The Arbitrage Funds
Advised by Water Island Capital


Notes from the Desk

Market & Event Updates from the Water Island Capital Investment Team

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Notes from the Desk: October 2018 in Review – Volatility Returns Once Again

October witnessed heightened volatility returning to the markets yet again in 2018. The CBOE Volatility Index (VIX) started the month at its lows (closing under 12 on October 3), only to breach 20 for the first time since April just one week later, on October 10. The VIX later reached an intra-day high of 28 on October 29. The S&P 500 index experienced a 6.8% decline for the month after having fallen as much as 9.3% during the period. The rest of the world’s markets suffered similar declines, with the Euro Stoxx 50 index, the Nikkei index, and the MSCI Emerging Markets index falling 8.2%, 8.8%, and 8.7%, respectively. (This brings emerging markets stocks down over 15% year-to-date.) We believe rapid changes in sentiment have been exacerbated by the growth in exchange traded funds (ETFs), factor models, risk parity funds, and commodity trading advisors (CTAs). Increasing correlation across asset classes surely indicates a risk-off mentality is prevailing amongst investors, and many alternative strategies – such as global macro, managed futures, and long/short equity – have not escaped the turmoil unscathed.

The foundation for this largescale recalibration of prices began on September 26, after the Federal Reserve decided to once again raise interest rates amid strong economic data and positive consumer confidence. At the time, investors seemed to de-emphasize the impact of potential tariffs on corporate earnings, and inflation expectations remained subdued. Yet on October 3, Federal Reserve Chairman Jerome Powell suggested rates are still a “long way” from neutral, setting expectations for another rate hike in December (and several more in 2019), and Amazon announced it would raise the minimum wage for all its employees to $15 per hour, rekindling inflationary fears. Furthermore, Ford guided earnings downward, citing increased costs due to tariffs.

Sharp increases in volatility should hardly come as a surprise to investors. Since the financial crisis, markets have been massively supported by central banks, quantitative easing, and low interest rates. We are now undergoing the massive unwinding of Federal Reserve asset purchases amid a scheme to normalize short-term interest rates. We believe markets will continue to reprice amid higher interest rates and less government support, and volatility is a natural biproduct. Nonetheless, the combination of higher rates, tariffs, and fears that corporate earnings have peaked has left many investors uncertain about where equities should trade. When faced with this uncertainty and increasing volatility, many have simply opted to sell.

Amidst this environment, event-driven strategies, including merger arbitrage, have generally performed better than the major equity market indices. Long/short credit and short duration bonds also performed admirably over the course of the month. Our outlook for the months ahead remains positive, as we believe a healthy universe of catalyst-driven opportunities remains. Early in the month, several definitive transactions were announced – including the stock-for-stock acquisition of Rowan Companies PLC by Ensco PLC, GFL Environmental acquisition of Waste Management Industries, and TransDigm’s all-cash acquisition of Esterline Technologies. More recently, ITE Management LP announced the purchase of Amercian Railcar industries for $1.4 billion, CMA CGM SA announced the acquisition of Ceva Logistics AG, Chesapeake Energy announced its acquisition of WildHorse Resource, and IBM announced plans to acquire Red Hat Software for $34 billion.

Volatility may create further opportunity for merger arbitrage investors who can take advantage of spread widening and lower prices in specific deals. While merger arbitrage spreads for straightforward, fully financed transactions have generally held steady, longer-dated deals and transactions requiring approval from the Committee on Foreign Investment in the United States or China’s State Administration for Market Regulation widened. Due to the short timelines of most mergers, these spreads often snap back as volatility subsides or as the deals near completion.

In the special situations space, spin-off activity remains on track. During Q4 we expect to see the completion of several high-profile spin-offs including Resideo Technologies from Honeywell, Equitrans Midstream from EQT Corp, and Arcosa Inc from Trinity Industries.

In the credit space, selling by high yield ETFs along with ETF arbitrage activity has caused a more pronounced sell-off in the more liquid part of the market (i.e., those bonds eligible for inclusion in ETFs). This has permitted bond investors who are unconstrained by benchmarks to outperform indices and peers, and to increase positions at more advantageous prices. We also continue to see private equity (PE) firms driving new transactions. The deals either involve public companies being taken private or PE firms purchasing privately-held assets or companies. Both situations may present investment opportunities for catalyst-driven credit investors. Even with general selling in high yield, we still see credit spreads near the tightest levels in the past five years. While this may be warranted if positive economic activity and low default rates persist, we think a flatter credit curve provides for more attractive short-duration opportunities without the need to take excessive duration risk.

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