July saw a continuation of last month’s market trends. Long-term US Treasury yields continued to drop, with investors adapting their positioning to a slightly more hawkish stance from the Fed, and growth stocks continuing to outperform as investors feared peak growth might be behind us. However, the almost-overnight wipe-out of most of the Chinese for-profit education industry caught everyone’s attention. The continuous pressure that the Chinese government has put on specific sectors has obviously raised a lot of questions about what investors should expect, going forward.
Equity market performance, pushed not only by the outperformance of the technology and healthcare sectors but also by growth stocks, was strong in most US and European markets. Logically, Hong Kong and China equity indices were the main underperforming equity indices.
Medium- and long-term US Treasury maturities, moved by a mix of some investors moving to safe-haven assets and others covering losses from reflation trades, continued to rally. Credit spreads continued to go tighter across the whole rating spectrum.
The HFRX Global Hedge Fund EUR returned -0.49% for the month.
Long Short Equity
July was a challenging month for Long Short Equity strategies, with a high level of dispersion of focus and style across regions. Although most brokers and indices posted average negative absolute performances, alpha generation was strong, mainly due to short book positions in energy, industrials and communication services. Asia Long Short Equity funds underperformed European and US peers, driven by the sell-off in crowded longs in both the internet and the for-profit education industries. Most managers continued to de-gross their funds during the summer to avoid being caught trading on lighter volumes in a volatile environment. Internet companies in China are a major source of investment thematics for Long Short Equity funds looking for steep growth trajectories. While international investors are a bit spooked by the strong government intervention, domestic investors seem to be taking this new reality very pragmatically. Don’t go against the government. They highlight emerging areas of investment in healthcare and business services which will be source of growth for years and be less prone to intervention.
Although this month remained difficult for Global Macro strategies, performances were more dispersed. The reflation trade unwind was still one of the main factors contributing to negative performance, with US Treasury rates going lower. While bigger managers need more time to unwind their sizeable position, smaller strategies are short again US long-term rates considering the move down was exaggerated and not reflective of current inflation risks, mainly in the US. While Global Macro funds can suffer at times from a noisy market environment, we believe they could be an interesting investment opportunity for those seeking to capture asset repricing moves in a persistent upward inflation market. We continue to favour discretionary opportunistic managers who can draw on their analytical skills and experience to generate profits from selective opportunities worldwide.
During the month, performances were mixed across quantitative strategies. Volatility around the US dollar currency crosses was generally one of the sources of the negative performance due to trend reversals. Long fixed income positions were generally positive contributors to trend followers. On average, CTAs remain positive on a year-to-date basis, despite the strong rally in US long-term Treasuries. Quantitative market-neutral strategies performed relatively well during the month.
Fixed Income Arbitrage
The US fixed income market has been dominated by the unwinding of the steepening trade, which triggered a violent flattening of the curve following the Fed comment. This movement has been amplified by the trend-following CTAs, which have put even more pressure on the rally, as they were piling up in this unexpected trend. Fixed-income managers hence had to apply all their skills to minimizing losses. In the relative-value space, those technicals should ultimately be brought to fruition, as trend reversal is being used to create a healthy environment for the strategy.
The repositioning of the investment community around the reflation trade generated short-term volatility on cyclical commodities and Emerging Market currencies, which were also affected by the move on the US yield curve. Emerging Markets will be natural beneficiaries of a continuation of the world’s economic recovery. However, there are important moving pieces, such as COVID-19 infection levels and the resilience of world economic growth, which will probably lead to higher volatility levels. Emerging Markets are an appealing investing ground for investors seeking decent-yielding fixed-income assets. Although EM fundamental managers reckon the space is an interesting option in a zero-rate world, considering the fragility of fundamentals, they usually adopt a very selective approach. Caution is required, due to the higher sensitivity of the asset class to investor flows and liquidity.
Risk arbitrage – Event-driven
Merger Arbitrage strategies were, on average, down for the month. Performances were negatively affected by the Aon / WillisTowerWatson deal break and by average deal spreads continuing to widen. Investors are incorporating the fact that the recent Joe Biden appointees to the US Department of Justice and to the FTC (Jonathan Kanter and Lina Kahn respectively) are public figures known for endorsing strong views against big technology conglomerates. It is feared that this new Administration will increase the level of scrutiny, prolong the time required to close deals but also require a higher number of concessions to validate mergers. Nonetheless, merger arbitrage teams remain optimistic, because the number of announced deals remains healthy, the company management teams survey demonstrates a willingness to pursue corporate activity designed to adapt to the current environment, capital is abundant and financing rates are low. Year-to-date, the strategy averages mid-single-digit returns but is able to deploy capital going forward at very interesting deal spreads.
Stressed and distressed strategies did well during the month, benefiting from idiosyncratic profitable trades and a positive risk-on sentiment. The last 12 months have been, on average, the highest performance period since the Great Financial Crisis (GFC) of 2008. The COVID crisis, managers believe, although very different by its origins and its impact, will be a source of opportunity for years to come. During the GFC, the market dealt with a financing crisis following the collapse of major financial institutions; the current financial landscape is characterized by relatively sound financial institutions but where bank financing, by force of regulation, has been replaced by support from non-banking financial institutions like hedge funds. The opportunity-set is hence wide and varied. We favour experienced and diversified strategies to avoid having to face extreme volatility swings. It is not going to be easy but this is the environment and opportunity-set these managers have been waiting on for the last decade.
Long short credit & High yield
Following the market crash at the end of the first quarter of 2020, hedge funds have opportunistically loaded on IG and HY credit at very wide spreads. Managers that were able to go into offensive mode were aggressively buying on the market or making off-the-market block trades, whereas other managers, unable to meet margin calls, needed to quickly cut risk. Since then, spreads have completely reversed 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.