Alternatives Update – January 2024

A significant amount of uncertainty remains surrounding the schedule of rate cuts in 2024. While the annual pace of inflation has fallen by nearly 66% since June 2022, geopolitical risk in the Middle East threatens a resurgence as shipping costs through the Red Sea have tripled since December amid continued attacks on merchant vessels in the region. None of this is likely to push the Fed to resume increasing interest rates, but it could push back the start of rate cuts.

The number of rate cuts expected in 2024 also differs widely. Fed SEP (Summary of Economic Projections) “dot plots” show the median FOMC member thinks three cuts this year are warranted. Contrast this with the interest rate futures market which is expecting six cuts by the end of the year, despite believing the first cut is no longer expected until May. Add to this the fact that retail sales surprised strongly again to the upside, and Q4 2023 GDP growth is expected to be a robust 2%, and the path forward is far from certain.

Against this backdrop, most factors struggled in December. However, since the start of the new year, many of those factors have rebounded — strongly. No set of factors has recovered as completely as Quant (see Figure 1), led by Low Frequency Quant, demonstrating that slower moving macroeconomic information is the dominating force in the current environment.
 
Momentum type factors, which also universally lost in December, have had a stellar 2024 thus far (see Figure 2). All momentum factors, other than Lottery, have positive returns in 2024. Interestingly, Reversal has continued struggling, indicating the market is operating under similar conditions as December, and the winners during that period continue to be the winners in 2024.

Further highlighting this notion that we continue to operate in the same regime as the end of 2023, Analyst Sentiment also performed well in January, with only 3M Recommendation Revisions seeing negative returns. Finally, on the Macro Beta side of factors, we will note that Sensitivity to Oil Prices struggled in response to crude oil, as the increasing hostilities in the Middle East came as a surprise to market participants.
 
Moving to managed futures, let’s start with rates. The Q4 drop in U.S. yields was in our opinion spectacular. Figure 3 shows that the 5-year yield dropped from a peak of around 4.8% in late October, to below 3.8% in late December. At the time of writing, it stands at 4.05%. The drop in yield created a major uptrend in US Treasuries. However, Figure 3 shows that over the whole of 2023, the 5-year yield appears quite range-bound. It peaked at 4.3% prior to the regional banking crisis, then hit a low of 3.3% in late Spring 2023. In this context, our view is that the December low of 3.8% looks neutral.

Consequently, a long-term trend-follower, for example using a 1-year window, would have been far less exposed to the Q4 US Treasury rally than a short-term trader using only the last month. Amongst managers with a large allocation to interest rate contracts, it is our belief that long-term trend followers will be leading the pack in 2024.
 
In the commodity sector, Oil recently hit an 8-week high. The spot Oil price is shown in red in Figure 3, highlighting a notable correlation to the 5-year yield in grey. Oil finished 2023 down around 10% but has recovered in January 2024. Possible causes of the 2024 rally could be attributed to the Chinese Government’s attempts to stimulate their economy, cold weather in the US increasing demand for Heating Oil, and continued tensions in the Middle East. Over the past year, we have observed Oil struggling to find direction, making it a very challenging market for trend-followers.

Figure 3 shows that Oil appeared to be rallying in Summer 2023, only to fully retrace its gains during Q4. Oil is a major component of the headline CPI inflation number. It is therefore interesting that Figure 3 shows that the peak in Oil prices preceded the peak in 5-year yields. Although central banks are more focused on core inflation, the drop in the headline CPI figure could be viewed as impacting the US Treasury market. Potentially, a continuation of the recent rise in Oil prices could precede a further increase in yields.

Finally, we end on a more positive story for trend-followers. Agricultural markets have trended downwards persistently since late 2023, with recent reports that US Corn seeding was down only 1.9% from 2023’s record. They also expect the fourth largest US Soybean harvest on record. This is supportive of continuing downward pressure on price.
 

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GLOSSARY:

Beta: Measure of the volatility, or systematic risk, of a security or portfolio compared to the market as a whole (usually the S&P 500).

Managed Futures: An investment where a portfolio of futures contracts is actively managed by professionals. Managed futures are considered an alternative investment and are often used by funds and institutional investors to provide both portfolio and market diversification.

Reversal: A change in the price direction of an asset. A reversal can occur to the upside or downside.