A Gloomy Start to 2016 for Markets

Economies worldwide find themselves in a tough structural spot

Originally published in the February 2016 issue

Many of the best known hedge fund managers are grimly bearish, and Davos certainly amplified the gloom. It seems increasingly arduous to take the bullish side of the debate. We believe any sense of optimism is made much more difficult by at least three factors:

  • The number of independent drivers (including China, oil, central bank policy and politics);
  • The obscurity that shrouds them;
  • The lack of an historical precedent to which we can turn for help.

For a century or more, political stability and progress in the west has been premised on the hope that economic growth solves everything. Population growth, rising economic participation, increasing productivity and expanding levels of debt have sustained this approach until the global financial crisis erupted in 2008. But now, suddenly, we seem to have to worry about each of these factors. This year it has started to feel like we can no longer postpone the question as to how it will all end. We feel the sense of urgency is manifest in three main worries over central bank strategy:

  • Uncertainty about the direction of central bank policy, manifested in the Bank of Japan's negative interest rates, and policy uncertainty surrounding the Fed, ECB and People's Bank of China;
  • Perceived lack of coordination among policy makers leading to ineffective consecutive rounds of monetary expansion and competitive devaluations;
  • Market skepticism about the ability of central banks to use monetary policy effectively to reflate their economies.

Overall, there appears to be a growing loss of confidence in the ability of policymakers to generate growth. The myriad nature of the challenges central banks are grappling with makes it entirely conceivable that nothing much different could have been done; or would have led to a more salutary outcome. This highlights the tough structural spot most economies find themselves in and underscores the very real limits to what central bank governors can likely achieve. Markets may thus be hyper-sensitive to negative fundamental news.

In simple terms, the message is that markets may not be allowed to find their own levels; instead they seem to be sustained by a set of policies which we all appear to find less and less convincing. The volatility seems to be here to stay. The noise could be the signal.

Hedge funds
The HFRX Global Hedge Fund Index fell2.76% for the first month of 2016, after a sharp decline in investor risk tolerance amid big falls in energy prices and heightened concerns about China's economy. The January fall reflected large declines in global equity markets led by falls in Chinese stocks, while oil slid below $27 for the first time since 2003.

Of the four main strategy buckets, only the HFRX Macro/CTA Index recorded positive performance in January, capturing the decline in energy and interest rates as the USD gained against the RMB, GBP and CHF.

Equity long/short saw the biggest performance losses, with widespread declines across regions and sectors. Event driven fell as credit spreads widened, while distressed issues declined again from exposure to energy and basic materials. In relative value, performance losses were generated as high-yield credit and arbitrage deals spreads widened.

The following comments on hedge fund strategies are based on provisional data and analysis which may be revised as new information becomes available:

Macro strategies had mixed performance amid an overall risk-off environment. Several macro managers exhibited losses in fixed income and equities, despite cutting risk levels early in the New Year, while others recorded gains from the continued USD strength. Against this backdrop, central bank policy action – hints at further accommodation from ECB, BoJ negative rates, the Fed's pared outlook for growth and inflation – looked inconclusive.

Emerging markets strategies were mixed. Managers positioned short BRL benefited from Brazil's continued political turmoil and sub-par growth prospects. But managers with significant Asia equity exposure suffered on the big move down in Chinese equities and Japan's descent into a bear market. Meanwhile, several discretionary macro and emerging market managers enjoyed gains after scaling back into short Asia FX trades, featuring the SGD, KRW and THB.

The chief source of performance for managed futures strategies were gains in fixed income. Commodities and FX also contributed, although equities were a minor detractor and the JPY proved hard to get right.

In equity long/short, most US managers couldn't overcome the hefty -5.1% fall in the S&P 500 and the -8.9% plunge in the Russell 2000. Value outperformed growth, helping a number of managers that struggled in 2015 to post good performance. Overall, however, managers remain bearish.

European ELS managers also found January difficult, as the -6.4% fall in the Eurostoxx 600 Index meant there was negative beta. Unlike the bigger drawdown months in 2015 (such as August and December), managers struggled to make up for the beta losses from alpha. Managers generally weathered the first half of the month quite well, when the index experienced its biggest declines, but then struggled to add value as the index rallied. European managers, too, are increasingly bearish and mindful of rising systemic uncertainty in markets.

Early indications are that statistical arbitrage managers enjoyed a reasonable start to the year. Technical models look positive amid the heightened market volatility, while fundamental factor models were broadly positive across regions, with the pattern of positive momentum performance and value models a detractor continuing in January. Meanwhile, managers that run futures strategies will have had a boost in performance following the positive returns recorded by managed futures during the month.

Deal activity has generally been resilient to macro headwinds, but market volatility in January upset that trend with announced transactions falling to $220 billion. Still, two substantial M&A deals were unveiled. As both involved tax reduction strategies, we believe they highlight how regulatory and political risk must be part of any transaction analysis. Elsewhere, foreign acquisitions by Chinese corporates began the year strongly and then accelerated in early February. Event driven managers recorded a wide dispersion in returns with most producing negative performance, though pure merger arb managers performed well and were up on the month. Managers continue to like the wide merger spreads (right up until closing) in large, liquid, strategic deals, and those with flexible mandates are generally leaning towards hard catalyst situations.

In credit, as with other asset classes, the first week of January set the risk-off tone for the month with a global flight to quality and a corresponding rally in government bonds. US HY saw higher quality contribute to performance, but total returns were still negative even though around half of the intra-month losses were recovered after dovish central bank comments spurred a rally in stocks and oil. There was also a positive turn in retail flows after heavy outflows earlier in the month. For the most part, January reflected what we saw in 2015 as US HY underperformed EU HY, while leveraged loans as well as US and EU investment-grade markets performed positively in the rush to quality. Performance among credit long/short and credit value managers was mostly negative, except for those who were either underinvested or had a significant short bias. In structured credit, widening spreads meant returns were flat to negative, while in convertible arbitrage returns suffered on the poor performance of the underlying equities.