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October commenced with the return of heightened volatility in the markets, with the CBOE Volatility Index breaching 20 for the first time since April and the S&P 500 experiencing a 6.7% decline from October 2-11. The rapid sell-off was exacerbated by the growth in exchange-traded funds, factor models, risk parity funds, and commodity trading advisors, and increasing correlation between asset classes indicates a risk-off mentality is prevailing amongst investors.
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 chose 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 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. The combination of higher rates and potentially lower earnings left many investors uncertain about where equities should trade, and in the face of volatility many simply opted to sell.
In the face of market volatility, event-driven strategies have held up reasonably well. Our outlook for the months ahead remains positive, with a healthy universe of catalyst-driven opportunities to select from. Over the past week, several definitive merger 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. Merger arbitrage spreads for straightforward, fully financed transactions have held steady, while 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 during the sell-off. Spin-off activity also remains on track. We expect during Q4 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. 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 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 due to positive economic activity and low default rates, we think a flatter credit curve has created good short-duration opportunities for investors without the need to take excessive duration risk.
Glossary: A credit spread is the difference in yield between a US Treasury bond and a debt security with the same maturity but of lesser quality. A deal spread is the difference between the price at which a target company’s shares currently trade, and the price an acquiring company has agreed to pay. High yield bonds have a credit rating lower than investment grade. A spin-off is the creation of an independent company through the sale or distribution of new shares of an existing unit of a parent company. The CBOE Volatility Index is an index that is commonly used as a measure of domestic equity market volatility. The S&P 500 Index is an index of US equities meant to reflect the risk/return characteristics of the large cap universe, and is one of the most commonly used benchmarks for the overall US stock market. Duration risk is the risk associated with the sensitivity of a bond's price to changes in interest rates. Risk parity funds use an approach to investing that focuses on allocation of risk rather than allocation of capital. Factor models are financial models that employ multiple macroeconomic, fundamental, or statistical factors to attempt to explain market phenomena or asset prices.
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