Long Short Credit resilience defies investors’concerns

Risk aversion continues to prevail so far in Q4, despite lower equity valuations and wider credit spreads. Expectations of a year-end rally in risk assets have faded, as concerns over Brexit remain acute and the probability of a recession in the U.S. keeps rising, albeit at a low level. The growth divergence between the U.S. and Europe has further widened in Q4, pushing the U.S. Dollar index to record highs this year in a context of multiple headwinds, according to the ECB at its latest monetary policy meeting.

These market conditions continue to favor low beta hedge fund strategies. Since early December, Merger Arbitrage and L/S Equity Market Neutral has outperformed, while L/S Equity remains under pressure. Relative Value Arbitrage was resilient. Based on a peer group of 28 onshore L/S Credit strategies, the median performance was -0.3% month-to-date (up until December 12th) and -1.3% quarter-to-date. Yet, liquidity concerns have investors in L/S Credit strategies in defensive mode.

According to Morningstar data, onshore Fixed Income strategies experienced large outflows in September and October.

Going forward, we note that U.S. corporate leverage has stabilized since 2015 at levels that prevailed in the run-up to the Global Financial Crisis. High-yield default rates forecasted by rating agencies in twelve months remain nonetheless benign for Europe and the U.S. These are expected to remain below 2.5% against an average of 2.7% and 3.4%, respectively, over the past five years. Yet, liquidity tensions could flare up rapidly in current market conditions and cause wide fluctuations in asset prices. We ourselves are bearish on credit. We expect wider spreads across regions due to softer macro data, the end of Quantitative Easing in the euro area and asset reallocation out of credit in favor of Treasuries. Investors are thus probably right to be concerned. Yet, L/S Credit managers are defensive in their positioning as illustrated by resilience in Q4.

In our view, the above supports a Neutral stance on L/S Credit strategies and a preference for strategies with lower market directionality. Such strategies could take advantage of higher dispersion in credit markets and generate performance from their short books.