Markets Weekly podcast - 26 April 2021
What to consider when investing in hedge funds, and why bond investors are on edge. Join host Michel Vernier, Head of Fixed Income Strategy, and Heath Davies, Head of Hedge Funds, both of Barclays Private Bank, for this week’s Markets Weekly podcast.
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Michel Vernier (MV): Hello, it's the 26 April and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will help you to navigate through the volatility of the global economy and the financial markets.
My name is Michel Vernier, Head of Fixed Income Strategy at Barclays Private Bank. Each week, we will be joined by guests to discuss the topics that matters most for investors and we evaluate the risks and opportunities.
Firstly, I will cover the events that moved the markets and grabbed the headlines over the course of the past week. I will then take a look at recent developments within the hedge fund segment, which have come back into focus through the recent distress scene with Greensill and Archegos. Finally, I will focus on some upcoming data and releases which are likely to shape the week ahead.
What have we learned this week? We have learned that Europe, for now at least, will not have a football super league. Fans said money can't buy everything and the same seems to apply for Europe.
So, let's turn our focus to Europe. Last Thursday, we had the European Central Bank (ECB) meeting. The ECB did not announce any changes to its current monetary accommodation, keeping the deposit rate at -0.5% and sticking to the current game plan with regards to the Pandemic Emergency Purchase Programme.
ECB President Christine Lagarde emphasised that Europe is in a different position compared to the US with regards to monetary accommodation. While the US Federal Reserve in the next coming months may increasingly discuss the tapering of the bond buying programme, the ECB said Europe is not ready for that and is still heavily reliant on monetary support. Lagarde said any phasing out was not discussed and it's just premature.
So the ECB keeps on buying European bonds at a high pace, trying to keep yields low at the entire curve. The euro has seen a bit of weakness from the elevated levels. So, going forward, the ECB will likely look at various factors, the renewed lockdown measures for example, which could potentially delay the recovery.
We've seen good news, too. The German court cleared the way for the €800 billion recovery fund but then political pressure and uncertainty is likely to reappear. The Italian budget outlook revealed the debt to GDP of Italy is rising towards 160% of the GDP, although a return to the 3% EU fiscal rule threshold is unlikely to be reached until 2024.
We also have German elections coming up later this year. The country’s Green Party seems to have gained ground and is now ahead of the major parties according to recent polls, so this may have implications for the future direction with regards to potential European fiscal unification. So, interesting times ahead for Europe.
In the US last Thursday, the White House revealed plans to almost double the capital gain tax rate for the wealthy from 20% to 39.6%. This has provoked a temporary weakness in the S&P 500.
Of course, it remains to be seen if the proposal will pass Congress in the current form. As things stand, the Joe Biden administration proposes to split the original $3 trillion fiscal plan into $2.25 trillion for the ‘American Jobs Plan’, focusing on infrastructure, and the ‘American Families Plan’.
Equity markets are likely to focus on the longer term perspective. Generally, there is a very supportive environment with economic data mostly surprising on the upside.
Data on Friday showed that US new home sales rebounded sharply in March to the highest since 2006. In the US, the composite purchasing managers’ index (PMI) climbed to 62.2 with new orders and export growth accelerating to an all-time high. PMI data has also accelerated in the UK, for example.
Apart from economic data, market participants will focus on the earnings season for the first quarter of 2021. Of the 120 companies in the S&P 500 that have announced their results in the first quarter, 85% beat analysts’ earnings per share (EPS). Looking at equity analysts’ earnings estimates, it seems that discretionary, the tax sector, and the materials sector will see the strongest earnings rebounds towards 2022, compared to pre-crisis levels.
Turning to emerging markets (EM), we've also seen market-moving headlines coming out of these nations. First, the Turkish lira showed renewed weakness as President Recep Erdoğan reshuffled his cabinet after the sacking of the trade minister. Currency traders are following events as the country generally needs to manage high inflation, low currency reserves. Recent changes of the head of the central bank did not help to gain trust in the Turkish lira so far.
In Brazil, President Jair Bolsonaro was able to put long-awaited budget rules into law which has led to a relief for the Brazilian real as it provides a go-ahead for the fiscal aid payments while trying to manage debt levels. The Brazilian real has gained on the back of the news.
And in India, Covid cases are creeping up at a worryingly high pace which could delay its crucial recovery. So, mixed news from the EM regions. Investors will be keeping a close eye on further developments in the region.
Last but not least, we have seen another record breaking mark reached – spreads for triple C rated junk bonds fell last week to 509 basis points, that’s the lowest since 2007. The yields, the overall yields of that segment, are just nine basis points away from the all-time low. Now Moody's sees the high-yield default rate falling to 4.2% a year from now from the current 7.5%. Also Fitch is very optimistic about decreasing default rates.
Now there seems to be a lot of optimism, but also risks. And this week we want to talk about how this relationship looks like in the hedge fund area. And I'm pleased to have Heath Davies with me, Head of Hedge Funds at Barclays Private Bank.
Hello Heath. Reviewing headlines over the last couple of months, Bloomberg reported last week that hedge fund assets reached a record-high of $3.8 trillion in the first quarter of 2021. What has driven the recent asset growth and what is the outlook for growth?
Heath Davies (HD): Yes, thanks Michel. Hedge fund assets under management (AUM) has naturally been boosted by the industry's strongest first quarter performance since 2000 on average and, depending on which index one looks at, gaining about 6% for Q1 2021. That compares to the S&P 500 which gained nearly 5.8% in the first quarter.
In terms of the environment with the new US presidency, we have had economic stimulus measures, COVID-19 vaccine administration and new virus variants all creating opportunities for hedge funds in the first quarter. This is while cryptocurrency volatility and sparking interest in heavily shorted deep-value equities like GameStop dominated the market. These, as well as the evolving macroeconomic and geopolitical dynamics, represented both risks and opportunities for specialised hedge funds’ actively managing portfolios.
In terms of outlook for growth, we've seen increased interest by investors in hedge funds. Barclays strategic consulting performed an annual survey that they released in February 2021 where they surveyed investors with over $5 trillion AUM and a net 28% of respondents stated that they plan to increase allocations to hedge funds in 2021 and beyond.
So to give you a sense at the industry level, in a Q4 2020 survey by the Alternative Investment Management Association, whose members account for over half of the AUM of the hedge fund industry, allocators that were surveyed named risk management as their number one objective moving in 2021 and over 40% of investors surveyed were expecting to allocate more capital to hedge funds in H1 2021.
This sentiment that we are seeing is in line with reports that we’ve seen from some of the very largest asset managers in the world like BlackRock – who reported similar positive investor sentiment towards hedge funds – and those reports were also released earlier in Q1 this year.
MV: Thank you. Interesting you're mentioning risk management. Another headline that attracted attention recently was Archegos, a family office that suffered substantial losses through the combination of concentration and leverage, which also caused billions of dollars of losses for banks. What have been the effects generally, and what has been the impact on the hedge fund industry more specifically?
HD: I think in terms of the general effects, the first thing to say is that recent reports have estimated the value of family office assets at almost $6 trillion globally, which is larger than the entire hedge fund industry.
So what we’ve seen is increased regulatory scrutiny that we would have expected to see given the size of the losses by the banks that you reference. We've also seen that reform advocates really seeking change, particularly in the US, that would require US family offices to register as investment advisers and on a forward looking basis publicly report holdings on a quarterly basis as most other types of investment firms are required to. New disclosures could include those family offices’ derivative positions and identifying of stocks that they are short.
I think in terms of the Securities and Exchange Commission (SEC), there's renewed focus on the SEC on asset swap or swap surveillance databases, so it could begin monitoring swap positions across the industry and the key point here is the banking finance industry would need to comply with the key requirements for that to become a success.
With regards to hedge funds, perhaps the situation is best summarised by Morgan Stanley CEO James Gorman who, on April earnings call, when he was talking about family offices and comparing them to hedge funds, he was talking about frank and I quote that “frankly the transparency and lack of disclosure relating to those institutions [so the family offices] is just different from hedge fund institutions”. That's something I'm sure the SEC is going to look at.
So from our perspective, when I read and hear CEOs of large banks talking about hedge funds in that context, it really talks to the developments in the hedge fund industry over the last 10-12 years post the global financial crisis. The industry has experienced very high levels of scrutiny from multiple quadrants: from regulators, to service providers like prime brokers, to administrators, to directors of the hedge funds and to auditors of the hedge funds.
And finally, and not to underestimate this final point, is the scrutiny by both ODD and IDD, so that's operational due diligence and investment due diligence, departments of allocators has been intense.
But to give you some sense of the changes that have happened in the industry over the last 10 to 12 years is that for hedge funds that are operating at scale, as allocators we expect to see and we have seen a change of seniority of staff and particularly in risk management.
So allocators expect experienced risk managers, not just risk analysts or risk aggregators, to head up the risk function at hedge funds. And there’s been a real focus on drivers of risk by hedge fund allocators when they underwrite portfolios of hedge funds that they are looking to invest in.
We’ve also seen that increase in the infrastructure, risk infrastructure, that's improved considerably. So, for example, we see risk transparency reports being provided directly by fund administrators to investors on a quarterly basis and that aggregates risk across counterparties and that allows allocators to get a greater understanding of risks in the portfolios.
We’ve seen prime brokers increasing the bar for hedge funds that they're willing to do business and they’re now providing detailed aggregated exposure data that's helpful to allocators in reviewing the funds that they want to invest in.
MV: That's great to hear so it's more oversight, more risk management. You briefly touched on the Q1 2021 hedge fund performance early on. Can you tell me a bit more about the performance of the last several years?
HD: Yes, thanks Michel. I think 2019 was a good year for hedge funds with the industry returning 10.4% after a more difficult 2018 when the industry lost roughly 5%. 2020 was also a good year with a gain of 11.6% and what was interesting in 2020, just sort of in hindsight, is we saw markets moving in to one of the quickest bear markets that we've seen on record.
But 2020 for hedge funds was a year of two extremes. So, for the first quarter, it was the worst drawdown period ever, which you would have expected given the market environment. The 2nd through the 4th quarters were the best three consecutive quarters ever for hedge funds since we started tracking the data.
So perhaps just take a step back and compare to the past for corrections or crises – which is the global financial crisis, the 2011 eurozone crisis, the 2015-16 correction, Q4 18 corrections – hedge funds performed slightly worse during the Covid drawdown period but significantly better during the subsequent recovery period. And I think it's that that investors are focused on today.
MV: OK. So we have equities, bonds, commodities – why would investors typically consider hedge funds in their portfolio?
HD: Generally, there are three types of hedge funds in our portfolio so I'm going to start off with the two extremes.
One is diversifiers and the second is tail risk types of managers. So for diversifiers, there’s a low historic correlation to the broad risk market, so you could expect correlation range of 0-0.2 for these types of funds. And you would expect, when you add this type of fund into your portfolio, expect overall portfolio volatility to reduce without a significant or proportional reduction in the expected return of the portfolio.
So by adding this style of hedge fund to one's overall portfolio you’d expect an increase in the risk adjusted returns of the portfolio.
In terms of tail risk funds, generally these funds have negative correlation to broad risk markets and the expectation is that they will make gains when markets fall.
And the expectation from asset allocators that consider these funds is that when market levels remain elevated or concern over market levels remain elevated over a period of time, these types of funds may be used so that the asset owners can remain somewhat fully invested while reducing risk in their portfolio.
The third type or category of fund is equity or credit substitutes and this category of manager typically have a higher correlation to markets relative to diversifiers and the typical correlation is 0.3-0.6. Investors that target this style of investing are generally looking to target specific opportunities either geographically or by style, investment style or investment strategy, or by industry sector. So allocators to this category of hedge funds are targeting the specialised skills in those areas and actively managed portfolios.
MV: No conversation about hedge funds seems complete without a discussion regarding fees. What are your thoughts and approach to hedge fund fees?
HD: You're right Michel, no conversation about hedge funds is complete without a conversation on fees and for each of the three categories of hedge funds we’ve just talked about we spend a lot of time thinking about the value each hedge fund brings.
We have a view that financial talent is spread across senior management and trading functions of banks and insurers across fintech, across private equity, and hedge funds.
We don't think it's credible to argue that a meaningful proportion of the world's top financial talent have decided not to enter and stay in the hedge fund industry. So we believe embedded talent is in the hedge fund industry.
The question is that, given our ability to consider the vast majority of the roughly 8,000 hedge funds, is the hedge fund that we decide to work with providing value for money and I think the concept of value for money is really key.
So, from our perspective, from a hedge fund perspective, when allocating to hedge funds we should be paying basis points for dedicated long beta.
For hedge funds in our diversifiers bucket, so that’s the first bucket we talked about earlier on, when a fund provides a decent return over a long period of time and proves to be uncorrelated to most major liquid assets.
For example US equities, European equities, UK equities, investment grade credit, high yield credit, emerging market bonds, government bonds, and also other hedge funds, when they provide their decorrelation benefit particularly posting flat returns or small gains when those assets are posting losses then we spend more time deeply understanding the drivers of those returns to see to what extent those returns are expected to be persistent and to determine if the fund meets our value for money metric on fees. And that value for money metric is really key to our thinking.
So in summary, perhaps tying back to where we started this conversation and as a parting thought, there have been developments in the hedge fund industry and that's perhaps been best demonstrated by the growth of the industry to $3.8 trillion. With recent strong performance we see investor appetite towards hedge funds continuing to improve considerably.
We believe that not all hedge funds are created equal and the hedge fund team sees tremendous high-quality offerings which we think deserve consideration in a well-diversified portfolio as they provide high value for money.
MV: This leaves me to look at the week ahead. Wednesday's US Federal Reserve meeting is likely to grab investors’ attention. We do not expect any significant changes to the Fed policy with elevated labour market slack keeping inflation worries at bay.
Last week we had the rather unusual situation that equity markets grinded higher, long-end yields consolidated from 1.75% to 1.55%. This may suggest that the market has more confidence in the Fed’s current approach keeping the short interest rates lower and it seems to be no need to increase the accommodation at the long end. As the Fed put it, inflationary pressures are transitory in nature. And also we have international flow from lower yielding markets which led to the consolidation.
It will be interesting to see if the Fed will mention the envisaged fiscal packages put out by the Biden administration and the potential pressure to lift rates. Investors also might get more clues about the current thinking of the Fed when it comes to tapering, with the paring down of the monthly bond purchases currently at 120 billion a month.
The Fed, of course, will keep a close eye on economic growth, inflation and the labour market and we have very interesting data coming up this week. Thursday’s first quarter GDP data for the US will give an indication of economic performance for early 2021. Given the progress on vaccination during Q1 and the incredibly strong data released in recent weeks, we expect Q1 growth to be in the region of 5% quarter-on-quarter.
We also have the initial jobless claims which moderated lower during March and early April with readings consistently below 800,000 and a print of 576,000 in early April the lowest since the crisis began. Signs of a gradual recovery in the job market, finally, which is very dependent on the economic prospects and developments on the Covid recovery.
Let's turn our focus to Europe. Friday's preliminary Q1 GDP data for the eurozone will give an indication of the economic performance. We expect to see contraction of 0.7% as COVID-19 has kept economic activity restricted throughout the quarter, and remember Germany and France have put new containment measures in place.
We also have the euro area harmonised index of consumer prices, which rose to 1.3% in March, supported by higher energy prices and progressively more favourable base effects. We expect to see a print of 1.5% year-on-year for Friday's release, still well below the ECB target of 2%. We also have job market data coming out of the EU on Friday.
Before we come to an end, a quick look at the UK and the real estate sector. UK house prices increased 5.7% year-on-year March, easing from a 6.9% rise in February. This slowdown likely reflected a softening of demand ahead of the original end of the stamp duty holiday before the extension was announced in the budget.
Recent signs of economic resilience and the extension of the policy support announced in the budget are likely to boost the housing market over the next six months. Thursday’s April data will indicate where the prices have rebounded again over the month.
And with that we have come to the end of this market weekly podcast. We hope you enjoyed this. We'd like to thank you for listening and wish you a successful week ahead.
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