CTAs are currently holding a net short position in commodities and developed market equities, and have increased their net long exposure to fixed income, in what signifies a clear, deflationary position. This defensive posture would suggest that managers are expecting further downward pressure on inflation expectations (to do with many factors, the most important being China’s slow down) and is a sign that CTAs think that further deflationary risks lie ahead.
This is a somewhat sombre, downbeat outlook for early 2016. The opening weeks of the year have been some of the worst on record for global stock markets. Over the first two weeks, the S&P 500 saw USD1 trillion erased off its market valuation, the Nasdaq was down 7 per cent. According to Bank of America Merrill Lynch, January’s volatility had wiped out an estimated USD8 trillion. China was forced to hi the circuit breakers and close its markets after the CSI300 incurred losses of 7 per cent in just 15 minutes on 7 January. It has, in short, been a period of wild volatility.
This has led to a severe reduction in trend signals as CTAs’ systematic models seek out the best contracts to trade across the globe. Within equities, CTAs have been quick to reverse their net long position from around 40 to 50 per cent (as a percentage of NAV) in November to a net short position of approximately -10 per cent. They are now holding a limited number of short contracts in equities. The same is true of commodities, according to Philippe Ferreira, chief strategist at Lyxor Asset Management.
“Back in September 2015, CTAs were, on average, -7 per cent net short whereas in the early part of January they were -11 per cent net short. Energy and precious metals are the two sectors, in particular, where they are most net short. More recently, they have slightly reduced their net short position on energy as a result of the higher volatility but as a structural trend, thy remain net short and we expect this to continue for the next few months,” says Ferreira.
Short energy has contributed most of the gains made by CTAs in January, which have made a good start to the year. The average CTA, according to Lyxor, returned between 3 and 4 per cent. The SG CTA Index (maintained by Societe Generale Prime Services) was up +4.35 per cent through 27th January, 2016.
As mentioned, CTAs are holding a net short position on developed market equities in tandem with a short commodities stance. Ferreira says that CTAs have reduced their exposure to US and European equities by an order of magnitude “comparable to the adjustment that took place last August”.
The third week of August in 2015 was another period of volatility with markets collapsing over a period of days. At that time, CTAs aggressively adjusted their weighting towards equities. A similar situation arose in January.
“Discussing this with numerous managers, they say that their trend models are identifying very few asset classes to allocate to. For example, Lyxor Epsilon Global Trend is a fund that looks across 60 different global futures markets. At present they have signals on a very limited number of contracts. Across equities, their positioning is concentrated in just a few areas,” confirms Ferreira.
Their ability to quickly reverse out of a net long position in equities as the stock market chaos unfolded in January not only helped CTAs to minimise losses; it also helped contribute gains, as models sought out the most attractive contracts to short. This is just part of the reason why CTAs can provide investors with an effective hedge to their portfolios in terms of market volatility.
“Being short equities, short commodities and long fixed income has proven to be the right combination so far this. This is the best performing strategy in 2016,” says Ferreira.
For the time being, the negative pressure on risk assets might push CTAs to maintain a defensive stance, with Ferreira believing they will likely remain long on fixed income for some time to come.
“Over the past two years CTAs have continued to allocate to fixed income while discretionary managers were anticipating higher bond yields. They have benefited from making the right call on fixed income, as yields have continued to fall. In other words, CTAs have not bought into the idea that the bond rally was over,” says Ferreira.
Currently, the average CTA is 20 per cent long on US fixed income and 50 per cent net long on European fixed income. This has increased since market volatility increased although, on aggregate, it is slightly lower than during November 2015. Again, as with equities and commodities, CTA models have found fewer positive trend signals in fixed income. This can best be appreciated by putting things into context: on the one hand, clear trends have been harder to identify because of rising short-term rates on US bonds in the wake of the first Federal Reserve rate hike last December in nigh-on a decade.
On the other hand, the chaos in global stock markets in January has led to a risk-off stance amongst investors. The market sell-off has helped support fixed income in a classic flight to safety move.
How long this lasts is anyone’s guess, but the point is that despite the Fed rate hike, Treasury yields are yet to show signs of upward momentum. Quite the contrary. The US 10-year Treasury yield, for example, steadily fell during January from 2.26 per cent to 1.92 per cent.
“These two conflicting trends have reduced the level of conviction among CTAs compared to the end of 2015, even though they remain net long. I suspect we will see more money being allocated to fixed income as the trend signals become clearer over the next few weeks,” concludes Ferreira.
At a time when market uncertainty abounds, CTAs are demonstrating that their ability to build a deflationary stance is proving effective.
