Man FRM Early View - September 2022

For those of us sitting in London, September was an especially eventful month. Not only did we gain a new prime minister and say goodbye to a much-loved monarch, but the month ended with levels of stress in gilt markets not seen throughout many of our careers, which threatened to (and may still) spiral into a wider financial crisis.

There are three layers to the difficulties in which the UK found itself towards the end of September. The first is that the structural fragility of the DB pension system was underestimated. The interplay between LDI leverage and lack of sufficient liquid assets to meet margin calls was not just an issue for each scheme in isolation, rather that stresses could cascade through the entire system. If the most levered LDI vehicle started unwinding their government bond exposure, it could push the next most levered into insolvency and so on. The second layer was that the current market backdrop was one of heightened risk. Traditional assets had been losing money all year, reducing the size of scheme’s liquid balance sheets, and the gradual rise in bond yields through the summer had already forced schemes to recapitalise their LDI portfolios. Furthermore, the weakness in sterling meant that schemes with FX hedging programmes for their overseas investments were facing an additional drain on liquidity. The third layer of the crisis was the catalyst that led to a run on gilts, namely the poor handling of fiscal messaging from the UK Government, with the decision to announce a ‘mini-budget’ that loosened fiscal policy without providing independent assessments of any long-term implications. It is a well-trodden path of financial crisis; too much leverage, too little liquidity, and a catalyst to light the fuse. As Hemingway observes, there are two ways to go bankrupt, gradually, then suddenly.

It now seems likely that had the Bank of England not stepped in on 28 September 2022 to buy as many gilts as necessary to calm the long end of the yield curve, then things may have unravelled rather quickly. UK DB Pension funds collectively hold around £1.8 trillion of assets, with margin calls from LDI programmes that were already reaching into hundreds of billions of pounds. A collapse in gilt prices, commensurate with selling pressure of this magnitude would have inevitably sent shockwaves throughout the financial system. Even with the central bank intervention, it seemed as though risk appetite across global equity and bond markets was fluctuating in line with the health of these UK pension schemes – not least due to them selling their liquid assets to meet margin calls.

However, in times like this, one must be wary of being too narrow in one’s focus. Liquidity concerns are present across many more markets than just gilts. The SOFA market (introduced in 2020 to replace LIBOR) saw its biggest positive and negative swings in 10yr swap spreads since inception on successive days towards the end of September. The MOVE index of government bond volatility peaked close to 160, only a fraction shy of the levels seen at the worst of the Covid crisis in March 2020. And a few days before the UK issues, the Bank of Japan was forced to intervene in FX markets to slow a seemingly exponentially faster weakening of the Yen.

These multiple points of stress should not come as a surprise. The shift from zero interest rate policy to an inflationary world is a real change of financial paradigm, and with it comes the requirement for an enormous shift of capital. Previous assumptions, such as those around the role of bonds in a portfolio as safe assets and a diversifier to equities, have been sharply upended by the magnitude of the concurrent daily, weekly, and monthly losses we now see regularly across both equities and bonds.

There are also material shoes still to drop in housing markets, corporate debt, and private assets. Higher rates should reduce both the demand for housing and the spending power of existing homeowners. Corporate debt markets are yet to face the double-whammy of weaker consumer spending and more expensive re-financing costs. Private assets could face a wave of selling pressure as investors seek to rebalance their portfolios to shore up reserves in those more liquid strategies that have been drained by recent market moves and liquidity demands. How these three emerging phenomena interplay with the existing market stresses is yet to be seen, but with fundamental data continuing to surprise on the more inflationary side of previous estimates, and with growing concerns over possible escalation of the war in Ukraine into a nuclear conflict, it seems likely that this period of rolling crises will continue for some time yet.

Hedge Funds

Hedge fund managers had a mixed month on average in September, although with the backdrop of such sustained risk in traditional asset markets it was notable how few managers reported large losses, and that on average the industry did well to protect capital and diversify investors’ portfolios.

What started off as a positive month for global equities came to a halt mid-month on inflation data, then worsening following the 21 September Federal Reserve meeting. There has been nowhere for investors to hide this month. Performance in Equity Long-Short was also challenged in September with funds capturing sizeable portions of the market downside. We expect this has less to do with exposure levels and more to do with stock selection. After outperforming in August, crowded long positions (see Goldman Sachs’ Hedge Fund VIP Index) – especially those of U.S.-focused funds – underperformed the MSCI World and S&P 500 indices during the month, suggesting negative long alpha. Beta also played a part in negative Equity Long-Short performance, but funds came into the month with muted gross and net leverage, therefore reducing the beta headwind. Flows show that funds have been active on the short side this month, adding exposure in both single names and ETFs.

In Credit, September was a challenging month on hawkish rhetoric from central banks and meaningfully higher bond yields across the curve. Floating rate leveraged loans once again outperformed the high yield and investment grade markets. Similarly, floating rate preferreds performed positively on higher short-term rates. Lower-rated US high yield credits underperformed higher-quality bonds due to relatively wider credit spreads more than offsetting the benefit from shorter duration. Corporate Credit managers posted mixed returns during the month. Portfolio level credit, equity and interest rate hedges were positive contributors. Convertible bonds saw modest cheapening driven by the sell-off in underlying equities and wider credit spreads. Similar to August, SPACs held up reasonably well as there was a pickup in deal activity. Some managers also saw gains from idiosyncratic capital structure arbitrage positions while certain stressed/distressed corporate credit longs were detractors. Structured Credit managers posted modest returns during the month, with portfolio carry and gains from hedges offsetting mark-to-market losses from spread widening.

In a difficult month for equity markets, most Event managers gave back early gains to end flat or slightly positive. While initially announcements like Citrix’s financing being confirmed, or favourable court rulings for Change HC and Twitter, merger spreads widened sharply towards month-end on bearish macro news. However, well-progressed deals have continued to de-risk and managers are generally adding on weakness, and Europe saw some counterbids. New deal activity started very slow, but picked up somewhat with some large transactions, particularly in the US, from a mix of strategic and financial buyers despite tightening of financing markets. Catalyst trades are mixed in Asia: holding up despite challenging markets in China and Japan, e.g., with Hitachi Metals, but several deals in APAC broke. Asia RV trades and convertible arbitrage continued to perform positively. The large Porsche IPO was a welcome catalyst for special situations.

For Discretionary Macro managers, the hawkish rhetoric that came out of the Jackson Hole Economic Symposium in August was the key for managers to re-risk into themes braced for higher global bond yields. Tactical trading had been a feature of the space, in some cases against managers’ underlying longer-term view, as choppy price action and momentum behind the ‘peak inflation’ narrative saw conviction falter. But macro managers entered September with the confidence that central bankers would not ease on their campaign of rate hikes to tackle inflation, thus increased their net short positions in US and European bonds and short-term interest rates. These appear to be well-timed, as investors have repriced policy paths higher in September, anticipating further rate hikes to overcome sticky inflationary pressure and, in some economies, fiscal expansion. Outside of fixed income, currency trading has broadly helped performance, notably by shorting currencies with deteriorating current account deficits and staying bullish on USD.

Quantitative managers have broadly navigated the volatile market backdrop well in September. Trend-followers’ short positioning in bond and interest rate futures has driven another round of impressive returns across the space, while continued USD strength against most majors was a tailwind for long positions. Tighter financial conditions and growing expectations of a recession next year has weighed on global bourses, in line with trend’s modest short stance in equity futures. Systematic Macro strategies have taken a more bullish position on stocks and commodities which has dragged on performance slightly., However USD positioning has lined up with trend-followers this month, as has net short positions across various fixed income curves. Performance in micro-focussed strategies has been mixed, with quant credit positive and machine learning strategies mostly flat.