The Goldilocks era seems already to have come to an end, or so the market seems to think. US treasuries moved up on higher inflation expectations, supported, among other things, by a FOMC release that seemed more hawkish than expected. This was one of the events leading to a sharp equity sell-off that was mainly the consequence of a multiple compression, since forward earnings actually rose by 2%.
This early-month equity sell-off impacted almost every market in the world. Many indices were close to double-digit negative returns at the trough. After mid-month, equities recovered but there was basically nowhere to hide. On average, markets finished the month between 3 and 4% down. Brazil outperformed, returning +0.52%. Technology companies recovered much better, with the Nasdaq losing 1.38% and the S&P 500 finishing the month close to 4% down.
US treasuries continued to push higher during February, with the US 10y flirting around the 3% mark. US rates increased on average 0.20% across the different maturities. European rates were rather steady. In February, the US dollar reverse course gained 3.17% vs the GBP and 1.66% vs the EUR. Commodities were among the best performers during the month, with corn, cotton, sugar and soybeans gaining between 1.5% and 5%. After five years of decline, demand is exceeding supply. Battery-linked metals continue to go up. WTI, copper, gold and silver were among the commodities that went down in value.
The HFRX Global Hedge Fund EUR index was down -2.72%.
As opposed to other recent equity market sell-offs, there was no strong sector or style rotation during February. The correction was mainly the result of risk-repricing leading to a multiple compression. In the US market, the technology sector again outperformed the rest of the universe, followed by financials and materials. Laggers were mainly companies affected by the rates expectation revision impacting highly levered companies or bond proxy names. Performance dispersion was high across long/short equity managers.
For some time, 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 positions across sectors or being long new economy versus short old economy. Going into this late-stage equity rally, and with rates taking off, this will draw investors’ attention to company fundamentals. We think this will favour intra-sector bets due to higher dispersion and more opportunities for strategies like market-neutral funds, whose lower net exposure could offer higher protection against market corrections.
The desert road seems to be coming to an end for global macro managers. For years, central bankers had been running the show, keeping rates stuck to the floor. This has an important impact, because sentiment plays 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.
Quant funds made the headlines during the month due to the heavy losses assumed. This was not the case across the board but mainly for directional trend followers, who entered the month very long equity. Obviously, there was also a lot written about the spectacular failure of a short volatility ETF that lost 90% of its assets in one day with the volatility spike. Short-term-driven models made money during February. A rise in market volatility will be beneficial for quant funds and usher in further 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 we looked forward to the December expiry. YTD, all managers in that space delivered strong risk-adjusted returns while positively exposed to volatility.
Even though the region continues to be looked upon with suspicion and as highly dependent on the dollar, EM, it should not be forgotten, covers 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 Donald Trump’s administration. The political noise from Washington that brought many uncertainties led corporations to stay on the sidelines awaiting further clarification. During February, event strategies were also affected by market moves, in particular special situations managers, who have a higher market exposure. Merger arbitrage fund performance was more dispersed, due to the resilience of deal spreads and some media acquisition developments .
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 off in 2018. Traditional businesses, for example, are pushing for further consolidation to be able to face tech giants, European champions are being created by merger, and China’s eagerness to buy foreign businesses will bring about technological enhancements.
We are closely monitoring distressed managers, due to the potential of 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 market is starting to reprice risk but 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, seriously affected by technology innovations, offer plenty of dislocations within the sector.
The quest for yield and the zero-to-negative rate environment are still strongly supportive of the asset class but volatility could spike if rapid changes in monetary policy surprise the market.