The adoption of the Trump administration’s tax reform triggered a market melt-up which started to create some discomfort among investors due to the velocity of the equity rally. Maybe because of its being too fast, too furious. Implementing the US tax reform at this point of the cycle may be counterproductive and simply be adding gasoline to the fire of an economy with an already tight labour market. The negative inflation impact to company margins started to become a threat on the horizon, as did, most importantly, the uncertainty of how the Fed would adjust its rate hike cycle, going forward.
Overall, equity markets performed extremely well. In North America, the S&P 500, Nasdaq and Dow Jones gained over 5% during the month. Commodity-driven economies like Brazil and Argentina, which returned 11.14% and 16.29% respectively, saw their indices take off. Canadian and Mexican indices lagged, due probably to the impact of Trump’s threat of NAFTA renegotiations. In Europe, led by the south, equity indices were mainly positive, with the FTSE MIB returning 7.57% over the month. The FTSE 100 lost a little over 2%. Indeed, Brexit remains a huge cloud over the UK. China, Hong Kong, India and Russia also saw strong performances from their equity indices. The Nikkei 225 posted a more moderate performance, of +1.46%, due probably to the appreciation of the yen versus the US dollar.
Increasing inflation expectations led to some pressure on rates. US treasury 3-to-10y maturities widened 0.30%, whereas short-term rates increased by 0.10 to 0.15%. Europe followed the move in a less pronounced way, with 5 and 10y rates widening by 0.15 to 0.20%. US dollar depreciation against major currencies continued into January, when it lost 3.42% vs the Euro and 3% vs the Yen. Commodities’ performance was a mixed bag. Oil was on the winning side, with the WTI returning +7.13% during the month.
The HFRX Global Hedge Fund EUR index was up +2.19%.
Despite a one-way market, January was, on average, a good month for LS Equity strategies. Market-neutral strategies, short-bias funds and specific strategies like REITS lagged due to a strong headwind but, overall, longs outperformed shorts and alpha generation was good. LS equity funds had one of their best months in years. Naturally, beta contributed significantly to performance.
For some time now, the best performers were long/short equity funds taking positions in long secular winners like social media and short structural decliners like traditional newspapers. That would often play out in a fund taking cross-sector positions or being long new economy versus short old economy. Going into this late-stage equity rally, with rates going off the floor, this will focus investors’ attention on company fundamentals. We think this will favour intra-sector bets, due to higher dispersion and more opportunities for strategies like market-neutral funds. Furthermore, their lower net exposure could offer higher protection against market corrections.
Global macro managers seem to be glimpsing the light at the end of the tunnel. For years, central bankers were running the show, keeping rates at rock-bottom levels. This has an important impact, because sentiment has played an important part in market moves. As a result, many macro managers posted disappointing performance figures. With central banks stepping down, investment risk will be repriced, causing significant shifts in asset prices. Macro strategies will be able to capture, and benefit from, these wide market moves.
CTAs had a fantastic month in January, when they benefited mainly from trend-following models with long positions in equity indices and energy futures. Low volatility levels have, nevertheless, constrained the full potential of quantitative strategies. A rise in market volatility will be beneficial to quant funds and usher in more opportunities.
We kept our fixed income arbitrage allocation at the same level. Despite increasing rhetoric from central banks that should ultimately lead to higher rates, volatility remained subdued. Access to balance-sheet lines in the US hadn’t been a problem in recent months as opportunities had shrunk. However, we remained confident on the strategy, as Europe and Japan still offered compelling opportunities, and looked forward to the December expiry. YTD, all the managers in that space delivered strong risk-adjusted return while positively exposed to volatility.
Even though the region continues to be looked upon with suspicion and as highly dependent on the dollar, it should not be forgotten that EMs cover very heterogeneous economic regions such as China, Brazil and Russia. On average, compared to developed countries, they are less diversified and robust economies, but also less indebted, have better demographics and are growing faster. We think this helps offer a wide range of investment opportunities across asset classes (currency, interest-rate curve, single-name equity and debt).
Although the strategy posted decent returns in 2017, it fell short of the expectations generated by the Trump administration. Political noise from Washington brought many uncertainties, which kept corporations on the sidelines awaiting further clarification. Now that the new US tax regime is real, 2018 started with a record month for buyback announcements by Corporate America. We think that there are still many opportunities to take advantage of in 2018. To name just a few, traditional businesses are pushing for further consolidation to be able to face tech giants, European champions are being created by merger and China is eager to buy foreign businesses. All this will bring about technological enhancements.
We are closely monitoring distressed managers, due to the potential for high expected returns, but remain broadly on the sidelines because the current environment continues to favour pushing the can down the road in repricing risk. The very tight spreads offer a negative risk asymmetry. Nonetheless, there have been some cracks in the painting, where the market or banks have punished severely highly levered companies that did not deliver on their promises or seemed too stretched to be viable. So far, the energy sector, in which there has been massive issuance in recent years, has provided an attractive pool of opportunities, given the volatility of oil prices and its impact on these securities. Traditional brick-and-mortar retailers, which are being seriously affected by technology innovations, offer plenty of dislocations within the sector.
Although the quest for yield and the zero-to-negative rate environment are still strongly supportive of the asset class, volatility could spike if rapid changes in monetary policy surprise the market.