Man FRM Early View - October 2021

With the Federal Reserve now near-inevitably set on tapering their bond purchase programme, bond investors have been pushed and pulled back and forth in trying to find a new equilibrium for a world of tighter monetary policy. One-year US interest rate swap rose by more in October than they had in the previous nine months of the year, reflecting the view that the first rate rise from the Fed would now come around this time next year. US 10-year breakeven inflation rates accelerated significantly for much of the month, at one point increasing by over 30 basis points before checking back slightly in the last two trading sessions. Supply side inflation pressures, particularly in the energy sector, saw extreme moves in the early part of the month, with power and natural gas prices in European markets exhibiting parabolic behaviour for the first week of October, while elsewhere there are numerous reports of supplychain bottlenecks affecting pricing and margins throughout the real economy. The commentary around the situation became increasingly frantic too, with comparisons of the current situation to the last inflation crisis (see the Deutsche Bank piece “Back to the 1970s”), and former Treasury Secretary Larry Summers (seemingly ditching his secular stagnation credo for a while) worrying that the Fed is closer to losing control of inflation than at any time in the last 40 years.

It’s therefore not surprising that volatility in bond markets is rising rapidly. Yield curves are trying to react to multiple pressures at once: higher breakeven inflation rates, less central bank control over the shape of the curve, and the possibility of policy error. The last of these can feel like a cheap shot, after all, it is much easier to worry about the tightening of monetary policy, when leaving it a little longer usually has limited consequences, than to criticise opening the taps in the worst of the COVID crisis (or the Global Financial Crisis, or the Eurozone crisis…), when the alternative is to allow capitalism’s invisible hand to immediately wreak its destructive wont. But the longer-term implications of the new, tighter, regime is leading to significant discrepancies between the longer dated bond yields between regions. For reference, see the October spread between 30-year bond yields in Australia (commodity sensitive, +42bps on 30- year yield in October) and the UK (where some of the loudest ‘policy error’ voices have been heard, -26bps on the 30-year yield in October).

There’s also a feeling of a new paradigm with the significant shifts of capital occurring outside of government bonds. The more volatile commodity price activity of the last two months has at least partly been driven by the changing way that energy is generated and consumed considering the increasing environmental importance of political decision making. These environmental concerns have also helped the continued rally of Tesla (also supported in October due to the partnership with Hertz), which rose by 43% during the month to become the fifth-largest company in S&P 500 Index. With the COP26 conference taking place at the time of writing, we feel that the environmental pressures on financial markets are set to rise further for the foreseeable future.

Another seismic equity story in October was the approval and launch of the first Bitcoin futures ETF, which became the fastest ETF in history to reach more than USD1 billion of assets. This wider adoption of cryptocurrencies by the traditional financial system helps to explain the nearly 40% rise in the price of Bitcoin during October. These rises, in Tesla and Bitcoin, are remarkable enough in percentage terms, but are more astounding in dollar terms – over USD300 billion added to the market cap of each, roughly the total GDP of countries such as Finland or Chile added to each of their value in just one month.

On the subject of Bitcoin, we feel that the role that digital assets play in the financial landscape of the next 10 years is of near-certain importance but uncertain scale. Some see their potential to revolutionise and decentralise financial activity as a key component of global GDP and productivity growth of the next few decades. However, their potential as a destabilising factor in traditional asset markets (much in the same way as tech stocks in the 2000 bubble) cannot be underestimated. Just as we look back now with mirth at the crazy valuations of companies such as the famously disastrous IPO of pets.com in 2000, we may look back with similar amusement at the current multi-billiondollar market caps of cryptocurrency tokens launched by small teams of developers with nothing more than an overly ambitious roadmap for digital asset delivery.

However, on all of these fronts – monetary policy reaction to inflation, environmental challenges, and the rise of digital assets – we feel that the postpandemic landscape is increasingly showing as the first real paradigm shift since the GFC. The interplay between markets, environmental legislation and technological innovation feels like a valuable source of return for experts who can understand the changing currents of the financial system. Similarly, the revolution in digital assets will, we think, provide a whole array of opportunities for hedge fund strategies such as trend following and arbitrage, and the industry clearly aims to be at the forefront of regulatory change in this space. We are extremely excited by the opportunities for hedge fund strategies to help investors to access and profit from this backdrop.

Hedge Funds

The hedge fund industry saw gains across many strategies in October, as risk seeking assets in equity and credit rallied, with notably positive returns from quantitative strategies across both ‘macro’ quant (such as CTAs) and ‘micro’ quant (such as statistical arbitrage). A better-than-expected earnings season and strong performance of commonly held names helped many equity focused managers during the month, whereas bond market volatility led to mixed results from both discretionary macro and fixed income arbitrage specialists during the month.

Equity long-short managers generally posted a positive month, with a range of different drivers depending on the specific strategy. Net long managers benefited from the index appreciation, whereas Growth-focused managers, particularly in the US, tended to benefit from a profitable earnings season and stock specific catalysts to commonly held names. Market-neutral quant strategies also enjoyed a positive month, with gains coming from strategies focused on earnings momentum as well as traditional market factors. Liquidity provision strategies also benefitted from single stock volatility against a backdrop of more benign index action. Machine learning strategies also appear to have had a positive October, although as usual discerning a reason why for these managers is particularly difficult.

Credit managers saw something of a reversal versus September, when equities were down around 5% and credit outperformed, whereas in October equity markets regained ground while credit underperformed on a relative basis. In many regions, higher government bond yields have squeezed credit prices lower, although index performance across both investment grade and high yield were close to flat on the month. Despite the risk-on tone in equity markets, there was modest underperformance of lower-rated high yield credits, except for energy and metals/mining sectors which benefited from higher commodity prices.

Convertible bonds and SPACs saw modest richening across the universe despite higher government bond yields. In a small, but notable, corner of the SPAC market there was one cocial media-related SPAC which became extremely popular with retail investors during the month, rallying from below USD10 to an intra-month high of USD175. Some hedge fund managers benefited from holding this position as part of a strategy to hold any SPACs trading below their trust value of USD10. Elsewhere in credit strategies, there was some weakness in the CMBS markets earlier in the month driven by supply, but that appears to have largely corrected by month end.

Returns to event arbitrage was mixed in October, with deal spreads generally tighter, but also with a handful of idiosyncratic events impacting manager returns. Merger activity continues to be strong across all regions, with a resurgence of US deals after an early September lull, and Australia and Japan have taken over leadership of deal activity in Asia following the slowdown in Hong Kong around the Evergrande crisis. Some volatility arbitrage strategies were positive in October, with a combination of Asian equity volatility and global bond volatility providing sources of opportunity.

CTA managers generally had a good month in October, as short bond exposure across all regions helped, with specific exposure to US, Germany and the UK leading the gains. Currency trading was also a source of profits with short positions in the Japanese yen benefitting performance and offsetting losses in British pound shorts. Equities trading was mixed, with gains from long positions in US offset by losses in Asian markets. Commodity trading was also mixed, with longs in crude oil generally positive throughout the month and Natural gas positioning recovering from the pullback early in the month. In general, managers trading seasonality signals across a variety of quant macro strategies also had an unusually strong month.

Discretionary macro strategies were also mixed during October, with difficulties stemming from accurately forecasting moves in government bonds given their heightened volatility profile during the month. Areas of pain were the long ends of yield curves, which adopted different dynamics at various points in the month and were characterised by large and relatively unexpected moves in yield, and fixed income arbitrage, which generally lost money despite the increase in volatility in the asset class.

Alternative risk premia strategies enjoyed another good month, continuing their year-to-date recovery from losses of last year. The best performing strategies were equity factor driven, time-series momentum and short volatility strategies in equities.