Most trading-oriented hedge fund managers question whether the strong 2023 and post GFC decade performance of the 60% equities/40% bonds portfolio is likely to continue, amid inflation, supply chain, geopolitical and demographic challenges.

Episode’s return pattern is different from forecasting-oriented discretionary macro, trend following CTAs and indeed systematic fundamental macro strategies. Episode has often profited during the months and years around reversals that have wrong-footed other hedge fund and traditional managers.

Reacting to irrational, behavioural and emotional extremes

Valuation anchors views but these are only actioned when behavioural analysis indicates opportune timing. Fishwick welcomes the conflicting and sometimes false signals in a more volatile macro climate: “If investors remain confused between strategic and cyclical as well as temporary myopic issues, we should find good opportunities from behaviour and emotional dynamics. Rather than forecasting, we are more interested in responding to excess price volatility because markets are very human and irrational. People want to frame fundamental explanations, such as AI explaining Nvidia performance in 2023, but investors reacted differently in 2022. Information is not interpreted in a static way because price action depends on how people feel”. Indeed, between late March and late April 2024, Nvidia saw a 20% pullback, absent any announcements, illustrating the point (even though Episode does not trade single stocks).

Fishwick sees no need to rationalize any sort of price action and would rather react to it: “There are always surprises and big market moves without any data or headlines. Markets are on a constant price journey of endogenous uncertainty and the hugely difficult question of how to price risk within a massive range of fair value. Markets move within bands of fair value for no reason”. Fishwick often alludes to academic research, and endogenous uncertainty is fashionable in analysis of macroeconomics and credit crunches.

He continues, “Turning points are often more about emotion than any fundamental catalyst or earnings stimulus. When we see extreme negativity, we see a better than normal chance of a rebound, even if there is no news. We are humans not robots. We are disciplined on valuation and when we make calls at turning points it is emotionally challenging, and we always feel super uncomfortable with how difficult and contrarian it feels”.

US versus non-US equities

A valuation gulf indicating a high probability of some reconvergence has inspired a short US and long selected non-US equities trade for part of 2024. The valuation disconnect still applies after adjusting for the sector mix, where the US has a higher weighting in more richly valued growth sectors such as technology and healthcare, and the gap is greater after cyclically adjusting China’s depressed corporate profits. From a portfolio construction perspective, Fishwick judges that the value markets outside the US should be less sensitive to higher for longer or higher rates.

Clearly, AI explains part of the gap and Fishwick does not necessarily question the materiality of AI for productivity and economic growth. He is more interested in the pricing of it and will be watching out for very rapid price action, but currently judges that, although US valuations are pushing limits, the situation is nowhere near 1999 extremes.

Referencing and recency bias may help to explain the behavioural investor preference for US equities. “The experience of the last decade is that US growth has been vastly superior, and this is deeply embedded into the market psyche. Last time, in 1999-2000, it took 5-6 years to work out and emerging market tech massively outperformed US tech,” recalls Fishwick.

2024 is not however a ‘Minsky moment’ and the trade is modestly sized because emotions are not at extremes. “There is a big equity valuation gap but there is no talk of bubbles or capitulation, and longs bar China are not unloved. We do not see an imminent collapse and the short size is much smaller than the 80% short global equities we had in 2000,” Fishwick points out.

The small US equities short is far from a broadly bearish call and is being actively and tactically traded. “In early 2024 we have been net long of equities in aggregate, having added equity exposure in October 2023 (echoing October 2022), and doubled China and Hong Kong equity in January 2024, but we also reduced it as earnings yields compressed,” says Fishwick.

Contrarian China equities call

With various funds, such as Sweden’s AP3 government pension fund, publicly saying they won’t invest in China, and net outflows from foreign investors, some may ask who the marginal buyer is, or the catalyst, for Chinese equities? Fishwick does not care and argues that, “Philosophically we do not need transactions for markets to move. The market can reassess the right price without any transactions or large volumes. We have seen some gap up price action since January without any news, just as it previously dropped without any real news. It has been going up simply because it stopped going down. Autoregressive markets correct overshoots in the short and medium term”. Once again, he hints at academic research.

There was no specific catalyst for Episode doubling the China trade in January 2024, but they judged it was an emotionally extreme event. “Correlated moves across sectors without any sector specific price action, such as the previous property driven declines, increased our confidence that this was emotional capitulation,” says co-portfolio manager, Stuart Canning.

Chinese equities have sometimes generated triple digit rallies, but Fishwick is not swinging for the fences: “Our China position is highly tactical and episodic. We may exit after a 15-20 percent increase,” he admits.

Non-US equities value basket

The largest long equity exposure is China, but there are also some other value equity markets. A contrarian position in US banks taken in late 2023 was replaced with Eurozone banks. The basket has also included UK, German, Mexican and Brazilian equities. “European banks still look cheap and discount a big period of stress. The others are also cheap markets, and there is also a negative narrative around the South American ones,” says Fishwick.

Long bonds picks points on the yield curve

At the big picture level, Episode reversed from short bonds during the huge and rapid move in 2022, to long bonds in late 2022, followed by a pause, before building longs prior to early November 2023. But the nuances distinguishing these trades are important. “Our 200% short in the 5-year in 2022 was a dangerous place to be for ex ante risk forecasting, and we did not expect such a big jump, though the yield curve move was less surprising. We switched to long in late 2022 after the yield curve inverted. The 2023 longs were notionally smaller than the 2022 shorts, and they focused on a different part of the yield curve,” explains Fishwick.

On September 28th 2023 the fund allocated about 70% long to a mix of US 30-year, UK 10-year, and German 30-year bonds. In early November, duration was increased further through the addition of US 5-year and a basket of emerging market government bonds, before long exposure was scaled back following yield declines that same month. Diversifying long duration exposure helped reduce the 2024 giveback of performance from the backup in rates, and the US equity short was also somewhat related. Fishwick admits that, “The equity short is partly to balance the risk of being long and wrong on bonds, though it is not a hedge per se. I lost faith in relying upon hedges earlier in my career when I discovered they often did not work”.

A further nuance is that the current bond position also contains its own internal differentiation, with potential elements of a growth versus recession straddle or barbell under some scenarios. “The US 5-year might rally on a growth shock. Conversely, while it would suffer from expectations of tightening (or delayed easing), if that led to recession fears, the 30-year could even benefit and cause the yield curve to further invert,” explains Canning.

Inflation

Just as Fishwick judged real rates were too low in 2022, in September 2023, the team judged yields were too high if inflation stayed around 3%, or only 1% above central bank targets. “We anchor price against valuation, and also expect to be right on medium term value. We were trading an episode against myopic investors,” says Fishwick. He is prepared for inflation surprises in either direction because some factors suppressing it for 25 years remain – pricing information, technological change, regulation and competition – but there are also pressures such as tight labour markets that could reignite it.

Dynamic currency carry trade

Episode’s short Yen profits have also been made by trend following CTAs, though it was a very contrarian trade within the discretionary macro community. “There was a deep consensus last year that shorting JGBs and buying the cheap Yen would be good trades, even in our office. But the Yen is a two-sided trade, and the US rate shock was a bigger one than the Japanese end of yield curve control,” recalls Fishwick.

Episode’s dynamically customized carry trade basket has continued to perform well throughout both 2022 and 2023. This flies in the face of extrapolative historical statistical analysis, which suggests that carry trades should perform badly amid US rate rises. “In fact, a carry trade using only the USD as a funding currency has not been a very strong performer, but our funding basket using other currencies, including the Japanese Yen, has done much better,” points out Fishwick.

The carry basket is also dynamic on both the short funding side and the long earning side. It has opportunistically picked up the South African Rand when it sold off on political news-flow. The Hungarian Forint, Polish Zloty and Chilean Peso were removed from the long side simply because they offered less carry after their rate cuts. The trade is based on spot interest rate differences and is not expressing an opinion on mispricing of forward rates.

The currency carry trade has also done well in some periods partly because it includes some indirect commodity exposure via commodity exporter currencies. Episode does not trade physical commodities.

How to harness economics

With overall levels of exposure well below historical averages in April 2024, current trades could be upsized, or new ones started. This may happen if more extreme episodes materialize, but not due to confidence in precise forecasting.

The team, some of whom have worked together since the late 1990s or early 2000s, share a scepticism about the power of forecasting that derives from Fishwick: “When I started at Prudential in the 1980s, markets often did the opposite for forecasts due to exaggerated price responses. I was humbled at many levels early in my career about what it is possible to know. We therefore major on surprises and de-emphasise forecasting”.

Naturally, Episode are forecasting asset prices in some kind of implicit or explicit way. “We must have a view on earnings and prices. But we do not want to exaggerate our prowess at economic forecasting. We use economists in a different way, more to gauge consensus forecasts and beliefs, and study trends, patterns and regimes than to obtain an edge in forecasting,” says Fishwick.

Episode’s regime sensitivity is somewhat longer term than some quant strategies programmed to shift exposures based on multi-week or month regimes. “Our economists think about longer term regimes, including the impact of AI on inflation, fiscal spending and bargaining power of labour, to assess if price moves are excessive. We are sensitive to multi-decade regime and valuation shifts. Bonds could have looked expensive from a systematic perspective in the 1990s, but the world had changed. We always look at regimes and value anchors,” says Canning.