Keeping the Bigger Picture In Focus

FRM Early View


We are rapidly approaching a fascinating inflection point in modern economic history. The falling bond yields and ever-looser monetary policy that characterised the most of the 25 years preceding the financial crisis of 2008 led to an over-leveraged financial system that came close to collapse. The policy response since 2008 has been to solve a debt crisis with more debt, looser monetary policy and more leverage (at the time of writing the Fed Balance sheet is $3.6 trillion and the US government debt is $16.9 trillion). It is now more likely than not that the Federal Reserve will, this month, instigate tapering mechanisms – the beginning of the end for the largest monetary stimulus ever seen. It is easy for market professionals to focus on incremental changes from day to day: the devil is often in the detail. Now is a time to keep the biggest of pictures firmly in focus.

Tapering dominates the agenda because the policy makers in the US, as the world’s biggest economy and easily the world’s most important currency, perform two roles – a global financial custodian and manager of the domestic US monetary policy. For five years, fulfilling these two roles has required the same response: free-flowing, fungible stimulus. But given the current strength of the US economy relative to the rest of world, the imperatives of each of the two roles is diverging. From a domestic perspective, there is little sense in further inflating the balance sheet of the Fed when the US growth statistics are back to near pre-crisis levels. From a global perspective, however, the economy is still in need of support. By focusing on only their domestic responsibilities, the US policymakers may be ignoring the fact that the US represents only 21% of nominal global GDP – and that the other 79% would presumably prefer the tap to be kept on for a while longer at least. The most obvious regions to suffer from reduced stimulus in the US are Europe and the emerging markets.

Europe remains beset by fiscal weaknesses of its peripheral nations and is only marginally out of recession. Last month, Greece was forced to concede the necessity of a third bailout package (albeit much smaller than the first two), and there is some concern that other states are postponing a full discussion of their needs until after the German federal election on 22 September, since further turmoil before this date may be detrimental to the re-election prospects of Angela Merkel (and unless there is a major swing in sentiment, it looks likely that the CDU/CSU union will be part of a ruling coalition and Merkel retained as chancellor, thus avoiding the bigger economic uncertainty that would accompany a Steinbruck victory).

In emerging markets, the situation is arguably more serious. In particular, countries such as India, Brazil, Turkey, and Indonesia are potentially beginning to show balance-of-payments issues that suggest an overdependence on foreign capital flows. These four countries alone represent over 8% of nominal global GDP, and have each seen their currencies depreciate versus the dollar by 20-40% over the past two to three years. Their equity markets have been similarly damaged by the talk of tapering – India’s Nifty Index lost 13% peak-to-trough through late July and August; Brazil’s Bovespa Index is -21% year-to-date; the Turkish BIST National Index has seen a -30% peak-to-trough sell-off since the end of the first quarter; and Indonesia’s Jakarta Composite Index sold off by 24% over a similar period. It is not yet clear whether this is just repricing an overbought asset, or whether reduced global liquidity has started to uncover more serious structural flaws in the economic landscape that could precipitate a more dangerous crisis.

Since 2008 and until recently, ‘risk-off’ moves in investor sentiment have been identified by a flight to quality; selling equities and buying government bonds. Tapering talk has changed that. Risk-off is now a deleveraging move; both equities and government bonds sell off as the balance sheet contracts. This was seen in late May and June, when tapering was first seriously discussed, and was again the case in August as the possibility of tapering became an expectation thereof. Last month, the S&P 500 returned -3.1% and the US 10-year yield widened by 20bps, from 2.58% to 2.78% (peaking at a max of 2.93%). These moves were against a backdrop of generally strong fundamental data.

Growth figures in the US, UK and Europe all exceeded expectations, and data on jobs, homes, manufacturing and consumer confidence were all broadly better or in line with consensus. As we’ve noted previously, until the market learns how to price the tapering process we will have a situation where good data is bad for markets (since faster tapering becomes more likely). Elsewhere, markets were broadly quiet in August, with few significant moves in FX and mixed data from commodities (stronger gold, stronger Brent Crude in response to growing uncertainty in Syria).

The importance of the inflection point in September 2013 will only be apparent in hindsight. Over the next few years we expect to see tightening measures in the US (and later, more chaotically, in other regions) proceeding for at least as long as the quantitative easing process took place. With 0% interest rates and inflation at 2% (or more), we are still very much in a non-normal world with a negative real cost of capital. If we accept the link between monetary tightening and financial deleveraging, then we should reiterate our concerns over the current pricing of credit instruments for the next few years. Credit, and the government bonds from which their spreads are priced, have both seen unprecedented flows over capital over the past few years supported by global stimulus. A period of deleveraging should, therefore, place at least technical pressure on the current prices of these assets.

In the short term, however, it is unlikely that we’ll see much more sustained pressure on the long end of the yield curve. Historically, the spread between short and long rates on the US yield curve (and, to a less stable extent, elsewhere) is somewhat bounded. Unless a US government default becomes possible, then the long end of the curve should be bounded at a ceiling of 3%-3.5% while short rates are zero.

Hedge funds
Given that the market price action in equities and bonds exhibited similar characteristics in August as it did in June, it is not surprising that hedge funds lost money again in August. The HFRX Global Hedge Fund Index returned -0.8% over the month, as managers again struggled to deal with concurrent falls in both equities and bond markets. The worst performing strategies were managed futures and equity long/short, while relative value and specialist credit managers generally produced flat to slightly positive returns.

The overriding factor affecting hedge fund returns in August was the increased expectation of tapering activity from the Federal Reserve and the impact this had on capital markets. At FRM, we have been focusing our efforts on trying to better understand how hedge funds will navigate and profit from a world of tightening fiscal policy and rising bond yields.

The return of higher bond yields and falling equity markets was generally detrimental to managed futures managers, after the rally in July had led many managers to position theirbooks in line with an upward trend in risk assets. However, the recent market gyrations have resulted in lower risk exposures in general across the trend-following community, and as such losses in August were muted. Managed futures managers who focus on shorter-horizon trends generally did well in August as they were able to realign for rising bond yields more quickly, and generally lost less money when yields stabilised towards the month end.

Commodity specialists experienced a very mixed month of performance. Some managers generated higher than +5% returns, while others posted similar sized losses. Amongst the best performing managers were those who focus on one area of the market, such as agriculturals or metals, and who correctly positioned themselves for the market moves in those markets. The worse performers were either multi-commodity-focused funds or managers in the energy sector where the escalation of problems in Syria led to a spike in the price of Brent Crude and a widening of the Brent-WTI spread.

Equity long/short specialists produced returns in line with their beta-adjusted expectations. As should be expected, managers with higher net exposure to falling equity markets lost more money than those with lower nets. However, in some regions, most notably Europe, market-neutral managers also lost money, suggesting that intra-market dynamics for adding alpha became less efficient during the month. Typically when market-neutral managers lose money in this fashion they can enjoy a ‘rebound’ of returns in subsequent months if their trading themes exhibit mean reversion. We shall have to wait to see if this is the case in September.

Relative value funds generally made positive returns in August across all strategies, but statistical arbitrage managers saw mixed returns during the month. It is interesting that statistical arbitrage managers are commenting that it has been harder to make money from their equity signals this month, as this correlated with the experience of market-neutral equity long/short specialists who have also found it hard to realise fundamental value in equity market discrepancies. In particular, Asian-focused statistical arbitrage managers have said that the intra-market dynamics changed through the course of August to reward growth signals at the expense of high-dividend-paying stocks, as concerns over the slowdown in China reduced during the month.

Event arbitrage specialists generally produced positive returns during the month, as most managers navigated both the relative paucity of deals in August and the unexpected deal break between American Airlines and US Airways early in the month. Convertible arbitrage and volatility arbitrage specialists generated small positive returns in aggregate, supported by small increases in the level of market volatility which led to gains for managers with well hedged portfolios.

Specialist credit managers generally produced positive returns despite a small widening in credit spreads and sell-off in credit indices. Many managers in this space are now close to market-neutral and have continued to benefit from idiosyncratic market opportunities. RMBS and CMBS managers generally lost money as ABS markets sold off in line with other risk assets. The worst performing AAA-rated tranche was the ABX S6-2 (loans originated in the second half of 2006) which returned -5.2% during August.