A Bad Case of the Jitters

February's market correction raised many questions

Originally published in the April 2007 issue

A sharp sell-off in the last two days of February completely changed the complexion of the month for investors, although many hedge fund managers were able to successfully navigate the volatility and remain in positive territory on a month-to-date basis. The sell off began in China, where the Shanghai and Shenzen index fell by 9.2% on the 27th, sending equity markets elsewhere around the world in to a sharp downturn. In the US, the S&P fell nearly 3.5%, while the FTSEurofirst 300 index of leading European shares closed 2.9% lower, its worst fall in nearly four years. This jolt sent the Yen and the Swiss franc higher, propagating concerns that the much hyped carry trade would start to unwind, as part of a flight to quality that also sent government bond prices in all the main markets higher.

The contagion was real, but it was unclear what had caused the degree of sudden panic. As one prominent macro manager we spoke to the following day pointed out, there was no real hard economic informational event which had precipitated this sell-off. It is true that China’s government had just appointed a task force to cool the market, and also that former Fed chief Alan Greenspan had just made a speech in Asia in which he discussed the state of the US economy and the possibility of recession (in fact his comments were widely misinterpreted – his point was that corporate profit margins “have begun to stabilize,” a signal that the economic cycle is entering its latter stages, and not that recession was suddenly imminent).

But on another day such soft news flow may not have had the stinging reaction it appeared to instigate. Some commentators have suggested that instead, a growing anxiety among investors through the month had meant they were simply looking for an excuse to take profits and pause for breath.

There are a number of factors which make such a suggestion seem reasonable. First, in a geopolitical context, Iran ignored a UN deadline to halt uranium enrichment on February 21, and as a result the US, Israel and Iran all sounded off abrasive rhetoric, and Washington sent a second aircraft carrier to the Gulf. There has been much speculation about the prospect of military intervention, and some risk analysts are now suggesting there is as much as a one in three chance that either the US or Israel will attack Iran this year. In response commodity prices rose sharply towards the end of the month, with oil (West Texas Intermediate) climbing above $61 for the first time this year.

Elsewhere in the markets there were a number of growing concerns. Following an extended bull run many investors felt that equity markets were becoming overstretched, and widening spreads in sub-prime mortgages were fanning fears of contagion and some kind of move in the credit markets. Moreover, the Bank of Japan doubled interest rates to 0.5%, prompting speculation that the Yen would appreciate and thereby force investors to unwind the carry trade (removing an important source of liquidity), and conjecture centering on problems with two of the world’s most powerful economies – the US and China – was intensifying. In the US the economy was showing signs of slowing down, while in China there were fears that it was overheating, as the government continued to reign in inflation. Take these concerns together and investor anxiety may appear to have been justified.

This accepted, there are a number of mitigating factors which put this environment in a slightly different perspective. The fact is that the sub-prime mortgage problem has not spread elsewhere in the mortgage markets, let alone the credit markets at large. The yen has appreciated, but as the month closed was at the same level it had been in early January (when investors were quite happy to exploit the carry trade). Hank Paulson and Ben Bernanke both sought to immediately calm investor fears on the US economy, pointing out that US exports and consumer spending were strong, real income was up, inflation was contained, jobs had been created and that the outlook for moderate growth and gradually lower inflation remained unchanged.

And in China, the markets rebounded the following day, recovering a significant chunk of the losses made on the 27th. What’s more, in a historical context, the size of the “correction” was relatively inconsequential. While it is true that the Vix (volatility index) shot up 60% on the 27th and ended February with the biggest monthly percentage rise since the Long Term Capital Management fallout in August, 1998, at its height it was around 18, which is still below a ten year average of more than 21.

However, the consequences of the sell-off were real enough, as hedge fund managers lost much of the gains they had made earlier in the month, with the HFR Fund Weighted Hedge Fund Index and the Credit Suisse/Tremont Hedge Fund index ending the month up just 0.6% and 0.7% respectively. Macro managers and in particular CTAs were most exposed to the sell-off and hence recorded some of the biggest losses, with long term trend followers taken by surprise by the sudden and unannounced nature of the drawdown. Elsewhere, event driven and arbitrage managers did well to hold on to a positive performance for the month, while there were some big numbers posted by a handful of managers who were on the short side of the sub-prime trade.

The other issue for hedge funds during February was regulation, as the G7 group of leading nations met to discuss the issue that had been pushed to the forefront of the agenda by Germany. The conclusion of the talks gave some cause for comfort to both sides: Hedge funds were relieved that no hard regulatory regime was discussed, while the G7 members came away from the meeting with some kind of progress on the issue, as Germany won support for a package of proposals designed to encourage greater transparency and stronger dialogue between hedge funds and national finance ministries. Some have suggested that this is good news for the industry, as hedge funds will not have their nimbleness and flexibility of approach impinged upon, while a less opaque industry will mean investors may ultimately be in a better position to assess the strengths of individual managers operating therein.

Going in to March, the early theme is likely to be just how long the “correction” of the end of February will last and how far reaching will be its consequences. Many managers have said that from time to time such a correction is actually very healthy for the financial markets, mainly in restoring confidence (once it has passed) and also by providing good opportunities for investors to get back in and build positions. In truth, the state of the global financial environment is not yet altogether clear: IMF chief Rodrigo Rato recently stated assuredly that: “The world economy is on a strong footing…You see Asian and European economies (growing) at a strong pace and the US slowdown seems to be a mild one.” But this did not stop him hastily adding: “It’s good advice for all investors to take into account that downside risks can materialize.”