World Trade 2010

In the latter part of 2008, the value of world trade plummeted as availability of trade finance evaporated at the same time that global economic growth slowed drastically. 2008 saw a reversal of globalization as the developed world consumer retrenched after a protracted period of operating too low a savings rate accumulating unsustainable levels of debt. The emergency measures taken by governments to reflate their economies be it in monetary or fiscal policy has sent nominal GDP rebounding with a more moderate impact on real GDP. This caused a recovery in world trade, albeit not to pre crisis levels. The inventory cycle led by lagged destocking and restocking led to a magnified response in industrial production and world trade. The cyclical nature of a lagged transmission mechanism had already manifested in the middle of 2009 where world trade faltered again. November 2009 saw further weakness in world trade. This is further evidence that the developed world economy’s recovery is yet fragile. Aditionally, the situation in trade finance is still difficult. Bank lending remains frozen. Unless banks can find additional capital or capital relief under Basel II, they will not be deploying capital.

And yet, one should not be too quick to lose heart. A lagged transmission system creates oscillations around a recovery path. The current recovery path is interesting. The balance of trade between the US and China is a good proxy, given the volume of trade between these two countries. Since 2001, the trade balance has evolved into a US deficit cyclically correcting but trending well into deficit. The current cycle has seen a sharp correction towards balance as the crisis took hold in 2008. The recovery in 2009 saw a resumption of the US deficit but not to pre crisis magnitudes. The deficit appears to have stopped growing and appears to be in the process of drifting towards balance. As the US trends towards a net exporting position the conclusions for interest rates, the USD and inflation are most interesting.

FX transaction volumes are dominated by speculative and financial activity. Asset-liability share of FX transaction volumes are in the minority, 20% to 25% is an estimate provided by several FX hedge funds. Yet speculative transactions impact on FX tends to add volatility and not drift to the process whereas trade driven transactions tend to introduce drift. The implications are therefore for a strong USD.

There is another factor impacting the USD and that is that as world trade recovers from the doldrums, demand for USD as a trading currency increases. This is especially true from inter emerging market trade which is more likely to settle in USD. Inter developed market trade will sometimes settle in USD but is more likely to settle in the vendor country’s currency. Countries with closed capital accounts, capital controls, currency risk, and political risk will almost exclusively trade in USD.

Macro conditions are stacked therefore towards USD strength and not weakness. At the time of writing, this is a contrarian view.

Extending this thread, a strong USD worsens the terms of trade for the US potentially countering the drift in the trade balance. If the US is to drift towards a neutral trade balance, and the lack of vendor financing certainly pushes in this direction, internal pricing must adjust where external pricing cannot, suggesting deflation.

I have long argued without success or conviction that interest rates were too low to be efficient, that a low interest rate encouraged over investment as the hurdle rate for putting capital in harm’s way was too low. My argument lacked conviction because with a central bank setting short rates, it was hard to tell what a hypothetical market rate of interest would be…

A naturally strong USD affords the Fed latitude in keeping policy looser for longer. A deflationary environment is likely to keep long term interest rates lower as well.

Where does that lead? Monetary policy that is chronically loose has implications for dollar peg countries. If China does not yet have an asset bubble, it will. But it could take some time. And one can always watch in disbelief and disapproval from the sidelines, for quite a long time.

Its All Greek To Me

January 2010 was a bad month for investing. Markets fell from equities to credit to commodities. The USD was strong by default. Fears of a sovereign default by Greece was blamed for the general de-risking.

Markets fluctuate. The almost constant rise of risky assets since March 2008 has muted volatility and confounded the sceptics and perma-bears. Until fundamentals change, or until the perma-bears defect, the upward trend is likely to continue.

That said, the market needs a breather and in the absence of news, would have been equally likely to correct. In a market correction, any credible reason is immediately guilty. Hence Greece.

The opaque and fragile nature of Greek public finances have been known for some time. Greece is too big to fail. Let me correct that. Germany is too big to fail, Greece must be kept in the Euro.

My bet is that it is now a good time to establish a long trading position in liquid risky assets, like equities.

Equity valuations

If investment strategy was easy in early 2009, its because it was. Valuations of equities relative to cash or treasuries was at an extreme low making equities highly attractive.

Equities were highly unattractive on the basis of their earnings yield gap in the periods 1981, 1983, 1987 and the early 1990’s. Equities have been attractive throughout the last 10 years. 2009 was an obvious buy. That’s all changed now and the earnings yield gap on the S&P now stands somewhere in the middle, indeterminate, providing no direction. If we have no view as to earnings prospects except that they grow at the long term rate of GDP growth and we expect treasury yields to rise on increased issuance, deteriorating public finances, then treasuries are a short and the yield gap is due to deteriorate further.

The picture of earnings yield spread against credit tells a similar picture. But neither credit nor equities are cheap after the 2009 rally.

The picture is pretty much the same in a global context.

Japan is looking better domestically.

tpxyg2010

The UK is no longer cheap.

Neither is Europe.

For the USD investor, US large caps look cheap. So does emerging market equities. Hong Kong and H shares as well as Brazil look cheap relative to India, Europe and Japan. In a local context Japan looks interesting despite a recent rally, which is interesting given the lack of domestic investor participation in recent times. Hang Seng and H shares still look cheap. India looks expensive.

Equity valuations

If investment strategy was easy in early 2009, its because it was. Valuations of equities relative to cash or treasuries was at an extreme low making equities highly attractive. Equities were highly unattractive on the basis of their earnings yield gap in the periods 1981, 1983, 1987 and the early 1990’s. Equities have been attractive throughout the last 10 years. 2009 was an obvious buy. That’s all changed now and the earnings yield gap on the S&P now stands somewhere in the middle, indeterminate, providing no direction. If we have no view as to earnings prospects except that they grow at the long term rate of GDP growth and we expect treasury yields to rise on increased issuance, deteriorating public finances, then treasuries are a short and the yield gap is due to deteriorate further.

The picture of earnings yield spread against credit tells a similar picture. But neither credit nor equities are cheap after the 2009 rally.

The picture is pretty much the same in a global context.

Japan is looking better domestically.

The UK is no longer cheap.

Neither is Europe.

Hedge Fund Performance 2009 and Outlook 2010

Hedge Fund Performance Table 2009:

hfri200912

Outlook 2010:

Managed Futures:

Investors flocked to CTA’s at the beginning of 2009 relative to other strategies for the outperformance of the strategy in 2008. Performance in 2009 was -1.99%. Trend followers tend to create a synthetic long volatility profile (just as mean reverters create a short volatility profile) and the mean reversion of volatility from the acutely elevated levels in 2008 to more normal levels in 2009 coupled with the sharp inflexion point in market levels in March and the difficult trading patterns from June onwards wrong-footed most CTAs. The future for CTAs is as unclear today as it has always been for the strategy.

Global Macro:

Global macro was another preferred strategy at the start of 2009 because of its outperformance in 2008 when large market dislocations and economic policy conspired to provide macro with a clear outlook on which to trade. This evaporated in mid 2009 as trading conditions became more uncertain with regard to policy, economic growth, FX, and markets. It is highly illustrative of investor behaviour that their 2 preferred strategies for 2009 turned out to be the worst performers. The outlook for macro is interesting, however, as economic policy becomes a more important driver of asset pricing in the coming year. The problem with finding talent in macro is that it is particularly difficult to discern between skill and luck in this strategy.

Convertible Arbitrage:

The worst performer in 2008 became the best performer in 2009 from a confluence of a recovery in credit spreads and equity markets. A normalization of financing conditions also helped convertible bonds immensely. Convertibles suffered acutely in 2008 as leverage for convertible bond investors provided by the banks was withdrawn wholesale as the banks found themselves capital impaired. This led to forced selling of the asset class and artificially depressed pricing. The recovery has been an easy trade. What lies ahead is a much less directional market where arbitrage and hedging become more important. Given the scale of capital withdrawn from this strategy the convertible market remains an interesting space for arbitrageurs and will likely produce robust returns in the coming year. The long credit and long delta game, however, is likely over.

Equity long short:

Equity long short returned 26% as a strategy. We can infer from the near flat performance of equity market neutral that the bulk of the returns have come from maintaining a long bias and or market timing. Given the difficulty of timing the market, it is safe to assume that returns have come from net long exposure. Given the importance of macro policy on market direction going forward long biased funds are vulnerable to increased volatility going forward.

Equity market neutral:

Equity dispersion, a proxy for idiosyncratic risk, had risen in 2008 only to collapse and steadily decline in 2009 and remains depressed. Without dispersion, equity market neutral strategies will struggle to produce returns per unit of leverage. The outlook for equity market neutral is highly dependent on dispersion rising again. While markets continue to be driven by macro policy idiosyncratic risk will take a back seat to systemic risk. With time, policy will be withdrawn or fade in relevance to asset markets, at which time market neutral strategies will regain their traction.

Merger Arbitrage:

Merger deal flow has accelerated then slowed then accelerated again. Deal premia have been rich as the volume of arbitrage capital has remained low following the crisis in 2008. 2008’s credit crisis had profound impact on private equity sponsored leveraged buy outs which in turn impacted merger arb funds via increased deal breaks and later a dearth of deal flow. The recovery has seen some recovery in deal flow but these of a more strategic nature. Deal spreads have been rich enough that required leverage has been low. Merger arb returned a paltry 11.3% in 2009, well below potential. Part of the reason has been the low barriers to entry to the strategy which has seen dilution of quality. The merger arbs known to and preferred by us have generated well above average performance even exceeding the returns of convertible arbitrageurs. The prospects for merger arbs remains good, provided one invests with the right manager. Deal spreads remain elevated, deals are less uncertain, derivative markets are not crowded and can be applied to trade construction.

Fixed Income:

Volatility in rates, a steeper yield curve, diminished distribution and uncertainty in inflation expectations conspired to help fixed income arb achieve a 22% return on fairly low volatility in 2009. The environment looks unchanged. Macro policy will likely maintain the elevated volatility, volatility in commodity prices and the pace of economic recovery will likely sustain the uncertainty around inflation expectations, and increased issuance is likely to create idiosyncratic opportunities in basis and relative value. The yield curve is likely to flatten, however, which would take away any static carry. Fixed income arb is expected to produce robust returns going forward at least until the factors that drive returns fade, namely that inflation expectations become fully priced, debt distribution is restored to pre crisis levels and indeed is improved to handle the expected increased issuance and the yield curve flattens out.

Distressed:

The HFRI Distressed investing index returned 27% in 2009. The story here is interesting in that the number of workouts has actually not been that high. While default rates have surged in 2009, this has occurred in a time frame insufficient to support the returns experienced in 2009. Instead, the returns have been more likely the result of a general credit spread tightening across all credit qualities from investment grade to high yield. What this implies is that we are at the early stages of the default cycle and that on the one hand there is ample time to invest in distressed debt, the best of the returns are not behind the strategy but ahead of it, but that in the interim there may be more volatility than investors expect. Most of the spread tightening has occured in the larger to mega caps. For the small to mid cap manager there is an element of beta available to be captured, if that is the objective. The small and mid cap space also presents a more interesting hunting ground precisely for its more reasonable pricing

Capital structure arbitrage:

There is no index to represent this strategy. Anecdotally we are aware that many funds have done well in this space in 2009. The volumes of capital deployed in this area shrank precipitously in 2008 and some funds had to gate and suspend redemptions. Proprietary trading desks certainly had to exit these strategies to free up bank capital. The meltdown in the markets in 2H 2008 resulted in capital structures becoming dislocated and thus mispriced due to the nature of the selling, based on capital utilization and funding as opposed to no-arbitrage pricing. The systemic nature of the recovery from March 2009 has not restored capital structures to efficient pricing and thus longer term investors have the opportunity to participate in structurally sound arbitrage strategies. The stra
tegy needs appropriately stable capital provisions.