Man FRM Early View - October 2022

The past few months have felt like a transition period from one market paradigm to another. Markets seem more febrile, and policymakers are grappling with how to position for this seismic shift in growth and inflation expectations post-Covid. In the UK, the political saga around the disastrous tax-cutting ‘mini-budget’ appears to have reached its apotheosis. First came the Bank of England’s decision to place a firm end date on its support for gilt markets, effectively playing a game of chicken over the stability of the £2 trillion UK defined benefit (DB) pension market. The move paid off and the government quickly folded, with the dismissal of the Chancellor of the Exchequer and an immediate retraction of nearly all aspects of the mini-budget. With her platform in tatters, Prime Minister Truss also resigned shortly afterwards. The appointment of Jeremy Hunt as Chancellor and Rishi Sunak as Prime Minister left the UK with its most market-friendly leadership for some time. Gilt markets calmed, with 30-year gilt yields ending October around 60 basis points (bps) lower than 30-year US Treasuries (having traded around 120bps higher shortly after the mini-budget).

If UK policymakers have learned not to fight the market, then the lesson is still being learned in Asia. The Bank of Japan executed its second attempt to stabilise the quickly deteriorating state of the yen. The central bank finds itself in a bind, with the highest debt-to-GDP ratio of any major developed economy and, unlike pretty much everywhere else in the world, very anaemic levels of inflation (bordering on deflation). This leaves the Bank of Japan unable to raise rates and committed to exercising yield curve control to manage borrowing costs, but the weak state of the FX position is now feeding through into material trade deficits of around JPY2-3 trillion per month. With US rates continuing to rise, it is hard to see how the yen doesn’t remain under pressure thanks to the widening rate differential to the dollar, forcing Japanese policymakers into more uncomfortable decisions. Across the East China Sea, there were further political and market confrontations, with President Xi strengthening his grip on power during the 20^th Congress of the Chinese Communist Party, leading to sharp declines in the value of Chinese equities, particularly those in the tech sector.

But perhaps the most important chapter in the balance between policymakers and markets last month occurred on 13 October, with the reaction to the latest US CPI print. The print itself came in a little higher than expected, as it has for the past few months, but the market reaction was telling. Equities immediately sold off sharply, as they had in similar reaction to hot prints in September and August, but within a few hours had recovered and finished the day much higher, with the S&P 500 Index seeing a rally of over 5% from trough to peak during the trading afternoon. Markets then continued to show strength through to the end of the month. This is important, as it suggests that investors in risk assets are now looking beyond the current inflation concerns. The forward path of both inflation expectations and the Eurodollar curve suggest that inflation falls materially over the next year, with rates topping out around 5-5.25% after a couple more meetings of the Federal Reserve. Natural-gas prices have fallen sharply from the highs seen in the summer in both the US and Europe and, while the year-on-year US CPI numbers are still high, monthly data are much more benign, with just 0.5% growth over the whole of the third quarter. In short, we are close to being done on worrying about inflation.

The growth side of the equation feels less certain, but the picture appears to be coalescing around ‘bad but not terrible’. The OECD cut its outlook for US real GDP growth in 2023 from 1.2% to 0.5%, but any form of positive growth in an economy that has seen rates move from zero to 5% to tackle high inflation will likely be considered a win for investors. Similarly, credit-rating agency Fitch forecast that US high-yield defaults were likely to reach 3.5% next year. Higher than average, but certainly tolerable (and in our view more than compensated for by the current level of credit spreads). The US third-quarter earnings season has been mixed, with stronger-than-expected numbers across most sectors, but some headline-making poor results in the tech sector. In fact, outside the larger growth names, the S&P 500 is currently trading close to historical low multiples of earnings. If we experience a ‘muddle-through’ kind of year in 2023 without large earnings declines, then the case for equities from these levels could grow stronger.

What this means is that, in our view, the primary source of risk in markets has shifted from inflation surprising on the upside to an exogenous growth shock. This shock could come from currently visible risks, such as an escalation in the Ukraine conflict to include tactical nuclear weapons or repercussions from the new far-right leadership in Italy on EU stability, or it could be something that is not yet on the radar (a new, vaccine-evading Covid variant, say). But critically, the market reaction to any of these shocks is likely to be a traditional ‘risk-off’ – that is, equities down and bonds up, rather than the correlated losses we’ve seen thus far in 2022 in reaction to higher inflation fears.

Hedge Funds

October was a mixed month for hedge-fund returns, with positive returns to longer-biased equity and credit funds, but negative returns from macro-driven strategies given the reversals in common themes such as short equities and long the US dollar.

In Equity Long/Short, the positive market performance helped, but there were volatile drivers of single-stock alpha. Earnings season for US companies kicked off near month-end, and this brought a mixed bag of reports. Shares of several blue-chip names (e.g. Apple, Amazon, and Meta) plunged on weak forecasts while other more inflation-resilient businesses had positive quarters and saw share prices rise. Separately, Chinese stocks saw more volatility in October. Both leading into and immediately after the Communist Party Congress, stocks traded down on continued growth fears and pessimism about economic reopening. In turn, Asia-focused funds – especially those with long Chinese exposure – experienced steep declines. Performance for Europe- and US-focused funds was positive in October, though upside capture remains diluted as funds have generally displayed more bearishness via lower directional exposures. Prime brokers noted some de-grossing driven by short covers; however, with positioning at or near lows, we note that the magnitude was not substantial.

In Credit, high-yield spreads tightened amid relatively light supply. Leveraged loans outperformed investment grade, which had another challenging month driven by duration. Lower-rated US high-yield credits, though, saw another month of underperformance relative to higher-quality bonds with longer duration. Corporate credit managers posted mixed returns during the month. Any credit and/or equity portfolio hedges were a meaningful drag on performance. Convertible bonds generally lagged during the month, but there were a few idiosyncratic bright spots in credit-sensitive bonds. SPACs were small positive contributors. Some managers saw idiosyncratic losses from certain stub trades, while some stressed/distressed corporate credit longs were positive contributors. Preferreds/hybrids had a tough month as higher rates were a headwind and there were outflows and selling in the space. Structured-credit managers saw muted performance in October, with returns largely driven by carry.

Event managers generally had a flat to slightly positive month. Challenging market conditions continued to spill over into event-driven strategies during October. This continued to drive significant dispersion in merger arbitrage, with safe and strategic deals trading at tighter spreads, while longer-dated and more complex deals have very wide spreads. Deal and corporate-action activity have been muted compared with historical levels, presumably due to ongoing uncertainty constraining board-level confidence. The $30 billion Albertsons/Kroger deal announcement is somewhat of an exception, but the market is sceptical of that deal’s outlook, as many supermarket mergers are being blocked. Performance in October was helped by several large deals that closed, most notably Twitter, which ultimately surprised as there was no price cut. Leverage levels trended lower as cash was not fully recycled. Greater China markets were rocked by extreme price action post the CCP Congress, which negatively impacted ADR and other relative-value arbitrage trades. China SAMR approvals were also delayed due to the Congress. An increasing number of SPACs are electing to liquidate early.

Discretionary macro strategies posted more muted returns in October. Managers in the space have taken gains in core themes and moderated risk levels over the month, citing a murkier outlook for central-bank policy as the synchronised tightening of financial conditions continues to reveal stresses in the global financial system. This appears to have been well timed, limiting losses in fixed income as markets reversed with investors pricing in a more dovish response from policymakers on the back of weak housing-market data in the US and softer guidance from the ECB. Reversals in the US dollar were also painful, though we saw more positive performance from UK relative-value trading as gilts retraced part of the Bank of England induced rally.

Quantitative strategies were mostly negative against an environment characterised by asset-class reversals and investor de-risking. Trend-following models gave back gains in currencies and rates as attempts to price a central-bank pivot gathered pace towards month-end, although we saw reactive strategies able to capture the multi-day uptrend that followed in equity markets. Systematic macro managers held a more neutral view on fixed income and were more bullish on a number of equity markets, which helped them offset losses from US dollar trading. More micro-focused strategies found de-grossing in equity markets challenging to navigate, particularly in Europe, with machine learning and statistical arbitrage strategies posting losses. Elsewhere, quant credit looks to have continued its positive run of form.