The Early View
Why Earnings, Not Elections, Will Shape the Market Narrative

 

At the time of writing, we have elections taking place in both the UK and France, and there is heightened pressure on Joe Biden to stand down as the Democratic candidate in the US election. Each of these events has the potential to change short-term market behaviour, and this article may be out-of-date by the time it is read. However, in the UK bookmakers and opinion polls have a Labour success priced at a near-certainty, and it seems hard to believe that any of the subplots around the relative strength of the other parties is genuinely sufficient to change the long-term narrative in global markets.

The French legislative election looks set to become a battle between the far-right Rassemblement National and the left-wing coalition Nouveau Front Populaire. Neither is market-friendly, and neither is positive for broader cohesion across the European Union, but it seems likely that markets will take time to digest the true efficacy of any new National Assembly in enacting market-sensitive change.

The US situation is arguably the most interesting, since all the alternatives to Biden poll well against Trump, therefore a change of nominee for the Democrats is likely to materially change the expected outcome of the election. Although, again, outside of specific sectors and companies, it is difficult to predict the market impact (and reaction) to a Democrat victory versus a Republican victory at this stage. A stronger Democrat victory would, one hopes, reduce the likelihood of the kind of shenanigans seen after the 2020 vote.

So, in summary, plus ça change– at least with respect to politics and the market implications. The bigger economic challenges remain regardless of the outcome in the various political machinations across developed markets. We continue to believe that the current market backdrop is unusual. Equity markets post new highs on ever more incrementally positive news, such as in early June when they rallied after the slightly soft US CPI print. One news article breathlessly extolled that the probability of a rate cut from the Federal Reserve in September had increased from 50% to 69%. It ignored the fact that we’ve moved from a position at the start of this year where markets expected seven rate cuts by January 2025, to a situation now where markets are pricing less than two and focus instead on the slight increase in the probability of one rate cut at one meeting, three months from now.

One should remember that we have inverted government bond yield curves that haven’t led to a recession (yet), an inflation shock which necessitated significant rate rises to ‘choke off demand’ which hasn’t led to a recession (unlike every inflation episode in the 1960s and 1970s), and government debt-to-GDP ratios in most developed countries at genuinely unprecedented levels (which hampers future options for fiscal stimulus along with other issues).

How has this paradox persisted for much of the last 12 months? The short answer is corporate earnings. Earnings remain significantly stronger than long-term trend expectations and in a world of higher discount rates, earnings today matter more than earnings tomorrow. At the company level, both discretionary and quantitative hedge funds are telling us that share prices have been particularly responsive to earnings beats and misses over the last year or so.

When aggregated to the index level, therefore, it is unsurprising that equity markets continue to post new highs while earnings remain strong. However, the sting in the tail, particularly for US equities, is that when a high price-to-earnings ratio is supported by unusually high earnings, the downside risk is compounded. If earnings fall back to long-term averages, then the economic backdrop is hardly strong enough to support an ever-more inflated price-to-earnings ratio. So maybe instead of focusing on the political outcomes in the second half of 2024, it is the two forthcoming quarterly earnings seasons that hold the most potential to disrupt the current market narrative.

Key Drivers of Hedge Funds Performance: An Early June Snapshot

Equity Long-Short:

• While the MSCI World Index has generated a strong month-to-date return, the performance of global equities has been mixed in June. Despite a (short-lived) pullback in Nvidia, large-cap US stocks are poised for strong gains while shares of European equities have been weaker—linked to anxiety surrounding Parliament elections.
• Performance for equity long-short funds has been rather modest in June month-to-date. Generally, funds have benefited from some beta but struggled to produce alpha as gains on the short side have been mostly offset by weakness in longs.
• Prime brokerage data showed signs of de-grossing in the back half of the month though despite this, gross exposure levels remain elevated versus historical averages. Areas of notable selling activity have been European equities and US Technology, Media, and Telecommunications stocks—specifically semiconductor and artificial intelligence-related names.
• Perhaps linked to the reduction in US Technology, Media, and Telecommunications exposure, we also note decreased exposure to the momentum factor, which had been running near all-time highs. This may suggest that risk appetite has cooled off slightly.

Credit:

• There were mixed and mostly modest returns for corporate credit managers in a relatively low volatility month for the credit markets that saw muted single name price action. There were slightly lower leveraged loan prices, little changed US high yield credit spreads, and positive total returns for credit in general.
• Convertible bonds were positive contributors to performance, with some of the gains offset by rates hedges. Convertible bond issuance remained brisk, though lower compared to the strong pace in May.
• Specific credit winners included certain Puerto Rico bonds, which performed well after positive developments related to debt restructuring, whereas spreads were close to flat for financial preferreds ahead of quarter-end.
• June was largely a carry-driven month for structured credit managers with modest mark-to-market gains in some sectors.

Event Arbitrage:

• It was a muted month for Event Driven, as spreads remained wide amidst a general lack of risk appetite and deal developments largely offset each other.
• New deal announcements include Stericycle / Waste Management (USD 6bn), Britvic / Carlsberg, Powerschool / Bain, Canadian Western / National Bank of Canada (all USD 4bn).
• DS Smith / International Paper created a lot of volatility, as initially, indications that Suzano was preparing a higher offer for International Paper caused a severe spread widening as International Paper rallied and arbitrage funds were forced to reduce risk on both sides of the trade. Subsequently Suzano ended its pursuit of International Paper, and the spread tightened again from ca. 30% to 3%.
• Covestro has engaged with Abu Dhabi National Oil Company (ADNOC) and granted due diligence after a year since the first approach, potentially valuing Covestro at EUR 11.7bn.
• Other positive deal news includes CSR, which closed, Hipgnosis, getting a small price bump, and Infocom in Japan (firming up of offer terms).
• Two US prospects withdrew their bids for Swedish Karnov Group amid shareholder resistance to the deal.
• News reports suggested that several merger arbitrage trading desks have significantly de-risked, following challenging returns in the first half of the year.
• In Japan, Kirin announced a tender offer for cosmetics business Fancl, expected to be at about a 30% premium.

Discretionary Macro:

• June looks to be a mixed month across discretionary macro strategies, leaning modestly positive at the time of writing.
• European macro themes have broadly added, with EUR shorts profiting as increased political uncertainty emanating from France has weighed on sentiment.
• Emerging market themes endured a difficult start to June as election-driven volatility hampered long fixed income and currency exposures. However, a handful of EM-focussed strategies are meaningfully positive at the time of writing, suggesting positions were topped up following the early-month weakness.
• Performance in the US has been mixed. Dovish views expressed in US Treasuries have added, while those expressed in equity longs struggled later in the month given a bias towards tech exposure. We have seen select Fixed Income Relative Value pods struggle against a choppy backdrop, with rumours of de-grossing in basis trades.
• Japanese macro themes have been frustrated by a dovish Bank of Japan, which delayed plans to cut bond purchases at their June meeting.

Systematic Macro:

• June has been a turbulent month for trend strategies with both traditional and alternative trend strategies generally struggling. Pain has been felt most acutely from short bond positioning which struggled through the beginning of the month and commodities where attribution has been more varied, but long precious and industrial metals exposure detracted. Within alternative trend, fixed income and currency positioning detracted.
• Systematic macro performance has been quite mixed in June. Some have struggled with their currency and commodity positioning while others have benefited from directionally long oil exposures.

Quantitative Strategies:

• June is looking like a very strong month for managers across the equity market neutral/ statistical arbitrage universe. Managers who struggled in May have rebounded with steady performance week on week.
• At a factor level, cross-sectional momentum has once again been a positive performer. Consequently, those strategies with exposure to momentum and quality factors have fared well during June.
• Machine learning strategies have posted positive returns in June with slower substrategies slightly outperforming quicker implementations. Strategies meaningfully utilising alternative data also looked to have generated positive returns.
• Quantitative credit is also looking positive for June, though returns are more modest than those shown by equity-oriented strategies.

On the radar:

• The fallout from European elections, particularly in France and the UK, could see a change of risk appetite in the region over the next few weeks.
• In the medium term, we think that the balance between fundamental data and corporate earnings is a key gauge for the continued success of equity markets.
• Longer term, we continue to believe that the high levels of government debt to GDP across the developed markets represents a different paradigm, and that monetary responses to future crises are even more likely to fuel inflationary periods.

 

All data Bloomberg unless otherwise stated.