However, the recently emerging problems are nothing new. Greenspan did in fact give a more acerbic commentary than usual on the deficits, but was it reasonable to think that such debt levels were healthy for the economy until now? Did the Chairman of the Federal Reserve finally have to speak out so that market operators would snap out of their torpor?
Credit differentials are widening sharply because of the alarming news about General Motors and Ford. The results are worse than expected. However, the credit hedge fund managers we spoke to two years ago were already seriously thinking that GM would and should go bankrupt. Indeed, their spreads were already extremely wide for highly-rated securities, reflecting investors’ mistrust of GM’s ability to generate sufficient cash flows to pay off substantial debt, including outsized pensions. Recent developments have only confirmed what those paying attention already knew.
So why this violent, widespread reaction? Stock markets have been weak since early March, following a series of weak and inflationary economic figures in the United States. We have maintained since the middle of last year, and we are reiterating it this year in particular, that the real risk is ultimately inflation because the markets don’t anticipate it. However, they are now starting to include this in their forecasts. Also, because this type of thing never happens in isolation, the stock markets, already prey to doubts, are suffering the full impact of Sino-Japanese tensions. Do these tensions over a textbook really affect the world’s economic equilibrium that much in the short or medium term? Did these countries really get along so well before this chapter was rewritten? We are part of a real waltz of geopolitical risks, relegating those who were the key players until September 2004 to the second division.
In fact, we are once again in a phase of doubt after the few buoyant months that followed the American elections. As investors are optimistic by nature, valuations have a tendency to become excessive in a bullish market, so the downturn is all the more brutal. The fundamental question in terms of asset allocation, if this combines traditional and alternative management methods, is whether we are in a transitional phase heading toward a new, fundamentally different environment, or simply the victims of a necessary adjustment after a period that was a bit too good.
For now, we’re leaning toward the second option. As we stated in the introduction, the recent emergence of bad news does not, for the moment, fundamentally change the economic and political environment – particularly when it comes to the major risk factors. Volatility is still low compared to the last 10 years, and credit spreads are still in a relatively rich zone, but one that reflects the quality of corporate balance sheets. Long-term interest rates are still in an accommodating range for the economy, while the rise in short-term rates has become predictable, at least in the United States.
In the short term, however, the impact on alternative strategies is substantial. April will join May 2004 and summer 2002 in the annals of periods of substantial losses, because the market downturn is brutal and is accompanied by major bouts of liquidity crisis. Thus, convertible arbitrage shows clear signs of imploding, after several months of weakness, with estimated performances down to -6% for this month. Only the best managers will get through this and carry on from here – not necessarily those who had the best performance until now. Now we can finally ask ourselves whether levels are attractive for the strategy, even if, in the short term, technical conditions are not yet set for a return.
Credit strategies have certainly suffered recently but the defensiveness of many managers who have structured their portfolios conservatively over the last few months should help to generate very minor losses, even gains in the future. Nonetheless, the optimal adaptability of these more experienced managers plus increased management flexibility, thanks to CDS-type credit-protection instruments or, quite simply, short selling, will be indispensable.
Long/short equity managers are also suffering from serious weakness on the markets, especially in the United States, with average performances around -2%. However, we are finding a healthy optimism when we speak to the managers. Such optimism is not tied to expectations of a market upturn, but to the fact that the current disruptions and indiscriminate sales, regardless of the reasons behind them, offer exceptional opportunities.
This is particularly true in credit and arbitrage, and these disruptions may be all the better captured by multi-manager portfolios structured to harvest the opportunities that emerge. In this sense, April could reveal many things about the management capacity of hedge funds and funds of funds. What is more, the next few months could finally reveal substantial differences in performance between the players in this changing industry.