Redemption D-Day For Hedge Funds And Dancing Dollars: Thoughts On Monday

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Includes: BXUB, BXUC, DIA, DMRL, EPS, FXE, IVV, PPLC, QQQ, RSP, RVRS, RYARX, SDS, SFLA, SH, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SSO, UDN, UPRO, USDU, USMC, UUP, VFINX, VOO
by: The Heisenberg
Summary

As we kick off the new week, I wanted to take a moment to address some reader questions about the upcoming hedge fund redemption D-Day.

Additionally, with the dollar making fresh highs, it's worth taking a moment to assess the greenback's 'heads I win, tails you lose' dynamic.

All in all, expect significant "chop" into year-end, even if you're buying the "squeeze higher" narrative.

Over the weekend, I penned something for this platform called "Here Are 3 Things Keeping Bullish Investors Awake At Night."

As the title suggests, that was basically just a summary of the trio of factors that together serve as a counterpoint to the idea that stocks are set up for a squeeze higher into the end of the year.

Actually, that's not entirely accurate. The "squeeze" thesis is a tactical trade and indeed, that was the point of my Saturday post. I wanted to make it clear that a "tactical rally" isn't the same thing as a fundamentals-based argument for a longer-term bullish thesis.

I wanted to briefly follow up on two of the issues raised in that piece, one of which prompted a number of questions from readers whose curiosity appeared to be piqued by a link to an article on my site about hedge fund redemptions following the October tech rout.

Before I get to the redemption story, let me quickly touch on Fed "risk." In the post linked here at the outset, I reiterated that the outcome of the U.S. midterm elections effectively takes another round of fiscal stimulus (and by that I mean Trump's brand of stimulus) off the table. Depending on who you ask, there's scope for compromise on infrastructure spending, but if last Wednesday's abysmal 30-year bond auction was any indication, financing a large spending package aimed at rebuilding America's roads and bridges is going to be difficult given the country's fiscal trajectory.

The fading fiscal impulse means U.S. growth will decelerate in 2019 and while that obviously has some negative ramifications, it's also desirable to the extent you think the economy is overheating, which the Fed pretty clearly does. The problem, though, is timing. The effects of the overheating labor market on wage inflation and the read-through from the tariffs on consumer prices are just now starting to show up. Average hourly earnings are rising at their fastest pace since the crisis and the most recent ECI data showed private sector wages and salaries rising at the swiftest pace since 2008.

(Bloomberg)

This week, we'll get October CPI and it's likely that the effects of the tariffs on $200 billion in Chinese goods (which were implemented on September 24) are going to be visible, if still small. Importantly, CPI data for August and September came in cool, which helped temper some of the jitters from rising wage inflation. If the October CPI data comes in hot, that's just more justification for the Fed to keep hiking. Here's a quick excerpt from a short Monday note penned by Nomura's Charlie McElligott:

The “data dependent” Fed has even more pressure on them into this week’s inflation-centric data, where there are clearly two camps forming: 1) those who see growing wage pressures building as the next catalyst for fixed-income weakness, vs 2) those who see the Fed’s current rate hiking as “pre-emptive” on inflation, which then is instead raising concerns that “the best is behind us” from a growth perspective.

That quote neatly encapsulates the risk. The Fed is keen on staying ahead of the curve on inflation, but that effort risks exacerbating the deceleration in the economy that would already play out as the boost from fiscal stimulus wanes. I continue to think that the most likely outcome is the growth data rolling over faster than expected (especially as the Fed continues to hike) while the inflationary pressures from the overheating labor market and the tariffs prove harder to ameliorate. In other words, I continue to think that the risk is a stagflationary outcome.

In the meantime (and this is something I talked about in more detail in the post linked above), it's by no means clear that the October equity selloff tightened financial conditions "enough". That is, it would take something on the order of a 15% decline off the September highs on the S&P (SPY) to approximate a 25bps rate hike. We didn't get that. As of Monday, U.S. equities are down just ~6% off the highs and financial conditions have retraced some of the October tightening (at least on Goldman's FC index). In short: The Fed likely still wants to see conditions tighten further.

Speaking of tightening financial conditions, the dollar (UUP) is now back to 18-month highs after briefly dipping following the midterms. The consensus was that a split Congress would be USD negative to the extent it portends less scope for more Trump-brand stimulus, but as the above-mentioned Charlie McElligott writes in the same cited note, the greenback is "getting the 'heads I win, tails you lose' treatment" from the following factors:

  • Superior growth relative to rest of G10;
  • Superior rate differentials;
  • Tailwind of US Shale / US as largest exporter of Crude;
  • “Dollar Shortage” thesis still very much “in play”—Fed hawkishness, “QT” (remember the upcoming enormous November 21st $27B run-off between UST and MBS) and UST issuance “supply shock” (to fund the deficit / pay for tax cuts) all as catalysts for higher yields in the near-term
  • Lack of alternatives (Euro, Yen, Pound, Yuan—really?!)

In the week through last Tuesday (i.e., in the week leading up to the midterms), specs took their net position in the dollar to the longest since January 2016.

(Goldman)

Helping the greenback on Monday is the euro (FXE), which sank to a 16-month low, beset by renewed concerns about Italy, where the populist government is staring down a Tuesday deadline to respond to Brussels' demands that they (the Italian government) revise their 2019 budget to ensure it's in accordance with EU guidelines.

All of that is bearish for risk assets and at the end of the day, it comes back to the Fed and the collision of monetary policy normalization (rate hikes and balance sheet rundown) with fiscal expansion (huge debt issuance at a time when rates are rising and the central bank is rolling back its support for the Treasury market).

So that's some additional color on Fed "risk" and the prospects for an ongoing tightening of financial conditions. Did I say that section was going to be "quick?" Sorry about that.

Moving on to the hedge fund redemption story, the reader e-mail I've received appears to stem mostly from folks reading a post I linked to over the weekend called "As Hedge Funds Face Redemption D-Day After ‘Red October’, Loeb Exits Facebook, Warns On Tech."

I'm not going to rehash everything that post contains, because judging by the numbers, most readers have at least skimmed it, but the gist of it is that hedge funds were burned badly last month and face a redemption deadline on November 15. Some fear a disorderly rush for the exits and there's more than a little speculation that any weakness you see in, for instance, Tech (NASDAQ:QQQ) ahead of November 15 could be a front-running effort.

As I write these lines, Tech is leading losses on Wall Street again, and the Nasdaq 100 is now on pace to underperform the S&P by an even greater margin than October.

(Heisenberg)

Well, for those inclined to taking a "glass is half full" approach, JPMorgan's Nikolaos Panigirtzoglou doesn't think we're going to see a "big wave of hedge fund redemptions." In a note dated Friday, Panigirtzoglou reminds you that on the whole (i.e., across a broad universe of funds), hedge fund losses were nearly 3% in October, which was the steepest decline since May 2010. Particularly hard hit were Long/Short funds. Here's Panigirtzoglou:

The monthly hedge fund indices also confirmed the major role the $900bn Equity Long/Short hedge fund universe played in the October correction, including the biggest ones that are included in the monthly indices. The monthly HFRI Equity Hedge Index lost more than 4% in October, the worst monthly performance since January 2016 (Figure 2).

One takeaway from that is simply that October's selloff was more "fundamental" in nature than February's which was primarily quant-based. That means when it comes to redemptions, Equity Long/Short funds will probably suffer the most. That said, Panigirtzoglou thinks the exodus shouldn't be all that acute. To support his contention, he cites a measure of redemption pressure (basically just forward redemption notices as a percentage of AUM at the start of a given month), and also recent precedent.

On that latter point, JPMorgan observes that lackluster hedge fund performance in February and March did not catalyze a mass exodus. Still, October's numbers don't bode well. Here's Panigirtzoglou one more time:

Modest outflows are likely to persist and increase in Q4 this year and during 2019 given worse hedge fund performance in October relative to last February/March. In particular, we expect that 2019 will look more like 2016 in terms of hedge fund redemptions with significant but still modest by historical standards outflows of around $5bn-$10bn per quarter, i.e. still far from the big redemption wave seen post Lehman crisis.

Does that relatively modest expected pace of outflows mean this isn't a concern? Well, no. Or at least not if you're keeping track of potential headwinds for equities. In other words, this is another example of a dynamic that is more or less important depending on who you are, how much you have on the line and where your allocation is concentrated.

Broadly speaking, what I would say is that you should consider this in conjunction with an expected deceleration in buyback activity in 2019. The corporate bid is still the largest source of U.S. equity demand, and that bid will eventually wane alongside the impulse from fiscal stimulus. All of that will coincide with falling earnings growth and indeed, Goldman was out late last week with a new note that projected S&P EPS will only grow by 6% and 4% in 2019 and 2020, respectively, a dramatic drop off from 23% in 2018 (more here).

(Goldman)

All in all, the above points to significant "chop" headed into the end of this year and a rather arduous path ahead in 2019. That is, even if technical flows (e.g., re-risking from systematic strategies, the last gasp of the buyback bonanza, etc.) do manage to squeeze everything higher, there are significant headwinds from tightening financial conditions and the blowback from the October rout, which raised serious questions about whether time has finally been called on the FAANG trade.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.