Central Banks Finally Spring into Action

The season of central bank action is upon us. The Bank of Japan (BoJ) unexpectedly raised rates this week and the Bank of England (BoE) cut borrowing costs for the first time in more than four years. The US Federal Reserve (Fed) holding fire during this week’s meeting was less significant than the shift in expectations for future meetings. The market now prices a September rate cut as a near certainty, with the US 2-year bond yield dropping by 35 basis points over the course of July.

The shift in monetary expectations began earlier in the month. The softer-than-expected 0.2% US CPI print piqued investors’ interest in more rate cuts over the next 12-18 months than are currently anticipated. A week later, slightly higher-than-expected initial jobless claims data added to concerns of an economic slowdown.

Markets quickly got the message. The S&P 500 Index gave back the 5% gain from early in the month to finish largely flat, but the activity under the surface was most telling of the change in investors’ appetites. The Russell 2000 Index¹ surged by over 10% during the month, while the Nasdaq underperformed. The 19% outperformance of the Russell 2000 over the Nasdaq during just 11 trading days in the middle of the month was the largest spread seen since the dot-com bubble. Factor measures of cross-sectional momentum dropped heavily, and we saw a substantial unwinding of the carry trade in foreign exchange, marked by a more than 6% appreciation of the Japanese yen against the US dollar.

And now what? Excess positioning in crowded trades was cleared in July and for investors the confirmation that the economic backdrop is indeed softening is as important as an actual policy decision on the day. Often, the hardest periods to navigate for hedge fund managers are those first signs of hesitation at the end of a run of risk-on market behaviour.

Is this market hesitation temporary, or will a more negative narrative become entrenched? Our industry's main role is to provide investors with diversifying sources of return. Therefore, it's often wiser to be cautious during these initial wobbles to avoid failure to diversify during a potential prolonged downturn.

Navigating cutting cycles that aren’t driven by large systemic stress is tricky. The old saying that rates rise on the escalator and fall in the elevator looks unlikely to hold this time around. Market expectations now include one rate cut at each of the next three Fed meetings, albeit with only a small probability margin for December. Even policymakers find parsing economic truth from fundamental data to be an inexact science. Over the last two years, small misses on inflation, jobs, and growth data have disproportionately affected short-term monetary expectations.

It is telling that it has taken seven paragraphs to get to politics. The Labour victory in the UK election and the lack of a majority for the far-right Rassemblement National in France at the start of the month feel like a long time ago. Since then, we have had an assassination attempt on Donald Trump, and President Joe Biden choosing to stand down from the US presidential election campaign. However, despite these seismic shifts, markets remain focused on the fundamentals, and the forward path of monetary policy continues to dominate fiscal policy for the time being.

We expect this to continue and see the path and pace of rate cuts in the US (and, to a lesser extent, Europe, the UK, and other developed countries outside Japan) as the main driver of market volatility over the next few months, regardless of what happens in November.

Key Drivers of Hedge Funds Performance: An Early July Snapshot

Equity Long/Short:

• July was marked by funds de-grossing and wider risk unwinds. Interestingly, equity long/ short funds didn't cut back as much as during other recent periods, with most equity risk unwinding coming from multi-strategy funds, commodity trading advisors, and longonly investors.
• The IT sector, especially software, tech hardware, and ‘AI beneficiary’ stocks, along with industrial stocks incurred the worst selling pressure in July, with investors selling more of their long positions than they were buying back to cover their short positions.
• Equity long/short fund performance was muted in July but not weak enough to present as an outlier at the strategy level. Asia-focused funds and those with heavy weighting in the ‘AI beneficiary’ theme struggled the most, while those with more diversified exposures posted flattish returns for the month.

Credit:

• Credit markets were relatively stable against the backdrop of volatile equities and rotation from large caps to small caps in the US. Lower bond yields helped boost credit returns.
• Corporate credit managers saw another month of mostly modest and largely positive returns.
• Convertible bonds did well as market volatility increased and credit spreads remained stable, although the travel, leisure, and automotive sectors performed poorly. Primary bond issues and refinancing took a breather after a strong couple of months.
• High yield long-short and capital structure arbitrage strategies performed well, but some managers faced losses from their interest rate and credit hedges.
• Carry and modest mark-to-market gains in certain sectors drove positive returns for structured credit managers.

Event Driven:

• July has seen good returns from event driven managers despite flat to down markets. Performance was driven by positive developments in ongoing transactions and a general narrowing of spreads. Several deals have (near-) completed, including Altium, Equitrans/EQT, and Westrock/Smurfit.
• New deal activity has been decent considering the generally quiet summer months, with activity in North America ahead of Europe and cross-border. At least seven new deals above $3bn were announced, including Enstar/Sixth Street and Paramount/Skydance, both in the $5bn range.
• An investor group backed by Permira and CD&R has made a buyout offer for cybersecurity firm Exclusive Networks. Grifols, the Spanish pharmaceutical under pressure from short-sellers, is in talks with Brookfield to be possibly taken private. Atos has reportedly made significant progress in concluding its $1.8bn restructuring plan with bondholders.

Discretionary Macro:

• Early estimates suggest a positive month across discretionary macro strategies in July, though we expect some moderation in the final numbers given the pickup in cross-asset volatility towards month-end.
• Long positions in emerging market local rates enjoyed a strong start to the month, notably in Brazil and South Africa, but many gains were lost as investors shifted to 'Trump trades' given the political news coming out of the US.
• Long positions in emerging market local rates enjoyed a strong start to the month, notably in Brazil and South Africa, but many gains were lost as investors shifted to 'Trump trades' due to US political news.
• Similarly, in currency markets, popular carry trades suffered losses as longs in Latin America were unwound while the Japanese yen, a popular funding currency, rallied strongly.
• Frustratingly, investors focused more on Japanese bonds, which saw less price movement compared to the currency. Meanwhile, selling off tech stocks led to losses in AI-related investments.

Systematic Macro:

• Most systematic macro managers struggled during July. Large moves in the US dollar and Japanese yen hurt their performance because many were long the dollar and short the yen.
• Most trend following managers were also positioned long the S&P 500, Nikkei, and Nasdaq, which suffered as AI and semiconductor-related stocks sold off. Alternative trend managers also struggled with losses in currencies, bonds, and energy markets failing to be offset by gains in long credit positions.
• More broad-based systematic macro managers also posted negative returns. Losses have been widespread across all asset classes. Carry and value-based strategies detracted, while more nuanced fundamentals-based signals also contributed to losses in July.

On the Radar:

• Over the next few weeks, we expect fundamental data and the earnings season to give us more indications of whether growth is softening. Even marginal negative surprises in inflation, jobs, or earnings in large-cap tech stocks could deepen the risk-off move.
• As the US election gets closer, market focus may shift from just the presidential race to the composition of the houses. The Senate looks set to go to the Republicans, so a strong Republican showing in both Presidential and House votes could see a clean sweep of Congress, leading to more market reaction to policy.
• Longer-term, we expect the conversation about the natural rate of interest (R*) to continue and there are some mixed signals. Longer-dated bond yields suggest that long-term inflation and interest rates will return to very-low single digits. However, economists point to geopolitical challenges and high government debt levels as drivers of a paradigm shift to higher inflation.

1. The Russell 2000 measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents the 3,000 largest U.S. companies. It is widely regarded as a benchmark for small-cap stocks in the United State

All data Bloomberg unless otherwise stated.