FRM Early View

April 2013

Originally published in the April/May 2013 issue

Investors entered April on the back of a strong first quarter for risk assets, supported by capital inflows into equities and a more benign economic landscape. The question in April was whether markets would follow the pattern of the previous three years, with a setback in the second quarter due to the re-emergence of economic issues (e.g. Greece in 2011) leading to risk aversion and outflows of capital from equity markets. Our view has been that a possible catalyst for a Q2 correction would be a slowdown in the US growth story. Two core US economic indicators missed expectations in April – the change in non-farm payrolls at the beginning of the month (88k vs. expected 190k) and Q1 GDP towards the end of the month (annualised 2.5% vs. expected 3%), but equity markets finished in positive territory, as the S&P 500 Index returned 1.8% during the month.

It seems that the equity market resilience was driven by renewed sentiment around the willingness of central banks to provide markets with liquidity. Explicitly, the aggressive monetary policy of the Japanese central bank led to the Nikkei rising by 11.8%, taking its YTD return to 33.3%, and other developed markets’ indices benefited by contagion. Implicitly, breakeven inflation in the US dropped substantially during April (see chart below). It had been steadily increasing over 2013 leading to concerns over the potential difficulties surrounding the cessation of the stimulus. The drop in inflation calmed concerns of the Federal Reserve cutting back or removing its QE programme in the short term. The move also coincided with a tightening of US Government yields, as real returns increased.

Interestingly, the fund flow from Japan indicates that the majority of flows into Japanese equities have been from foreign investors, rather than domestic investors (despite the continued decline in the value of the Yen). If Japanese household financial assets, of which nearly JPY 9tr is held in non-interest bearing accounts, as well as JGB investments, are rotated into equities there is no reason the rally should not continue. (Source: Morgan Stanley). Over the short term, however, valuations have reached levels where the market could possibly be overheated with the real risk of profit-taking exacerbating any market downturn.

Further support for equity markets is given by the health of corporations in the US. Q1 earnings season has been moderately positive thus far with companies beating analyst expectations, albeit downgraded ones, despite the weakness in top line results and outlook. Markets have been driven by macroeconomic data so much over recent years that it is worth remembering that indices only represent the value of the underlying corporations. Additionally, corporate balance sheets remain very strong, this is not only beneficial on a company specific level, but also because it raises the prospect of companies deploying cash in the form of investments. Investorsentiment remains cautiously optimistic, although many are mindful of the correction seen in equity markets in recent years.

The other big story during April was the large sell off in commodities in the middle of the month. Precious metals were hit particularly hard, partly for supply and demand reasons, but partly due to their status as inflation-protection securities. Gold suffered its largest daily decline in 30 years and fell to levels not seen since 2009. The widespread sell-off coincided with weaker than expected GDP figures released from China. Whilst the Chinese economy is still growing at a quicker rate than most of the rest of the world, the headline figure missed expectations in April (Q1 GDP 7.7% vs. expected 8%). The balance of sectors contributing to this growth appears to have shifted, with infrastructure and other commodity-heavy sectors falling, and service sectors contributing a larger proportion of the growth. A portion of the move in gold could also be attributed to the leaked news that Cyprus was considering funding some of its deficit by selling gold reserves.

In Europe the picture was mixed; Italy finally managed to be at least partially coherent in their views by re-electing Giorgo Napolitano, the first Italian president to be given a second seven-year term, and later managing to form a parliament with Enrico Letta at the helm. This result leaves the likelihood of further elections reduced, with markets reacting positively by pushing the yield on Italian 10 year bonds back down to pre-crisis levels (3.9%). This decline in Italian yields is despite the fact that the political instabilities remain as real as before, and the ability/will to push through much needed reforms is still seemingly lacking. It appears that for now investors are ignoring the uncertainties in the political backdrop and instead focusing on the pledge of the ECB to do “whatever it takes”, as well as the widespread talk of an ECB refinancing rate cut, using EFSF safety net as a method to collect a higher yield.

Italian yields were not the only European market movements that belied the fundamental backdrop. French yields also tightened, falling below 1.7%, and the Dax 100 Index rose by over 2% on the day that weaker than expected PMI figures displayed the flagging global export demand. Germany is an interesting source of risk in the medium to long term. With elections due in September, Angela Merkel currently looks very safe, however if this situation changes it is possible that markets will react in a negative manner. Additionally tensions between Germany and the rest of Europe appear to be rising, with the Bundesbank and the ECB clearly in disagreement over the proposed cut to refinancing rates.

Hedge funds
The hedge fund industry continued its recent positive performance, the HFRX Global Hedge Fund Index finishing the month +0.6% and taking year to date returns to +3.8%. Once again, data suggests that performance was generated across a range of strategies with very few ending the month with negative aggregate returns. The largest gains were posted by long-term trend following managers, almost all of whom captured the large commodity movements mid-month.

Our central belief is that stock and sector picking should generate the bulk of Equity Long-Short manager performance, as investors can access naked market exposure more cheaply elsewhere. We were therefore wary of the potential for renewed risk aversion in equity markets (as discussed in the markets section above) to reduce dispersion in stock prices, since investor outflows tend to be less discriminatory than inflows, and that this would reduce the good opportunity set for Equity Long-Short that we have seen thus far in 2013.  

This has not happened. All indications suggest that Equity Long-Short managers continue to generate positive returns that exceed the expected level given by their net exposure to markets. In April, discrepanciesbetween pricings of sectors, and between stocks within sectors, generally remained as fruitful as they were for the first three months of the year. Even in the Japanese equity markets, with their very strong rally in response to central bank monetary stimulus, stock-specific risk remained a driving factor of share price, particularly during the mid-month earnings season. Provided that the current market conditions persist, with fundamentally driven prices and constructive fund flows, our outlook for Equity Long-Short managers remains positive. Managed Futures performance was positive, but there was a large discrepancy between long term trend followers, who appear to have recorded the strongest returns of any hedge fund strategy in April, and short-term traders, who struggled during the month. Long-term trend followers were becoming increasingly short commodities during the first quarter, particularly in metals as they slipped from their end-2012 peak, and therefore were correctly positioned for the mid-month sell-off. Conversely, short-term traders held relatively flat positions in commodities, largely missed the sharp sell-off, but then built a short position too late and suffered in the subsequent rebound. Longer-term managers also benefited from long positions in equities and government bonds during the second half of the month – illustrating the benefit of a diversified portfolio in deriving returns from trends that develop and dissipate in different asset classes at different times.

Evidence continues to suggest that Emerging Markets are now weaker than Developed Markets, with concerns around both inflation and growth metrics released from various emerging economies. It looks likely that, in a continuation of the year to date movements, Emerging Markets will trail Developed Markets during stable or risk seeking market regimes, leaving beta exposure to most Emerging Markets an unattractive position for Global Macro managers. There are, however, opportunities for managers to capitalise on differentiation between different Emerging Market countries as a result of divergent fundamental data, and discrepancies in central bank activity. In a similar manner to many other sectors, currently we feel that the environment here is more conducive to specialist managers, able to profit from idiosyncratic opportunities, rather than generalist managers.

Conditions in credit markets continue to be suited to specialist hedge funds over long-only exposure, with hedge fund managers once again appearing to outperform the market. This theme has developed strongly this year following the large beta gains in 2011 and 2012, and currently compressed yield levels leaving little room for further capital appreciation. Dispersion between single names has gradually improved in 2013, with fundamental factors and idiosyncratic events determining value rather than market technical pressure. Having lagged behind in February and March, due to weaknesses arising from the Cyprus situation, the financials sector of the credit market outperformed over April. Whilst credit remains overpriced in our view, there is no obvious catalyst for a market reversal at this stage. In this environment we continue to believe the best returns will be generated by managers running books without large directional calls, focusing on idiosyncratic opportunities.

Despite the bearish environment for commodities, hedge fund managers still remain broadly positive on the opportunity set since the price movements remain, on the whole, fundamentally driven.  Indeed, the average specialist commodity hedge fund was correctly positioned for the sell-off of metals in April and made strong positive returns, however movements in crude oil, and derivatives, generally detracted from manager performance. Large price movements generally present opportunities for hedge funds with specialisms to capitalise on mispricings driven both by those less informed and by non-speculative market participants.

In Relative Value, Event Arbitrage managers appear to have had their strongest month of the year so far, but volumes in M&A activity remain subdued. Managers that have done particularly well are those focused on a range of arbitrages, such as the mispricing between holding companies and underlying businesses, where the mispricing is more likely to be resolved in fundamentally driven equity markets. Statistical Arbitrage managers generally produced flat returns. Mean-reversion strategies did well, but we expect there to be some overlap between these strategies and short-term trend followers in their momentum strategies, and as expected these sub-strategies lost money during April. Convertible Bond Arbitrage managers saw the best returns from Japan, where strong equity market returns pushed most convertibles closer to the money, and managers benefited from long gamma exposure to these moves.

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