piece of the puzzle in the overheating story. The current situation is reminiscent of the previous taper episode in 2013, where the refrain of 'good is bad, bad is good' once again feels apt. Equity markets are unlikely to react kindly if the subsequent jobs data suggests the April number was just a statistical blip.

And so, it's easy to build a list of worries about what can go wrong if inflation concerns bubble up again. Hedge fund positioning in equities remains very full, with net and gross exposures close to record highs. Thus far, we believe concerns in risk assets, whether they are specific (such as the Gamestop or Archegos sagas) or structural (such as the factor rotation from Growth to Value) have been seen as an opportunity to 'buy-the-dip' by most participants and we haven't yet seen what happens when a sell-off becomes strong enough to trigger a rush for the door.

Positioning in other asset classes presents a strange risk dynamic. Systematic macro specialists, both CTAs and non-CTAs, are generally long commodities and short bonds, both of which feel like good inflation hedges. They've also built larger positions in FX in recent months, supported by lower volatility in the asset class relative to others and trending behaviour as markets normalise post-Covid. In our view, one position that stands out for its popularity is short Japanese yen. Traditionally, the yen has behaved as a 'risk-off' asset, one of the few global currencies to rally versus the US dollar in periods of economic stress due to repatriation of foreign assets back to Japanese owners.

Since the Covid selloff last year, this relationship has broken down. The yen has exhibited a positive correlation to equities over the last year, since the most common cause of the equity selloff has been inflation concerns (particularly US inflation concerns), which has tended to bolster the US dollar against all currencies, including previously 'safer' havens like the yen. The large short in the yen therefore also feels like a good inflation hedge, but that relies on the correlation dynamic of the last 12 months holding true. Investors have spent so much energy into trying to work out (and hedge) the inflation picture, that they may have left themselves even more exposed to a non-inflation-based market shock. After all, the typical crisis playbook goes, equities down, bonds up, commodities down, yen up. Current hedge fund positioning looks like it could be wrong on all four counts.

But thus far, we believe these trends have ridden the wave of modest, but not overwhelming, inflation concerns, and trend-following strategies are enjoying one of their best starts to a year in a long time. Other active managers are also benefitting from a noisy but ultimately stable backdrop in 2021. Even passive equity investors are mostly sitting on double-digit gains for the year so far, so it feels right to remain wary of the risks implicit in such an unstable situation. Cutting risk too soon would have been a mistake at several points over the last year but staying liquid and nimble still seems to us like the best policy for the rest of 2021.

Hedge Funds

May was a mixed month for hedge fund performance after a strong April, with disperse returns from traditional strategies such as equity long-short and credit. In general, relative value strategies continued to do well, although the factor landscape remains volatile and quantitative market neutral styles saw a range of outcomes depending on factor biases. Macro strategies generally performed better, with good returns to CTAs, although defensive and contrarian approaches generally lost money as markets continued to favour more of a risk-on sentiment by the end of the month.

In equity long-short, manager performance was very much driven by both beta exposure and factor exposure. The first half of the month saw a selloff in indices led by tech stocks, as investors again showed concerns around inflation risks with upside surprised to core inflation data. This was a challenging environment for managers with net long exposure and Growth/Momentum factor exposures. Once again, in these factor rotations, crowded names were a larger contributor to negative alpha. The second half of the month was something of a reversal of the first, with indices recovering and inflation concerns abating, and many equity long-short managers recovered performance during the second two weeks of the month.

Prime brokerage data shows an uptick in single name short exposure relative to the index/ETF exposure seen earlier this year. This may suggest that managers now feel more comfortable taking single name short risk in expensive stocks given the market dynamics of the last few months, having previously been concerned by the ability of expensive stocks to reach new highs in the second half of 2020. Similarly, data suggests that average net exposures of managers has softened over the last few months (although it remains high relative to the longer term), while the larger short books have kept gross exposure close to record highs.

It was a quieter month for credit markets than equity markets, with investment grade outperforming slightly (given the rally in bond yields). In high yield there was relatively little dispersion across the universe, with lower quality credits marginally outperforming in general risk-on sentiment. Primary market activity has fallen back from the very high levels seen recently, but remains elevated relative to history, and data suggests that there continues to be modest outflows from high yield funds and inflows into leveraged loan funds.

Against this quiet backdrop, the returns to credit hedge funds were similarly unremarkable, with few meaningful single-name drivers of return. SPACs saw a continuation of the pull-back from March and April, although this move was also more muted. Convertible bond arbitrage managers are still digesting the heavy new issue calendar of the last few months, with returns buoyed by these new issues trading in line with the wider market. In structured credit, spreads have ground tighter across many sectors but returns remain carry-driven with relatively little volatility in the asset class.

Event arbitrage managers continue to enjoy high levels of deal volume, particularly in the US. While Europe is lagging the US a little, there have been several private equity bids for UK targets in the last few weeks. Managers continue to be at high levels of investment, especially as all-stock or partial-stock deals require more gross exposure. The landscape continues to see price increases and counterbids across transactions in all regions; for example, in a widely held North American railroad consolidation trade, one operator saw multiple bids in May from competitor firms. With all the new deal activity merger spreads remained stable during the month, reflecting the balance between arbitrage capital and deal volumes.

Quantitative equity market neutral strategies generally performed well in May, with further positive returns to factor models, continuing the strong 2021 recovery. One point of interest in May was that the Momentum factor has started to decouple from Growth (given the poor performance of Growth year-to-date). Therefore, traditional strategies built around a Value and Momentum axis were less affected by the tech selloff than they had been in previous factor rotations.

Systematic macro strategies also made money in May, particularly CTAs, which benefited mainly from trends in FX and commodities. Managers are generally also long equities, which hurt in the first part of the month but then helped the managers finish the month strongly as markets recovered. Fixed Income was more mixed given that positioning is varied across managers (based on the speed of their signals) and markets were more range-bound in May than earlier in the year.