Please find attached the latest “Early View” from FRM, Man Group’s global alternatives investment specialist. Early View summarises industry and market trends for the last month and looks ahead to potential sources of return.
Markets
Markets are currently discounting a higher probability of recession than economists believe is justified by the fundamental economic data. Since mid-February investors have been gripped by a dilemma: are the markets warning us about an impending change in the economic data or does this represent a buying opportunity?
We believe this is not a buying opportunity
The economy in the US is in better shape than elsewhere. But we believe the problem is that the cycle is mature: employment is fairly full and inflation is picking up. The Fed’s decision to pencil in several hikes is surely problematic when trying to construct a case which is bullish enough to make the risk worth the trouble. That the markets tripped on the first hike is not encouraging.
With Europe, we have to talk about the politics. The economic and constitutional arguments on “Brexit” are entirely subsumed by the relentless, cacophonous popular press campaign against immigration and the equally high minded knife fighting and career mongering inside the government. The proud pound has been justifiably dumped – not that anyone seems to mind very much – yet the unpredictability that surely accompanies all of this is not in European prices.
Uncertainty has much to feed on in this situation – when the EU and Turkey will meet in a March 7 summit on migration, and the political ramifications will be serious for both European cohesion and Chancellor Merkel who remains the keystone of the EU arch.
The other key character in Europe, European Central Bank (ECB) President, Mario Draghi, is also in a tricky position. Much is expected of the ECB now – in fact, it feels as if something substantial is already priced in – but what, exactly? We believe the failure to settle the policies for handling stressed banks in Europe while markets were stable is still likely to be the focus for future trouble. Portugal has just reminded us why this is so scary. So, too, has Deutsche Bank. Yet it is hard to see more QE as the alternative. The markets would like the ECB to produce a new trick, but conjuring rabbits with a mandate like Draghi’s is not easy.
BoJ Governor Kuroda, has more or less told us he didn’t have any more rabbits – and then proved it. Domestic investors have been told to buy equities, which they dutifully did. With Japan’s market down 16% YTD and 10 year bond yields down nearly 30 bps in February alone, investors don’t feel too well. Perhaps this is a reflection of a renewed dip into recession, leaving Abenomics, another strategy, in big trouble.
Since the crisis, central banks have been entrusted with keeping the show on the road. But monetary policy is losing traction and the central bankers are losing credibility. If monetary policy is exhausted then we either take what comes (a drop in global growth) or we have new political leadership and a new approach to fiscal policy. Global bond markets have a strong view on this one: it’s not going to happen.
So, in sum, the US is the best horse in the glue factory; there isn’t much left that monetary policy can do beyond negative rates – which is frankly a terrifying experiment – and though we haven’t dwelled on it, liquidity is so low we are largely in the dark about what the market really thinks about it all anyway. Of course this kind of polemic is a classic buy signal and some of that is going on now: the equity markets are trading short and the default move is up not down. We believe positive data now will continue to have a positive impact.
But a bear market is when everyone is bearish and prices still go down, and that’s increasingly how we see the world. You don’t read so much about long grinding bear markets because the true bear market is a shy, rare beast and many of us will have forgotten what the last one felt like when the next one comes along. We don’t rule out a much more extended squeeze, but we will be looking to sell higher, not buy. So too, we suspect, will the sovereign wealth funds of the oil producing nations and the retail owners of risk assets when they see their statements.
Hedge Funds
The pace of the decline in global financial markets moderated in February following a mid-month reversal that saw risk assets recover some of their losses. This left the HFRX Global Hedge Fund Index down -0.32% (compared with -1.11% on February 17) and increased the year-to-date loss to -3.08%. Concern about slowing economic growth saw global equities and energy prices fall. The USD also fell against most currencies as Treasury yields declined amid fading investor expectations of near term rate hikes.
Equity Hedge was the biggest decliner amid considerable volatility in the Financial, Technology, Biotech and Energy sectors
Market Neutral strategies lost performance on declines in mean reverting, factor based strategies
For a second consecutive month, the HFRX Macro/CTA Index recorded positive performance, with longs in fixed income making the biggest gains, followed by shorts in the energy sector and in equities
Relative Value strategies fell as deal spreads in high yield credit and arbitrage widened
Macro strategies that had a larger risk allocation to fixed income performed well from receiving Bund, US10yr and 30yr, and the JGB 10yr. The volatility was particularly pronounced in oil, where the price declined, but then rallied to recover some of the losses into the month-end amid expectation of supply restrictions. Treasury yields fell as the investors reduced expectations for near term rate increases by the Fed and the US Dollar fell against most currencies.
US Equity Long-Short managers encountered significant volatility in February. The S&P 500 fell -6.1% to mid-month and then rebounded to end February down -0.4%. The volatility served to whipsaw managers using sound risk management practices to reduce exposures, which crystalized losses, but left them to miss out on much of the bounce. In contrast, managers that maintained exposure, and likely incurred large drawdowns in the opening weeks, were better positioned to recoup losses.
In Europe, ELS managers faced even more difficult conditions. The market sell off continued from January as the Euro Stoxx 50 plunged -12% before recovering to end the month down -3.3%. A number of managers reacted to losses early in the month by reducing risk further, and thereby exacerbating the liquidation trade that was running through markets. This led to losses on both the long and short side of a number of strategies. As markets stabilized and then began to recover in the second half of February, many ELS managers were substantially less leveraged than at the start of the month, and, therefore, experienced less of a recovery in performance. The upshot is that managers remain very cautious, and are fearful of getting whipsawed again as markets struggle to find a coherent price dynamic. There is also wariness of weakening global growth and the risk of US recession, coupled with the possibility of higher inflation once the oil price decline stabilizes.
The significant sell-off in global growth expectations created waves for Stat Arb managers with heightened volatility among the many factors used to explain stock returns. Within fundamentals, the models with a bias towards stocks chosen for their quality characteristics fared relatively well. On the technical front, medium term reversion factors performed poorly. This seemed to reveal a number of funds in the space that have traditionally posted very steady returns and implies these mid-length time horizons may have become a little crowded. The fastest technical managers that we receive data for generally performed well: generating performance from the uplift in volatility and trading volumes.
In managed futures, gains came from shorting the energy complex where shorts in crude oil and natural gas performed positively. However, gold shorts emerged as the biggest detractor as the precious metal rallied 11% in the first part of the month. Shorts in some base metals, including copper and zinc, were also detractors. With equities, a short position in Japanese stocks was the largest contributor, while shorts in Asia ex-Japan initially performed well but then detracted when Chinese issues rallied on PBoC support following the Lunar New Year. In FX, short EUR and AUD against the USD detracted as both currencies rallied in February, though short GBP vs USD recouped some of the losses. Among commodities strategies, shorts turned to longs in precious metals in the second half of the month, while shorts in both energy and agricultural contracts were reduced.
Spread widening caused Event Driven strategies to record negative performance in February, although most of the losses got pared in the second half of the month. Early returns from across the strategy show highly elevated performance dispersion. Once more, merger arbitrage strategies performed well in February and are in positive territory for 2016. Spreads on deals were volatile with a significant number becoming tighter, driven by a mix of competitive bid dynamics, regulatory approvals and transactions nearing closure. Special situations and softer catalyst trades generally performed poorly. Deal activity rose from January to hit $430 bn, led by a chemical company’s bid for an agriculture company.
Credit spreads also succumbed to a selloff in the opening week before staging a strong recovery after European banks and oil prices stabilized. Buyers also emerged for US HY credit after outflows earlier in the month. US and Europe HY markets were little changed with most of the large movers driven by fundamental news, notably earnings misses. Once again, quality outperformed with treasuries and high grade markets beating high yield.
Performance was somewhat mixed for Credit Long-Short and Credit Value managers with the continued volatile macro backdrop. The few bright spots in the month were managers that came in positioned with a short bias. Exposure to financials’ credit was generally painful as that sector performed poorly amid weak reported earnings and concern about exposure to oil and commodity sector lending. Among sovereign credits, periphery Europe spreads were flat to wider, while in emerging markets Argentina debt jumped on a resolution with debt holders.
Returns were mostly negative for Structured Credit managers, but look to be better than the markdowns observed in January. Newer issue vintages in CMBS and CLOs again took the brunt of the selling.