The upcoming US elections and the possibility of a rate shift in the UK and Europe could present hedge funds with alpha hunting opportunities, writes Hedgeweek Editor-in-Chief, James Williams…
The last decade was dominated by sustained central bank intervention, giving rise to supercharged performance in equity and bond markets. And stripping away volatility like one would offensive wallpaper in a new home. This was not a period for hedge funds to operate at their optimal best, but perhaps this new decade – and indeed this year – could start to re-introduce some much needed volatility and give hedge fund managers something to really shout about.
The upcoming US elections and the possibility of a rate shift in the UK and Europe could present hedge funds with alpha hunting opportunities, writes Hedgeweek Editor-in-Chief, James Williams…
The last decade was dominated by sustained central bank intervention, giving rise to supercharged performance in equity and bond markets. And stripping away volatility like one would offensive wallpaper in a new home. This was not a period for hedge funds to operate at their optimal best, but perhaps this new decade – and indeed this year – could start to re-introduce some much needed volatility and give hedge fund managers something to really shout about.
Geopolitical events, such as the US/Sino trade tariff war, which saw the VIX Index spike up to 24.5 on 5 August last year and cause the S&P 500 to drop nearly 5 per cent on the day, presented short-term trading opportunities. But they were short lived. 2019 was punctuated by bouts of volatility, but nothing of a serious, sustained nature. Since August, US equities have rocketed up 15.6 per cent (at the time of writing).
A quick look at industry performance data tells us that equity long/short funds, on average, had a great year. According to eVestment, they returned 14.26 per cent. But this needs to be placed into context.
In December 2018, the US market had a significant sell-off. Equity-focused funds ended the year down 7.01 per cent. This was an over-reaction by the market, and devoid of fundamental economic reasoning. Investors were spooked. But it was short-lived.
Many of the gains subsequently made in 2019 simply offset December’s losses.
“People have a habit of looking at calendar years, as opposed to averaging out returns,” says Ray Nolte, co-CIO of SkyBridge Capital. “With respect to US equities, if you’d averaged out returns over the last three years, you’d probably be in a low teens area; and that’s a lot different to looking at a 25 or 30 per cent uptick in 2019.
“Yes, it was a strong year for US equities, but not when you put it into the context of that aggressive sell-off. So I would advise people to maintain a sense of perspective.”
Whether there is a US equity contraction this year (or 2021) could depend on the outcome of the US presidential election on 3rd November – it is a key driver and one that will determine to what extent volatility will rise.
In Nolte’s view, the chances of a US recession this year are 1 in 4 (he thinks it’s more likely to be 2021). Who the Democrats back in the summer could be a key window of opportunity for active managers.
“Joe Biden is still the lead horse. Elizabeth Warren and Bernie Sanders are neck and neck. As we move into the summer, they will be drawing from, and therefore splitting, the same voter base. Ours is not a winner take all system, it’s a proportionate system. It’s not inconceivable that we get to the summer and we have a ‘brokered convention’, where no one goes in as the outright winner in the first round.
“Then it becomes a lot of horse trading. That could be the window of opportunity that Michael Bloomberg looks to capture.
“The feeling here in the US is that if Trump goes up against Sanders or Warren, in both cases Trump wins,” argues Nolte.
Over in Europe, last quarter saw the Eurozone grow by approximately 0.1 per cent, according to the dynamic factor model used by IHS Markit. That is the lowest period of quarterly economic expansion since 2013.
This might present short-selling opportunities for hedge funds, especially in companies that have thrived in a near zero interest rate environment (negative if one considers Germany) for years, exploiting cheap debt to support their business activities; which would otherwise have seen them collapse in a more modest rate regime.
Even though Q4’s growth figures were disappointing, there are signs that the EU might start to introduce fiscal expansion measures and raise rates having run out of monetary policy levers to pull, if inflation returns in some capacity.
If this does happen, it will probably be a case of Europe following the UK’s lead.
“As much as the UK economy will enjoy a boost from the public purse, be in no doubt it will also be spurred on from private sector investment, funded from within and overseas,” says Dr Savvas Savouri, Chief Economist and Partner, Toscafund Asset Management.
He points out that having seen purchasing manager sentiment fall throughout 2019, and inventories bled as a consequence, both are likely to rebound, providing a welcome boost to production.
“Over on the Continent, I expect the realisation that the monetary policy tank is empty to trigger a not dissimilar fiscal response (to the UK); something which has long been needed but resisted; notably within Germany and other hard-core EU Member States.”
If rates do rise, this will present opportunities for fixed income traders and global macro players. In the US, one investor tells me that they expect US Federal Reserve policy to be neutral in the first half of 2020, to potentially one of tightening later in the year.
“In Europe, it appears they are going to at least try to move back to a zero interest rate policy (ZIRP) from a negative interest rate environment. Even going back to a flat rate environment, the magnitude of a bond sell-off could be extremely fast and violent. So I think we are going to see some interesting rate moves coming this year,” Nolte tells me.
Brexit and the fact that Germany’s industrial output fell in November are obvious points to raise against a rate hike argument. As Reuters reported, “current pricing suggests a roughly 45 per cent chance of a hike by year-end”.
Where hedge funds could also benefit, if and when we move into a higher rate environment, and possibly a more volatile equities market, is reduced investor confidence to plough assets into low cost passive products, which has rightly delivered tremendous performance during this prolonged bull market.
More volatility – which would be fuelled further by an ETF sell-off – will support discretionary stock pickers as opposed to passive products, where companies are bought indiscriminately, regardless of their true fundamental value.
“Security selection, whether it is in equities or fixed income, is going to matter again in 2020. It will give hedge fund managers a fighting chance of doing a bit better than during the previous years; it hasn’t been a ‘horrible’ period for them but it hasn’t be overwhelming,” says Nolte.
This summer could be a key period, ahead of the US election and ultimately determine, to some extent, whether hedge funds end up having a resurgent year or another mediocre year.
A lot will depend on what is driving the broader markets – from both a rates as well as an equities perspective.
