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US equity markets experience best month in a year in July

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The Hennessee Long/Short Equity Index advanced 1.81 per cent in July after the US equity markets experienced their best month in a year on better-than-expected corporate earnings. 

The top performing sectors were materials (+12.2 per cent), industrials (+10.3 per cent) and energy (+8.0 per cent).

The healthcare sector was the worst performing sector in July, up only 1.3 per cent, and is the worst performing sector year to date, down 7.6 per cent, according to the data from Hennessee Group. 

Long/short funds lagged equity markets during the broad-based rally, due to low net exposure levels and losses experienced in short portfolios. Thus far this year, stock picking has been challenging with the main issue being the very high correlations in stocks and sectors. Periods of high correlation are not uncommon, but are temporary. They also produce opportunities as fundamentals become misaligned with prices. 

Since many hedge funds rely on fundamental bottom-up research, the recent market, which has been dominated by macro themes, has been difficult. As second quarter earning reports were released, the markets started to respond more to fundamentals, allowing managers to generate alpha. Hennessee says this should hopefully bode well for an improvement in long/short equity performance during the second half of the year. 

“One of the primary concerns of hedge funds is related to income tax and regulatory policy. Recent regulatory action is considered by most managers to result in a drag on future GDP growth,” says Charles Gradante, co-founder of Hennessee Group. “In addition, the regulatory environment has also proven to be extremely unpredictable causing reduced appetite for risk. Hedge fund managers historically have reduced exposures when they have less clarity in fiscal and monetary policies. The current environment is prompting funds to be defensive, with managers closely monitoring the political landscape and the November elections.”

The Hennessee Arbitrage/Event Driven Index advanced 2.06 per cent in July (+4.51 per cent YTD). Arbitrage and event driven managers posted gains as volatility declined, liquidity improved, equity markets rallied, and credit spreads tightened. 

During the month, the spread on the BofA Merrill Lynch US High Yield Index tightened from 713 basis points to 657 basis points. Managers remain selectively optimistic in credit as high yield spreads remain wider than historical averages, default rates are expected to decline significantly, corporate balance sheets are greatly improved, and low interest rates are driving increased inflows into high yield. 

The Hennessee Distressed Index increased 1.75 per cent in July (+6.05 per cent YTD). Distressed funds benefited from their net long bias and experienced a rebound after sell offs in the two previous months. While low interest rates are allowing many companies to refinance and otherwise avoid bankruptcy, there remain many over-leveraged companies that will struggle in a muted growth economic environment. In addition, managers are looking towards 2012 to 2015 when USD1trn in high yield and leveraged loan securities are scheduled to mature.   

The Hennessee Merger Arbitrage Index advanced 0.80 per cent in July (+2.41 per cent YTD). During the sell off in May and June, previously unattractive spreads on quality deals widened to attractive levels, with the average deal spread reaching ten per cent to 12 per cent at the beginning of July. Managers added to core positions in June and benefited as stocks rebounded in July. In addition, deal activity has accelerated, with more than USD90bn in announced deals during the last few weeks. Managers remain optimistic due to large amounts of cash on corporate balance sheets, large amounts of investable cash at private equity firms and low interest rates, which allows companies to raise capital cheaply. 

The Hennessee Convertible Arbitrage Index advanced 2.69 per cent (+3.03 per cent YTD) in July. Managers are relatively optimistic on convertible arbitrage as the May-June sell off created attractively priced opportunities. Corporate credit remains stable as companies have built defensive cash balances and have reduced leverage on balance sheets. In addition, the low-interest rate environment allows funds to utilize leverage and enhance the positive carry on portfolios. Volatility is also elevated, which provides trading opportunities for hedge funds.

“Hennessee Group remains concerned over the Treasury market bubble. Besides the end of 2008, the ten year treasury has not been below 3.00 per cent since the 1950s. Nonetheless, macro managers continue to lose money on bearish treasury yield curve bets,” says Gradante. “In addition, the spread between the ten and 30 year treasury has widened to 110 basis points, near a historical high. For the first time in many years, managers and the Hennessee Group are talking about the possibility of a ‘hockey stick’ yield curve. The Fed is likely to keep the ten year bond low to assist the housing market while financing its deficit in the 20/30 year sector.”

The Hennessee Global/Macro Index increased 1.92 per cent in July (+0.29 per cent YTD). After three months of losses, international equities reversed course in July and experienced a sharp rally as the MSCI EAFE Index advanced 9.41 per cent (-6.70 per cent YTD). 

During the month, European stocks performed well after favourable results from bank stress tests, with the MSCI Europe Index increasing 11.54 per cent (-8.97 per cent YTD). 

Hedge funds lagged due to conservative portfolios, as the Hennessee International Index advanced only 1.77 per cent (-0.48 per cent YTD). The Hennessee Macro Index declined 0.60 per cent for the month (-0.26 per cent YTD).

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