Man FRM Early View

August 2017

Originally published in the September 2017 issue

One of the difficulties of commenting on financial markets in real-time is that the magnitude of the importance of events is only truly apparent in hindsight. In February 2007, HSBC warned that bad-debts from their sub-prime mortgage book would be higher than expected. That month the S&P 500 Index fell by around 2% but then rallied back to fresh highs over the next four months. Of course, from our current vantage point it is now easy to draw a causal path from that point through to the collapse of Lehman Brothers in September 2008.

We may look back at August 2017 as another turning point in the risk appetite of investors. Once again, the S&P retreated following a good run, down around 2% during the month, only to rally over the last two days to finish the month flat. Of course, the late rally probably means that things have returned to normal – the macroeconomic backdrop remains strong enough to carry risk assets in the absence of a large exogenous shock (Trump making a mess of the presidency doesn’t appear to be enough of a shock while the data stays good) and Central Bankers seem to be competently managing the end of Quantitative Easing (“QE”). The long-awaited Jackson Hole Symposium failed to deliver anything seismic and, in isolation, there is no reason for us to believe that Central Banks could not start to collectively shrink their balance sheets in a controlled manner. But as history shows things do not take place in isolation, and it is the improbabilities of the current outlook that interest us, since they appear to be growing in our view.

The last six weeks have easily been the most chaotic of the Trump presidency so far. The failure of the Healthcare bill has raised questions over Trump’s ability to enact his pro-growth agenda, and this was followed by a catastrophic mishandling of the far-right rally in Charlottesville which culminated in a mass walkout of CEOs from the White House Business Advisory Panel. Throughoutthe month the President became increasingly isolated from cabinet members – after a flurry of hiring and firing, those that still have a job appear to be cooling in their support. It therefore feels to us like an inopportune time to face either the geopolitical crisis of North Korea or the fiscal crisis of the impending debt ceiling discussions.

We frequently hear that it is impossible to quantify the risk of escalating tensions between North Korea and the US. We fear that this is shorthand for ignoring the risk. Left-tail risks (i.e. a significant military engagement or a nuclear strike) are always difficult to handle probabilistically. 9 times out of 10 your probabilistic forecast will be too low for, say, the Equity market (and you’ll earn a reputation as a perma-bear in the process). However, the risk of a complete failure of the Trump presidency is a more ‘normal’ risk. Given the deterioration of support within the upper echelons of the Republican Party, we have little confidence for either an advancement of Trump’s pro-growth agenda or a smooth resolution of the debt ceiling issues. In addition, it appears that Trump is now in a very fragile position with respect to any possible impeachable outcomes of the Russia enquiry.

In response to these risks, the Equity market is a difficult read – when the VIX hitting a paltry level of 13 or 14 is described as a spike then we are clearly starting from an abnormal base, and the small pull back in Developed Market Equities has made hardly any change to their overvaluation (at least relative to historic averages). We think the Bond market is perhaps a better indicator. US 10yr yields were around 1.8% before Trump won the presidency. They reached 2.6% before the end of 2016 on expectations of his growth agenda, but near the end of August they dipped back below 2.1%. Given that the Federal Reserve (“Fed”) has been largely on track with normalizing the short end of the curve, you could read the flatter yield curve as a sign that pretty much all of the ‘Trump effect’ has been reversed, at least in Bond pricing.

So far, hedge funds appear to have navigated these nascent risks without too much trouble. We talked last month about it being better to be too quick to react than too slow, and the net Equity exposures of some hedge fund portfolios have dropped by around half over the past couple of months. These managers risk being caught off-side if the Equity rally begins again in earnest, but prudent risk reduction ahead of potential volatility is something we’d rather see than not. After all, Equity market beta is something many hedge funds try to avoid, and investors probably have plenty of that in the rest of their portfolios already (where it is likely to be cheaper).

And if we do see a change in risk appetite, we think that the recent vogue for passive investing may emerge as an opportunity to the remaining active players in the markets. Historically, the repositioning of capital around paradigm shifts generally occurs slowly and the more unconstrained funds might ride ahead of the changing currents of capital flows.

Hedge funds
Hedge funds generally had a positive month in August despite the pull-back in risk assets. The best performing strategies were Statistical Arbitrage managers, although Equity Long-Short and Managed Futures also performed well. Credit managers generally produced weaker performance.

Equity Long-Short managers held up well during the first half of August when most major markets finished in the red. They were aided by a continuation of favorable stock dispersion as crowded hedge fund longs bucked the trend and moved up notably, and crowded hedge fund shorts fell in line with markets. In terms of positioning, long exposure looks to have been extended in Asia and reduced in Europe. Activity was mixed in the US, but both Healthcare and Energy saw boosts in long exposure.

In Event strategies, deal activity remained limited though it is worth highlighting that there were a few $10Bn+ deals announced this month which has been previously positive for the strategy overall. In the meantime, Mobileye/Intel closed successfully during the month. From the universe, performance appears flat to negative on average for Event Driven. Managers are slowly increasing their weight to Europe. In addition to the cross-border M&A opportunities, shareholders activism is starting to take root in Europe as several campaigns from famous activists have been announced (such as Elliott’s positions in BHP and Akzo Nobel).

Statistical Arbitrage managers had a particularly favorable month, with positive returns from futures strategies and from quantitative fundamental signals in Equities. Technical signals performed less well, but were still positive on average during the month.

In Global Macro strategies, the most anticipated macro events in August were speeches made by European Central Bank (“ECB”) president, Mario Draghi, and Fed chair, Janet Yellen, at the annual Jackson Hole Symposium, though expectations for clarity on ECB QE tapering and monetary policy shifts were more muted in the days leading up to the event. Yellen’s speech was decidedly dovish, as the Federal Open Market Committee (“FOMC”) has essentially made higher inflation a necessary condition for firmer forward guidance on rate tightening. As we expected, Draghi was very constrained in his comments, though his apparent lack of concern on the strength of the Euro led to the currency breaking the 1.20 level relative to the USD, a new high for the year.

Cross asset volatility remains near long-term lows despite fleeting spikes in the VIX in August, due in part to the North Korea nuclear threat. Gold made headlines as it is on track to outperform Equities for the first time since 2011. Gold call options and long gold have been staples of Global Macro manager portfolios all year.

One other wild card on the interest rates side is the impending debt ceiling deadline, which could result in a government shutdown in early October. We believe the uncertainty around resolution will likely keep the Fed neutral at their September meeting, and has caused front end stress particularly in T-bill markets with curves inverting on October bill yield spikes.

Managed Futures managers had a robust month in August. The bulk of the performance appears to have come from Fixed Income and Commodities, with FX close to flat and Equities a detractor. In Fixed Income long positions in Europe were the primary driver. Net positioning in the US was mixed at the start of the month, but the managers that we have observed are now long across almost all regions. Commodities were also notably positive, but were quite mixed across sectors. Gains were driven by long positions in industrial metals and short exposure in agricultural products. Energy was mixed, while a number of managers did well from net long exposure to precious metals.

US High Yield mutual funds as well as retail loan mutual funds (driven by the rally in treasuries resulting in lower demand for floating rate paper) saw outflows in August. Telecoms, Retail, Energy, and Cable and Satellite (Dish) were some of the worst performing US High Yield sectors.

Structured Credit outperformed Corporate Credit in August as most securitized products sectors, with a few exceptions like Credit risk transfer (which is one of the best performing sectors YTD) and commercial mortgage-backed securities (CMBS/CMBX), posting modest positive returns in the month. Corporate Credit managers were mostly flat to negative in August with few meaningful P&L drivers in the month. There were a handful of idiosyncratic Capital Structure Arbitrage positions (Commodity-related; long Credit vs. short Equity) that performed well in the month driven by a steep selloff in the underlying Equities, but otherwise Commodity-related post-reorganization Equities were a modest drag on performance given the poor performance of the Energy sector in August. The situation in Venezuela also continued to evolve in the month with the initial US sanctions coming in better than the worst case scenario.