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Should investors be worried about credit spread return expectations or expectations of credit default losses in the current environment? Before we answer the credit questions about the current environment, investors may need a framework for weighting the types of risks in the credit markets. This is the fundamental question concerning holding any credit exposure, and an exhaustive research using variance decomposition of a large dataset shows that you should be worried about both. See “What Drives the Cross‐Section of Credit Spreads?: A Variance Decomposition Approach”, by Yoshiio Nozawa in the October 2017 Journal of Finance.

Global equity index signals suggest short positions while bonds are showing stronger long trend signals. The repricing of risk usually is associated with movement from more risky to less risky assets. Short rates suggest more uncertainty on Fed making good on rate rise promises. Metals are signaling a growth slowdown. The general tenor is that trends in most liquid markets more likely.

Most trend-follower will say that they are “non-predictive”.  While I think this is true in the sense they do not form forecasts or expectations, trend-following is also based on the prediction that the price direction through some set of price weighting from yesterdays and today will continue into tomorrow. Trend-followers do not try and forecast expected returns rather they extract signals from past data under the assumption that price moves will have memory of at least direction. These managers find trends across a large diverse set of markets and then invest long or short based on these trends. If the markets are moving higher, they are a buyers, and if price move lower they are sellers. Buy high under the assumption that prices will move higher and sell low under the view that prices will move lower.

A recurring global macro theme has been how investors should think about stock bond correlation. The negative correlation between stocks and bonds has been the single best diversification provider for any portfolio. There are very few alternative investments that have offered the same amount of diversification and provided a significant amount of alpha. This simple diversification is why variations on the 60/40 stock/bond portfolio mix have been such winners since the Financial Crisis. But times change, or more specifically, regimes change.

The choice between using futures versus employing options for a trend-following program is worth reviewing after the recent market events. Would trend-followers who used options have done better than those who expressed their directional bets with futures? The key to this answer is whether the trend-follower had a view on volatility.

As far as the laws of mathematics refer to reality, they are not certain; and as far as they are certain, they do not refer to reality.  -Albert Einstein

We follow the dispersion, volatility and correlation indices generated by Standard & Poor’s which show intra-index stock behavior over time. When the correlation across stocks within in an index is high, there is a clear sign that the market is facing a macro shock. Performance should be biased toward beta risks. Fund returns will be driven by their beta exposure and timing skill not by their stock-picking skill. When correlation is low across stocks within an index, we can say it is a stock picker’s environment because skill-based traders will be rewarded for exploiting differentiation across firms. This lower correlation will generate more dispersion in returns if there is additional volatility.

The recently released Preqin Investor Outlook, Alternative Assets, H1 2018 describes the demanding environment for hedge funds. Investors do not believe hedge fund are meeting their expectations, allocations may be smaller, flows may be reduced, and there is a desire for better alignment of interests. Of course, there is also the desire for more performance. To address these issues hedge funds will have to change.

The Willis Towers Watson annual survey provides a wealth of information on global pensions and their asset allocations. Pension asset allocations around the world continue to show a move away from the simple equity and bond betas. The current survey shows only 75% of allocations are between equities, bonds, and cash with equities only given an allocation of less than 50%. These allocation numbers, however, show an increasing exposure to global equities and bonds. The other basket, representing the remaining 25%, includes real state and alternatives which can include a wide range of investment products. Pensions continue to move out of equity and bonds for alpha capital appreciation and income. The US equity allocation is down 10% since 2007 (60% to 50%) while the other category is up 10% from 18% to 28% over the same period.

A review of the trends that current exist across market sectors suggest that there is significant noise about directions and fundamental changes from last month. The equity bounce post the volatility shock seems to have played out and now new information such as “trade wars” seems to be defining new trends. Bonds seem to be moving back to the core negative correlation with equities. The dollar sell-off also seems to have paused except for traditional safe asset currencies. Metals are now trending down but commodities are responding to a weather shock. While there may be profitable opportunities later this month, current signals are mixed.

Hedge funds as measured by the HFR indices suffered with the overall market decline with only RV strategies being able to take advantage of the higher volatility environment. In general, the equity hedge fund declines were consistent with their longer-term betas (approximately .3 to .6). The outliers for the month were the event driven, special situations, macro and systematic CTAs indices. The year-to-date returns show significant dispersion with equity hedge fund indices generally positive while special situations, systematic CTAs, and event driven indices falling between -2.50 and -3.75 percent.