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FRM Early View, January 2015


Last year we were correct to think that the financial environment was no more complicated than our simple mantra – “follow the money”. We think it would be rash to assume the same any longer. Last month we predicted that this year would be more complicated, but events this month, both political and market based, have served strongly to re-enforce this turnaround in our view. Politics in Europe has once again reared its head, and Central banks have started to act unpredictably. The market moves have been commensurately volatile and we believe are a foretaste of the environment to come.

We have always held the view that in Europe politics is more important than economics. Politics has held the Eurozone together, and politics is what could eventually tear it apart. The election of Syriza in Greece – the first populist party in Europe to succeed in forming a government – is especially concerning, given their aggressive rhetoric on the existing debt. We are watching to see if there is a domino effect elsewhere. Already there have been large demonstrations in Madrid in support of the leftist party Podemos.

The second big event, the announcement of QE in Europe, is more ambiguous for the Eurozone. The decision by the ECB finally to join the “unconventional monetary policy” pioneered by the Fed and the BoE five years ago suggests to us that, after a seemingly interminable debate, the will of Germany was finally blocked. German domination of Euro decision making has been an immutable fact of life in the fifteen years since the formation of the Euro. Now a possible danger is that the Germans may be less willing to play if they aren’t in charge of the rules of the game. That would be a significant watershed in the European austerity debate. The steps that are taken over the next month to determine how to mitigate the Greek debt problem could have profound implications for the future.

Just as there has been a significant shift in Europe’s politics, so the transition from uniform to idiosyncratic behaviour by central banks may also have profoundly unsettling implications for markets.

The actual announcement by Mario Draghi of QE in Europe was impeccably handled. Instead of disappointing market expectations as we had feared, the actual announcement slightly exceeded the markets’ hopes. The same could not be said of the action of other central banks in January. One of the most stable and historically dependable central banks, the SNB, has just delivered financial markets one of the biggest policy shocks for decades. The abrupt abandonment of the pseudo peg on the Swiss Franc was a complete reversal of its previous policy announcement issued just weeks before. And in its first unscheduled policy decision since September 11th 2001, the Monetary Authority of Singapore reduced the slope of the Singapore Dollars appreciation versus a basket of currencies. Denmark too surprised markets with a rate cut, matching the SNB in testing the lower bound for interest rates with a negative 75bps rate.

The only central bank to maintain a consistent stance is the Federal Reserve, though this is itself a cause of uncertainty. The Fed has held an unwavering point of view on the future course of US rates. There is however a clear divergence between what the Central bank is saying and what the market is pricing. St Louis Federal Reserve President, James Bullard, confirmed that “the market has a more dovish view of what the Fed is going to do than the Fed itself”. The Fed is clearly focusing on the momentum in the US economy in recent months, and evidently does not feel that this is consistent with interest rates at zero. Financial markets seem to disagree with the supposed momentum in the economy and are apparently more focused on deflationary risks as measured by 5yr/5yr inflation forwards which have fallen to a post financial crisis low.

The contrast between the Federal Reserve seemingly set on raising rates this year and other central banks still cutting has obvious implications for the strength of the Dollar. There is currently nothing to suggest that this trend will falter, but the consequences of a strengthening Dollar are more complicated to predict. Its negative impact on indebted emerging markets is clear, but it also weighs on US company earnings. Dollar strength has already been cited repeatedly as a significant factor in recent adverse earnings reports. And cuts in planned Capex by energy companies in response to the lower oil price also imply a clear headwind to certain sectors of the US equity market. An oil dividend resulting in improving consumer consumption may not entirely offset Capex reduction and job cuts in the energy sector. So a stronger Dollar is not an unambiguous good for the US.

In short the grounds for instability have grown. Central bank policy is diverging, politics in Europe is once again moving centre stage, a strong Dollar creates tension, and the markets seem to fear deflation more than they believe in growth.

So we have abandoned our “follow the money” paradigm, at least for the time being. Markets are currently endorsing our point of view with higher realised volatility and persistently higher implied volatility. That strongly implies that market participants should reduce their risk exposure. This could however be a false alarm. The liquidity driven beta trade could continue to run for some time longer given the recent large policy initiative from the ECB. But whereas previously the environment was simple to predict, we now think that the combination of increased uncertainty, higher volatility and the Fed threatening to tighten earlier than the market anticipates, merits a more cautious stance in the markets.

Hedge funds

Amid the heightened volatility, there was a wide range of returns for hedge fund managers in January with the aggregate returns marginally negative; the HFRX Global Hedge Fund Index ended the month down 29bps. The strongest performing strategy was once again Managed Futures. They have benefitted from the continuation of trends across a range of markets, particularly those in fixed income and currencies. Following the strong month in December for Statistical Arbitrage, early indications are that January was roughly flat. The weakest performing managers were in Discretionary Macro, where a number of managers were caught off guard by the SNB decision.

Managed Futures managers were once again the strongest performing hedge fund strategy in January, continuing the very strong run at the back end of 2014. Many of the themes of their performance were unchanged with Fixed Income and Currencies producing the bulk of the returns. Fixed income in particular has been a driver of performance in the last twelve months, with managers holding long exposure for the entire period. Currencies have also been profitable, with the divergent monetary policy (particularly in the US versus the rest of the world) forcing large trends that this strategy captures more efficiently than others. There were some differences in performance drivers; the large short exposure in energy commodities had been a big driver of performance in the back end of 2014, but was a very small driver of returns in January, and the position has been scaled back. Other than this, the exposures across the industry are largely unchanged; long fixed income across regions, long equity with a marginal shift towards Europe from year end, and long USD versus a number of other currencies.

December was a month of large dispersion amongst Discretionary Macro managers. This was principally caused by the decision by the SNB to abandon the currency floor with the Euro. A number of managers in the strategy had large short exposure to the currency, which caused a few large negative returns. In some cases this was sufficient to force the managers to return capital to their investors. Aside from this event, it was actually a relatively strong month for managers, and those who were not impacted by the move generated strong returns. Short Euro in particular is a very commonly held position, and the delivery of QE in Europe by Mario Draghi meant this worked well for managers. Short Japanese Yen is the other large consensus currency trade, but this had a more difficult month. Within commodities the main difficulties were for metals managers as the base metal spectrum continued to be dragged lower both by the Oil price and due to fears of a slowdown in global growth; Copper traded down to a five year low in mid-month. Agricultural managers had a positive month as bearish positions in Soy and grain markets worked well.

Similar to wider Equity markets, Equity Long-Short manager performance varied by region in January. European managers had a strong month, while returns in the US were negative. In Europe the market was down close to 5% at one point before a large rally through the second half of the month. Growth outperformed value, potentially due to the strong rally in interest rates, and the periphery underperformed the core. Despite the help of market beta, the majority of the strong performance in Europe was down to idiosyncratic stock moves in a more volatile environment. The Swiss franc move was beneficial to the strategy overall, as a number of managers held short positions in Swiss exporters. On the negative side, banks continue to underperform the wider index, and oil continues to be a net detractor. The environment in the US was more difficult. Earnings reported so far have been mixed, with a number of large misses, and at the same time Apple recording record profits. A number of multi-nationals have commented on the recent strength of the US dollar as a headwind, and managers now have short exposure in aggregate to these companies, with long exposure increasing in consumer discretionary stocks. Gross exposure has been reduced in the heightened volatility, but interestingly the concentration in the portfolio has increased.

For Event Driven managers there was clear dispersion between the US and Europe. European managers in the space typically have larger exposure to special situations type trading, and therefore typically have a higher level of beta than their US counterparts. This was clearly a positive for them in January, and caused a significant outperformance of European Event managers. US manager returns were more mixed than those in Europe, and will end the month roughly flat. The majority of deal spreads that managers are involved in tightened through the month, but the Comcast/Time Warner deal detracted from performance following a setback to the chances of getting past antitrust hurdles. Additionally US special situations trades were largely a detractor for managers. Going forward there is pretty clear interest in the Energy sector, both from a special situations standpoint (which worked well in January) but also interest on the M&A side with very little consolidation of the industry thus far. Deal activity was lower in January than over the last few months, but did include some larger deals, including a 47bn USD deal between Cheung Kong Holdings Ltd and Hutchinson Whampoa Ltd. which was the largest ever in Hong Kong.

Early indications are that Statistical Arbitrage managers had a small positive start to 2015. Interestingly one of the weakest strategies for managers was their futures trading components; January was another strong month for Managed Futures. Value based signals detracted from performance, particularly in the US and Europe, while price momentum signals worked well across regions. Quality signals were mixed across regions. There are a number of year end effects that mean that the strategy has historically performed well in both January and December. It’s possible that the fact this was not observed in January was that they had largely played out already and were seen in the very strong December performance.

Credit Long-Short managers had poor returns in the second half of 2014, with credit spreads widening, and the majority having little to no interest rate exposure to offset this. January was a repeat of this in many ways with spreads widening and interest rates falling. As a strategy Credit Long-Short will have generated small negative returns. There were however a number of idiosyncratic trades which worked well for managers. Fannie Mae and Freddie Mac instruments had a positive month following the rejection of a bid by the US government to put on hold a number of court cases. Another trade that worked well was long exposure to floating rate perpetual preferred shares. These instruments have a fixed floor on the coupon, and benefitted from the Federal Reserve’s statements about the timing of rate rises.

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