Barring a significant polling shock in the second round of the French election, Macron winning the French presidency would seem to usher in a new era of confidence for risk assets. We are not so sure.
Beyond the brief respite from political worries, the positive case rests on the current state of global growth: it is broader, more robust and more sustainable than at any point since 2008. Emerging Markets are a growing component of that growth, but even there the issues around balance of payments and commodity dependency seem to be less prevalent than they have been for much of the last few years.
The problem is how Central Banks react to this better landscape and the implications for the risk free rate of return. Hidden in all the excitement around the French election were robust Purchasing Managers’ Indices and earnings data across the Eurozone. A Macron victory may be the last piece of the puzzle for Draghi to begin tapering Quantitative Easing at the June European Central Bank (‘ECB’) meeting. Add to this a snap UK election, which if polls are correct will give the Conservatives a stronger majority, and we could see the Bank of England (‘BoE’) reverse the emergency moves it introduced after the Brexit vote last summer. In this view, we have a world with three of the major Developed Market Central Banks reversing the policy of the last decade.
So perhaps the change in the direction of travel from Central Banks is now upon us (in hindsight, it clearly wasn’t in December – the Federal Reserve (‘Fed’) raising rates matters little to global risk assets when other Central Banks start pumping harder in their place), which may mean more normal markets: a higher risk-free rate, Bond yields up from their record lows, and Equity markets reacting to bad news without an enormous bid waiting on the side-lines to buy the dip.
We believe Central Banks will taper and raise rates with caution, little-by-little, and not be afraid to reverse course if necessary. But the combined effect of all Central Banks turning could be uncertain in the extreme. In our view, economists have for too long been able to ignore the lack of productivity gains since printing money has no downside in a period of sluggish growth. The balancing act between stifling the recovery through normalizing too quickly and allowing inflation to get out of control would be hard enough for a single Central Bank, but for a range of Central Banks to deal with this problem in concert could be a recipe for mistakes and uncertainty. If nothing else, the unshakable confidence in Central Banks to do the right thing, which we all had when they were easing together, might be tested as they try to turn the super-tanker.
This is important for risk assets, since the most obvious explanation for the potential over-valuation of Equities is the amount of cash pumped into the system by the Central Banks since 2008. Is it any wonder that markets have failed to consolidate any sell-off in the face of any bad news for the past few years? Or that volatility of Equities continues to scrape against record lows while the Chicago Board Option Exchange (‘CBOE’)
Global Economic Policy Uncertainty Index has reached the highest level since it began 20 years ago?
While the normalization of policy (and the risk free rate) may be a problem for risk assets, we have been saying for some time that we believe this could potentially help with hedge fund alpha. The historical connection between the Bond yields and hedge fund alpha was reaffirmed in April – for the first half of the month Bond yields compressed further and hedge fund alpha generally struggled, and then through the last week of the month alpha appeared to recover as the Bond rally faded and yield rose. We don’t think this is an Equity beta effect, since these returns were most pronounced in Macro managers who don’t trade a lot of Equities, or in Relative Value, Statistical Arbitrage and Equity Long-Short, where we can measure the impact of beta more closely.
So why are Bonds not moving further if the economic landscape is so good? Remember, the US 10yr Bond yield fell by around 10 bps over the month of April, recording the lowest monthly close since the US election. Well, perhaps the problem is that we are still in transition: for the first three months of 2017 the combined asset purchases of the Fed, ECB, BoE, Bank of Japan (‘BoJ’) and Swiss National Bank (‘SNB’) was $1 trillion – the fastest three months of asset purchases by Central Banks in history – and no matter how much the street wants to be short Bonds, it seems difficult to fight that kind of buying power, especially, in our view, with disruptive events like the French election in the immediate vicinity.
This doesn’t change our longer term thesis that the potential for macroeconomic alpha may be available from dispersion of policy. As different Central Banks react differently to the challenge of implementing tighter monetary conditions, then there could be many periods with Banks moving in different directions. Or at least, the missteps by one or more Central Banks may be seen as sharp swings in relative Forex (‘FX’) and Government Bond pricing. Higher rates may also bode well for more rational pricing of individual Equity and Credit securities.
And, of course, the French election is not a done deal. Macron is the best of a bad lot in our view, but he was a distinctly unpopular Finance Minister who doesn’t have a party apparatus, and who has been performing poorly in winning further public support since the first round of the election. Should Le Pen pull off the biggest of all the political shocks of the last 12 months on May 7, then we can tear up everything written above. But a Macron victory might not be quite the panacea that markets seem to be expecting.
Hedge funds experienced a mixed month in April, as Credit and Equity Long-Short managers generated minor positive returns, Relative Value strategies were mixed and Global Macro strategies generally struggled.
In Equities, the first half of the month saw a period of risk-aversion ahead of the French election and this was generally negative for hedge fund alpha. However, in the two days following the benign first round result of the election, we saw positive contributions from alpha and beta across Equity Long-Short managers. In general, this effect was greater in European managers than US managers, where the market has continued to struggle to price policy changes by the Trump administration.
Global Credit markets were positive in April as risk assets generally performed on reduced tail risks after the results of the first round of the French elections. US High Yield outperformed leveraged loans as new issuance was fairly light and Treasury yields were lower on the month. Most US HY sectors were positive for the month with the Healthcare and Utility sectors underperforming other sectors. As has been the case for the past few months there continued to be some negative performers in the Retail sector driven by poor fundamentals.
Corporate Credit managers were generally positive in April driven in part by positive idiosyncratic events with several credits in the Energy sector despite a softer underlying commodity backdrop. Post-reorganization Equities were a positive contributor for many managers. The Puerto Rico municipal complex also staged a partial recovery after posting steep losses in March. Returns were also positive for many Structured Credit managers. The non-agency residential mortgage-backed securities (‘RMBS’) sector continued to perform well driven by noteworthyfundamentals while returns for the collateralized loan obligation (‘CLO’) mezzanine sector which has been a robust performer YTD were more modest in April. The synthetic CMBX index recovered somewhat from Q1 losses and was a drag on performance for some managers along with the rate hedges.
April was a poor month for Managed Futures, with negative returns posted in Equities, FX and Commodities. Equities were the worst performer this month, with negative performance across regions, ending the positive streak for the asset class this year. Managers generated positive returns in Fixed Income with those that have a greater carry component in their strategies managing to outperform peers. Within Commodities, Energies and Industrial Metals positions were detractors.
Discretionary Macro managers had mixed performance in March, with many managers suffering from holding a short US rates bias. Financial conditions have eased given the March “dovish hike” which provided managers with opportunities to add to bearish rate positions. There has been substantial discussion on the System Open Market Account (‘SOMA’) reinvestment of US Treasury (‘UST’) and mortgage-backed security (‘MBS’) proceeds, though many managers seem to believe the market is somewhat complacent on the pace of Fed rate hikes. Fed underpricing may be a result of investors fearing the unwind of the post-election reflation trade and the recent decline in Commodity prices. Some Macro managers continue to maintain longs in gold futures as a hedge to their Fixed Income / USD positions.
Many managers reduced directional risk overall coming into the French election, particularly rates and FX. Potential election specific hedges such as French Government Bonds (‘OAT’) versus Bund wideners or EUR/USD puts resulted in losses, though some managers gained from pro-Macron positions such as buying calls on Eurostoxx financials and long Nikkei.
Emerging Market (‘EM’) risk assets continue to trade higher with the current inflow into EM-dedicated funds now lasting 12 weeks taking YTD flows to $25 billion. While EM has benefited from both an unwind of US reflation as well as a perceived reduction in risks around protectionism, political risk in Latin America continues to remain elevated in our view. Price action in EM FX remained dispersed, however, and some EM managers suffered losses in long BRL and MXN. The Peso, for example, on April 26 had its worst single day since January, selling off 2% on headlines that President Trump was considering legislation to leave North American Free Trade Agreement (‘NAFTA’) (only to be reversed hours later). The aggressive price action in EM FX pairs suggests that positioning remains active in the space.
April was a favorable month for Statistical Arbitrage strategies. Fundamental strategies generally had a positive month, particularly those managers with a concentration in Asian markets, where both Value and Momentum based signals continue to be attractive. Other regions were more mixed, but ultimately positive with Momentum strategies contributing and value detracting. Technical Equity strategies were relatively muted, but also ended the month with minor gains. Futures strategies were the most mixed, with managers having a heavy bias to momentum performing poorly, while faster more mean reversion based strategies doing better.
In Event Driven, it was generally a positive month even before the post-election rally in markets with decent spread compression on a few deals on the back of positive developments and then broader spread compression triggered by a market rally at the end of the month. Deal activity remains encouraging with a handful of $10 billion+ deals announced in April, though overall most activity is in the upper-middle market.
From a positioning perspective, we have seen an uptick in interest in Event Driven strategies generally, and prime brokers report that there were net inflows to the strategy in Q1. We feel managers are generally at the top end of their risk budget utilization with Risk Arbitrage being the largest risk allocation – we saw some profit taking on special situations as those played out in the recent months and concerns around valuations dampen enthusiasm.
Man FRM Early View
Originally published in the April | May 2017 issue