The global economic outlook is foggy, and the start of the year has kept on adding additional layers of complexity. After the sell-off triggered by the start of the war, the market stabilized mid-March with investors buying the dip on oversold sectors. Europe is again in a tough spot. At the end of 2021, European assets seemed to be in a sweet spot benefitting from cheaper valuations relative to the United States, from a market with a tilt to cyclicals and from a pandemic under control. Those days seem long gone. The impact of higher energy costs on sustained inflation levels will be significant and have a detrimental impact on the European economy.
Overall, equity markets benefited from a rebound during the month, particularly those exposed to commodities exporting. China and Hong-Kong equities were among the worst performers during the month since local authorities preferred to impose new lock-downs to fight a rebound of COVID infections. Energy, Materials and Healthcare were the leading performing sectors.
Sovereign yields continued to move upwards during the month. The move was particularly evident on US Treasuries and European bonds as investors expect Central Banks to be active in fighting uncontrolled inflation levels.
Unsurprisingly, most commodities futures continued to lead higher, reflecting a tense market where prices are not only affected by the current imbalance between demand and offer, but also by future supply chain disruptions.
The HFRX Global Hedge Fund EUR returned +0.43% during the month.
Long-Short Equity strategies were on average flat to slightly negative during the month. Nonetheless, dispersion levels were high around the average. Performance was mainly driven by negative alpha on the long books. Although strategies recovered some of the losses accumulated during the first 2 weeks of March during the 2nd half of the month, funds significantly lowered their gross and net exposures during the month, which contributed to below average relative performance versus indices. According to Morgan Stanley Prime Brokerage, US and European funds have been sellers of Technology, Cyclicals and sectors exposed to rate hikes. Hedge Funds were net buyers of Energy names. Peer group averages hid some very strong results achieved by fundamental Long-Short stock pickers whose performance has been driven by strong alpha generation on the short book. We do not expect LS funds to add significant levels of risk until there is more clarity on a resolution of the current Ukrainian conflict. Over the short-term, we expect good Long-Short Equity strategies to protect capital for their investors by maintaining gross and net exposures close to their lower ranges. The current war will exacerbate some of the challenges companies around the world are facing. Picking the right stocks will be important, but being able to do so from a long-short perspective can bring a solid edge to long only equity solutions.
On average, Global Macro managers performed during the month as they have been among the biggest beneficiaries of rising volatility levels, confirming the saying that there are always different perspectives to a story. Savvy discretionary and systematic strategies have used to their benefit a higher volatility regime and asset risk-premia repricing in equities, rates, currencies and commodities to deploy capital in successful investments. Long positions in equities and commodities generated the best performances but macro managers specialized in rates have been able to print decent returns. We did say in past pieces that Global Macro would have a better environment to deploy capital as Central Banks were starting to reduce liquidity injections and planning for rate hikes. This infamous war has just jump started some of the market volatility that we were anticipating due to less fiscal and monetary support. Asset risk premiums are moving across the board and Macro managers should be able to capitalize on these market moves. We continue to favour discretionary opportunistic managers who can draw on their analytical skills and experience to generate profits from selective opportunities worldwide.
Quant strategies are doing really well on a relative but also an absolute basis. Trend following strategies have generated strong gains during the month, mainly trading fixed income and commodities. Multi-Model Quantitative strategies continue to use the higher volatility regimes to their advantage to generate good returns. The latter are usually strategies that offer returns that are more consistent across different market environments. However, the level of resources required to play in that arena is high, making it a league for only a happy few.
Fixed Income Arbitrage
Last month, the fixed income market was animated by opposing forces. While the Ukraine war is far from being over, inflation forces took the lead and pushed yields higher. The 2-year swaps soared from 1.60% to 2.55% on the back of hawkish Fed fund rhetoric, while the yield curve flattened further. If you could imagine a perfect playground for a fixed income manager (directional or relative value), you just have to think about March’s fixed income market dynamics: the short part of the US yield curve underestimating both the magnitude and the pace of rate hikes, volatile swaps spreads, volatile futures basis across the yield curves, trend of the US yield curve meant to be inverted … while inflation has never been so pervasive. In this environment fixed income managers took advantage of the very supportive environment to post strong returns.
The performance of Emerging Markets strategies remained very dispersed during the month. The results were mainly driven by macro factors that outweighed idiosyncrasies. Emerging European assets rebounded in March but the situation remains highly instable and China is still struggling to contain COVID through additional lockdowns. Latin America is one of the bright spots benefitting from rising commodity prices. We will continue to closely monitor the situation as it is too early to draw any lasting conclusions.
Risk arbitrage – Event-driven
Overall, Event-driven strategies were flat for the month and since the start of the year absolute returns are on average in negative low single digits. The strategies have demonstrated strong resilience during periods of a market in panic mode. Merger Arbitrage strategies, which are structured around hard-catalysts, tended to outperform Special Situation strategies, which have higher beta sensitivity. The industry does not expect a repeat of last year’s record activity in deal making in 2022 but it does expect to have plenty of deals in the pipeline to deploy capital on. Rising interest rates and equity volatility are risk factors to be taken into account more seriously going forward, but they will also contribute to maintaining wider spreads and a less crowded strategy. There is an element of cyclicality that is structural to this industry; however, the impact of COVID-19 and industries undergoing structural transformations will generate further corporate actions, giving managers opportunities to deploy capital. With investors currently looking for diversification, Merger Arbitrage provides an interesting tool that is structurally short-duration, where deal spreads are positively correlated to increases in interest rates.
The environment is relatively calm for distressed strategies for the moment. Credit spreads have started to widen since the beginning of the year as economic fundamentals are deteriorating. Nonetheless, apart from specific cases, spreads on bonds, loans and structured products remain relatively tight. While the opportunity set remains relatively modest, current economic uncertainties are not easily overlooked anymore as current inflation levels will limit the Central Banks’ possibilities to once again save the market. Furthermore, reference rates are still at the bottom as the Fed has not yet made its first hike and the ECB has not yet guided towards a clear timeline. Volumes of issuance since 2010 have been very high and conditions of credit access have been relatively loose, therefore, the pipeline of opportunities should be relatively high. The geopolitical and economic changes caused by the war in Ukraine will not help to make it easier going forward.
Long-Short Credit & High Yield
Credit spreads have widened but remain close to historical lows. Investors believe now that the power of the “Fed put” will start to fade away progressively improving the opportunity set for credit picking from a Long-Short perspective. China real estate-related credit opportunities are making their way into some of the hedge funds with research capabilities in Asia. Although, the Evergrande debacle is still on everyone’s mind, the possibility that the Chinese government would allow a repeat of a Lehman scenario is thought to be less probable considering the importance of real estate in the Chinese economy. Emerging Markets credit spreads have widened considerably. This is an opportunity considered appealing by many managers since EM Central Banks are considered to be ahead of the curve tightening policy and high commodity prices will help exporting nations maintain their balance sheets in check.