by David Kupperman, Co-Head—Neuberger Berman Alternative Investment Management, Neuberger Berman
Four years ago, markets threw a “tantrum” when the Federal Reserve hinted at tapering its quantitative easing (QE) program. Over the past fortnight we’ve endured a “mini-tantrum” in government bond markets as the Fed girds itself to shrink its balance sheet and other central banks have adopted a more hawkish tone. The end of QE may be finally becoming a reality.
Step back, and that’s shocking. It has taken four years and QE is still growing. By May of 2017, asset purchases by central banks had already topped $1.5 trillion and are on pace to exceed $3 trillion by year-end. The Bank of Japan owns approximately two-thirds of all Japan ETF assets, as reported by Bloomberg earlier this year. The Swiss National Bank (SNB) has bought $80 billion of U.S. equities as of the first quarter. These anomalies, which few would have imagined when the Fed kicked this off in 2008, barely merit a column inch in the press.
If we are reversing this, it’s surprising the bond market hasn’t thrown more toys out of its stroller.
QE Surrealism and Massive Passive
The serenity in equity markets is even more mysterious, because here a second huge wave of flows is compounding the QE distortions.
These flows are from non-discretionary investment—passive, quantitative, algorithmic, trend-following and “smart-beta.” J.P. Morgan has estimated that, collectively, this now accounts for around 60% of equity trading. Morgan Stanley reckons almost $90 billion flowed into U.S.-listed ETFs in January and February alone, five times more than the past seven years’ trend would have predicted.
If the high-water mark of QE surrealism is the SNB taking bites of Apple stock, that for ETFs probably came earlier this year, when a Junior Gold Miners product got so big that, in a number of stocks, it reportedly started to run up against the regulator’s 20% ownership threshold, which triggers an automatic takeover offer.
Seismic Tremors
Put these two things together and I think you have an explanation for today’s peculiar market conditions: super-low volatility, low single-stock correlations and high valuations, paired with fragile geopolitics, creaking commodities and flat yield curves. My colleagues Erik Knutzen and Joe Amato have argued that fundamentals can tell a lot of the story, too. That argument stands up. I believe it’s also worth considering the alternative, however, because if it is even partly correct, the negative left-tail of the potential return distribution is much fatter than markets assume.
Tech-sector volatility since mid-June could be a seismic tremor from this build-up of stress. When discretionary fundamental portfolio managers decide a sector is overvalued, they tend to trade on relative valuations and create greater dispersion within that sector. By contrast, when passives, trend-followers and quants get the same idea into their algos, they tend to turn in a highly correlated way.
That is the nature of style rotations today. The only reason we see for why the left-tails haven’t been fatter is that abundant central bank liquidity exists to lubricate all the moving parts, which is why the removal of that liquidity could be so consequential.
‘Fake Markets’
A recent note by Francesco Filia of Fasanara Capital summed up these dynamics with the zeitgeisty phrase, “Fake Markets.” I think he’s right. When those markets get real again, it could be painful. To limit that pain, investors could benefit from strategies that can survive the transition and thrive in the reversal.
We think that hedge funds—particularly those styles that have historically exhibited low correlation with bond or equity market risk, such as equity market-neutral, volatility arbitrage and fixed-income arbitrage—have the potential to eke out returns as they await the moment of dislocation.
They have been in abeyance for a few years, but an environment of stretched valuations, low volatility with fat left tails in long-only markets, low single-stock correlations and technically distorted pricing potentially creates an unusually rich set of opportunities. And behind all of that, regulatory constraints on competing market players continue to open a space for strategies such as structured credit.
It’s notable that news on hedge funds, which haven’t caught a break in the press for ages, has gone quiet this year. Perhaps that’s because the HFRX Global Hedge Funds Index was up 6.25% for the 12 months through the end of June.
While that doesn’t make an exciting headline, it may pique the interest of investors, because hedge fund performance can be a little like a seismograph. These are not normal markets, and the stress is building.
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