From FRM Investment Management
China’s financial troubles and the Fed’s zeroing in on lift off for the next interest rate cycle have combined, as we thought they might, to place deflation at the forefront of investor concerns. Moreover, it is clear that the problems emanating from China, other emerging markets and many commodities sectors have multiple origins. As such, they are not easily susceptible to a silver bullet type policy solution and are, therefore, likely to be here for some time.
The biggest threat to global markets is China’s economic situation, which looks more problematic with each passing week. China began the year with a flurry of initiatives to advance the primacy of domestic financial markets and to speed integration with the global economy. But the bursting of the stock market bubble has led to massive intervention, the changing of the rules for investors and a poorly communicated devaluation of the RMB. In just a few weeks, the policy balance has titled from encouraging market forces to state fiat.
With conflicting anecdotal evidence on the ground even veteran China watchers are unsure of the rate of the slowdown in domestic growth and how the market will respond to this. But it is clear that the changing state of the Chinese economy is having an impact on global markets. The question is how bad things are fundamentally. On the face of it, pretty bad seems to be the indisputable truth. The reality is that underlying economic growth and debt are probably worse than they seem. This is significant since it does look as if what is ailing China isn’t susceptible to a quick fix by central bank activism.
Meanwhile, the rates market tells us there is about a 30% chance of the Fed pushing the lift off button immediately. Should this happen, it would surely mark the triumph of the Phillips curve. The sustained rise in employment is one reason the Fed might move. The need to declare victory on economic ‘normalisation’ might be another. Yet what may underpin the broader rationale to the Fed’s thinking is that moving further to unwind the monetary policy response to the crisis is necessary for the domestic US economy.
Hedge funds, so far, look to be in reasonable shape collectively and are serving investors by dampening volatility and protecting the downside. However, while CTAs and volatility targeting strategies may be scaling back exposure, there is probably more selling to come as they turn short. Equity Long-Short funds have not done much if any de-grossing, so that is another potential source of unwind pressure. It follows that the downside risk that we have articulated in recent months definitely remains.
On the other hand, we think that the moves we are witnessing are exaggerated by liquidity conditions which are at best poor, and sometimes worse than that. As a result, prices are intermittently implying more certainty of outcome than is remotely justifiable. One such example was the way some blue chip stocks traded at the US open on Monday, August 24th.
Hedge Fund Strategies
The HFRX Global Hedge Fund Index declined -2.21% in August, pushing the index into negative territory at -1.00% for the first eight months of 2015. The fall continued the pattern set in the first half of the month (August 14th) when hedge funds dropped -0.71%. Performance in August was negative across all broad strategy buckets as global financial market volatility surged, following a devaluation of the RMB and a second consecutive monthly decline in Chinese equities.
The biggest declines came in CTAs, Equity Long-Short strategies and Event Driven triggered by falls in commodities and Chinese stock prices. Managed Futures endured losses on commodities as well as on the fallout from the RMB devaluation and the decline of the USD versus the Euro and the Yen. The gains that Relative Value strategies reported in July reversed as spreads ballooned on increased stock market volatility.
Discretionary Macro managers recorded losses across most strategies. Managers that were long risk assets in any region generally lost the most performance. For many managers, the RMB devaluation was neutral or even positive due to protection afforded from options positions. In the wider Asian emerging market region, the knock-on impact from the devaluation led to a sell-off in most currencies. Since this was among the most concentrated risk positions held by macro funds, the impact was almost uniformly positive for managers who had net short exposure of emerging market currencies. But while the currency deprecation was mainly positive for Macro funds, it was negative for emerging market equity funds, particularly so since most managers operate with a long bias in both equities and implied emerging market currency exposure.
Ahead of the Federal Open Market Committee meeting on September 17th, managers positioning themselves for a hike via short exposure at the front end of the US yield curve suffered negative performance. However, most managers avoided this pitfall after cutting exposure to the trade following the weak quarterly Employment Cost Index data released on July 31st. Yet, conversely, many managers remained long USD (on the basis of a normalising US interest rate regime) and thus suffered negative performance as the currency weakened against the Euro and the Yen.
Managed Futures recorded negative performance across most asset classes as trend following programmes got whipsawed in the extreme price volatility. Long positions in equity index futures were the biggest driver of losses as they were hit by the spill over effects of the sell-off in Chinese shares during mid-August. Other areas that lost performance were value and carry strategies as equities and emerging market currencies (among the highest yielding asset classes) declined. The fall of the USD against the other G3 currencies was a further performance negative especially as being long the greenback has been a major area of risk concentration in recent months. Commodities had generated positive performance during July and much of August as managers successfully exploited price falls across the energy complex. But a substantial portion of the gains managed futures funds made throughout much of August got reversed as crude oil prices rallied in the last three trading days of the month.
The repositioning in recent months of US Equity Long-Short managers to larger short exposure provided some downside protection and helped to limit losses. Large cap stocks narrowly outperformed small caps with the S&P 500 down -6.3% compared with a -6.5% fall for the Russell 2000. Macro concerns spawned volatility in US stocks from mid-August onwards, bringing an end to the more constructive environment for managers that had prevailed in July. A number of managers entered the second-half of August with month-to-date performance intact and managed to stay in the black in the initial days of the downturn. Tactical improvisation saw some managers cover short positions with reduced gross exposure. This served to raise net exposure levels and generate portfolio gains from the partial rebound in markets that occurred in the closing days of August. A few managers were so adept at doing this that they chalked up performance gains for August. As a rule of thumb, managers that failed to perform in this environment had small short books and didn’t dynamically manage their exposures.
Equity markets in Europe endured large falls with the Eurostoxx 50 dropping 9% during August. Much of the decline came in the second half of the month with a big sell-off on August 24th driven by fears of slower than expected Chinese growth and questions around the PBOC’s capacity to deal with the problem. However, the European recovery story remained on track with slightly soft PMI and growth data being offset by better-than-expected unemployment data. Most of the moves in European equity markets were futures driven, with indices reacting first and cash stocks moving in concert on low volumes. Unlike some previous market corrections, many fund managers maintained risk levels, with some adding to long positions as prices fell. European Equity Long-Short managers, overall, added alpha in August with low net and market neutral strategies generating positive returns.
The rapid increase in stock market volatility during August meant that Statistical Arbitrage and quantitative market neutral managers had a challenging month. Anecdotal evidence (but with scant data backup) suggests that more technical approaches are doing well. However, none of the usual factor-driven exposures were rewarded, while in Asia and Japan value-based themes were punished. It appears that futures offered a small amount of respite from the broader pattern of losses.
US corporate credit markets again underperformed Europe helping managers with higher quality European names to outperform. High Yield and leveraged loans in the US both lost performance in August with lower-rated and distressed names under-performing higher-quality credits. Credit Long-Short and Value managers were mostly negative for the month with exceptions coming from idiosyncratic winners, especially on the short side. Once more, exposure to commodities-related sectors generated losses as did exposure to the solar sector. For structured products, spreads were wider, but to a lesser extent than with corporate credit spreads. With Convertible Arbitrage low premium, deep-in-the-money names outperformed the distressed and credit-sensitive parts of the market.
Event Driven strategies recorded significant losses as spreads widened considerably in response to the extreme volatility. Oil related deals suffered particularly negative performance. Yet M&A activity remained healthy with volumes hitting the $300bn mark, although if macro uncertainties persist and volatility remains high we would expect deal flow to slow. Large deals unveiled included Shire bidding $30bn for Baxalta, while Schlumberger agreed to pay $14.8 billion for Cameron. Meanwhile, it is likely that Event Driven managers will have been hurt by two notable breaks: Monsanto withdrawing its bid for Syngenta and federal US regulators rejecting Exelon’s $6.4 billion offer for Pepco.