Markets Weekly podcast – 2 October 2023

 Julien Lafargue (JL): Welcome to a new edition of Barclays Private Bank Market Weekly podcast. My name is Julien Lafargue, Chief Market Strategist at Barclays Private Bank, and today I will be your host.

As usual, we will start by reviewing the week that was before transitioning to our guest segment. And, this week, I’m very pleased to be joined by Heath Davies, the Global Head of Hedge Funds here at Barclays Private Bank, to discuss all things hedge fund.

But now, let’s focus a bit on the week that was. Although equity markets remained on the downtrend last week, the tone of the data was somewhat constructive, and, as we mentioned last week, it was really all about inflation.

We got a slew of readings, and all revealed a further cooling in price momentum. Those readings included Germany’s CPI, which came at 4.3%, versus the 4.5% that the market expected.

We also had weaker-than-expected Italian PPI. But in core inflation it came in at 5.8%, again below expectations for 6%. Even in Japan, inflation surprised to the downside at 3.8% for the Tokyo’s core CPI, when the market was looking at 4.9%. 

The eurozone CPI, the French CPI, the French PPI and German import prices were all lower than expected.

But the big number that people were looking at, obviously, was the US PCE deflator. This number tends to be a bit lagging versus the CPI figure, simply because it’s released later, but it’s still the Fed’s preferred inflation gauge. And that number came in, again, lower than expected. Actually, it slowed to a 33-month low of 0.1% month on month, which was below expectations. The consensus was hoping that it would remain stable at 0.2%. On an annual-rate basis, again, the PCE decelerated from 4.3% year over year to 3.9%, and in line with expectations.

Meanwhile, a 6.1% month-on-month increase in energy prices, of course, boosted the headline PCE number, which accelerated from 0.2% month on month to 0.4%. But, again, this was below expectations. The market was expecting 0.5%. So, all over, pretty good news on the inflation front.

That being said, I think we need to recognise that we are, you know, very far from central banks’ targets. Even at 3.9%, the PCE is basically twice what the Fed would like it to be. 

And the other key question investors should ask themselves is whether this disinflationary trend a sign of a weakening macroeconomic backdrop, in which case I don't know if we really want to welcome this kind of development. 

The other key element that investors looked at last week, and what was somewhat puzzling, is the divergence we’re seeing across asset classes in terms of price action. As we said, stocks were lower. On the other hand, oil prices continued to defy gravity and go against this broader narrative of weaker growth ahead.

And the story was very similar on the rates side, with the US 10-year yield now having dropped some 74 basis points in the third quarter and now firmly above 4.6%. And a similar picture in Europe, with the benchmark 10-year government bond yield closing in on 3%, having been as low as 1.8% at the end of last year.

So, there is a lot happening marketwise in terms of central bank expectations. At the moment the market is pricing in 65%. We understand the Fed is not going to hike in 2023. If you remember, the ‘dot plot’ suggests one more hike. So the market is currently disagreeing with the Fed, not only when it comes to a hike but the market is also pricing in an earlier-than-expected interest rate cut in 2024. Not by much, but, still, the market sees maybe a first cut in June, when the Fed is telling us that it’s probably going to be more in the second half of next year.

Our message, taking all that into consideration, is that although inflation is trending in the right direction, central banks are unlikely to declare victory before year-end at the earliest.

This suggests that the current volatility isn’t going away any time soon and that rates may drift higher still. But, with this macroeconomic picture showing signs of deterioration, the air is getting thinner and thinner. Maybe this is our last chance to lock in those yields before they start dropping.

Now, that was for the week that just passed. Let’s move on to our guest segment. If there is one part of the market that can explore most of the opportunities that we see, it’s really the hedge-fund space, with, you know, a very wide range of strategies and very wide range of implementation possibilities within this asset class to be able to cherry pick the alpha that can be generated in today’s environment.

So, Heath, first, welcome to the podcast, great to have you. So, when we talk about hedge funds, and, again, I want to stress that hedge funds are not for everybody, they are for people who understand them, but I think it’s still very important for any investor to understand what’s going on in this industry and this part of the market.

And when I think about hedge funds, it seems sometimes they are in fashion, and everybody is talking about them and saying how great they are, and sometimes they seem to be disregarded by investors. Why is that? Why do we see this change of behaviour when it comes to the approach to investing in hedge funds, and do you think this is fair?

Heath Davies (HD): Yeah, Julien, thank you firstly for the invitation to join today. As usual, it’s a great privilege to be able to talk about hedge funds to the wider audience. But I think it’s a key question that we ask ourselves when we think about a hedge-fund programme.

Sometimes I think it’s helpful and constructive to look at longer-term history. So, if we have a look, for example, since 2000. Hedge funds overall, if you just take a commonly used index, the HFRI, they’ve returned just over 5% over that 22-year period versus global equities yielding just below that, at about 4.6%.

But the interesting point is that hedge-fund volatility has been just over 6%, whereas we all know that global equities volatility over that period has been in double digits for this period. In fact, it’s actually just been at 16%. And hedge funds over that period of time have captured about 30% of the downside, about one-third, and just below 50% of the upside.

So, the key pointers as to why do hedge funds sometimes come into fashion or seemingly go out of fashion. And I guess it’s just relates to what’s going on in underlying equity markets.

So, if we have a look at the more recent history of hedge funds, 2015 through 2019, we saw equity markets rallying and this led to pressure on the role of hedge funds. We saw an ultra-low interest rate environment and we saw questions over the level of fees, given the strong performance in equity markets.

But then, interestingly, in 2022 especially, but also in Q1 2020, when we saw a risk-off environment in equities and bonds in 2022, we highlighted again the role of hedge funds as a diversifier. So, we saw large losses in the broader markets and hedge funds provided the role as diversifier.

The one thing that we look at again over sort of a 20-year period, if you have a look at global equities, global bonds and hedge funds, hedge funds have come first 9% of the time on an annual basis since 2002 and, second, adding 3% over time. So, roughly 90% of the time hedge funds have come first or second versus global equities and global bonds. Whereas global bonds, for example, have come third, out of those three asset classes, about 60% of the time. 

So, the message I’m trying to portray is, yes, there will be times where seemingly, you know, hedge funds come into fashion. That’s typically around just after there’s been a big risk-off environment when investors have lost meaningful capital in primarily global equities, but more recently in global bonds, and they’re sort of thinking about, well, where do I get diversification from? How do I diversify my portfolio? And then we tend to see, you know, hedge funds coming back into fashion at the margin.

But what I would say, you know, the hedge-fund industry has grown to $4 trillion. We know it’s not been a straight line, but it has been fairly consistent growth in AUM over the years, certainly over the last two decades.

JL: I think you raise a very good point and based on my conversations with clients I feel there is sometimes some misconception just about the concept of hedge funds. Some people think that it’s a provider of significant upside and it’s a way to make a ton of money quickly, so to speak, a very speculative type of instrument or strategy, and some people actually are probably more recognising them for what they are, those hedge funds, which are the provider of diversification and a way to, in many instances, try and lower the overall volatility of your portfolio. 

So, how do you think, from your point of view, investors should think about hedge-fund exposure when it comes to a portfolio allocation?

HD: I think this cuts to the value discussion about hedge funds. So, the way we view hedge funds at Barclays Private Bank is that there’s three types of hedge funds, when it’s all said it done.

The first category is equity credit substitutes and here those type of hedge funds they do run market exposure, long market exposure. And so in a sell off that we talked about earlier on, we would expect to see those managers lose money, but perhaps less than the overall market. So it reduces the amplitude of losses.

The second type of hedge fund is roughly 25% to 30% of the overall hedge-fund industry. And this is the key point. Those hedge fund managers are diversifiers, true diversifiers. We define them as diversifiers. So, managers in this category would expect to have low correlation to underlying equity markets. 

In our work we focus on funds that actually have low correlation to equity and bond markets and the hedge-fund industry, and also when those markets are actually losing money. So a key focus for us is diversification when it matters, and that’s the value discussion that you raised in your first question is, well, the hedge funds seem to go out of favour and then back into favour. We tend to find that hedge funds that provide diversification when bonds are selling off and/or equities are selling off have a valid place in clients’ portfolios.

The third type of hedge fund, and I do want to get to it, is a risk mitigator. So, post 2008, we saw a big interest in 2009, 2010, 2011 in strategies that we’d define as risk mitigators, where clients are buying, in effect, protection from markets and it might be protection via the equity markets or protection via the credit markets, or it might be protection via derivative markets. But investors are paying a premium to be protected. 

So, in a big risk-off environment, investors have the expectation that those hedge funds would make money. Every crisis, every big risk-off environment, is driven by different factors compared to the ones that have come before. But the expectation on that third category of hedge funds is that they should make money when the market loses. 

And I think you’re right, I think there is confusion in certain investors’ minds, but if we just keep it to those three categories, those funds that have some long market exposure, those that are diversifiers, so market neutral, and those that provide protection in a risk-off environment, we find that that’s quite a good channel to talk through the different types of hedge funds that you can get in more complex strategies. So, we think that’s one way to think about hedge funds.

And we then talk through and think through with clients the very large, very well-known institutional offerings, institutional investors in hedge funds, and what we see is some of those disaggregate equity exposure that they get from their hedge funds into their overall equity programme. 

Those we tend to find as more sophisticated programmes, the very, very large sovereign-wealth funds, the very large endowments, tend to do that, but what we have seen is that those programmes are long-term investment programmes that are not switched on and switched off in a year or two. They’re designed to function over a five-year minimum holding period up to decades, multi decades. And, in those programmes, we often find folks working out what it is that they want from their hedge-fund programme in terms of performance level, in terms of risk characteristics from their hedge fund, and how that then ties into the overall portfolio.

So, those are a few of the points I would make when you start thinking about how clients or investors should think about hedge fund exposures and their portfolios.

JL: I absolutely love how you sort of segregated the hedge fund universe because the reality if I tell someone, you know, macro hedge funds have done this, event driven, long, short, whatever the subcategory of hedge fund, it is very difficult to think about what they are actually doing for me? Whereas here we’re identifying the purpose of the investment in the first place, which I think is great.

Now, you talked about the fact that the industry, you know, has its ups and downs over time but has grown over the last 20 years or so. Maybe if we zoom into the most recent past, what have you seen happening in this industry? Where do you see flows going, or maybe where is the money leaving? And in terms of performance, what’s worked, what hasn’t worked?

HD: Good question. I think before I talk about more recent performance and what’s worked, let’s just sort of have a quick review of H1 2023. So, what happened in H1 2023? Well, we had a banking crisis. We then had AI mania. We’ve had a narrow equity rally, a last-minute deal on the US debt ceiling. There’s questions about inflation, has it been under control. We spoke about inflation early on in this podcast, which talked us around to expectation of a recession. So, there’s been a lot for investors to digest.

In that environment what’s been happening? So, you know, we’ve seen perhaps some of the more topical points. ESG, you’ve seen manager policies and procedures being rolled out for ESG to include increased adoption of that, certainly over the last three years and that’s continued sort of this year.

We’ve seen increased adoption of ESG impacts in modelling, in financial models for equities and debt, and the fundamental modelling that all investors that have a fundamental approach to investing would have. And we’ve also seen some programmes dedicated to ESG. 

We talked about AI mania a bit earlier on. We continue to see the adoption of AI in the investment due-diligence processes of managers and using the power of big data and algorithms to look for behavioural biases from both a fundamental and a systematic process. 

Systematically speaking, I won’t go into a lot of detail now, it gets very complex very quickly, but you would have complex algorithms running AI models. We’ve seen increased adoption of that. There’s still question marks around the long-term effects of that.

In terms of other developments in the industry, you asked about that. We’ve seen discussions with hedge-fund managers now in a higher-rate environment around putting hurdles into performance fees, which means that managers would need to meet a certain level of performance before performance fees would come into play, given the higher-rate environments.

We’ve seen changes in the structure of hedge funds, and we’ve seen a change in the regulatory uncertainty around certain aspects. You referenced event-driven managers that are very active in mergers and acquisitions. So, we’ve seen some development in the regulatory environment. So, there’s been a lot going on in the industry and there’s many fascinating developments and a lot to keep our eye on.

In terms of what’s worked and what hasn’t worked, I think hedge funds overall are up, probably to the end of August, in about a 4.5 range for the year. I think equity discretionary managers has performed well. Event driven has performed well. Multi-strategy types of funds that invest using a number of different underlying strategies have performed well. Fixed-income relative value, that’s also performed well. Credit’s performed well. What’s performed less well is macro, and some systematic strategies.

And then in terms of flows, we’ve seen hedge-fund flows as another big driver. We always think about hedge-fund flows. We’ve seen net performance in 2022 in equity markets off substantially. So, we saw hedge-fund assets continue to grow in 2022/23. In terms of flows, most of the flows have been into multi strategy, and the industry jargon would be multi-portfolio manager funds, followed by equity long/short. That’s where most of the capital has gone.

So, in terms of report card for the first half of the year, we don’t have Q3 data yet, obviously we’ve just finished Q3, but in terms of sort of first half of the year and into August, performance has been in line with expectations. So, lower performance in equity markets, but with much lower volatility. So, if, for example, we look at the sort of the five-year risk-adjusted returns for hedge funds, it’s just about double global equities. So, that risk-adjusted return is something that many folks think about when they invest.

So, for example, global equities over the last five years have returned just over 5%, at 5.6%. Hedge funds just below 5%, but the risk, the underlying volatility of the hedge-fund portfolio, is much lower than for equities. So, your risk-adjusted returns, which some investors are interested in, that’s, you know, hedge funds have been roughly double that of global equities over the last five years. 

I think that’s quite constructive in terms of when one thinks about global asset allocation. That risk or reward for every unit of risk, what is the expected reward, those folks that think in those terms continue to be interested in looking at the hedge-fund industry.

JL: I think it’s always difficult to generalise about something that is as diverse as the hedge-fund industry, so to speak, and I guess that’s where, you know, you and your team’s skills come into play, trying to identify the right strategies to be included in an asset-allocation decision. From a top-down perspective do we want, as you were mentioning, to do it on credit replacement etc or, within that, what type of managers are best positioned to deliver what we expect them to deliver.

So, on that note, and to conclude, and keeping in mind that, you know, hedge funds are definitely not for everyone. But I still want to hear from you where you see opportunities at the moment in the generic sense.

HD: Thanks, Julien. We remained focused on diversifiers. We do think diversifiers, those types of managers with low correlation, are key. And again, we focused on those types of managers where they provide diversification, or have provided diversification in the past, in very difficult market environments. So, that’s what we focused on, diversification in up markets but, importantly, diversification in down markets.

In terms of opportunity sets, we do like the multi-portfolio-manager model. We continue to like credit and equity and convertible bonds and event driven, but expressed in a multi-portfolio-manager construct, primarily in developed markets. 

What we are also very interested in is following what’s happening in Asia. Asia is about a third of global GDP, it’s a third of global equity markets. You know, the opportunity for diversification in Asia is tremendous, as we’ve got higher rate environments. So, there are going to be sectors, industries and companies that will be losers and there’ll be sectors and industries and then, obviously, underlying companies that will be winners. 

As you see, the slowing Chinese economy, we see higher rates, as we spoke about. We do think about sort of a market-neutral environment in Asia, as a way to take advantage of changes in the region without actually having to be concerned about the direction and the size of market moves. 

So, that is interesting because many clients are underweight Asia, naturally underweight Asia. It’s difficult to get exposure to Asia on a directional basis, just given the volatility of the market and the nature of the market to be very susceptible to global flows. So, we think market-neutral Asian exposure is interesting.

And then, finally, just to wrap up, I think there are different parts of the, you know, credit complex that are very interesting. Where we tend to be focused on is at the margin and we’ve been talking with, and discussing with, managers that are focused on stressed credit, distressed credit. They’re starting to see some really interesting trades more recently in some of our multi-PM models. Managers that we follow, but particularly with managers that are able to understand the interest-rate cycle and the impact to underlying companies and ability to refinance those types of managers that have been doing that for many decades, we think are quite interesting to follow. So, we’re spending a bit of time there.

And, lastly, we do think the macro environment’s interesting, where traders are able to trade across different parts of the capital structure. They’re able to trade across interest rates and across currencies. Some may invest in emerging market debt, some may invest in emerging market quasi sovereigns on both the long and short side. So, there’s a lot to be done in that space too. 

So, I don’t think there’s a shortage of really good investment opportunities to consider in this environment, but I think it’s being very disciplined about where we take risk and managers with whom we choose to work, that those managers need to have a really strong and identifiable attitude to taking risk. So, the risk frameworks need to be highly focused and highly developed and evolved with the correct risk systems to be able to take those opportunities we’ve just spoken about.

JL: Thank you. And I cannot stress enough how much hedge funds can help to make my life and my job easier because one of the questions when referring to Asia, and one of the questions that we get the most at the moment is what do we think about China and the path for China going forward. 

It’s so convenient to be able to say, well, actually, you don’t really need to have a strong view as to where China is going if you have a strategy that is able just to focus on specific opportunities, you know, long, short, with very little if no market exposure. You’re just playing the alpha without having to worry too much about, you know, where the Chinese economy is going. I think this is very valuable.

Anyway, that was great. Thank you so much for joining us. We’ll definitely have you back. I think it’s a fascinating topic. Before we conclude, I just wanted to run through a couple of things to put on your agenda for this week.

Last week was all about inflation. This week is going to be about the US labour market. We’re going to get the jobs report on Tuesday and the always closely-watched September job report, that will come out as usual on Friday.

There will be some other releases that I think are worth monitoring, more with the inflation lens. We‘re going to get the manufacturing ISM price-paid index. I think people will pay close attention to that as well as the services one a bit later in the week. 

We will definitely cover that in more detail when we are back next week. In the meantime, as always, I wish you all the very best for the trading week ahead.