The outcome of the FOMC meeting was June’s main macro event. The debate about the risk of inducing persistent inflation into our economies by providing an excessive dose of monetary stimulus continues. However, the division of opinions among FOMC board members comforted the camp of those believing the Fed would not let inflation run wild. Indeed, this institution announced that it was leaving its short-term borrowing rate unchanged but brought forward to 2023 the date by which it could start raising rates.
The market was taken by surprise by the Fed’s hawkish tone, which led to a significant flattening of the yield curve. Long-term US Treasury yields declined by 0.2%-to-0.25%. During the month, sovereign and credit spreads across the world declined to close to their all-time lows. The US dollar, one of the beneficiaries of this change of tone, gained in value versus most major currencies.
The cooling-down of the reflation trade had a positive impact on equity indices with strong exposure to growth equities and long-duration business models. The Nasdaq Biotech and Nasdaq 100 outperformed, returning high single-digit returns. Overall, equity markets were positive, returning low single-digit returns. Chinese large-cap equities underperformed, declining by low single digits. This is partly due to a regulatory crackdown on specific companies and business models, which, the government fears, are building monopolistic positions within their specific markets.
The HFRX Global Hedge Fund EUR returned +0.34% during the month.
Long Short Equity
Core equity indices were positive during the month, progressing towards all-time high levels, but sector and style returns were dispersed. Strategies with a growth bias benefited from the easing on US long-term interest rates while strategies with a focus on cyclicals and value underperformed during the period, tracking the unwind of the reflation trade seen on rates and currencies. In June, North American funds outperformed European and Asian funds due to higher exposure levels to Growth. According to Morgan Stanley Prime Brokerage, since the beginning of the year, Long-Short Equity funds across the US, Europe and China have averaged mid-single-digit returns, however, on a relative basis, China-focused strategies have a much higher upside capture ratio of equity index performance than their American and European peers. On average, managers’ reduction of their gross and net exposure levels is understandable, since, during the summer, markets tend to trade on lighter volumes and display higher volatility levels.
It was a challenging period for Global Macro strategies. Many managers were surprised by the Fed’s change of tone, which led to price swings that were probably amplified by a crowded US rate-curve steepener. This trade had a bigger impact on Systematic Macro strategies and Discretionary managers with higher levels of concentration. The reflation trade pull-back negatively impacted long positions in commodities and cyclical equities. Global Macro strategies with higher levels of diversification tended to be flat-to-slightly-positive. We continue to favour discretionary opportunistic managers who can draw on their analytical skills and experience to generate profits from selective opportunities worldwide.
The shockwave sent to the markets by the unwinding of the reflation trade tended to negatively impact Quantitative strategies. Losses accumulated in rates and currencies tended to surpass the p&l generated on other asset classes. On average, the trades that detracted the most from performance were long positions on the front end of the US yield curve, short positions on US long-term rates and a short position on the US dollar. Long- and medium-term quantitative models, impacted by trend reversals on US rates and currencies, tended to detract from performance.
Fixed Income Arbitrage
The US fixed income market has been dominated by the unwinding of the steepening trade, which triggered a violent flattening of the curve following the Fed comment. This movement has been amplified by the trend-following CTAs, which have put even more pressure on the rally, as they were piling up in this unexpected trend. Fixed-income managers hence had to apply all their skills to minimizing losses. In the relative-value space, those technicals should ultimately be brought to fruition, as trend reversal is being used to create a healthy environment for the strategy.
It was a challenging month for Emerging Market managers. The repositioning of the investment community around the reflation trade generated short-term volatility on cyclical commodities and Emerging Market currencies, which were also affected by the move on the US yield curve. Emerging Markets will be natural beneficiaries of a continuation of the world’s economic recovery. However, there are important moving pieces, such as COVID-19 infection levels and the resilience of world economic growth, which will probably lead to higher volatility levels. Emerging Markets are an appealing investing ground for investors seeking decent-yielding fixed-income assets. Although EM fundamental managers reckon the space is an interesting option in a zero-rate world, considering the fragility of fundamentals, they usually adopt a very selective approach. Caution is required, due to the higher sensitivity of the asset class to investor flows and liquidity.
Risk arbitrage – Event-driven
Merger Arbitrage strategies were, on average, down for the month. Performances were affected by a large-cap deal widely held across the merger arbitrage community. The US Department of Justice and FTC decided to take a tougher stance on the acquisition of Willis Tower by Aon. This event led to a widening of spreads applied not only to this specific merger but also to the majority of the outstanding deals waiting for regulatory approval. It is feared that the newly appointed Democrat antitrust team will increase the scrutiny of pending deals. The consensus around the Willis Tower / Aon deal expects it will close successfully after further negotiation with the regulators. Merger-deal activity is expected to continue in the near future and offer interesting opportunities. The activity is driven by the need to restructure in stressed sectors like energy and travel, the willingness for consolidation in healthcare, financials and telecom, and the need to adapt to today’s new reality by externally acquiring technologies that would take too much time or money to develop, like in the semiconductor space.
Stressed and distressed strategies did well during the month, benefiting from idiosyncratic profitable trades and a positive risk-on sentiment. The last 12 months have been, on average, the highest performance period since the Great Financial Crisis (GFC) of 2008. The COVID crisis, managers believe, although very different by its origins and its impact, will be a source of opportunity for years to come. During the GFC, the market dealt with a financing crisis following the collapse of major financial institutions; the current financial landscape is characterized by relatively sound financial institutions but where bank financing, by force of regulation, has been replaced by support from non-banking financial institutions like hedge funds. The opportunity-set is hence wide and varied. We favour experienced and diversified strategies to avoid having to face extreme volatility swings. It is not going to be easy but this is the environment and opportunity-set these managers have been waiting on for the last decade.
Long short credit & High yield
Following the market crash at the end of the first quarter of 2020, hedge funds have opportunistically loaded on IG and HY credit at very wide spreads. Managers that were able to go into offensive mode were aggressively buying on the market or making off-the-market block trades, whereas other managers, unable to meet margin calls, needed to quickly cut risk. Since then, spreads have completely reversed to pre-COVID levels. Multi-strategy managers have significantly reduced exposure to credit and high yield, as current valuations present limited expected gains and a negative risk-return asymmetry.