Man FRM Early View

July 2019

Originally published in the August 2019 issue


Markets are dangerous when we all agree about what’s going on, and in these dog days – of Summer for those of us in the Northern hemisphere – we have built a lazy consensus of striking proportions. At the heart of this consensus is the idea that inflation is dead. Properly dead. Part of what lies behind the inflation story is the gloom about the manufacturing outlook, pretty much everywhere. People say that from the awful numbers out of Germany to the collapse in the cost of freight it all starts with China, where to compound their more observable problems there has been a contraction of the monetary base. Monetary contraction has been somewhat global too, but now the Central Banks it seems, are in widespread agreement that it is time to ease again.

Markets have been reading this writing all over all the walls, and drawn the obvious conclusion: everything that matters had to go up – a lot: lower rates lead to higher bond prices, clearly, which in turn encouraged expansion of PE multiples and contraction of risk premia. With a 60:40 portfolio you might be up 15% this year provided you didn’t try to do anything too clever. Better still, take a profit here and lock in the returns for the year. Go to the beach without a phone. Various measures of equity outflows show that this has been going on at a lively lick all year.

So wherein lies the danger of the consensus this time? The risk is in the degree and timing of the ease. The US rates market (and The President) have been very aggressive in their expectations for multiple cuts, and certainly more than the FED seemed willing to endorse. This stand-off is tricky and introduces the material risk that as far as the risk asset markets are concerned there is no right answer to the course of monetary policy. The problem is further increased by propensity for global trade to tip quickly, one way or the other. With China a keystone in the arch of debates both about the slow down and trade, the Central Bank task is unenviable.

Given the way survey data is collected, it is quite hard for some of the indicators to stand still at this point and there are two troubled scenarios to negotiate: the first is that we follow through into a full recession, in which case the equity market is too high: the point has been well made that easing only averts the recession about half the time. How much leverage do the Central Banks have anyway – in Europe, for example? At least in this scenario the bond positions survive and some equity profits have been taken. But this requires that the consensus is rewarded, and not least among the reasons why markets tend not to be that kind is that it’s not how they work: it is your next trade that moves the markets, not your last one.

The other risk is that the global Central Bank ease hits just as the growth was about to bounce anyway. As one group here at Man argues, the conditions for recession are just not there: inflation is not accelerating; margins are not down; real rates are still close to zero; the curve is not inverted; credit spreads are not widening; unemployment is not rising. But their leading indicators of a bounce most certainly are. And it’s not really about manufacturing anyway: we should be more focused on services which don’t look nearly so sickly. The consequences of excessive stimulus at this late stage of the cycle would be elegantly catastrophic: the Central Banks would find themselves wrong footed with real problems getting in synch again. Investors get forced back into equities higher up, then they get forced out of bonds lower down and finally they have to sell the equities…again.

Alpha production is not easy in these conditions, and the returns from value based trading are still weak. The hedge fund industry has seen material outflows this year as it pays the price for a period of underperformance culminating in the failures of 2018 when traditional markets were almost universally horrid. The exception this year is that strongly directional markets such as these are good for momentum traders. (And there’s nothing like a bunch of articles announcing the death of a strategy to get it up out of the ashes.) CTA returns have been good this year, and on the face of it, they may yet be good looking forward too: stick with the trend until it turns and then reverse it quickly. How else to manage a bull market in its latter stages? Not uncharacteristically, they have mostly made more than all their money in rates products this year and lost small amounts everywhere else…

…except sterling, of which I suspect they have been short for a while. We try to keep talk of politics out of these pieces, but the deterioration of the outlook around Brexit in the first few days of our new prime minister has caught even the market cynics by surprise. Please, spare a thought for us, on our island, as the oceans rise and Britannia slips below the waves it once so (insert your own adverb here) ruled. Actually for us there’s nothing new in a falling pound. Even back in the 1970s if sterling ever ticked up, the cable trader on the spot foreign exchange desk would call out ‘proud pound, strong as an ox!’ and his team, a chorus of spotty youths with sharp haircuts and shiny suits, would shout back ‘yours!!’ in an atavistic echo of the sailors’ labouring songs as they hauled the ropes on the great imperial warships. But, to adapt the disclaimers at the end of this piece somewhere, hedge funds can go up as well as down, even when the markets go down instead of up…even British ones.

Hedge Funds

Hedge funds enjoyed a continuation of their recent positive performance in July, as both equities and bonds broadly ground higher during the month, although returns to factor driven equity market neutral strategies remained challenging. Credit and macro strategies both posted positive returns in aggregate, with mixed but generally positive returns from equity long-short and relative value strategies also.

In equity long-short, world equity indices were broadly higher in July following the strong rebound in June supported by a combination of expectations for central bank easing and Q2 earnings that have been better than downwardly revised. With more than a third of companies reporting thus far in the US and Europe and more than 10% having reported to date in Japan, initial results indicate a positive earnings surprise of between 1% and 5% in all three regions.

From a hedge fund perspective, Goldman Sachs reported exposure levels have remained elevated with gross and net leverage of their prime brokerage clients each currently in the 96th percentile on a trailing 12-month basis. Performance was broadly flat to slightly positive, driven by world equity beta and, to a lesser extent, momentum exposure. Crowded positions also continued to perform well with the GS VIP list trading 3% higher and is now up 26% YTD.

Equity factors continued their recent trends, as growth continued to outperform value by over 100bps on the month in US markets (and extends the outperformance on a YTD basis to >1000bps). By S&P 500 sector, Information Technology and Communication Services led while Energy lagged. Large caps outperformed small caps and emerging markets lagged.

Event focused managers benefited from the broad opportunity set in corporate activity in July. Merger transactions continue to progress, with Fiserv’s acquisition of First Data closing during the month and the deal spread between Anadarko Petroleum and Occidental narrowing as confidence of completion increases.

It was a fairly quiet month in credit, with most managers posting small gains. In US HY, higher quality bonds, despite the small backup in treasury yields, modestly outperformed lower quality credits, maintaining the trend for the year. Unlike June, when all JPM US HY industry groups were positive, returns were a bit more mixed in the month. Energy sector was an underperformer given the softness in crude oil prices. In addition, several credits in the sector performed poorly driven by idiosyncratic factors. Leveraged loans, after underperforming relative to US high yield through the first half of the year, narrowed the performance gap in July helped by light primary market issuance, moderating outflows and a strong secondary bid from CLOs.

Spreads across most securitized products sectors, with the exception of CLOs driven by supply, were flat to modestly tighter in July, but underperformed the tightening in corporates. Legacy residential mortgage backed securities sectors were relatively range bound while the agency credit risk transfer sector saw meaningful spread tightening in July. Structured credit manager returns in July were largely driven by carry with losses from hedges offsetting some of the mark-to-market gains in the month.

Discretionary macro manager performance was flat with some managers benefitting from positions in long USD and long European rates. Global growth concerns remained on managers’ radars as geopolitical uncertainty continued with the ongoing US/China trade war, the leadership transition in the UK and protests in Hong Kong.

The hunt for yield was on full display in Europe as Italian and Greek government debt rallied sharply in July – Italian 10 year debt yields falling ~50bps in July and Greek 10 year bonds in line with US 10 year bonds in yield terms. USD strength relative to other developed market currencies while emerging market FX performance was more mixed and relatively flat for the month in aggregate. Commodity market performance was mixed with liquids and agriculturals generally down mid-single digits percentage points while metals were mostly higher led by nickel and silver. Rates volatility (as measured by the MOVE Index) fell sharply after showing signs of life in June while FX volatility remains extremely subdued.

Trend following managers generally continued their positive 2019 performance so far, with gains in July from equities, bonds and FX. In a number of cases, the returns from FX exposure outweighed the better-publicized gains from long positioning in equities and bonds. Returns to commodities was generally mixed to slightly down for most trend-followers.