There is a lot of dust in the air for the moment. After being caught off guard by the Fed in January, investors are watching a tragedy unfurling in Ukraine which will have deep implications for the world’s political and economic equilibrium. Unsurprisingly, capital flows favoured safe assets such as US government bonds to shelter from volatility. All eyes are on commodity prices, however, as the countries at war are major producers of oil, gas and also soft commodities. Out-of-control price rises for essential inputs to our economies will simply fan the flames of already fierce inflationary fires.
The behaviour of the equity markets can be broken into two main groups. Equities from commodity-rich exporting nations finished the month slightly up, while the vast majority of indices representing economic regions relying on price stability for their industrial inputs declined in mid single digits. At a sector level, cyclicals such as energy and materials outperformed, including defensive sectors such as healthcare and consumer staples.
Fixed income yields were volatile during the month. Yields dropped for most sovereign yield issues as war broke out and investors sought safe havens. Higher inflationary pressure and macro uncertainty are pushing yields the other way and moving credit spreads wider for IG and HY.
Commodities futures have done well, maybe too good since spot prices for certain energy and agriculture futures have reached a level that might lead to people demonstrations around the world.
The HFRX Global Hedge Fund EUR returned -0.47% during the month.
Long-Short Equity strategies had on average a good month relative to equity indices. There was some level of dispersion, since Commodities-focused strategies tended to have very good returns, while managers focusing on TMT and Consumer Discretionary had another tough month. Average performances are up slightly for the overall universe. Naturally, directional strategies underperformed low net and market neutral Long-Short funds. Considering current levels of uncertainty and volatility, managers have lowered gross and net exposures across the board. We do not expect LS funds to add significant levels of risk until there is more clarity regarding a resolution to 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 faced by companies around the world. Picking the right stocks will be important but being able to do so from a long-short perspective could bring a solid edge to long-only equity solutions.
Global Macro strategies are among those with the highest level of dispersion in returns, as the volatile environment offered many opportunities to deploy capital. The strategy’s average performance for the universe was modest but positive and the best performers returned high double-digit returns for the month. The main performance drivers for the strategy have been trading in rates, long positions in commodities and portfolio hedges. 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 rate hikes. This war has now jumpstarted 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 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.
Quant strategies are doing really well on a relative as well as an absolute basis. Trend-following strategies generated strong gains during the month, mainly trading fixed income and commodities. Multi-Model Quantitative strategies continue to harness the higher volatility regimes to generate good returns. These are usually strategies that offer returns that are more consistent across different market environments, although significant resources are required to play in that arena, making it a league reserved for a happy few.
Fixed Income Arbitrage
The fixed income market is under the influence of opposing forces. On one side, a flight to safety as the Ukraine war triggers short squeezes and pushes yields lower. On the other, inflation is gaining momentum on the back of increasing commodity prices, pushing yields higher. The question is no longer whether inflation will be short-lived, but how pervasive it will be. As a result, interest-rate volatility has spiked and curves have flattened, while swap spreads in Europe have soared and market dynamics for higher rates are challenged. In this environment, a trading and flexible mind-set is vital. Despite this challenging environment, several fixed-income managers are positive and are benefiting from this challenging environment.
Emerging Markets strategies had a tough month as the first reaction to a war, and more specifically a war implicating two important members of the EM complex, is usually to fly to safe haven assets. That said, the geopolitical impact of the Russian invasion will probably have such longer lasting impacts on the world, and a sustained period of high commodity prices might offer investment opportunities in commodity-rich regions such as Latin America. We will continue to monitor the situation closely, as it is too early to draw any lasting conclusions.
Risk arbitrage – Event-driven
Event-driven strategies demonstrated strong resilience during the month on the face of a market in panic mode. On average, returns were modest but positive. Merger arbitrage strategies, which are structured around hard-catalysts, tended to outperform Special Situation strategies, which have higher beta sensitivity. The industry in 2022 does not expect a repeat of last year’s record activity in deal-making but it does expect to have plenty of deals in the pipeline on which to deploy capital. Rising interest rates and equity volatility are risk factors to be taken into account more seriously going forward, although 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, although the impact of Covod-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 and where deal spreads are positively correlated to increases in interest rates.
The environment is relatively calm for distressed strategies at the moment. Credit spreads have started to widen since the beginning of the year as economic fundamentals have deteriorated. Nonetheless, apart from specific cases, spreads in bonds, loans and structured products remain relatively tight. While the opportunity set remains relatively modest, current economic uncertainties are no longer easily overlooked, as current inflation levels will limit central banks’ capacity to save the market once again. Furthermore, reference rates are still at the bottom as the Fed has not yet announced its first hike and the ECB has not yet indicated a clear timeline. Issue volumes have been very high since 2010, while access to credit has been relatively loose, so the pipeline of opportunities should be relatively high. The geopolitical and economic changes brought about by the war in Ukraine will not make things any easier going forward.
Long-Short Credit & High Yield
Credit spreads have widened but remain close to historical lows. Investors now believe that the power of the “Fed put” will progressively start to fade away, 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 in 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 to the Chinese economy. Emerging Markets credit spreads have widened considerably. This is seen as an appealing opportunity 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 to keep their balance sheets in check.