Those of us in the UK, as the stereotype goes, enjoy nothing more than talking about the weather. February has proved a fertile environment in this regard – shifting from snow at the start of the month to record temperatures of over 20 degrees Centigrade as the month draws to a close. Financial markets seem similarly disjointed. Government bonds have continued to rise through 2019 in much the same way as they did in the fourth quarter of last year. By mid-February there was a record USD7.9 trillion of government bonds trading on negative yields, much more than at any time during QE. Looking at the bond market since the start of the year you’d be forgiven for thinking that we were in a ‘flight-to-quality’ regime – but not many of those come with an 11.5% return to the S&P 500 Index.
So what’s going on, and what has changed since Q4? There’s not much of an answer in the fundamentals. Global growth (as shown in PMIs) has been fairly weak, and the corporate landscape is generally one of falling earnings expectations (though, in our experience, this tends to lag the market rather than lead). We have pressure on both sides of the price to earnings multiple, and the CAPE Shiller PE Ratio for US equities is now back above 30x.
Perhaps the biggest change has been the substantially softer rhetoric from central banks, which twinned with the significant step down in breakeven inflation through the fourth quarter of last year goes someway to explaining the level of bond yields. When you factor in the softening of the trade war tensions, and an active management industry that had significantly deleveraged through November and December, things start to click into place. Is it surprising that investors are now willing to pay a high multiple for stocks that might either be a source of growth (that scarcest of commodities these days) or that pay a dividend in excess of the carry available elsewhere in the investment landscape? Credit spreads have also tightened materially since the start of the year, and behavior across markets points to a hunt for carry in various formats (indeed, intra-equity moves saw higher-yielding companies outperforming).
Against this backdrop, the gyrations (rather than the level) of the equity market also start to make sense – market valuation in a low rates world is an inherently unstable business. One can build a narrative that sees inflation continue to surprise on the downside, lower but still positive global growth, and an ever-tighter hunt for yields that sees equity markets continue from here without any real improvement in corporate fundamentals. Why not have valuations at 40x earnings when there is nothing else to do with the vast swathes of money generated by the central banks over the last decade? Why not buy equities when you can make as much in capital appreciation over two months as you would receive in carry over the next 25 years holding 30yr German government bonds?
The instability, of course, comes from the necessary conditions of this narrative. We saw in February and October that at high valuation multiples it is easy for the market to get spooked by the first whiff of inflation (we’d encourage readers to dust off a copy of the September 2018 Early View which outlined these thoughts in detail). And while US 10yr breakeven inflation fell from around 2.1% to around 1.7% during the fourth quarter, this has now crept back to 1.9%. The oil price has followed a similar path. Powell has made it quite clear in recent comments that he is more concerned by asset prices than by inflation – so maybe the world can tolerate higher inflation without higher rates (at either the short or the long end of the curve). After all – most of the developed world has accepted negative real rates on their long bonds for some time now, would it be that much of a surprise if the US followed suit? It’s possible, but as we’ve seen from the difficulty of European and Japanese indices to regain their pre-2008 highs, such a path may only add to the longer term instability of US equities.
It has become something of a cliché in these letters to dance around the recent market behavior (whatever that may be) and then conclude that the answer is to buy hedge funds. In a break from tradition, this month we will be more nuanced. While we aren’t forecasters, the expected volatility from all asset classes is, in our view, higher. Finding the correct relative valuations of different asset classes in a low growth and low rate world is really difficult and unstable at that. We think that sharp moves of +/-20% in an asset class will be both more likely and harder to forecast. In such an environment, diversification is king. One doesn’t need to say that the return to skill based investing (that elusive ‘alpha’) will be better or worse than in other periods, but we would encourage readers to focus more closely on two things: 1) the correlation of their risk asset betas; and 2) the correlation of their ‘alphas’ to their risk asset betas. Where they can find truly diversified alpha sources, we believe these will have an important role to play in their portfolios over the next few years.
Hedge funds posted gains once again in February to continue the positive start to the year. As with January, this was bolstered by those strategies that carry risk asset exposure (notably in the longer biased equity, and credit mangers). However, unlike January, this month risk asset beta was accompanied by a healthy run from trend following strategies. Within the equity market, there was reasonable alpha available to market neutral stock selection strategies in the first half of the month, before drying up in the second half.
Equity long/short managers had a positive month in February, helped by: the continued tailwinds from January; higher equity markets; falling volatility; broad outperformance of small caps over large caps; and an expansion of the aggregate gross book across the industry following heavy deleveraging in Q4. The last point is particularly relevant, as more popular hedge fund trades have generally outperformed the broader market, at least on the long side of the book.
As we alluded to above, the earnings season has generally been quite mixed from a corporate perspective, with a softening of earnings expectations across the board, but more signs of shareholder friendly behavior (such as share buybacks) to temper the weaker news. Stocks continue to react significantly post earnings announcement, but managers are reporting more rational pricing i.e. stocks that beat earnings estimates are rallying and holding onto gains. Managers remain cautious on the overall outlook for equity markets, and have generally increased gross exposure more than net, although there has been a small increase in beta across the equity long/short universe.
Statistical arbitrage managers were able to generate positive returns in the first half of the month, and most held onto this rather than improving upon in the second half of the month. This was predominantly from technical models rather than fundamental strategies, with broker models suggesting negative performance from basic factor models.
Similar to equities, credit markets continued to build on robust January gains. US high yield and leveraged loans as well as the European high yield market posted another noteworthy month in February. In US high yield markets, there were once again persistent returns across the rating spectrum with most sectors up in the month. Though on the mend, gross US high yield and leveraged loan issuance remains meaningfully lower year-over-year given the slow start to 2019. However, net new issuance is now in line with last year. Fund flows remained mixed in February with high yield funds enjoying inflows while outflows continued from loan funds.
Against this backdrop, corporate credit managers were largely positive in February with a number of idiosyncratic P&L drivers including the late-January bankruptcy filing of a gas and power company, where we expect managers to be increasingly involved over the coming months. The completion of the Puerto Rico COFINA restructuring and the announcement of the largest bank merger in a decade (with positive impact on bank capital securities) were other notable drivers during the month.
In the structured credit world, spreads across most securitized products sectors were also tighter in February, but lagged the significant rally in corporate credit. Credit risk transfer and CMBS sectors outperformed. Returns for structured credit managers were driven largely by principal and interest income, with corporate credit and equity hedges offsetting the modest mark-to-market gains.
Event driven managers broadly generated positive returns. Most continue to ramp up portfolio exposures as deal activity remains robust in the US and the regulatory backlog from the US shutdown continues to clear. European activity continued to be weighed down by Brexit uncertainty. The main driver of performance was the soft catalyst event books, which continue to perform positively on the back of equity market strength.
For macro managers, the month was far less interesting. As we have mentioned, both the yield curve and the USD were relatively stable (indeed the MOVE index is now back close to all-time lows), and equity up is not necessarily an environment all that conducive for macro strategies. The most relevant topics for managers continue to be the Fed rhetoric; continued improvement in US-China trade negotiations; and the policy rate divergence between developed and emerging economies – most EM countries have been easing (Brazil, India, China, and Russia), Mexico is the exception. Many have also commented on the new record amount of sovereign bonds with negative yields (USD7.3 trillion).
While discretionary macro was contained, February was a positive month for trend following managers. By asset class, Equity and FX were generally positive, while fixed income and commodity trading were flat. In equities, long positions were broadly positive as major indices drove higher throughout the month. Most managers switched their US equity exposure from short to long at some point between mid-January and early February, and benefitted from the continued rally in the equity market. In FX, most managers were positive as short JPY, EUR and AUD exposures made gains. In fixed income, long positions in Australia, Germany, and the UK were positive while long positions in the US detracted. Commodity exposures were more varied across managers, however in aggregate, positions in energies detracted and short positions in wheat and coffee contributed.
Man FRM Early View
Originally published in the February | March 2019 issue