Hedgies

Last week, Louis Bacon decided to call it quits. After three decades at the top of the hedge fund industry, Mr Bacon’s decision to close Moore Capital Management to outside money is understandable — but nonetheless symbolic of how difficult “global macro” hedge funds such as Moore have found the past decade.

Many traders that once profited handsomely from big, bold bets on seismic economic trends have lately struggled to live up to the reputations they forged in the 1990s. As if to hammer the point home, Stone Milliner Asset Management, a $3bn macro hedge fund established by Bacon acolytes, last week also told clients it was winding down, according to Bloomberg.

This followed the closure of other prominent macro funds, such as those managed by John Burbank’s Passport Capital and Hugh Hendry’s Eclectica.

The hedge fund industry as a whole is facing headwinds with performance stuttering, investor money seeping out and closures on track to outpace new launches for a fifth year in a row. But for macro hedge funds, Mr Bacon’s bowing out may prove a landmark in a slow, potentially terminal decline.

Journalists are naturally wary of predicting the death of anything, given the long record of rash prognostications marking a turning point. Businessweek running a cover story on “the death of equities” on the cusp of the strongest stock market bull run in history is an apt example.

Macro funds still manage $245bn, according to eVestment, despite suffering $23bn in outflows this year. Several of the biggest — such as Brevan Howard, Caxton Associates and Tudor Investment Corp — are enjoying something of a renaissance lately. Greg Coffey, another prominent Bacon protégé, has also had a banner year.

But there are several reasons why macro funds, at least as we have come to know them, might be in at least secular decline. In his final letter to investors, Mr Bacon said “disappointing results . . . obviously inform this decision” but in a call with the FT he expanded on the crux of the problem: “One part of the macro toolbox is missing — volatility.”

It is true that market volatility has been sloping downwards for years. Aside from the occasional burst of turbulence, stocks, bonds, commodities and currencies have all become increasingly quiet.

What is less widely appreciated is that this market tranquillity is not caused just by low interest rates and quantitative easing — though central banks have played a big role — but it also reflects an era of macroeconomic calm.

This may seem odd, given that the global financial crisis, Europe’s subsequent turmoil and periodic bouts of emerging market chaos are still seared in the memory. Nonetheless, the data paint a remarkable picture of macroeconomic “secular stability”, as M&G Investments’ Eric Lonergan has dubbed it.

Yes, the 2008 recession was severe but it was less destructive than many feared a global crisis of that magnitude would prove. And both before and since, a range of economic indicators have been far less volatile than historically has been the case.

Inflation is the most notable example, proving astonishingly resistant to both booms and busts over the past two decades, but JPMorgan Asset Management has calculated that the rolling 20-year growth rate across 17 developed economies is now the steadiest it has been since the late 19th century.

That is a difficult environment for hedge funds that specialise in profiting from economic trends and dislocations.

Of course, this era of tranquillity for the global economy could shatter. But many of the tricks of the trade that the industry’s big players pioneered are now commoditised and systematically mined by quant funds.

The talent pool is also drying up. Most of the well-known macro hedge fund managers learnt their craft at the proprietary trading desks of investment banks. But those have been hacked back since the financial crisis and being a good market maker is a fundamentally different skill from placing big punts.

That raises the question of where the next generation of great macro traders is going to come from.

There will still be opportunities in certain areas, such as finely constructed trades around political events that machines will always struggle to fathom. Macro hedge funds are clearly not going to disappear. But they will look very different from the firms that once reigned over the industry. 

Crowd. bonds.

When we start to measure the most eye-popping market moments of 2019, the accumulation of negative-yielding debt to a peak of $17tn in late August will take some beating.

The stack of debt in the deep freeze, which effectively forces buyers to take a nominal loss when holding to maturity thanks to achingly high prices, has since shrunk. Even so, the tally still stands at about $12.6tn, including $1tn of corporate debt.

The still elevated total is a symptom of a bigger problem — some central banks are continuing their grand adventure in keeping policy rates below zero while others in the UK, Australia, Canada and the US are holding just above that dividing line.

That leaves investors, particularly those of a younger age, facing a tough time building portfolios that benefit from the textbook trade-offs between fixed income and equities, as seen back in August.

This aspect was recently highlighted by Richard Clarida, vice-chair of the US Federal Reserve, when he noted “the value that bonds have provided over the past 20 years as a hedge against equity risk”.

In short, a diversified investment portfolio that experiences a big drop in the value of risky assets such as shares and corporate bonds is bolstered in part by an appreciation in the value of long-dated government paper.

During periods of strong performance for risky assets, the fixed returns of long-dated government bonds also provide a stream of income that can be reinvested over time at higher yields.

Now there is a groundswell of concern among investment managers about how the current financial system is built on shakier foundations — negative-yielding paper and government bonds that provide meagre fixed coupons of interest. This limits those bonds from playing an effective role of acting as ballast for portfolios should they suffer in the event of a market shock.

The yin and yang between government bonds and equities has been on full display during the past 12 months.

The 10-year US Treasury yield peaked just shy of 3.25 per cent in early November of 2018 as the Fed was tightening policy and shrinking its balance sheet.

When equities and credit markets subsequently plumbed the depths in December last year, long-dated government bonds were already appreciating sharply in price terms, sending their yields tumbling.

David Kelly at JPMorgan Asset Management makes the point that, since 2009, “a plain vanilla, 60/40 portfolio of US stocks and bonds, rebalanced annually with dividends and coupons reinvested,” has generated “a total return of 221 per cent, or roughly 11.2 per cent per year”.

So far this year, the S&P 500 index has gained 28 per cent, including the reinvestment of dividends, while an index of long-dated US Treasury debt has delivered a total return of nearly 19 per cent.

But if a shock were to hit, the exceptionally high prices in Japanese and European bond markets mean there is less scope for a further rally.

Indeed, some investors have already taken advantage of Treasury yields climbing from their lows of August.

Earlier this month, the Treasury sold 30-year bonds at a yield of 2.43 per cent and demand was so strong that banks managing the deal were left with their lowest underwriting share on record, around 21 per cent.

But the limits of this bond hedge are clear to some investors, particularly when combined with the interest rate sensitivity, or duration, of key bond indices.

This explains why long-dated bonds have performed so well in the past 12 months as their high duration has spurred a pronounced appreciation in prices compared to paper with short-dated maturities.

Many market participants fear that this helps to make long-dated bond prices unusually wobbly.

BlackRock Investment Institute noted this week how a rising average duration in bond benchmarks “makes them more sensitive than in the past to swings in interest rates, with potential for greater volatility”.

Even without a sharp economic downturn, bonds could prove to be a feeble bedrock for a portfolio.

“Fixed income will provide very little in the way of real returns if the economy merely moves sideways,” said Mr Kelly at JPMorgan Asset Management.

This, he said, forced investors to look elsewhere for solid ways to diversify a portfolio, including considering real estate and stable dividend-paying companies, and areas of emerging markets where dollar-denominated bonds have performed strongly this year with relatively high yields.

For the conservative-minded who have up to now enjoyed the security and solid returns of a portfolio split between bonds and equities, this year’s spike in negative-yielding debt suggests investors need to alter their approach towards what is truly fixed income.

Late cycle m and A.

It is boom time once again in corporate America as chief executives agree to a rush of multibillion-dollar tie-ups.

But the consolidation — which topped $70bn this week alone and included deals for the high-end jeweller Tiffany and discount broker TD Ameritrade — has left investors with a burning question — is this a signal of the bull market’s impending end?

The rising proportion of stock-based M&A deals — the highest level since 2000 — is just one alarm bell of possible late-cycle behaviour.

Takeovers where an acquirer pays only with its own stock, as brokerage Charles Schwab did this week when it agreed to buy smaller rival TD Ameritrade for about $26bn, account for nearly 20 per cent of deals this year, according to data provider Refinitiv.

High valuations for the $3.4tn worth of takeovers agreed so far this year have also made US stock investors nervous. Companies and buyout groups are paying about 22.5 times the net income a target generates in a year.

While that is down from a 2018 peak, it remains at its second-highest level since 1998. This has affected how companies are deciding to structure their takeovers as well as whether they go ahead with a deal at all.

Winston Chua, an analyst at TrimTabs Investment Research, pointed out that flurries of M&A tend to peak around market tops as “companies attempt to buy growth rather than grow companies organically”. In the past, record dealmaking has coincided with market peaks as it did on the eve of the dotcom boom-and-bust in 1999-2000 and then again ahead of the financial crisis in 2006-07.

Mark Grant, chief global strategist at investment bank B. Riley FBR, said equities were “toppy”, given stretched valuations and slowing earnings momentum, adding: “The rash of M&A deals shows companies are looking for growth.”

Optimists believe this time is different. To them, supportive monetary policies from major central banks, including the US Federal Reserve and the European Central Bank, can lengthen the ageing and vulnerable M&A and stock market cycle.

“A pick-up on M&A could fuel and lengthen any ongoing rally in the stock market,” said Jim Paulsen of the Leuthold Group. “It may eventually signal a market peak but it could be from much higher levels. M&A is just a single indicator among many impacting stock market conditions.”

Meanwhile, investors’ ferocious appetite for returns and yield, particularly against the backdrop of trillions of dollars of negative-yield bonds, has sent them looking for income and opportunities in equities.

“What we are seeing in the recent bump in M&A activity is that corporates and other investors have concluded that despite the advanced age of the current cycle we are not about to descend into a recession, rather that the current cycle still has legs,” said Eric Shube, head of US M&A at law firm Allen & Overy.

Hedge fund investor Thomas Hayes of investment firm Great Hill Capital said dealmaking could yet accelerate without signalling a market top, particularly if a trade deal between the US and China is agreed and a global downturn is averted.

One test case that investors can look to is 2015 when M&A set a record high. While that year was followed by a brief slowdown at the start of 2016 alongside a slide in commodity prices, deal-making and stock prices ultimately recovered.

“The cycle has room to run and will be reflected in accelerating M&A,” he said. “It’s a sign that animal spirits are coming back into the market and fear is thawing.” But the rush of big-ticket M&A deals set against the old age of the current upswing in major equities markets still has many market watchers on edge.

The risk of a near-term pullback for the benchmark S&P 500 index is “quite high” following its 25 per cent surge so far this year, said Lori Calvasina, head of US equity strategy at RBC Capital Markets.

“Levels of confidence have been trending lower and are well below the highs of the current cycle,” she said. “The most noteworthy deterioration has occurred in the Conference Board CEO gauge, which is actually nearing levels typically seen in recessions.”

Bankers who work on mergers said that the higher prices for companies, as well as fear that the stock market is due for a correction, has prompted boards to use their own stock for deals with the view that if stocks do decline, they will at least be saved from overpaying for a takeover with cash.

Investors have warned of other signs of a market top already this year, pointing to overhyped valuations of venture capital-backed groups such as property leasing company WeWork — the SoftBank-backed group that ultimately had to restructure itself.

News that private equity giant KKR had submitted a bid for the $70bn drugstore chain Walgreens Boots Alliance, which would amount to the largest leveraged buyout in history if agreed, also reverberated across Wall Street, with some investors pointing back to the last big PE boom ahead of the financial crisis.

Days earlier, rating agency Fitch warned that losses on leveraged loans, a market that is critical in funding buyouts, would experience greater losses than it previously thought.

‘The cycle has room to run. It’s a sign animal spirits are coming back into the market’