As usual in 2015 most managers seem upbeat on their own strategy, with nobody offering to return capital to us although some managers are close to capacity. This illustrates a hard wired human bias that most people consider themselves to be “above average” drivers, amateur sportspeople, and of course investors.

So what is changing in 2015? Well the Fed is scaling back asset purchases, albeit at a slow pace. Markets are now expecting a US rate rise this year, although some of our managers still think it could be delayed until 2016. Meanwhile in Europe and Japan sovereign debt descends deeper and deeper into negative rate territory as policy rates turn negative and consequently some banks and custodians are charging funds to hold cash.

In much of Europe, zero interest rate policies, or ZIRP as the acronym goes, are now negative interest rates.  The question is why.  In preview, it seems to us that one end of the Eurozone’s financial plumbing may not be connected to the other.

For investors the implications are clear.  Firstly, few wish to actually pay interest on cash balances.  We contacted the hedge funds that we cover and found that most were taking steps to avoid paying on cash balances wherever possible though a few seem to be stuck having to pay a small amount.

And, secondly, whatever policy makers now intend, falling rates have been driving a search for yield for years.  Investors have to judge and accept credit risk, or indeed equity risk, in order to earn a positive return.  But we should be careful.  The rentier may well have been euthanized but so too might the careless investor![1]

SWISS SURPRISE

Watching the Swiss franc open up 30% one morning a few weeks ago, like a junior mining stock that just struck gold, was slightly surreal (Chart).  Thomas Jordan, Chairman of the Swiss National Bank, faced impending QE by his gigantic neighbour, Mario Draghi’s ECB.  SNB’s policy of unlimited euro buying would now contend with €60 billion per month of freshly printed money.  The franc-euro peg had to go and Swiss 3-month LIBOR sits today at -0.9%.

CHF EUR

The consensus view is that these macro divergences – combined with wide differences between currency and equity markets in various countries – improves the opportunity set for macro traders and CTAs. Last year CTAs had a universally strong year but the picture was much more mixed for discretionary macro with at least two funds shutting down this year.

Several discretionary macro traders have it seems been caught on the wrong side of the Swiss Franc free float, with one, Everest shuttering altogether while Comac returns some capital to investors and Fortress just had a bad week. Systematic macro funds and CTAs fared better, perhaps ironically because some of them exercised discretion to remove pegged currencies, including the Swiss Franc and Danish Krona, from their investment universe! This illustrates how many aspects of the investment process are in fact discretionary even for systematic managers.

The Swiss episode seems particularly surprising when historically the most celebrated hedge fund macro trades involved currencies breaking free from pegs. George Soros infamously made a fortune shorting the Pound Sterling in 1992, and Soros is still notorious in Malaysia for the collapse of the Ringgit currency.

So clearly the currency markets are a double edged sword where there will be winners and losers (the nature of the beast!), but that said many of the macro managers we monitor did make most of their money in 2014 from currencies, which swiftly delivered an explosion of volatility after an extended period of abnormally subdued volatility.

RENTIER BECOMES LIQUIDITY PROVIDER

Wider divergences are not confined to macro markets. Equity and credit market sectors are also no longer moving in lockstep. The obvious losers last year were energy and commodity plays, with airlines being an obvious winner. But even within these and other sectors there were wide gaps between sub-sectors.

The potential to generate alpha on both long and short books is growing, and some of our managers are finding Asia in general, and China in particular, very fertile ground for stock-picking – not least because regulators in Asia have made it possible to short a growing universe of stocks.

This is a far cry from the shorting bans of the late 1990s and it shows how academic research from EDHEC and others has persuaded the broader community of the benefits of shorting, which include better market liquidity and the ability to profit from frauds. That regulators seem much less likely to ban shorts reduces the risk of managers being forced to exit their shorts at the worst moment.

Within the credit markets, European credit has outperformed US credit in 2014 partly because the former has very little energy exposure, but also because falling interest rates and expected ECB credit purchases provide some tailwind for credit. However we would observe that US credit spreads now look somewhat wider than those in Europe – and the US economy is clearly in a healthier fundamental state, expected to grow at 2-3% against 0-1% for Europe. 

“France hasn’t borrowed this cheaply since the ‘50s – the 1750s. Real rates are negative as far as the eye can see, suggesting perpetually anaemic growth.” - Mark Carney, Governor of the Bank of England

Convertible arbitrage had a dreadful year in 2014 as it was skating on thin ice in terms of liquidity with forced sellers facing painfully low prices. The asset class may be looking theoretically cheap but we are told it is still not as cheap as in late 2011.

Merger arbitrage was another relative value strategy that was wrong-footed in 2014, due to deal breaks. Now spreads may well be selectively attractive, but the spectre of more regulatory intervention, such as Obama’s raising of the bar for tax inversions, may well justify wider spreads.

We would always remember that merger arbitrageurs are in effect selling puts (some might say picking up coins in front of a steamroller) and that a clutch of deal breaks in one month can lead to double digit losses – or worse for heavily leveraged funds!

INHERENT VICE

So how should we think about risk aversion that has pushed interest rates below zero in much of Europe in 2015?

Bank of England Governor Mark Carney described Europe’s debt trap in his recent speech, Fortune Favours the Bold: “France hasn’t borrowed this cheaply since the ‘50s – the 1750s.  Real rates are negative as far as the eye can see, suggesting perpetually anaemic growth.”[2]

Governor Carney notes limited cross border Eurozone banking, so savings cannot easily flow to investments.  And virtually no cross border fiscal flows.  As such, Yanis Varoufakis, Greek Minister of Finance, faces the polar opposite problem of the Swiss.  His Modest Proposal is well worth a read amid the general media coverage.[3]  One can feel sympathy for the Greek people, who currently lack the opportunity to expand trade of their goods and services as a way out of debt.  As Carney concludes, the solution is ideally a supportive Eurozone fiscal policy to recycle surplus private sector savings, until recovery is self-sustaining.  Instead we have negative interest rates.

Today’s European deflation looks very much like the world British economist JM Keynes described in his General Theory in 1936.  This was a rich time for investment writers.  Benjamin Graham and David Dodd’s seminal work, Security Analysis, dates from 1934.  Perhaps an example of necessity being the mother of invention.

Keynes observed that investors desire prospective yield, which is in turn dependent upon adequate growth in the wider economy.  Yet the decision to hold wealth en masse can undermine this very growth.  Savings unless they are in turn borrowed and spent by business and households tend to depress the economy, as Governor Carney describes in Europe today.

Negative interest rates will unlikely bring production forward, as risky processes are not greatly changed by cost of funds, and may inadvertently magnify credit risk.[4]  Graham and Dodd argue that yield is an inferior reward for credit risk.  Far better is a discounted price, which encourages proper analysis.[5]  It is hard to imagine bonds at a discount if prevailing interest rates are negative.

So the inherent vice, or instability, in negative interest rates is that they reinforce deflationary trends and unwinding could be perilous.  While the opportunity set for enterprising investors increases with market turmoil, so too have the risks – as the Swiss surprise amply demonstrated.

Hamlin Lovell, CFA & Keith Tomlinson, CFA

[1] Keynes, JM (1936). The General Theory of Employment, Interest and Money. London: Macmillan. 227 (Keynes described the rentier as a functionless investor that exploits capital scarcity as opposed to the entrepreneur who assumes risk and earns reward on reasonable terms.)

[2] http://www.bis.org/review/r150129e.pdf (Lecture by Mr Mark Carney, Governor of the Bank of England and Chairman of the Financial Stability Board, to honour the memory of The Honourable James Michael Flaherty, PC, Dublin, 28 January 2015.)

[3] http://yanisvaroufakis.eu/euro-crisis/modest-proposal/

[4] Keynes. 124 (Negative interest rates provide little incentive for business to bring production forward as production processes become sub-optimal.)

[5] Graham, B & Dodd, DL (2009). Security Analysis. New York: McGraw Hill (Sixth Edition.) 164 (Graham & Dodd argue that only the opportunity for principal enhancement (discounted price) properly accounts for higher default risk.)

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