The value of gold is that it generates no cash flows, it cannot be consumed, it cannot be used for much beyond ornament. It is in effect quite useless apart from the fact that humans have assumed it as a standard store and measure of value. Were it not scarce in supply it would be completely and utterly worthless.

Were gold to pay a yield, were it useful in the production of useful goods and services, were it unlimited in supply, gold’s value true value would be discoverable.

If holding gold paid a yield it could be valued on the present discounted value of the income stream derived.

If gold could be used to make something useful, it could be priced in terms of the marginal value it added in producing those useful goods.

Gold cannot be priced in those terms. Gold can be priced, however, as an alternative to other stores of value, to other claims on wealth. One could argue that all other assets should be priced in gold.

Today, gold is precisely being priced in terms of all other alternative stores of value. It is telling us nothing more than that investors prefer this worthless, valueless object to government bonds, corporate bonds, equities, other goods, and most other commodities but for a few exceptions such as cotton.

It says a lot.

Three years after the financial crisis of 2008 and one bull market later, the world looks like a highly risky and uncertain place again with troubles in the Middle East, disaster in Japan, sovereign debt concerns in Europe and dare we say it, the US, food inflation in emerging markets and surging energy prices.

During this quarter, equities (MSCI World) gained 3.93%, global bonds (Barcap Global Bonds) gained 0.80%, commodities (CRB Index) gained 8.00% and hedge funds (HFRI Index) gained 1.60%. Go back 12 months and hedge funds have gained 9.42% while the MSCI gained 11.79%, Global Bonds have gained 6.60% and commodities a robust 31.50%.

On a 5 year annualized basis, however, hedge funds have returned 4.98%, MSCI a paltry 0.83%, Bonds 6.79% and commodities a mere 0.17%.

On a 10 year annualized basis, hedge funds returned 7.15%, MSCI 3.10%, Bonds 6.33% and commodities 6.97%. The volatility of hedge funds has averaged 6.9%, equities 16.8%, bonds 4.1% and commodities 20.2%.

Clearly hedge funds provide a superior return profile compared to the other asset classes once the risks are factored into the equation. Whereas passive exposure to equities or bonds or commodities may provide periods of significant outperformance, these periods are unpredictable and difficult for the non-professional investor to take advantage of.

During this quarter, Event Driven funds returned 3.5% according to the HFRI strategy indices, outperforming other strategies. A surge of activity in mergers, spin offs, carve outs, tender offers, exchange offers helped drive returns in this strategy. Distressed debt investing returned 3.20% as the recovery took hold. Convertible arbitrage turned in a very consistent 2.7% as credit continued to tighten and implied vols to richen. Mortgage backed security strategies continued their outperformance with a 3.45% quarter as the dynamics between servicers, borrowers, GSEs and regulators continued to present relative value opportunities.

It is tempting to invest based on one’s outlook for a strategy. The reality in hedge fund investing is that a good manager can and does outperform his peers to an extent as to confound the strategy outlook. Nevertheless, calling the strategy right is a useful exercise in the talent scouting process and is helpful in portfolio construction if the investor (such as a fund of funds) is sufficiently large that a concentrated portfolio is not possible.

The available tools in convertible arbitrage continue to recommend it as a strategy. The ability to rotate between delta, gamma, vega and credit provides the arbitrageur with an arsenal with which to attack a range of market environments. The enemy of convertible arbitrage is convertible arbitrage itself. Once too much capital is deployed in this area, not only do returns become more moderate, but risks rise as well as arbitrageurs apply more leverage to maintain returns on equity just as returns on gross assets become compressed. Currently convertible arbitrage is still an attractive strategy.

In the last 12 months the merger arbitrageur has found plenty of deal flow, but tighter spreads and most have struggled to make decent returns. There are exceptions to the rule of course, especially those who approach risk arb from a more creative angle calling not only deal closure or failure, but the path of the transaction. I expect that spreads will widen to reflect deal break risk as the macro environment continues to become more risky. Acquirers are being rewarded at the same time as targets and it is likely that more hostile and competitive bids will surface. Event driven strategies are likely to profit handsomely in this environment.

Fixed income (we lump arbitrage, relative value and macro in this segment) should have generated higher returns that it did in the last 12 months. The environment for fixed income has become more risky and unclear. The obvious trades of front running the world’s central banks was an easy trade which was surprisingly not as widely exploited as one would have expected. The opportunity has largely passed. Some of these ‘central bank’ front running trades were well played by the mortgage arbitrageurs as the Fed bought mortgage assets. The same opportunities in treasuries under so-called QE2 were not exploited.

Equity hedge funds maintain their net long bias and thus introduce correlation. The prospects for equity funds remains difficult as the proportion of stock price variation due to macro factors still dominates that due to idiosyncratic factors. Equities can therefore remain mispriced for protracted periods of time.

Credit hedge funds based on fundamental stock picking have an advantage over their equity counterparts in that credit trade expressions have a day of reckoning whereas equities can be mispriced indefinitely. For stockpicking hedge funds, credit is by far the better trade expression. Capital structure strategies like convertible arbitrage present a wide array of trade expressions which present no shortage of opportunities in any environment.

Global macro managers are too heterogeneous a group to speak about as a group. As noted before, the world has become a more risky and uncertain place and the opportunity for macro to make and lose money are equally heightened.

2011 promises to be a fascinating year. In the developed markets, economic policy (inflation, employment and growth policies) confronts sovereign balance sheet integrity. In emerging markets, rampant economic growth confronts income and wealth inequality. The ad hoc and desperate measures in addressing the financial crisis of 2008 have persisted and evolved into a prolonged yet unsustainable tactic of asset and liability transfers and liquidity and credit infusions. The economist worries about these real problems. The trader or investor deals in nominal terms and realizes that they are merely redistributing wealth, hopefully in their own direction. Theirs is not to reason why…

By June 2011, Quantitative Easing 2 will be over. But it will not be the end of the book, only of a chapter. I have always suspected that Quantitative Easing 2 was driven not so much by the need for monetary stimulus but by the need to monetize government debt. I suspect that going forward the Fed will have to find some other way of aiding and abetting Treasury. In some ways, its near zero nominal interest rate policy has mobilized the banking system to be part of the consortium for monetization. For this reason, I believe that it is no mystery why loan growth has been so weak, despite an apparent recovery in the real economy. Banks are presented with the opportunity to pay near zero short rates and receive a significantly higher long rate of over 3.5%. Levering this 20 times can be very profitable indeed. As long as the curve sits in this position, bank lending will be muted.

The other possible consequences of the expiry of QE2 are very much unclear, especially in the short term. In the longer term, more debt needs to be raised or refinanced than natural buyers can be found and a resumption of some sort of monetization is very likely. In the meantime, the Fed’s balance sheet will remain highly levered with an asset portfolio of some questionable loans to cash flow insolvent homeowners and one very large cash flow insolvent sovereign.

The short term effects are much murkier and could include a sharp reversal in the USD (yes, USD strength) as the force of debasement is turned off, a sharp reversal in nominal output, which is a risky outcome as it may expose weakness in the velocity of money previously masked by QE, or it could reverse inflation, at this point not a bad thing to see. It might impact gold and other commodities as investors substitute into USD assets. The prospects for cyclical metals is certainly highly uncertain, metals being cyclical and thus correlated with real output growth but also being priced in USD. Equities could fall as valuations are impacted by higher discount rates and companies face higher funding costs. Interest sensitive emerging markets with USD pegs or managed floats could suffer disproportionately as well.

Investors may take the end of QE as a sign of confidence by the Fed and thus continue to drive equities and other risky assets higher. Perversely, with the end of QE2 telegraphed to the market and higher rates built in to the front end of the curve, the end may drive investors back to the bond market depressing yields at the short end. Banks might begin to lend to the private sector again to earn a higher yield. (If they do not, one has to ask serious and seriously awkward questions about banks’ ability, not willingness to lend, questions which will ultimately focus on the quality of their assets.)

The range of possible outcomes is diverse and highly uncertain as the scale of Fed intervention is unprecedented and its withdrawal similarly on an unprecedented scale.

Most of the structural ills stem from the fact that you cannot cure morphine addiction with more morphine. The Fed has thrown its considerable resources at reviving credit creation in an economy which has imploded on the back of excessive credit in unsustainable structures. Debt has been transferred wholesale from private balance sheets to public balance sheets where they can be monetized. But debt is only eroded through inflation, repayment or default and reorganization.

The process of ending quantitative easing is one best watched from a distance. In this time of inflation, I am with cash.

Portugal needs a central bank willing to monetize its debt. It has no central bank of its own but shares one with the rest of the Eurozone. The independence of the ECB, at least of the plots and purposes of Portugal, Ireland, Greece and Spain means that there will be no monetization of their debt. Its a good thing and a bad thing. The good thing is that you are less likely to have runaway inflation or hyperinflation. The bad thing is that there are times when morphine is needed and none is forthcoming. The default solution may unfortunately be amputation.

Wait. Worry. There is never an easy time to invest but it is a convenient and effective excuse for those who invest or trade in fear and ignorance.

In the 80’s we worried about inflation and recession, the aftermath of the S&L crisis, the Latin debt crisis, an escalation of the cold war. In the 90’s we worried about the Euro, recession in Britain, a devastating earthquake in Japan, inflation in the US, economic crisis in Asia, the solvency of Russia, systemic failure in the death throes of LTCM, and Y2K. In the 2000’s we fretted over the bursting of the Internet bubble, recession in the US, terrorist threats, trade imbalances, leverage in housing markets, the great financial crisis, the survival of capitalism as we know it, depression, deflation, inflation, and sovereign default.

Worry is what we do. Crises are normal. Some of the reasons are behavioural and unavoidable, but others are of our own construction.

Today we worry about sovereign default in peripheral Europe, the state of the Japanese economy, the future of MENA, and the impact on the flow of oil, and of course inflation.

The fact is that the Euro was a singularly poor idea. In a single act, one major degree of flexibility for price adjustment was taken away from an entire region, requiring price adjustment to occur locally, and if not, to result in sub-optimal price signals and allocations. A single currency also imposed a single monetary policy upon a region of diverse fiscal regimes and potentially out of phase economic cycles. The current fears of sovereign default, inability to reach consensus over policy, political instability both in the periphery as well as in core Europe, are but symptoms of a more profound inefficiency: that one size does not fit all in Europe.

The political situation in MENA is a quagmire. The European intervention in Libya, nominally to protect Western interests but also as a matter of principle and humanitarian sensibility (so perverse have the local politics of financial and fiscal stress become), is lacking a clear exit strategy or metric of success or failure. In MENA repression and inequality of wealth are endemic accumulating pressures for revolution. The Arab, regardless of whether a have or have not, will tell you that revolution has been a long time coming. Were it not for the importance of MENA to global oil supply, no one might care but oil is now trading at over 100 usd per barrel and could become a drag on economic growth.

Fears of deflation in early 2009 turned to fears of inflation in late 2010. The inflation stemmed in part from rising agricultural commodities and food prices, a resumption of the secular forces in dietary trends in emerging markets, weather volatility, from rising oil prices due to the political unrest in the Middle East and North Africa, as well as from the global concerted efforts at quantitative easing now in their third year. The emerging markets have been quicker off the mark to address inflation with higher interest rates while developed countries have kept interest rates firmly to the floor to prop up their insolvent banking systems. These countries, the UK, the US and the Eurozone now risk stagflation.

The earthquake and subsequent tsunami in Japan has profound effect on the global economy. Domestically, it is expected that the immediate effects on the Japanese economy will be negative but transient and that the rebuilding of infrastructure will drive growth in the second half of the year. This seems to be the consensus. Externally, Japan has been a shrinking marginal participant in world trade and it is therefore argued that the impact of a slowdown in Japan is unlikely to be felt elsewhere. However, the importance of Japan in the global supply chain should not be underestimated. Japan is an important link in the chain in technology and a supplier (sometimes a sole supplier) of key components in many global manufacturing processes. The estimation of the true impact of the disruption requires a micro analysis of the affected industries. We know that in the auto industry Detroit and Frankfurt have faced severe disruptions to key components in fuel management systems.

A risk that has not yet been addressed is inflation in the US, where official inflation numbers appear benign but may in fact be mis-measured. The mis-measurement of inflation can lead to a mis-estimation of real GDP growth, potentially masking a current or impending US recession.

Then there is the problem of bank balance sheets. The stress tests that marked a turning point in the financial crisis were largely self assessments made by an industry whose reputation for integrity is in question. That banks have been repeatedly recapitalized and re-liquefied and yet have failed to convincingly return to normal propensities for credit extension must arouse some suspicions.

A broader and more general observation must hypothesize that the ‘goldilocks’ economy of the 1990’s was due to the ‘export’ of inflation through the offshoring of productive capacity allowing a lower NAIRU. The consequence of the successful pursuit of this strategy must necessarily be an increasing current account deficit. A reversal of the current account deficits must also imply a return to a more natural NAIRU, a higher one.

What it also means is that long term interest rates are likely to be higher for longer. This is not necessarily a bad thing as long as interest rates are endogenously determined and not the product of a unilateral effort to finance government or the operation of a deliberately inflationary debt management strategy.

Unfortunately there are no trading strategies that immediately arise from the above observations. However, markets remain liquid and normal and provide the tactical trader with ample opportunity to make and lose money in equal measure. Good luck.