Man FRM Early View

July 2017

Originally published in the August 2017 issue

Conversations about volatility sometimes feel like conversations about gold. There are people who seem to have a bottomless pit full of opaque, conspiratorial and technical knowledge out of which they cook up a witches’ brew of the most terrifying forecasts which infect the imagination and wake you up at night. They aren’t often right, so it is easy to resent the loss of sleep, and they are making a lot of noise right now.

Calls for higher volatility were commonplace in the annual outlook documents at the beginning of the year. Back then, politics and the end to a decade of flooded liquidity were the triggers. With perfect foresight on these issues, we doubt many of these pundits would have changed their volatility forecasts. But they all seem to have been wrong so far and at the half way mark, short volatility strategies are performing well.

Growth numbers are better than we might have expected; global and solid, without being worryingly strong in our view. And the weaker dollar – historically a benign influence on global liquidity – seems to have surprised many. And any good news out of European politics (Macron and the French election) has been beneficial. This has made it possible to listen to the Central Bankers’ warnings about the end of the party in a state of preternatural calm.

But for many investors, this kind of talk doesn’t seem to cut it. They appear worried, and we have seen growing interest in ‘Crisis Risk Protection’ and ‘Risk Mitigation Strategies’. And no wonder. We believe there may in fact be a crisis in asset management and we could be caught between a rock and a hard place. In our view traditional assets are not currently offering the potential returns we seek and we feel the chance things stay this way is much too big for us to sit out of the game waiting for better prices. In Japan, they’ve been relying on this strategy for quite a while now, and only last week another Global Macro fund1 put out a paper explaining why that experience can’t be ignored by the rest of us. There is only so much esoteric, illiquid stuff you can allocate to, so the answer may be the inevitable leverage and more leverage. Some investors say they don’t use leverage… they just buy shares in companies that do it for them and they buy those (uncollateralized) Government Bonds issued in tins that say ‘risk free’.

We believe at the global level, leverage is analogous to a colorless gas – you can never figure out exactly where it is, but you know it’s there because it smells bad. And then, of course, it’s potentially explosive. And we believe the threat of higher Bond yields is the all-too-visible naked flame. The potential fatal risk is that higher yields are themselves an increase in the price of leverage and so could force people to reduce exposures. This in turn can take down risk assets and potentially flip the correlation between Bonds and Equities from negative to positive. At a stroke, this could expand the value-at-risk metrics and potentially force further deleveraging, all in the context of prices falling across the board.

We saw a flicker of this in late June and early July, with a Bond sell off first, and then Equities grinding lower. On the surface, the market moves were nothing out of the ordinary – but leveraged multi-asset portfolios (particularly quantitative risk parity and CTA structures) saw larger losses. We believe this highlights how much a leveraged multi-asset program relies on an assumed correlation matrix.

So what is the potential solution? When it comes to leverage we believe it helps first to know how much you can take on and second how to get out decisively and quickly should it start going wrong. We believe that hedge funds are often too fast for their own good, but in this situation we feel it’s better to be too fast than too slow.

And, right now diversification benefits seem to be in scarce supply. In general we are seeing that CTAs are long Equities, carry strategies are short volatility, and Fixed Income risks for once, as we have said, are becoming more correlated. True, the CTAs are no longer long of Bonds but the positions are light. So as diversification drops away, everything starts to feel like a long Equity position in our view. While leverage may be unavoidable, we are thinking it may be best to take a bit less now, and we are hopping around like a penguin on a hot tin roof worrying about the need to move further, and quickly.

Hedge funds
July was a favorable month across the board for hedge fund strategies. Many managers suffered losses in the last week of June as the correlation structure between Equities and Bonds turned positive and most risk exposures struggled. However, this phenomenon eased during July leading to a snap-back in returns across pretty much all strategies, with the exception of Credit Long-Short which generally performed better in June and therefore had less to recover.

Earnings seasons in major markets were a positive tailwind for most Equity Long-Short managers in July. In the US, around 20% of the S&P 500 has reported so far and the level of positive surprises is in line with prior quarters with no major disappointments to challenge the market’s run. Hedge fund performance, while mostly positive, has lagged the market as a robust short book has become a critical focus for many managers given the current level of valuations – the market multiple is at the 89thpercentile compared with the last 40 years and the typical stock is at the 99th percentile of historical valuation2. This has helped push gross exposure levels up notably and net has pulled back from recent highs though is still above 2016 levels.

One of the main stories for Global Macro managers has been the continued weakness YTD of the USD, which has fallen to its lowest level since September 2016. Positioning among Managed Futures programs is also the most bearish on USD in several years, mostly on account of bullish EUR price action. Discretionary Macro managers have also generally shifted positioning throughout the year, reducing Trump catalyst trades and shifting notably to a more bullish EUR stance. Expectations of fiscal policy progress in the US have continued to weaken, while US financial conditions remain loose.

The past month has been characterized by a notably hawkish shift in the stance by the Bank of England (BoE), Bank of Canada (BoC), and European Central Bank (ECB) with discussion of potential European Quantitative Easing tapering. US monetary policy expectations, on the other hand, have become less hawkish with the probability of a December Fed hike dropping from 60% two months prior to lower than 40% as at July 28, 2017.

One of the more notable shifts in the outlook has been in China, as the RMB has continued to appreciate (+3.2% YTD) and Bond yields have eased since Q1. China’s economic growth rate has accelerated over recent quarters and recent regulatory and policy measures implemented by Chinese officials and the People’s Bank of China have afforded greater control of the exchange rate. In addition, the liquidity situation may improve further in the near term as the People’s Bank of China is showing a clear bias toward maintaining liquidity stability while positive changes in capital flows are providing additional support.

Asian managers are citing the introduction of the China Bond Connect as a further catalyst for attracting foreign capital – particularly given low foreign ownership of outstanding Chinese Bonds of sub-5%, compared to the US which is nearly 50% foreign owned.

Elsewhere, many Global Macro managers cite a North Korea confrontation as the primary global geopolitical risk, which is highlighted by the increased frequency of recent missile launches (78 under Kim Jong Un vs 16 under Kim Jong Il)3, as well as the heightened tension in US-China relations in recent weeks.

In Credit, it was another favorable month for the broad Credit markets with loans, investment grade, and high yield all positive for the month. Not surprisingly given the risk on sentiment US High Yield was the outperformer with all industry groups posting positive returns in July. With the rebound in crude, US High Yield energy sector posted noteworthy returns in July. Metals and Mining and Healthcare sectors were also positive performers. The Telecoms sector was an underperformer. Performance for Corporate Credit managers was mixed and fairly muted in July with a lack of meaningful idiosyncratic events in the month.

Threat of US sanctions resulted in a further repricing of risk in Venezuela resulting in modest losses for some managers on their positions in a large oil and natural gas company. Otherwise Equity stub trades and reorganization Equities were positive performers offset by single-name and index Credit shorts.

With US High Yield Credit spreads once again approaching post-crisis tights the risk/reward for owning outright plain vanilla Credit risk remains unfavorable in our view. Away from Corporate Credit, declining volatility and liquidity risk premium remained supportive for Structured Credit in July with many managers posting positive returns for the month. With the notable YTD spread compression we expect mostly carry-driven returns in the near-term.

July was generally a positive month for Event strategies. While RiskArbitrage remains positive, its contribution was less meaningful than in previous months. Deal activity was relatively muted again, with ~ $220bn of deals announced (excluding proposed deals) as at July 28, 2017. Relative Value strategies which were generally negative last month were mostly positive in July. We saw that Softer Catalyst and Special Situations were generally the largest performance driver in July on the back of positive idiosyncratic events, as well as a strong market backdrop. While Credit remains a smaller allocation in many Event Driven portfolios, it helped in July that there was a rebound from High Yield Energy sector names, and Energy post reorganization Equities.


1. Source: Dymon Asia Q2 2017 Quarterly Letter
2. S&P 500 as at July 28, 2017
3. Source: Bloomberg