Q1 Strategy Outlook: Credit Revised to a Near-Term Opportunity

We have revised credit to a near-term opportunity set as we have already seen a substantial recovery, while our outlook has become increasingly positive in other areas such as event-driven strategies.


The environment for hedge funds remains broadly attractive in credit, specialised equity long-short, quantitative and equity arbitrage strategies.
 

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1. Introduction

We maintain a positive outlook across an unusually large spectrum of strategies, spanning credit, equity long-short, macro and relative value. As expressed in previous quarters, credit has been among our highest conviction strategies following the sell-off in March 2020. While we maintain a constructive view on the space, we have revised this to a near-term opportunity set as we have already seen a substantial recovery, and investors might seek to lock in some of the substantial gains in the coming months. Meanwhile, our outlook has become increasingly positive over the past quarter in other areas such as event-driven strategies.

Our outlook for hedge funds stands in unison with an optimistic outlook for the financial environment, namely equity markets more broadly. While there are a number of risks that remain on the horizon, we believe the base case in the coming quarters is that the combination of an expected accelerating economic pick-up in the spring, dovish central banks and continued fiscal support will extend the market rally.

Cognizant of this bullish expectation for equity markets, we believe investors should remain disciplined around the goal of portfolio positioning, which is to provide diversification if this expectation turns out to be wrong – not to beat the market if we experience a strong year for equities. However, this is not to downplay the interesting opportunities for hedge fund managers.

2. Financial Environment Outlook

Despite the challenges that markets faced during the fourth quarter of 2020 – a slowing economic recovery; political risks from the US elections; and Brexit negotiations – equities and corporate credit rallied, boosted by positive Covid-19 vaccination news. Additionally, the outcome of the US Presidential election proved to be market-friendly, despite the lengthy process to ratify the results. In predictable European fashion, Brexit negotiations went down to the wire, but a compromise was ultimately found. US equity markets closed this remarkable and exhausting year at price levels that seemed out of reach only a few months ago.

The boost in investor sentiment from the prospect of a wide rollout and acceptance of effective Covid vaccinations led to a violent rotation within equity markets at the beginning of November. Stocks that had benefited from consumers’ adjustments to the work-from-home environment declined. Vice versa, sectors that had suffered, such as airlines and energy, rallied hard.1

While valuations of risk assets became more stretched in the fourth quarter, and this quarter’s economic growth outlook is grim due to the rise in infections in Europe and the US, many market observers are noticeably bullish for 2021, especially for US equities.2 A combination of earnings recovery and multiple expansion is expected to fuel an ongoing melt-up in stock prices. Optimists justify expensive valuations with low interest rates and abundant liquidity. Despite significantly lower corporate buybacks in 2020, inflows into equity markets easily absorb the high capital markets supply.

We see the bullish line of argument above as the base case scenario for the year ahead: the combination of an accelerating economic pick-up in the spring, dovish central banks and continued fiscal support is likely to carry the rally further. Indeed, traditional valuation metrics could be stretched much further given the scarcity in assets that generate real yields.

A key driver for global growth this year and beyond will be China. Its importance for markets became most obvious in 2009, when it acted as the biggest fiscal stabiliser to global growth.3 In 2020, it was the only major economy that brought the pandemic under control and avoided a temporary economic collapse. It was not forced to monetise its debt. Different to the Federal Reserve, the Bank of Japan and European Central Bank, the balance sheet of the People’s Bank of China has remained stable. As its economic growth engine accelerates this year – with a view of overtaking the US as the largest economy in the next five years or so – it will not only positively impact equity markets of export-oriented countries, but also continue in the path of institutionalisation of its financial markets. The gradual appreciation of its currency over the coming years is likely and could be a stabiliser for the financial system. Accessing opportunities in China should be a focus for investors in 2021.

Despite our constructive outlook, we recognise that segments of the market exhibit speculative excesses that remind us of the late 1990s.4 Therefore, we remain focused on what we believe are the key risks for markets: a sharp rise in interest rates; rotations; and possible policy mistakes.

A sharp rise in interest rates could impair the risk-on sentiment and impact some strategies negatively.5 As we discussed in the last quarterly outlook, the risk that markets re-price inflation expectations is higher today than it was after the Global Financial Crisis, given the forceful combination of monetary and fiscal stimulus, as well as the new policy framework of the Fed. Inflation itself may not appear in the first half of 2021 given the output gap and the fact that economic output will not reach pre-pandemic levels until the later part of 2021. However, this does not preclude a rise in inflation expectations that could lead to the sudden adjustment in interest rates. We note with caution the rise in 10-year US breakeven inflation rates (Figure 1).

Figure 1. 10-Year US Breakeven Inflation Rates

Source: Bloomberg; as of 27 January 2021.

The risk of rotations within markets remains high. Capital markets will adjust to material changes in the prospects for different economic sectors depending on the future path of the pandemic. These adjustments could occur quickly, challenging seemingly hedged, but levered, portfolios. This risk is especially prevalent in crowded trades such as cross-sectional momentum, as we saw in November 2020. A rotation out of the extended short US dollar positioning is another risk. It would likely occur in a risk-off move and hurt portfolios where systematic strategies have aligned long equity, long commodity, and short US dollar exposures. As often when positioning gets lopsided, it may not need a grand narrative to trigger an adjustment.

Policy mistakes are at the forefront of possible catalysts that could disrupt the consensus. A big policy risk for markets is a premature withdrawal of stimulus. In Europe, Northern countries are likely to shift their focus to debt reduction post the 2020 spending binge once the public health crisis is brought under control. We are especially watching Germany’s future political constellation after its federal election in September. Last year, it gradually moved its position away from the austerity camp and aligned itself with France. A retreat from fiscal integration would threaten to open the funding costs between the core and periphery. If credit risk is priced back into higher indebted Southern European countries’ debt, it poses a risk for the whole European financial system. Banks in the Eurozone have increased holdings of government debt of their home countries by 19% this year.6 This has occurred at the same time as sovereigns’ debt burden have increased further due to the costs of the fiscal stimulus. As compressed sovereign debt spreads indicate, this risk is small today, indicating the expectation of an intervention by the ECB through higher bond purchases if necessary. However, the room for error is small as Europe’s financial house continues to stand on an unfinished foundation.

In the US, the risk of a withdrawal of fiscal support has decreased following the Georgia senate run-off elections, which finally brought a resolution of the US election. However, with the blue sweep comes a likelihood for more substantial change, particularly when considered relative to the stability that markets were welcoming with the prospect of a split government. Due to the close balance in the Senate, there is unlikely to be appetite for any extreme progressive policies to take hold, but the pro-business policies of the prior administration could be reversed. A return to a more stringent regulatory environment and an increase in corporate taxes would negatively impact long-term return expectations for US equities.

The bullish consensus outlook is in our opinion the base case scenario for the start of 2021. Does this lower the value of holding alternative investments in portfolios? Absolutely not. On the one hand, we see interesting opportunities for managers (see the following section). On the other hand, it is not the role that hedge funds should play to beat the market if we experience a strong year for equities, but rather they should provide diversification if uniform predictions turn out to be wrong. The goal of portfolio positioning should be to provide significantly higher returns than bonds in a calm market but protect capital if unforeseen events cause renewed volatility. In case it was forgotten, 2020 has taught us how valuable diversification and risk management are.

3. Strategy Outlook

We maintain our view from the prior quarter that the environment for hedge funds is positive across a broad set of strategies. We continue to be bullish on credit managers, however we have revised this to a near-term opportunity following the strong rebound in credit markets through the end of 2020. Our view on equity long-short also remains positive, as we believe dispersion, which creates opportunities for managers to exploit, will persist. In a similar vein, we believe that opportunities for discretionary macro managers could arise from higher asset class volatility, for example in interest rates due to higher inflation expectations. In relative value, we are positive on both classic merger arbitrage strategies, which are benefitting from improving deal activity and sentiment, as well as broader-based event strategies with the potential to exploit both hard and soft catalyst opportunities. Finally, we expect quantitative micro strategies, such as statistical arbitrage and systematic credit, to benefit from ongoing stock price dispersion and reversionary forces.

3.1. Credit Strategies

We continue to like the opportunity set for corporate credit strategies in the near term. Despite a strong rebound in the credit markets (Figure 2), single-name and sector-level dispersion remains elevated.

Figure 2. US High Yield CCC Spreads and Leveraged Loan Price Index

Source: Bloomberg; as of November 2020.

Covid-19 continues to have a varying impact on companies with different business models, creating winners and losers, which credit long-short managers have been able to exploit. As economies recover, there is potential for these managers to express longs in cyclical, beaten down sectors versus shorts in companies in a secular decline.

There remain ongoing dislocations within capital structures that have resulted in profitable debt versus equity trades. As companies continue to address near-term liquidity needs, liability management trades are an area of potential opportunity.

In financial preferreds, spreads are wide to pre-Covid and long-term average levels. Strong profitability and increasing capital cushions for large US banks should be supportive of the markets. However, we are carefully monitoring the rise in interest rates which could be a headwind for fixed rate preferreds.

The opportunity set for distressed also remains attractive in the near term. However, we are less optimistic than previously over the medium term. There have been USD137.5 billion of defaults YTD7 including distressed exchanges, which is the second highest after 2009 which saw USD205 billion in defaulted paper. The par-weighted US high yield (‘HY’) default rate of 6.15%8 is close to the second highest since 7.4% in February 2010. This should bode well for the near-term pipeline for managers in the space. However, we have seen a moderation in expectations of a full-blown default cycle. Capital markets have been receptive of issuance, which has allowed companies to roll over debt. Economic support and the prospect of an end to the pandemic are other factors that have led to change in the default outlook. JPMorgan now estimates 3.5% default rate for US HY in 2021, down from 5%. There has also been a meaningful reduction in the overall supply of distressed paper, with the BAML HY distress ratio back to pre-Covid levels. Lastly, while still tight, there has been a meaningful improvement in lending conditions in the latest Fed Senior Loan Officer Survey.

We expect distressed managers to monetise existing positions currently in restructuring, or expected to be in the near term, as well as post-reorg names. Sectors directly impacted by Covid-19, e.g. energy, retail, travel, leisure, gaming, etc, should continue to present opportunities in the near term.

Convertible arbitrage remains an ongoing area of focus for many credit managers. Broad markets have recovered strongly from the March lows, but are still trading somewhat cheap to estimates of fair value and equity volatility has remained elevated. While a lot of uncertainty has come out of the market after the US elections in early November and the recent Georgia Senate run-off races, sector and name-level volatility is expected to remain elevated in the near term as the incoming administration starts to implement its policies.

Lastly, convertibles primary markets have remained very active, resulting in an increase in the overall size of the convertible bond market and presenting mangers with new issue-related, as well as flow-driven, opportunities.

One of the potential risks to our outlook for convertible arbitrage is a significant volatility compression or a systematic event, e.g. a sudden and substantial backup in Treasury yields.

We also remain favourable on the near- to medium-term opportunity set for structured credit managers as many securitised product sectors have lagged the recovery in corporate credit and equities. Loss-adjusted yields, despite more conservative assumptions, remain higher as a result versus pre-Covid levels. The sector also presents good relative value in a ‘chase for yield’ world given the stock of negative yielding debt globally as well as the relatively low yields across the investment grade and high yield markets.

The fundamental backdrop has continued to improve as there has been a steady decline in mortgage payment forbearance levels over the past few months, a V-shaped housing recovery, and favourable credit trends in consumer and credit card data. The key risk for the sector remains declining cashflows (forbearance, delinquencies, eventual defaults/losses) in the near to medium term.

3.2. Equity Long-Short Strategies

Our view on equity long-short remains positive, as we believe that stylistic, regional and sector dispersion will persist and possibly expand as we move back to a post-Covid ‘normal’ through 2021, in turn creating opportunities for managers in the space to exploit. We believe that there is merit in paying increased attention to managers’ sensitivity to a change in the Growth/Value leadership, particularly as the threat of rotations looms with record high concentration of the top five stocks in the S&P 500 Index, alongside corporate and consumer behaviour normalising.

Although we recognise that equity prices across many sectors and industries are still markedly below their pre-crisis level, we believe that from a regional perspective, there is more headroom for a recovery in European equities relative to the US, as long as Europe continues to support its economy.

If inflation expectations lead to steeper interest rate curves, it would support the idea of a value recovery, since steeper yield curves are generally more punitive for the valuation of longer-duration growth stocks. Given the objective of portfolios to provide diversification, we believe investors should focus on managers who can generate alpha from the changing opportunity set rather than taking a static directional bet.

We have growing conviction that ESG will become an even more important focus for investors, given generally strong performance from ESG-related names in 2020 and the expectation that social development goals will return to the fore once public health concerns diminish. We are bullish on managers who can recognise ESG themes and opportunities and tactically trade in and out of these. The ability to be nimble is important – as we have already highlighted, many regions and sectors are still yet to ‘normalise’, thus there is a danger that many mispriced equities with significant ‘ESG’ beta could be particularly risky.

3.3. Relative Value Strategies

In relative value:

  • We are neutral to positive on quantitative micro strategies, i.e. statistical arbitrage and systematic credit. In 2021, we will focus on opportunities trading onshore Chinese equities, but these are scarce capacity and subject to availability;
  • We have a balanced, but positive, view on classic merger arbitrage due to improving deal activity and sentiment, despite tight spreads. We remain positive on broader event-driven strategies due to the ability to pursue opportunities in soft and hard catalyst situations, including capital market events like SPACs;
  • Fixed income relative value should continue to do well in a period of generally good market liquidity and reduced tail risks.

In quantitative micro, we believe multi-quant firms have a significant edge over smaller managers (further demonstrated by their resilience in March 2020 and subsequent outperformance) and, with the exception of opportunistic niches (like China A below), we prioritise the former. Traditional statistical arbitrage enjoyed the more volatile equity markets in the second half of 2020. We think this can continue in 2021, but it will be more muted and consistent with a healthy functioning market and some reduced competition in the space. We think systematic credit has shown strong promise as a useful additional source of return. Finally, we continue to look for ways to participate in the broad, liquid and inefficient China A onshore market. We believe investors should lean towards experienced quantitative managers that avoid excessive borrow costs by running long biased or with some other innovative approaches.

Our outlook for merger arbitrage has become more positive for the following reasons:

  • Merger and other deal activities have recovered significantly across all regions. Both large-cap and small-cap activity has accelerated in lockstep with market stability and positive global sentiment;
  • Merger spreads have normalised to close to pre-Covid-19 levels, particularly perceived safe deals tightened very rapidly. However, there is a lot of dispersion and managers can realistically target higher average annualised spreads in their portfolios;
  • While deals in certain sectors like retail and commercial real estate are still at risk of renegotiations and price cuts following the economic shocks, deal break risks generally appear to be becoming more remote. Newer deals can be expected to incorporate the pandemic impact and should complete at historical rates.
Figure 3. Global M&A Deal Count and Volume

Source: Bloomberg; as of December 2020.

We remain more positive on broader event-driven strategies that can pursue opportunities in both soft and hard catalysts, including capital market events like SPACs. Strategies like holdco discount trading, restructuring and stub trades should continue to benefit from normalisation trades that reduce market dislocations.

SPAC mergers will continue to be a popular method for companies to go public and the IPO proceeds is likely to drive a lot of M&A activity. The SPAC shares themselves offer interesting optionality with downside protection. Event-driven strategies typically focus on the arbitrage potential of SPACs, i.e. are happy to sell if a positive deal is announced that drives the SPAC’s share price above its NAV, but equally ready to accumulate SPACs trading below trust value with a patient view of harvesting the yield from the eventual closing of the NAV discount as they liquidate at par. We expect managers to generally hold a diverse and broad cross-section of the SPAC market and to closely monitor any excess premium and control the at-risk exposure with a higher degree of downside equity hedges. Established managers in the space with good broker desk relationships are also more likely to get good fills in attractive new IPO issuances.

Asian markets continue to offer a broad and growing opportunity set as various corporate governance improvements and market structure developments continue to unfold, particularly in China (e.g. SOE reform, ADR privatizations) and Japan (e.g. increased activism and pressure on holding companies).

Fixed income relative value should remain a source of positive returns in a period of generally good market liquidity and reduced tail risks.

3.4. Global Macro Strategies

We remain positive on discretionary macro strategies as we anticipate the potential for elevated volatility across asset classes, for example in interest rates in light of higher inflation expectations, to create opportunities for managers. Furthermore, individual economies will emerge from the pandemic at different rates, creating relative differences across countries and regions, which could be exacerbated by diverging fiscal policies. For example, as expressed in the previous section, we see a risk of a premature withdrawal of stimulus in Europe, meanwhile in the US, this risk has decreased. Against this backdrop, we are bullish on experienced discretionary macro managers with proven trading abilities and the structuring skills needed to navigate the opportunities and risks that are expected to arise. In addition, managers with exposure to Asia, as well as selected emerging-market regions are compelling based on the more optimistic growth prospects of those markets, especially when combined with FX trading expertise.

In quantitative macro, our outlook is that the stabilising Covid situation should provide opportunities for trend followers and systematic macro managers, with the latter having the edge in absence of unexpected events. We believe new opportunities will arise in part due to manager innovation. Consequently, we believe investors should use this opportunity to review some of the more innovative solutions e.g. quantitative overlays in FX, low-cost trend following and systematic tail hedges. In addition, changes to QFII rules have opened attractive opportunities in trend following in Chinese commodity futures, which we view to be at least as attractive as trend following in developed markets. Namely, empirical evidence suggests faster momentum strategies have much greater efficacy in the China market than elsewhere, which is encouraging. We also expect this exposure to be beneficial in that it is highly diversifying.

 

1. See Man FRM Early View – November 2020, Man Institute.
2. See Views From the Floor, December 8, 2020, Man Institute.
3. Source: Wong, Christine (2011), “The Fiscal Stimulus Programme and Public Governance Issues in China”, OECD Journal on Budgeting, Vol. 11/3.
4. As Jeremy Grantham points out in: Waiting for the Last Dance, January 2021, GMO.
5. For example, Convertible Arbitrage and based on positioning at the end of December 2020, Trend Following. Clearly, some strategies could benefit; for example, Value funds.
6. Source: ECB.
7. Source: JP Morgan, November 2020.
8. Source: JP Morgan, November 2020.