Market Normalization Still to Come

Divergence between regions in September

FRM EARLY VIEW, SEPTEMBER 2014

Economic data began decisively to diverge in September as the US recovery looked even more established and European data, by contrast, confirmed subdued activity accompanied by persistently weak inflation. China also exhibited weakness, as did Japan, all of which gave impetus and certainty to US dollar appreciation.

We stick to our core investment case that the markets are essentially liquidity-driven, with the bulk of the liquidity coming from central banks. In the US, where QE is coming to an end, public sector liquidity creation is being replaced by a revitalized private sector. Europe is poised for an increase in central bank intervention, and faltering numbers in Japan suggest that further stimulative measures from the BoJ may be forthcoming. We believe that the backdrop for risk assets is still broadly positive, but that nervousness about the timing of Fed action will continue periodically to unsettle the markets. And a strong dollar puts pressure on emerging markets. So cross-market correlation is falling which also creates opportunity. As before, geopolitical noise remains for the moment largely noise, which is subordinate to liquidity. The Middle East, though messy, is likely to be contained, Ukraine has become a “frozen” conflict, and China is likely to refrain from a violent solution to protest in Hong Kong.

Once again central bank attitudes are proving decisive in determining the future path of markets. Fed watchers may draw comfort from the fact that Chair Yellen retained the “considerable period” language in her comments on the future path of interest rates, but the Fed is clearly data-dependent, so there may be false comfort in interpreting too closely the language of Yellen’s statements. Markets are, unsurprisingly, interpreting the data to conclude that economic strength in the US will lead to rate rises at the earlier end of expectations.

The central banker to watch right now is unquestionably Mario Draghi, following his forceful speech at Jackson Hole in August. Early in the month, Draghi announced a forthcoming ABS purchase plan, and then followed up with a statement that ABS purchases would be big. Not content with that message, he later commented that the euro recovery was losing momentum and that he was ready to use additional unconventional measures. We know what he says; now we have to watch what he does.

At the time of writing, ECB president Draghi’s statement on the details of the ABS purchase programme had just been released, and later in the month of October the results of the AQR stress tests will open the way for banks to take greater advantage of the TLTRO funding provided by the ECB. Initial reactions to the press conference were disappointment that he revealed no new initiatives and that he was not more specific on the size of the ECB balance sheet expansion. He reiterated further the view expressed at his Jackson Hole speech that fiscal reform at the sovereign level was required in tandem to ECB actions, and that Europe could not rely on the ECB alone to solve the twin problems of little growth and falling inflation. Importantly with regard to the ABS programme, Draghi stated that, “The eligibility criteria for guaranteed mezzanine tranches of ABS will be communicated at a later stage,” leaving ambiguous his view on this when the market was hoping for more clarity.

Notwithstanding the market’s initial reaction to the ECB, we believe that ECB actions will over time generate a powerful rally in the European banking sector for the following three reasons: (i) the European banking sector has materially underperformed the rest of the European market during the rally of the past three years, and is currently priced at discounted levels, particularly when measured on price to book – the value of which is about to become clearer; (ii) recent announcements by the ECB of TLTRO lending and ABS purchases directly benefit the banking sector, and (iii) the underlying macro landscape in banking is improving, with lending demand growing, provisions for bad loans falling, and earnings increasing. Future milestones in the path of this investment idea include the AQR results, Q3 earnings figures in November, which may show a continuation of earnings growth, and, as a longer-term catalyst, the take-up of the third tranche of TLTRO in March 2015. In order to improve growth in Europe, the ECB is pumping around 10% of Eurozone GDP into a banking sector which is already showing nascent signs of recovery. We believe that this is a theme that will unfold over the next 12 months.

In Japan, the data continues to disappoint, but hopes that the BOJ will respond seem less likely as the USD/yen approaches the key milestone of 110. Equities are still somewhat hopeful of a boost from allocations from the GPIF, but the combination of a falling yen with the BOJ staying on the sidelines seems to be the perfect recipe for a self-sustaining move. In China, weaker data is contributing to a slight weakening of the renminbi, but as the HK Shanghai Connect programme draws closer, the narrowing of the A/H spread continues, aided unexpectedly by the protests in Hong Kong which have exacerbated weakness in the H Share market.

September has seemed a slightly challenging month, but we have been expecting for some time that the approaching end of QE in the US would be a cause of some setbacks. It would probably be more accurate to say that the approach of the end of QE will bring a degree of normalization to the markets. That is what we have experienced recently, after a long period of abnormal synchronicity with low volatility.

Hedge funds
The global hedge fund industry had a negative month in September. The broad HFRX index fell 0.8%. Global equity markets mostly fell, with the notable exception of the Nikkei which rallied 4%, almost mirroring the yen’s 5% fall against the dollar. The S&P, which had ended August at a record high, fell 2.4% and European equities were mixed, as the euro fell almost 4% versus the dollar. The Hang Seng was weak in response to the protests in Hong Kong, which gave added benefit to those trading the A/H spread. Bond yields rose 8bps in the US but mostly fell in Southern Europe, except Greece.

Performance in macro, managed futures, commodities and emerging markets reflected the dispersion that has become more prevalent across markets. Discretionary macro managers had a good month overall, profiting from FX moves, particularly the strongly trending moves in short yen and short euro positions. Managers focused on emerging markets had more mixed results. EM FX weakness was a problem, and in Brazil, where rate receivers were a popular trade, polls for the upcoming election which showed a swing in favour of the incumbent, Dilma Rousseff, exacerbated currency weakness and caused rates to rise.

Argentina, by contrast, recovered steadily based on some positive signs regarding the hold-outs, but the trade remains very volatile. Commodity markets were weaker, with weaker economic data from China the driver for industrial commodities and the supply picture pressuring agricultural commodities further as the downtrend in prices continued.

In Asia, Japan was the stand-out performer among equity markets, rallying 4% as the yen fell, bucking the trend of generally weakening markets worldwide. The market is not reacting to economic data but is rather being sustained by hopes of reallocation to equities by the GPIF, expectations of possible further action by the BOJ, and the weakening yen. China A Shares weakened but H Shares weakened more in the face of the student protests in Hong Kong, thus giving extra impetus to the A/H trade which we have previously discussed in connection to the HK/Shanghai Connect programme.

The equity long/short landscape in Europe was positive despite flat performance from the Eurostoxx 600 (+0.3% on the month). After an early bounce on the announcement that the ECB would include ABS purchases in its stimulus package, the markets ground lower through the rest of the month on generally weaker GDP and PMI data, compounded by a lack of corporate data during the hiatus between Q2 and Q3 earnings seasons.

Stock-specific winners for managers were focused on the short side of the book, in particular oil services names, which have beena structural short on lower demand and further suffered on the retracement in the price of oil. Names such as Seadrill (-24.5% on the month), Transocean (-12.5%) and Subsea 7 (-11.0%) were common winners. Another thematic short winner across the hedge fund industry in September was UK food retail, which continued to sell off on poor sales figures and earnings forecast irregularities at Tesco. Tesco was -19.0% on the month, joined by J Sainsbury at -13.4% and Wm Morrison at -5.2%. A third common theme is long positions in Italian banks, which ended the month in only slightly positive territory after giving back most of the benefit of the ECB bounce on concerns over wider Italian growth.

Looking forward, managers remain largely bullish on Europe, despite the current weak macro backdrop. Valuations (particularly versus the US) remain very attractive for the region, and there is a consensus view that the ECB actions of TLTRO lending and ABS purchases will be sufficient to stimulate growth (not least through a weaker currency) and stave off deflation. The biggest concerns are that these measures will take time to circulate through the banking system into the wider economy, and thus investors may lose patience in waiting for the recovery in the short term.

There was a wide range of performance from the US equity long/short managers in September, with the worst down -3.4% and the best 3.2%, resulting in roughly flat performance overall. In terms of drivers, the significant underperformance of the Russell against the S&P meant that the market cap composition of portfolios was important in determining performance. In addition, corporate activity was again a large driver on both the long and short books. The generally negative tone to markets over the month required active trading on the short side to protect any idiosyncratic gains on the long book.

Credit, which has been one of the main beneficiaries of QE, was until recently priced for perfection. The difficulties experienced in July and August worsened in September as the end of QE is that much closer. Fed Chair Yellen’s July remarks about asset price bubbles forming in some markets such as leveraged loans and lower-rated corporate debt have continued to concentrate minds. So, in addition to the usual concerns about headline official rates, September saw a broader reassessment of credit risk. US high-yield fell circa 2% in the month, driven by 60bps of credit spread widening and losses accelerated in the last week of the month. In line with the general reassessment of credit risk, the lower the credit, the worse the performance. Given that most managers have a mild net long bias, losses were experienced across the board.

Statistical arbitrage managers had a good month in September, and those managers that are more factor-dependent generated strong returns in the US and EU. In Asia returns from A/H trading were strongly positive as the unease caused by student protest gave further downward momentum to the H Share side of the trade, generating ~5% spread compression.

In event trading, new rules on tax inversion added to volatility, but the setback on the announcement gave managers an opportunity to add to positions which rebounded strongly, generating positive returns. Managers fortunate enough to have exposure to the Alibaba IPO profited strongly from the ensuing rally.