Timing Investment Decisions

Increased correlation occurs despite diversification

LUCA RUBINELLI, PORTFOLIO MANAGER, XENFIN CAPITAL

The timing of investment decision making has never been more important than it is now given the recent Euro correction, the trouble with both the Greek balance of payments and the debt to GDP ratio, as well as the threat to the systemfrom other peripheral European countries. Recent events have shown us that during extreme market shocks portfolio diversification doesn’t work as theory would suggest due to the increased correlation of risk assets. This has happened in fixed income with bund and Treasuries contracts and may even happen with gold prices at some point. Going forward, the biggest concern among economists and investors is what plays out in three areas: 1) price inflation or deflation; 2) acceleration or stagnation of economic growth; and 3) emerging markets versus developed economies. The resolution of each of these concerns will be considerably impacted by the huge liquidity available. Cash sitting on the sidelines may be kept there owing to market volatility. Yet after any major fall in equities prices, liquidity is there to push the market up, perhaps leading to opportunistic bids for companies as investors look to put money to work.

Risk has been transferred from troubled banks to government balance sheets. This has contributed to a generally low interest rate environment which could persist for some years to come. Unusually, companies that restructured or refinanced their balance sheets in the last few years have healthier debt ratios than some governments, particularly in Europe.

When Xenfin Capital was set up by Duncan MacInnes it sought to trade the small trends in foreign exchange markets on a daily basis. Our core model is a systematic approach that covers the G5 currencies. The model contains 10 separate time tested sub-strategies and each model is not correlated within the basket. The strategy is particularly profitable in both directional and non-directional markets, having the advantage of not taking longer term market views, and in consequence avoiding longer term decisions in what are likely to be very crowded markets.

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Euro downside may grow
One natural trade for Xenfin to focus on is €-$. After sharp falls the euro has partially rebounded but that may not go on indefinitely. We believe that the euro will have much more downside in 2011 than in 2010 if the Fed tightens rates and the European Central Bank (ECB) is forced to stay on the sidelines to facilitate economic growth. Therefore, if the move to parity or 1.10 for the euro is delayed to 2011, it isn’t difficult to see €-$ trading around the current rate of 1.20 into the yearend. If the €-$ cross remains around the current rate, it will be interesting to see how this affects the development of the euro as a funding currency for carry trades using high yield currencies from emerging markets or the Australian and Canadian dollars. Of course, this favourable outcome for the euro is subject to European authorities approving and delivering support to member states. It also requires the European political response to be well coordinated, otherwise the future of the euro as well as the stock and credit markets will be dark.

The allocation of the three month repo operation by the ECB was key for the markets, regardless of the outcome sentiment could be viewed positively or negatively. In fact, corporates have been using alternative routes to funding directly with banks. The recent announcement by Siemens AG to apply for a bank licence in Germany is significant. Is the finance department of this large international conglomerate looking for alternative ways to lease products to end customers, or is it a way to ask directly to the Bundesbank for cheap funding and repo lines?

Additionally, either a small or a large drawdown on the repo operation will be particularly supportive for the euro, as traders and economists will remain worried about the liquidity of the banking system, the sovereign funding ability, the balance sheet of the so called Club Med countries. Notwithstanding unprecedented levels of fiscal intervention to help the economy and moves to regulate investment banks and hedge funds through tax levies, the credit markets still remain mostly shut, not only for the general public but for most institutions.

Chinese equities correlation
A very interesting phenomenon is how Chinese equities correlate to world equity markets. When the A or H share indexes tank, it is generally the case that other major equities markets slip into negative territory. However, on a total return basis, some economists are finding that US and European equities are more correlated to each other than with equities in China. What happens then if the Chinese left hand side engine of the plane is not exporting to the US right hand side engine because of stronger yuan appreciation? There seems to be little knowledge about how this would play out or what the authorities in China might do.

The degree to which decoupling between credits and stocks happens will continue to be driven by the perceptions of event risk and economic risk. The correlation will remain high if attention continues to focus on event risk. However, if the market focus returns to concerns that growth will be anaemic then credit will probably outperform stocks. Companies with US investment grade credit ratings have already built massive amounts of liquidity at cheap rates as well as levels of capital and reserves well above the levels before the credit crisis began in 2008. Capex will be saved, and falling T-bond yields will remain supportive for corporate credit spreads and yields. It means that the downside in credit spreads is probably limited at the current juncture and well below the equity risk and volatility.

Luca Rubinelli recently joined Xenfin Capital to run their Global Macro ART strategy. Using a top down approach, the proprietary trading strategy filters daily and intraday signals of the most liquid ETFs.