Financial markets started the year on the right foot. Investors were pricing a further extension of the current cycle driven by an improvement of corporate earnings and the easing of trade war tension between the US and China. This led to strong market performances across the board, until the Chinese Government released some piece of information on the potential dangerousness of the coronavirus. It sparked a strong risk-off move among investors, struggling to grasp the potential negative impacts of this virus to the world economy.
Apart for a few exceptions, most equity markets finished the month of January in the red. The NYSE Arca Oil Index, an index of leading oil Exploration and Production companies declined just above 12% during the month. Chinese equity indices were closed during the last week of January and dropped around 8% on the first trading session of February.
Sovereign debt was the go to runway solution for many investors looking for safety. Government yields dropped across the board for most issuances. The US Treasuries’ yield for a 10Y maturity declined by around 20 basis points to end the month at 1.59%.
As it is usually the case, in a risk-off environment, commodities linked to industrial production did not perform well during the month. Futures on natural gas, oil and copper were down low double digit figures.
The HFRX Global Hedge Fund EUR declined by 0.07% during the month.
LS Equity funds held up well during the month, however, performance was dispersed across regions and styles. According to prime broker data, US focused funds outperformed strategies investing in Europe and Asia. US LS Equity managers returned on average 1% for the month while European and Asian funds declined, on average, by 1%. The start of the year saw a strong contribution from style factors, with Hedge Funds benefitting from being long growth and short value. Information Technology sector specialists were among the biggest beneficiaries of this spread due to the outperformance of their longs relative to their shorts. Value bias strategies underperformed competing LS Equity strategies. Gross exposures remain relatively high, but, net exposures are moderate, indicating some level of caution across managers due to economic uncertainty and rapid sentiment changes. The market is tricky due to stretched valuations and a cloudy outlook. However, there are many interesting ways to invest in the equity market from a directional or a relative value perspective. Good managers will benefit from the current situation to build a balanced portfolio of long and short investment opportunities. This strategy offers a wide range of levers that, from a long or short perspective, can be used to benefit from industry restructurings and sector dispersion.
It was a tough month for Global Macro strategies, especially, managers with a net long bias. Many were long risk following the first stage agreement between the US and China on trade, and were expecting a positive impact on financial asset prices from further fiscal stimulus and monetary easing announced by China. Fundamental managers with winning idiosyncratic trades managed to print interesting performances. Shorting energy and being long fixed income were also money makers. Before the coronavirus, Asia and Latin America seemed to be gathering some consensus among investors as an opportunity to invest in 2020. Until this health crisis is contained and taken care off, the outlook becomes a bit more blurry. With developed market rates pointing downwards, EM high-yielding assets are somewhat desirable again. In this environment, we would tend to favour discretionary opportunistic managers currently on the sidelines awaiting asset price dislocations. These managers can use their analytical skill and experience to generate profits from a few strong opportunities worldwide.
There was a relatively high dispersion among quantitative strategies during the month. Trend following models tended to be flat to negative because gains on fixed income were balanced by losses on currencies and equities. Break out models tended to do well during the period, benefitting from rising volatility levels. Morgan Stanley pointed out in their Quant Trends report early this year that quant strategies is a business with entry barriers getting lower by the day, however, barriers to success are still very high. Advances in technology have helped democratize the access to become a quant manager, but the rising costs of data, talent and business set-up, have made it very difficult to be in the elite winning circle.
Along many other markets Fixed Income adopted a risk off character in January with some concerns over the impact the coronavirus would have on the global growth. The US curve bull-flattened as investors ran for safe assets. Emerging Markets and commodities sold off against the dollar. The 10Y rallied by over 40 bps. Despite the interest rate curve flattening, implied volatility on the short-end surged as investors were forced to re-define the path of official rates. Managers are assessing the impact of the Chinese economy on the rest of the world. For countries with large economies, where trade with China does not represent a significant part relative to its overall size, the impact should not push these countries into recession. For the others, the impact has already been priced in, but if contained, the effect will only be temporary. Interest rates volatility offered opportunities to Fixed Income managers.
Emerging Markets are recovering from previous losses and benefiting from improving investor sentiment on relative value analysis. The big picture still presents high levels of uncertainty, however, in a sluggish growth environment. Emerging Markets assets remain interesting opportunities for investors hungry for yield. Furthermore, declining US rates are kicking the problem of dollarized debt EM economies down the road. Argentina will be closely followed as a future indicator for the country and of the EM region as an attractive investment proposition. It has not been an easy environment for EM strategies. Nevertheless, there are strong dislocation-generating opportunities for seasoned opportunistic managers.
2019 was a strong year for M&A. During the 4th quarter, there were around $1 trillion dollars of deals taking the total of the year to just over $4.1 trillion. Technology and industrials sector drove consolidation across the World, and healthcare mergers were very active in the United States. The start of the year was slower in terms of deals.
January was a decent month in terms of performance for merger arbitrage strategies. Bristol-Meyers Squibb completed its acquisition of Celgene, AbbVie / Allergan spread tightened after receiving regulatory approval from the EU, NVidia / Mellanox Technologies deal contributed to performance as investors were confident that the transaction would close successfully.
Some of the managers we track point out that hard catalyst deals are pricing a 10% unlevered IRR, which, in a low rate environment is in the shopping list of many investors. Assuming that Brexit and trade wars are less of an issue in 2020, Asia and Europe M&A might provide a positive tailwind since there has not been a strong M&A environment for some time.
Distressed strategies have not performed well last year. Performances have been impacted by idiosyncratic situations like the bankruptcy of PG&E and by investors’ reluctance to bid for complex situations during times of high uncertainty. The 2019 recovery was accompanied by a deterioration of sponsorship in the more complicated parts of the credit spectrum. CCC bonds in the US are now trading above a 1000bp spread. Should corporate bond default, rates would begin to rise over the next 2 years. One could expect a repricing of credit risk across the whole credit spectrum. Managers are raising cash levels to keep dry powder, waiting to reload their portfolio with any new issues that hit the distressed market. We are closely monitoring distressed managers, due to the potential of high expected returns, but remain broadly on the sidelines.
Despite some more volatility, spreads – supported by the hunt for yield – are still heading in the same direction. Hence we remain underweight, as there is limited-to-no comfort in being short the credit market, where there is strong demand and the negative cost of carry is quite expensive.