The Early View
Why We Welcome The Era Of Higher Rates

The market’s narrative feels well set. Corporate earnings are strong, companies and the consumer appear to be able to stomach higher interest rates without recession, and inflation isn’t coming down quickly enough to suggest central banks have oversteered. Ergo: higher rates for longer.

Markets and investors both seem robust. Equity markets quickly recovered in May from April’s sell-off, and positioning-driven market wobbles over the last few months have been digested without systemic contagion. True, momentum themes reversing course in the first few days of May was painful for trend-based strategies. However, this proved to only be a short, sharp, shock to some overstretched positioning; rather than the start of a material change. Similarly, ‘retail raiders’ re-emerging to target well-shorted stocks such as Gamestop was briefly concerning, but outside of a few hours of panic over the odd stock here and there, we saw significantly less impact than in 2021. Bonds are a little weaker, which is unsurprising given the growing expectation of ``higher for longer’’ and its associated softening of the yield curve inversion.

These constructive conditions are always at risk from an exogenous shock. Right now, commentators are worrying about the limits to the Japanese Central Bank’s buying program in supporting the level of Yen; whether the People’s Bank of China decides to devalue the Yuan; and, of course, multiple strands of depressing geopolitical risks which could quickly escalate to dominate the decision-making of market participants.

But to us it feels more likely that we will see a gradual shift in the underlying fundamental data undermining the narrative. What is that shift? Our view is that the most credible risk is a combination of weaker growth with more stubborn inflation. Neither needs to be sensational. It seems possible that the current episode of unusually high earnings will start to wane, as companies increasingly face higher borrowing costs. The refinancing of corporate debt was largely put on hold through 2023, as rates were high but faced (in extreme predictions) up to seven rate cuts in 2024. “Higher rates, for longer” changes that dynamic, and refinancing fixed-rate debt at a new higher rate could be a slow-moving dampener on corporate cash flow – and hence economic growth – over the next 18 months.

The inflation side of the argument is trickier, but several factors suggest that keeping inflation at or below target will be harder now than in the pre-COVID-19 period. What appears to be structurally smaller workforce participation, together with a falling tolerance for immigration in developed countries, may lead to continued wage inflation pressures for the foreseeable future. There is now more acute pressure on government spending in areas such as defence, decarbonisation and redressing income inequality than in the 2010s. This could act as both a fiscal stimulus and an inflation driver.

If this is true, it’s hard to make a strong long-term case for above-average returns from equities and bonds from here (at least, not as strong as for during the last 15 years). But we should welcome this in a healthy economic system. The zero-interest-rate policies and growing government-debt piles that supported asset growth for much of the last 15 years are somewhat counter to capitalism’s key principles. Positive real borrowing costs, responsible policy-makers and ultimately creative destruction in the form of corporate winners and losers are necessary for a well-functioning economy. As hedge-fund investors who ultimately leverage off the efficient functioning of markets, we welcome this new phase of higher rates

Key Drivers of Hedge Funds Performance: An Early May Snapshot

Equity Long-Short:

• Equity markets reversed course in May, and with that we saw a general improvement in performance across the equity long-short (ELS) space. Upside capture was a little below net exposure levels, as alpha generation was slightly challenged, owing mostly to the short side of the portfolio.
• Asia-focused long-short returns diverged throughout the past two months; China long-short performance recovered alongside a broader market rally while Japan long-short performance lagged amid alpha challenges. During May, we noticed signs of a more significant de-grossing in Japan – both outright and relative to other regions.
• Funds were net sellers of equities in May; selling on both sides of the book. Funds actively added to their short books, while slightly reducing their long positioning, meaning their gross exposure stayed relatively constant month-on-month.
• Prime brokerage data continues to show elevated exposure to the momentum factor. In addition, exposure to profitability and size has increased, suggesting that hedge funds are emphasising quality attributes and balance-sheet strength in a higher interest-rate environment.

Credit:

• It was mostly a positive month for corporate credit hedge-fund managers, with a few exceptions. Managers continued to participate in and benefit from refinancing and liability-management transactions across the high yield, loan and convertible bond markets. Capital-structure arbitrage (typically long-credit vs. short-equity) and outright high-yield stressed/distressed credit positions were generally profitable, with some of the gains offset by portfolio-level credit hedges.
• Hedged convertible bonds modestly appreciated in May. Financial preferreds performed well, driven by spread tightening as well as duration exposure, after a modest weakness last month. Primary markets were also active.
• It was also a good month for structured-credit managers, driven by price gains across most sectors as well as strong ongoing portfolio carry.

Relative Value:

• May was a mixed month for returns in relative-value strategies. In merger arbitrage terms, a number of interesting new deals were announced, e.g. Marathon Oil / ConocoPhilips ($17 billion), Banco Sabadell / Banco Bilbao ($13bn hostile Spanish banking approach), Squarespace / Permira ($6 billion software private equity bid). After Anglo American soundly rejected several improved bids, BHP officially abandoned the pursuit of its rival.
• There were positive developments across multiple existing merger transactions, e.g. Hess shareholders approved the Chevron terms, despite resistance from ISS and some fund holdouts. Altium / Renesas received several anti-trust clearances. Pioneer / Exxon and Morphosys / Novartis deals closed.
• However, the DS Smith / International Paper deal was a material detractor for event-strategy performance, after the acquirer became the target of a levered bid. As this potentially fragile bid is also contingent on International Paper dropping its DS Smith bid, it introduced a lot of volatility, and the spread now sits at ca. 21%.
• Nippon Steel continued meeting with US Steel stakeholders in ongoing efforts to win approval for this politically sensitive deal.
• In Japan, despite the softer equity market, idiosyncratic catalyst trades were profitable, owing to corporate restructurings generating growing benefits. Also, certain event trades in Korea and China were profitable. Event credit, particularly European credit, continues to see an interesting pipeline of debt tranche restructurings.

Micro-Quant:

• May’s performance was more mixed than that of previous months this year.
• Despite a mid-month wobble/mini-reversal, momentum has once again had a strong month from a factor standpoint. Strategies with exposure to higher beta, growth and volatile style exposures are likely to have prospered.
• Some machine-learning strategies struggled, while others generated muted positive returns. Alternative data-heavy strategies continued to perform well.
• Quantitative credit is up slightly over the month.

Macro:

• May was a mixed month for discretionary macro-strategy performance, with the average manager posting a negative return at the time of writing. Short positions in Japanese government bonds (‘rates’) broadly worked well alongside long holdings in equity indices and the metals sector.
• However, moves in yields later in the month generally worked against the strategies’ macro positioning. Long holdings in emerging market local-currency rates proving difficult, while we reduced our exposure to US rates considerably coming into May. In currencies, the EUR short positions detracted from performance.
• Trend strategies are likely to finish the month close to flat, rebounding from a difficult first couple of weeks where our short Japanese Yen and short bond positioning detracted from returns. The only positively performing asset class in May appears to be equities, where managers have maintained their bullish positioning across global markets. Alternative trend approaches appear to have performed in line with traditional trend during the month.
• Systematic macro performance was negative in May. Long-US-dollar positioning has been painful for many, others have struggled with their commodity positioning with long energies and short soybean exposures detracting.

On the radar:

• Looking forward from here, we are watching economic data closely. We are monitoring for signs of stress in the interplay between labour-force participation, wage inflation, corporate health (as measured by earnings and the rate of debt defaults) and the leading indicators for the Consumer Price Index (CPI) 6-12 months from now.
• Other ‘game-changers’ for the market narrative include: surprise political or central bank actions, not least from the People’s Bank of China potentially devaluing the Yuan. We remember the experience of August 2015 keenly, when a Chinese devaluation injected a dose of volatility into an otherwise multi-year equity bull market.

All sources Bloomberg unless otherwise stated.