The environment for hedge funds remains broadly attractive in credit, specialised equity long-short, quantitative and equity arbitrage strategies.
Since our previous update, the financial environment outlook has become more challenging. Valuations have increased throughout the summer, while the economic recovery is slowing. Europe is in a second wave of the pandemic and in the US, new hotspots are forming. Monetary stimulus remains in place to support equity and credit markets, but the inability to renew fiscal support by US policy makers is concerning markets. Additionally, political events such as the US presidential election may test the efficacy of the monetary support for markets, in our view.
The recovery of economic activity has continued on its uneven path. The pace of the recovery in developed market (‘DM’) economies is likely to slow in the fourth quarter due to the expected increase in infections during autumn and winter. However, we believe that country-wide lockdowns as in the spring that caused the cardiac-arrest of the economy are unlikely to be imposed due to the enormous negative externalities. The magnitude of the economic shock of Covid-19 is reflected in the expectation that pre-crisis output levels will not be reached before the second half of 2021.1
2. Financial Environment Outlook: Political Risks, Inflation
The combination of rising prices for risk assets and an uncertain forecast for corporate earnings was summarised by the Bank of International Settlement in their usual matter-of-fact language: “The evolution of aggregate valuations appeared to be somewhat at odds with the general economic outlook”.2
We concluded last quarter that the stimulus would continue to support markets, even if the recovery slows down. However, we feel challenges to this view have arisen; the absence of additional fiscal stimulus in the US has weighed on markets. With the US Presidential election approaching, a compromise on a new, large programme is increasingly unlikely before then. In Europe, pressure is rising from policy hawks to scale back fiscal and monetary support.3 Whilst public sentiment prevents a shift back to austerity for now, policy mistakes could lead to a convergence of market valuations with the general economic outlook, as unsettled markets in September showed.
We note on the positive side, though, the introduction of the new policy framework by the Federal Reserve. Whilst the market’s immediate reaction was tepid, it creates long-term certainty of loose monetary policy. The new framework reacts to the persistent shortfall of headline inflation relative to target which has cemented the slippage in long-term inflation expectations. The Fed is using the flexibility from the reduced responsiveness of inflation to a declining unemployment rate. The flattening of the Philipps curve results from structural changes in the economy such as technological innovation and globalisation.4
The return to orderly functioning markets and the rally in risk assets allowed the Fed to reduce the size of the monthly purchases of US Treasuries from c. USD700 billion during the second quarter to about USD80 billion. There is little doubt that the Fed would stand ready to dial up purchases if necessary and follow the European Central Bank, which on the other hand has increased its footprint in corporate bonds. Credit spreads of US corporates have continued to tighten, but still remain wide relative to pre-Covid levels – especially for lower-rated credits (Figure 1).
Whether monetary support alone could keep valuations high will be tested in the coming weeks as political events approach: the US election and Brexit. Risk has been priced into implied equity volatility around the date of the US election. We believe the key risk is that the outcome is not only delayed due to a higher number of absentee votes, but also contested due to claims of irregularities. The populist fever in the US makes this an uncomfortable scenario that could trigger a risk-off move.
Figure 1. US HY CCC Spreads and Leveraged Loan Price Index
Source: Bloomberg, September 2020.
The election outcome itself has of course also the potential to move markets: a scenario where the Democrats control the White House and Congress could lead to a steeper US interest rate curve in anticipation of more fiscal spending. Within equities, we could see rotation from Growth to Value stocks. A sell-off in the US dollar is also a possibility. The outlook for the greenback is however rather challenging regardless of the winner, as we believe the next few years could see a reversal of the exceptionalism of US capital markets after years of enormous foreign inflows.
In our view, an election outcome with a divided government could contain volatility – a wild card is the trade war though. A re-election of the Trump administration could probably be considered a mandate for even more forceful behaviour of the US towards China. Given the more challenging backdrop of high valuations and a weakened economy, this could trigger higher volatility than that experienced in 2018. China has been an important driver behind the bullish sentiment in markets. Similar to the recovery of the world economy from the Global Financial Crisis (‘GFC’), China is stabilising global activity thanks to its early and quickly controlled virus outbreak, as well as its policy support through infrastructure investments. This has lifted commodity prices and export-oriented equity markets like the German DAX Index. An escalating trade war could challenge this.
With regards to the exhausting Brexit saga, the end of the transition period between the UK and the EU on 31 December of this year poses another political risk for markets. It is probably more localised than the US elections as markets have had time to adjust for an exit without a deal, but it still represents a potential source of volatility for FX and European equity markets.
Looking further out, the main question is how quickly and how effectively the pandemic can be contained. However, regardless of the success of a vaccine, one of the economic fallouts of the pandemic will probably be high issuance of sovereign debt for years, which adds to the already high stock of debt. There is no imminent default risk as long as central banks purchase debt. Will inflation remain a concept that economists can only study in textbooks or emerging markets (‘EM’)? The debate about inflation risks is different than post-GFC. Following the 2020 crisis, more money went directly to households, while after 2008, quantitative easing benefited mainly financial assets. The savings rate of US households shot up during lockdowns, but as restrictions are eased, the velocity of money is likely to increase. This, together with the signalling of the new policy framework, could lead to higher inflation expectations and initiate a new market paradigm.
Another risk that could develop longer-term is a possible reversal of the forces that allowed the Fed to introduce the new policy framework. The populist wave in Western democracies has already created a movement in that direction as globalisation is in retreat. Wage pressure could be a result. Furthermore, the speed of technological innovation may slow down if the new administration imposes restrictions on the business model or size of tech companies.
In summary, our market outlook has deteriorated since last quarter. We believe that diversification is extremely valuable for investors’ portfolios. Unfortunately, traditional instruments such as Treasury bonds have a diminished potential to act as diversifiers in a correction. To the opposite, if inflation expectations take hold, they could become the source of the correction. Therefore, we see value in allocations to hedge funds. Below, we discuss which strategies are, in our opinion, attractive going forward.
3. Strategy Outlook
Our preferred strategies remain largely the same as last quarter. We note that the environment for hedge funds remains broadly attractive across a number of different strategies. We continue to be bullish on credit managers within suitable portfolios. Equity long-short specialists are, in our view, well-positioned to identify trends that arise out of the economic recovery. In relative value, we are bullish on quantitative strategies and on equity arbitrage.
3.1. Credit Strategies
We remain favourable on the opportunity set for credit strategies, despite some degree of recovery in markets following the sharp dislocations in March:
- In corporate credit, US high yield spreads are still wider and leveraged loans still cheaper than before March. The universe of distressed credits is larger across sectors, which coupled with an expected pickup in defaults, continues to set the stage for a strong idiosyncratic credit-picking environment, in our view;
- In structured credit, the selloff across securitised products sectors has led to higher yields and steeper credit curves. However, it needs to be balanced with deteriorating fundamentals (increased unemployment; softer higher purchase agreements/commercial real estate prices) and declining cashflows (forbearance, delinquencies, eventual defaults/losses) in the near to medium term.
We are therefore bullish on credit managers. Note that we do not expect the positive returns generated by the credit managers since April to be repeated in the coming months. In addition, there could be a general market retracement given the recent positive returns or US election-driven market volatility in the coming weeks. Still, we believe that central banks’ implicit support for risk assets should reduce the potential for a March-like tail risk event.
Credit long-short managers continue to source attractive capital structure arbitrage trades (typically long bonds versus short equity) in sectors that have ongoing needs to de-lever.
Spreads remain wide relative to pre-Covid levels in many sectors and there also continues to be a high sustained dispersion environment, a positive for fundamentally-driven credit-pickers.
While the pace of downgrades has slowed since the second quarter, we believe the record year-to-date volume of fallen angels presents trading opportunities for managers, as does the record pace of issuance in the US investment grade and high yield markets.
The opportunity set in financial preferreds also remains interesting as large banks in the US have generally reported good earnings, with net income solidly ahead of expectations, particularly for banks with trading operations. The balance sheets for these banks remain in good shape as most are adequately provisioned for the Fed’s severely adverse stress test scenario. Average spreads in the sector still remain wide to pre-Covid levels.
Distressed remains a medium- to long-term opportunity. Corporate default activity has been elevated for the past few months, with the par-weighted US HY default rate close to a 10-year high and expectations of a sustained high default environment for the foreseeable future (Figure 2).
Figure 2. US Corporate Bond and Loan Defaults
Source: JPMorgan; as of August 2020.
We expect managers to take advantage of opportunities arising from rescue financings as well as bankruptcies, restructurings, and liquidations across industries directly impacted by Covid-19.
Convertible arbitrage also remains an area of focus for many credit managers, in our view. While the markets have recovered from the lows in March, the broad convertible universe still remains cheap relative to fair value estimates.
It has been a persistent high volatility environment, despite the equity market rally driven by some of the factors below:
- Ongoing macro risks (US/China trade tensions);
- Potential increase in Covid-19 infection rates and vaccine related developments;
- Upcoming US elections.
Ample liquidity provided by central banks and the elevated equity markets should be supportive of the strategy. Primary markets have remained fairly active as companies continue to seek cash/rescue financing.
Convertible arbitrage managers are also actively engaging with issuers to fix balance sheets and participating in buybacks and tender offers to generate additional gains.
Many structured credit sectors have lagged the recovery of the broader equity and credit markets, especially the lower-rated, below the ‘fulcrum’ tranches. However, after an initial spike, mortgage forbearance requests have levelled off at lower than initially feared levels. Housing markets have remained resilient as affordability has improved and demand, coupled with the tight supply, should be supportive of home prices going forward. A slowdown in new originations also sets us up for a positive technical backdrop. Credit curves remain steeper and loss-adjusted yields in most securitised products sectors remain higher versus pre-Covid levels, even under conservative assumptions that build in higher front-end delinquencies, higher defaults and losses, and lower prepays.
We continue to see good opportunities across legacy residential mortgage-backed securities, credit risk transfers, private student loans, and potential secondary market opportunities in collateralised loan obligations and collaterised debt obligations, as well as select commercial mortgage-backed securities conduit sub-investment grade bonds that remain close to the wides of mid-March (Figure 3).
Figure 3. CMBX 6 BBs (2012 Vintage)
Source: Bloomberg; as of September 2020.
3.2. Equity Long-Short
Discretionary equity long-short managers continued to perform positively post-crisis as markets recovered their pandemic-induced losses. Equity market volatility calmed on the back of unprecedented central bank action, yet factor volatility remained elevated, with the Value factor generally suffering given the backdrop of low and falling nominal and real rates (which, in turn, provided a tailwind for Growth).
We believe that there are still dislocations that specialists can exploit, more so then generalists, as we fit into a new regime. A discretionary approach, in our view, is well suited to identifying opportunities that arise out of the economic recovery and the upcoming political events, whether that be a display of factor awareness or recognising a growing theme such as ESG investing.
As discussed last quarter, equity long-short managers have previously been subject to concerns regarding alpha generation and return inconsistency. However, we believe that sector and regional specialists are in a better position to buck this trend in the medium term. We have also noted the positive performance of Chinese long-biased managers over the last few years, with high alpha generation and downside protection when indices fall, and we intend to investigate this area further.
As has been the case for most of the year, volatility in equity factors has proved difficult for portfolios to navigate, in particular the discrepancy between Growth, Value and Momentum factors. Under some metrics, the Value-Growth dynamic is now at levels comparable to the dot-com bubble (Figure 4) as the recent economic environment has been conducive for Growth stocks. The increase in volatility could be a symptom of the changing regime within the equity market as companies and investors react to the new environment. As these spreads widen, there is growing optimism about the opportunity in Value stocks if we see either an economic recovery or inflation surprising on the upside.
Figure 4. Ratio of Cumulative Russell 1000 Value Return to Cumulative Russell 1000 Growth Return (1995-2020)
Source: Bloomberg; as of 13 September 2020.
3.3. Relative Value
In relative value, we are:
- Positive on statistical arbitrage and quantitative strategies;
- Neutral on merger arbitrage; and positive on broader event-driven and other equity arbitrage strategies;
- Neutral on fixed income arbitrage.
Our outlook for statistical arbitrage and quantitative strategies comprises the following summary views:
- We continue to believe that multi-quant firms have a significant edge over smaller managers (further demonstrated by their resilience during March 2020) and, with the exception of opportunistic niches, we prioritise the former;
- Traditional statistical arbitrage and reversion enjoyed the more volatile equity markets in the second and third quarters. We believe this can continue into 2021, but it will be tempered by more liquidity risk (than we saw over the summer) due to political and Covid risks;
- We think systematic credit has shown strong promise as a useful additional source of return;
- We believe opportunities exist in the large, liquid China A onshore market. Increasingly, we are bullish on quant managers that run long biased and have reported considerable success.
Our outlook for merger arbitrage remains neutral for the following reasons:
- Merger and other deal activity is recovering across all regions (Figure 5), but equally important, merger spreads have normalised to close to pre-Covid levels and particularly perceived safe deals tighten very rapidly as abundant capital is available;
- While certain sectors are still at risk to deal breaks following the economic shocks, renegotiations and price cuts are also possible. Newer deals can be expected to incorporate the pandemic’s impact and should complete at historical rates;
- The impact potential of the expected volatility around the US elections and the corresponding outcomes is unclear but unlikely to be material for M&A.
Figure 5. Global M&A Deal Count and Volume
Source: Bloomberg, August 2020.
We are more positive on broader event-driven strategies that have multiple return drivers and investing flexibility beyond only merger arbitrage, e.g. the ability to rotate into softer catalyst opportunities like holdco discount trading, restructuring and stub trades.
The dramatic increase in special purpose acquisition company (‘SPAC’) IPOs in recent months has also been picked up by many event and other relative value managers as a source of new transactions and arbitrage opportunities. Another growing opportunity set is events in Asia, as a result of various corporate governance improvements and market structure developments in China (e.g. state-owned enterprise reform, American Depository Receipts privatisations) and Japan (e.g. increased activism and pressure on holding companies).
Our view on equity arbitrage remains positive, as activity levels around capital restructuring transactions such as block trades, placements and rights issues remain high. Barriers to entry are significant as the strategy relies on long-term relationships between managers and bankers. High market volatility continues to make hedging of transactions challenging and the appropriate skills and experience are paramount.
We remain neutral on fixed income arbitrage given the continued involvement of central banks globally in managing rates and curves, which is expected to limit opportunities in the near term. A political regime change in the US and/or a shift in inflation expectations could be a positive for the medium- to long-term opportunity set.
Relative value strategies in general have to focus also on managing downside risks given the potential for market volatility in the near-term.
3.4. Global Macro
We are currently positive on discretionary macro strategies, as the current environment of elevated volatility should create numerous catalysts and inflection points with the potential for alpha generation. Trade structuring and portfolio construction skills, as well as experience, are required to successfully navigate the upcoming opportunities and risks. Managers are starting to put more directionality into their portfolios, but relative value themes remain significant. We see future opportunities especially in FX markets, which could become a valve for economic divergence between countries that can’t be released in rates, which are anchored.
1. OECD Economic Outlook, Interim Report, September 2020.
2. Bank of International Settlement, BIS Quarterly Review, Q3 2020.
3. Jens Weidmann in his recent speech “Calling on the government”: “Competitive and resilient economies, sound public finances and a monetary policy stance that is clearly geared towards price stability [are] fundamentals and principles that guarantee Europe’s prosperity”; 2 September, 2020.
4. The Federal Reserve’s Review of its Monetary Policy Framework: A Roadmap, FEDS Notes; 27 August, 2020.