Man FRM Early View - November 2022

It had to happen eventually. On 10 November, after months of slightly higher than expected inflation data from the US, the monthly print on both CPI and Core CPI came in 0.2% lower than expectations. Although only a marginal miss, and with annual CPI still running at 7.7%, the unexpectedly soft monthly number was the catalyst for a dramatic repositioning of markets. Breakeven inflation dropped sharply, and the seemingly greater clarity on the end of the high-inflation period led equities and government bonds higher. The possibility that fewer rate rises would be necessary also led to sharp moves in Eurodollar forwards and a reversal in the spot price of the US dollar, particularly against currencies such as the yen, which had been under pressure from a continual dollar strengthening for much of the year.

This was a quintessential momentum reversal move and the impact for active market participants was severe. For hedge funds, we believe the pain was felt equally across macro strategies with a trend-following approach and bottom-up strategies that held long positions in YTD winners and short positions in YTD losers. The sharply negative return to equity-market factors such as cross-sectional momentum and short interest shows how the change in market narrative was pronounced within markets as well as at the index level. The positive performance of many hedge-fund strategies year-to-date led to two exacerbating effects here; firstly, positioning in pro-momentum trades was extended due to those gains; and secondly, managers were more likely to reduce exposure quickly at the first sign of trouble to protect performance fees that, in many cases, crystalise at the end of the year.

The outlook for markets is more complex now that this repositioning of fast money has largely been completed. There are fewer crowded trades and the longer-term outlook remains as mixed as it was before the rally in risk assets. There has been no real change in rhetoric from the central banks – we should expect higher rates (as least relative to the past 15 years) for the foreseeable future – and it is unlikely in our view that the second-order effects of a higher-rate environment on corporate balance sheets have been properly discounted by market commentators or sell-side analysts. There is clearly a path for 2023 where the economic slowdown is greater than expected, leading to more credit defaults, and a greater frequency of corporations being in worse financial health than first expected. It is hard to see risk assets performing well in this environment. Equally, one could foresee a continuation of lower-than-expected inflation prints and a more benign corporate environment that persuades market participants to look ahead to 2024 and 2025 and see an opportunity to capitalise on an unusually healthy risk premium in both equities and bonds. As a result, most hedge funds are prudently not trying to forecast markets from here.

But perhaps the biggest unknown risk to markets as we move into 2023 is, in our view, the spill-over from valuations of less-liquid assets. Private equity and private debt investments have seen far fewer write-downs on valuations compared with their public counterparts in 2022, and a prolonged weakness in economic conditions could start to present itself in institutional investors’ portfolios – particularly in pension schemes that find themselves underfunded once their private exposures are revalued. The valuation of property and infrastructure investments also faces an uncertain path in the higher-rate environment next year, and in our view it could again be a source of volatility for investors’ portfolios.

Hedge Funds

Hedge funds had a mixed month in November, with losses to momentum strategies in Trend Following and Equity Market Neutral, but positive returns to longer-biased exposures in Equity Long/Short and Credit Long/Short, as well as some Relative Value strategies such as Event Arbitrage.

For Equity Long/Short, markets were largely in positive territory in November. Below this, though, there was a momentum reversal which impacted hedge-fund returns early in the month. The November US CPI print was better than expected, leading to an indiscriminate two-day equity rally. Funds entered November with more bearish positioning, and were forced to pivot quickly, covering shorts and adding longs in previously unfavourable areas of the market (e.g. technology and consumer-discretionary stocks). As a result, upside capture has been more limited and there has been extreme dispersion in Equity Long/Short performance this month. While the average fund’s performance shakes out to be modestly positive, the difference between top and bottom decile Equity Long/Short fund performance is over 10%. More beta-heavy and long-biased strategies generally outperformed in November, as have Asia-focused ones (benefitting from the recent strength in Chinese equities).

For Credit managers, market exposure to risk assets – including credit – generally built on October gains on favourable inflation data, better-than-feared earnings, and expectations that the Federal Reserve (Fed) will slow down the pace of rate hikes relatively soon. A meaningful rally in Treasuries helped the investment-grade market outperform US high yield and leveraged loans. Lower-rated high-yield credits saw another month of underperformance relative to longer-duration higher-quality bonds. However, corporate Credit managers posted another month of mixed returns in November. Portfolio-level credit, equity and interest-rate hedges were a drag on performance. Preferreds/hybrids enjoyed strong gains as credit spreads tightened and Treasuries rallied, and tender activity and higher coupon resets were also positives. Convertible bonds saw mixed performance as there was dispersion in returns across credit-sensitive names. Crypto-related issuers underperformed, but SPACs were positive contributors as the discount to trust value narrowed. Certain stressed/distressed corporate/sovereign credit longs and post-reorg equities were also beneficial, while credit spreads were wider for certain growth names despite the positive market backdrop. Structured Credit managers saw modest positive performance in November, largely driven by carry as spreads were relatively unchanged across most sectors.

November was a month with a lot of positive potential for Event Driven strategies, as several merger deals closed on terms, including the completion of the sizeable Zendesk LBO and the Swedish Match tender, or otherwise made progress, like the Shaw/Rogers tribunal case. Deal activity was decent, with a few new deals in excess of $10 billion (e.g. Abiomed, Vantage Towers and Origin Energy). The positive CPI print and subsequent market rally mid-month boosted special-situations strategies. In Asia, positive sentiment was particularly accretive for equity relative-value trading. However, November kicked off with the unexpected termination of the Rogers/DuPont deal; several managers were too optimistic on the break price and so were over-exposed and realised material losses, placing a large blemish on an otherwise constructive month. Index arbitrage had a busy month with the MSCI rebalancing, and the listing change of Ferguson as it exits the FTSE 100 and moves to the NYSE. A large number of SPACs have imminent shareholder votes for early liquidations and extensions due to a new tax on redemptions effective in 2023.

In the Macro strategies, discretionary macro funds posted mixed returns in November. Managers continued to run relatively light levels of risk, covering short bond positions in expectation of a more subdued pace and magnitude of rate hikes from central banks before they eventually pause. The softer-than-expected CPI print in the US caused some pain in long US dollar positions as investors priced in a more dovish outlook for the Fed. However, the risk reduction meant the space generally avoided heavy losses in short-term interest rate and bond-market themes. Better performance came from tactically focused strategies that added modest long exposure to G10 sovereign bonds as the ‘peak inflation’ narrative gathered pace, while strong gains made earlier in the month trading Chinese stocks look to have been surrendered following rising Covid cases and renewed lockdown restrictions in China. Quantitative macro strategies fared much worse. Trend-followers and systematic macro managers held bullish views on the US dollar, particularly against the likes of the yen, which rebounded strongly. Gold’s surge higher this month also proved difficult for short positions, while trend-followers have been frustrated by whipsaws in energy markets and reversals in fixed income.