The markets navigated a bumpy road to the end of the year. The spread of Omicron across the world raised uncertainty levels about the economic path going forward, driving equity markets’ implied volatility close to the current year’s highs. However, the Federal Reserve’s announcements of a greater focus on inflation came perhaps earlier than expected, contributing to significant market moves and adjustments.
Equity markets recovered from last month’s virus scare sell-off. Investors seem to have incorporated the thesis that although highly contagious, Omicron seems to cause less severe forms of the illness, in turn causing less disruption to the health system and the economy. Overall, the main equity indices were up mid-to-high single digits over the month. From a style perspective, value outperformed growth, as the rate hike cycle negatively affects longer duration stocks. Consumer staples, utilities, healthcare and materials outperformed consumer discretionary, information technology and energy.
Sovereign yields from the major economic regions have adjusted higher across mid- to long-term maturities, incorporating a more hawkish scenario from central banks going forward.
The HFRX Global Hedge Fund EUR returned +0.32% over the month.
It was overall a good month for Long-Short strategies. Despite the strong sector rotations occurring during the month, average performances were resilient and even offered opportunities of alpha generation for managers that were short on expensive technology stocks. 2021 was a decent year in terms of performance for Long-Short Equity strategies, which averaged mid-to-high single-digit returns. On an absolute basis, strategies with a focus on US and Europe generated better returns than Asia and Emerging Markets funds. However, on a relative basis, strategies with a focus on Asia outperformed their benchmark equity indices, averaging mid single-digit returns. We think Long-Short Equity strategies offer an interesting investment opportunity to consider in 2022, as expected returns for long-only equity strategies are modest, with current profit margins close to all-time highs and increasing intra-sector dispersion levels that will offer opportunities on both long and short books.
Performances were dispersed for Global Macro strategies depending on the manager’s asset mix and regional focus. Diversified and balanced strategies tended to generate returns close to flat or slightly negative. Profits generated by long equity positions were negatively offset by long bond positions in Developed Markets and long positions in Natural Gas futures. Since the start of 2021, performances have overall been positive, with Discretionary Managers outperforming Systematic Strategies. The level of dispersion in performances for the year was very high. Investments in equities and commodities were strong P&L generators, while strategies with a focus on rate arbitrage had difficulties positioning their portfolios correctly to benefit from increased interest rate volatility. We are currently seeing a progressive decoupling of monetary policies in some major economic regions. While China is trying to steer away from the heavy monetary stimulus of the past, the United States and Europe are approving massive investment plans that will probably have a significant impact on the borrowing rates and currencies of these regions. Macro managers should be able to capitalise 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.
Most quantitative strategies did relatively well during the month, apart from trend-following models, which printed negative returns over the month for the majority of strategies. Gains in long equity futures were negatively offset by losses in fixed income, currencies and commodities. However, Quantitative strategies have managed to use to their benefit higher market volatility regimes and volatility regime changes by printing low double-digit returns since the start of the year. Multi-Model Quantitative strategies can offer smoother return streams, as they can use different alpha sources to deploy capital.
Fixed Income Arbitrage
The November rhetoric around tapering, mixed with the revival of inflation fears triggered by skyrocketing energy prices and the sudden change in Fed rhetoric, resulted in a brutal and painful awakening of the fixed-income space. Like the moves managers experienced in May 2021, the last spike in interest rates triggered a flattening of the US yield curve. This move was at the heart of one of the most sanguine moves for the strategy due to the consensus steepening trade and triggered a reduction in risk across managers. In December, short-term rates continued to creep slowly higher, while the long end kept showing higher volatility and less clarity about the ultimate direction. As January begins, the long end of the yield curve seems to be joining the party, but needless to say, this part of the curve will be very sensitive to central bank rhetoric.
The last two months of the year were challenging for Emerging Markets, as investors were flooded by news headlines on Omicron and the Fed rate hike cycle, two themes that do not suit Emerging Market investments. Equity markets in EM ex-China did well over the year. Global growth remains supportive for 2022, and higher commodity prices are a nice tailwind for many countries. Investing in fixed income and currencies was more challenging, as the idiosyncrasies of each asset are trumped by the Fed narrative on the US rate hike cycle. We remain cautious on Emerging Markets.
Risk arbitrage – Event-driven
Performances for Merger Arbitrage strategies were positive but modest for the month. On average, returns for the strategy from the start of the year were good, but not as good as the record number of merger deals announced during the year might suggest. The industry does not expect a repeat of 2021’s record activity in deal making in 2022, but 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 will also help maintain wider spreads and a less crowded strategy. There is an element of cyclicality that is structural to this industry, but the impact of COVID-19 and industries undergoing structural transformation 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. The volatility seen in sovereign yields has not yet spilled over into corporate spreads, apart from specific situations. Year-to-date, performances for the strategy are good. They were mainly driven by stressed investment opportunities occurring after the COVID-19 crisis in 2020 and by high energy prices that helped heal the balance sheets of a sector that is often affected by commodity price volatility, and also by continued liquidity support from central banks. The opportunity set for the strategy remains modest or limited to specific sectors. Nonetheless, we remain attentive because, as central banks initiate tapering and rates start to rise, this strategy might become more attractive. We favour experienced and diversified strategies, to avoid having to face extreme volatility swings.
Long short credit & High yield
Following the market crash at the end of the first quarter of 2020, hedge funds opportunistically loaded on IG and HY credit at very wide spreads. Managers who were able to go into offensive mode bought aggressively on the market or made off-market block trades, whereas other managers, unable to meet margin calls, needed to quickly cut risk. Since then, spreads have completely reversed back 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.