Peak but ephemeral bond and equity shorts 

For parts of 2022, Episode’s short 5-year US Treasury exposure reached 200%, its highest ever notional level, and this was also the second highest ever bond short on a duration-adjusted basis. But it was far from a hard-wired position: tactically trading around and dynamically rescaling positions has been very important to harvest profits and sidestep – or sometimes even profit from – what have been dubbed as bear market rallies. The bond bounce after Russia’s invasion of Ukraine afforded the opportunity to max out the short as Fishwick felt the rally was out of kilter with strong US economic data. The bond short was subsequently halved to 100%, halved again to 50%, and taken off altogether, in response to escalating yields. Thanks to this, covering equity shorts, and general downsizing of risk, the portfolio incurred only modest losses of about 3% during the summer “everything rally” between May and August, by which time Fishwick was ready to re-short bonds – which then slid spectacularly over late summer and autumn.

The fundamental valuation rationale for the short was simply real interest rates being too low and this held true for most of 2022, but trading around the view has been essential given the volatility. Had profits not been banked returns would have been much lower. The equity positioning has also been well timed, with US longs switched to shorts in early 2022, and covered a few months later. Fishwick has cut and reversed equity exposure twice: starting the year long around 30%, adding a 25% short in US equities, pausing for breath, and then going long again mainly non-US equities in late October.

Hitherto, bond shorts had been more often in European and UK sovereign debt while US bonds had been traded more from the long side. “In the climate of low inflation, risk off views had instead been expressed through owning Treasuries and equities never became expensive enough to short,” points out Fishwick.

Though valuation alone is seldom sufficient for Fishwick to enter a trade, Episode’s first short in equities since 2002 was in part explained by US equity valuations that Fishwick deemed the most expensive since the TMT bubble in both absolute and relative terms, combined with elevated earnings expectations. Both elements of this thesis were borne out: during 2022 valuation multiples have contracted, earnings have disappointed, and earnings estimates have been revised down. 

Episode certainly contemplated equity shorts post 2002 but did not pull the trigger. For instance, during the Covid crisis, some of Episode’s conference calls did toy with the idea of shorting the Nasdaq but argued that valuations had become hypersensitive to low rates.

Overcrowding and oversold markets 

In September 2022 some managers started to cover Treasury shorts for a somewhat technical reason: becoming “special collateral” made them pricier to borrow and short. Fishwick, who prizes liquidity, had no material issues with the shorting of Treasury futures, but did recognize that the trade was becoming more crowded as part of his technical overbought/oversold analysis.

He observes a framework conceived by Stanford University’s Mordecai Kurz, based on monitoring a distribution of views. “It is normal and rational to have a range of views. When the distribution becomes very skewed in one area shocks can cause a larger shift. When the consensus view moved to inflation being no longer transitory, it became more dangerous to continue the short. The shift in 30-year yields from 3% to 4.5% was very rapid and correlated with equities and reflected deteriorating beliefs about the value of ownership. The rapid price action showed it was deeply oversold and the behavioural finance analysis revealed deep pain.”

A wide variety of indicators contributed to this view. For instance, though Episode does not trade cryptocurrencies, they are monitored as one risk appetite signal. “Since we view crypto as having very weak valuation anchors, leaving more degrees of freedom, it is an especially good risk appetite measure but is only one of many parts of the jigsaw,” says co-portfolio manager Gautam Samarth, who helps to manage various Episode macro and multi-asset portfolios, as does Stuart Canning. 

Trading hiatus

The team’s synthesis of multiple signals led them to switch into cash and take a brief break from active trading. It is very rare for Episode to be entirely in cash. The strategy has a cash hurdle rate under the performance fee, but more importantly Fishwick normally has some sort of quarrel with the market: “The market is usually on a journey to some new narrative, perspective, bubble or misalignment. But after prices in August, September and October had moved episodically in our favour, we did not want to pick a fight with the market based on the valuation roadmap or behavioural analysis”. 

Resurgence of risk appetite

The hiatus of the portfolio lasted only three and a half weeks. By late October, a steeper US yield curve and a higher 30-year yield was too tempting to ignore, and the portfolio was moved into 30-year Treasuries, a basket of value-oriented equity indices, and a customized basket of emerging market currency carry trades.

Forecasting futility

Valuation, price action and investor behaviour have been the key drivers of portfolio shifts. Though Fishwick’s October 2022 newsletter felt confident enough to tentatively venture that inflation could have peaked, he is certainly not confident about making precise predictions for its trajectory. 

Fishwick did not in fact find inflation “surprises” versus official forecasts surprising in 2021 and 2022 since he was prepared for an even wider range of outcomes. He thinks that “the narrative of central banks controlling inflation was false. They have taken far too much credit for disinflation caused by exogenous forces, such as globalization, deregulation and technology, beyond their control. Now rate rises of 25, 50 or even 75 basis points will not make much difference, as exogenous forces will bring inflation back down”.

Fishwick has a murkier outlook for inflation over the longer term. He is not sure how the battle between capital and labour will pan out and even if inflation has peaked economies may not swiftly revert to current official inflation targets around 2%. “Higher unit labour costs must feed through to either prices or reduce corporate profits. If inflation eventually settles down to 3-4% that also feeds into equity and bond valuations. Covid has further complicated the situation by increasing the focus on environment, equality and inclusion,” argues Fishwick.

There is some debate over how strictly central banks will observe the inflation element of their mandates: “A sharp demand shock would be needed to get inflation back down. Central bankers with dual mandates or multiple target mandates might not be prepared for pain of a proper recession, which we have not seen since 2000 or 2008, and the associated unemployment. Given worker grievances about flat or declining real wages, there is some discussion about official inflation targets being increased,” says Fishwick.

A popular prediction is that inverted yield curves already forecast recession in any case. Fishwick is not convinced that an inverted yield curve must predict an economy wide recession, since booms and busts can be lopsided. “The yield curve could predict stresses in some parts of the economy but not others. After the TMT bubble imploded there was a housing boom. 2015-2016 saw China, manufacturing and commodities slow down but the rest of the economy did okay.” Fishwick closely monitors consensus forecasts, including the inverted yield curve views, but his uncertainty should be underscored. He has always been sceptical about forecasting in general (and high frequency forecasting in particular), pointing out that data frequently fall outside even the most extreme scenarios put forward by economists and central banks.

Equity positioning

Episode’s tactical October 2022 excursion into equities was geared towards areas that would benefit from economic and earnings recoveries. It was mainly in value-oriented names, including Chinese equities, UK equities and the only pure sector wager was US banks. “We see little risk of a rapid and complete return to the playbook of the past decade that led growth to outperform value,” says Samarth.

Given that Fishwick sees potential threats to corporate profit margins, could he contemplate using corporate credit instead of equities? That would fit better under different scenarios: “We have historically tended to use credit, including high yield and homebuilders, more for liquidity episodes than value”.

A resurgence of commodity price inflation could threaten some corporate profit margins and the portfolio can obtain some indirect commodity exposure. Episode does not trade commodities directly but can express views via commodity-related equities or currencies. “Back in 2016 a basket of mining equities tripled from the troughs in a matter of months, and early in 2022 there was some pure commodity equity exposure. The October equity basket also included some commodity names via the UK FTSE 100 Index. Commodity currencies such as the Brazilian Real and South African Rand have also been helpful,” says Samarth.

Emerging markets currencies offering mid-teens carry

Episode has in recent years invested in local currency emerging markets sovereign debt but is currently just using emerging markets currency without any duration to earn substantial carry. This is partly designed to avoid duplicating the 30-year Treasury interest rate exposure.

Rather than buying a standardized basket of emerging markets FX, Episode has carefully filtered out both the carry and the funding parts. “The funding basket avoids US Dollars, partly because that would reduce carry. There is also some active trading of the basket: the short GBP part was removed near its recent lows in September,” says Fishwick.

The long basket includes units in Eastern Europe, Asia and South America, that are chosen partly because they have different drivers and there are also some episodes within the basket. “The Hungarian Forint and Polish Zloty have also gone through a valuation episode of rapid price action,” says Fishwick. The weighted average carry on the basket was around 14% in early December.

Bond diversifier?

All positions need to be justified on their own merits, and 30-year Treasury bonds are partly owned in their own right. They could also be a diversifier for the risk-on equity and emerging markets currency exposure, particularly if there is a growth shock that might perhaps reverse the positive bond/equity correlation seen for most of 2022. Fishwick judges that, “30-year bond yields yielding 360 are clearly less compelling than the 460 at which we entered the position, but are better than the 200 basis points seen not so long ago and could still offer some diversification benefit”. Nonetheless, as of early December he had taken some profits on the bonds and equities but kept the emerging markets FX for the carry.

During much of 2022, Fishwick was puzzled by the VIX Index of equity implied volatility grinding lower while equities fell. One explanation is that US Dollar appreciation softened losses for some investors. And another is that the volatility surge was manifested in bonds, with metrics such as the MOVE Index of bond implied volatility at very extended levels. “The narrative of panic and pain of loss was more obvious in bond markets, which felt riskier and more dangerous. Yet we did not see any real capitulation so far, which is one reason why exposure in late 2022 left plenty of dry powder to upsize positions if there was a real panic,” says Fishwick. The Episode strategy has lots of headroom in its risk budget to trade the twists and turns that may lie ahead in 2023 and beyond.