Friday, 27 February 2015
Last updated 2 hours ago
Dec 10 2013 | 10:08am ET
By Brian Walsh
Chairman and CIO, Saguenay Strathmore Capital
The overriding issue confronting markets today is Central Bank activity. They have dominated markets’ consciousness over the last three years and this looks set to continue for the foreseeable future. This article explores the impact Central Bank activity has had on the economy, the markets in general and on hedge fund strategies.
The impact of QE on the economy remains in dispute and is not surprising given that much of the Central Bank activism of the last five years has been an unprecedented experiment. The good news is that Central Banks have bought time for financial healing, have helped de-leveraging through low rates and undoubtedly prevented financial Armageddon in 2008. As explicitly stated by Chairman Ben Bernanke, QE and the zero interest-rate policy (ZIRP) theoretically act on the economy by creating a wealth effect. This wealth effect is driven by an overall reduction in interest rates or discount rates which lead to rising asset prices, especially in stocks and housing. In reality, the Fed’s intention is to eradicate safe haven investments and encourage people to invest in riskier asset classes. The wealth effect is supposed to lead to higher consumption and investment spending, hence boosting economic growth.
To date, the actual wealth effect has not matched the Fed’s models, witnessed by the Fed consistently over-estimating future economic growth over the last two years. I believe the main reason the Fed’s models have misfired is the overall level of debt in the economy. The over-indebted economies of the OECD have all followed the path of recovery depicted in Rogoff and Reinhart’s book, This Time is Different. The critical problem pre-2008 was excessive debt, and it’s not realistic to assume that monetary policy can solve all of our economic woes. Many indicators, especially the velocity of money and the money multiplier, suggest that QE programs are not gaining enough traction in the real world, yet the Central Bank in too many instances, has been the only game in town.
Market Impact of QE
While the impact of Central Bank’s action on the economy remains in doubt, the impact on markets is more apparent. Previously, it could be assumed that the large increase in the monetary base would lead to inflation, but with the money multiplier no longer translating into growth in M2, inflation has been low and it can be argued that deflation remains a threat. Thus the dilemma Central Banks now face is that their actions are not working as expected in the real economy, but are they distorting markets? The end result of QE is financial repression, which by distorting discount rates has had knock-on effects on most financial markets. Financial repression, an intended consequence of QE, has led to the lowest interest rates (on a global basis) since World War II. These low rates benefit those in debt and hurt savers. The apparent addiction to easy money has forced market participants to focus on tapering. In May and June 2013, violent reactions occurred across yield sensitive instruments caused by talk of tapering asset purchases.
An argument can be made that the inflation not evident in the economy exists with asset prices. The S&P 500 has nearly tripled since its bottom in March 2009; never before has the S&P 500 had such a sustained increase without at least one 20% correction. The 26% increase in the S&P 500 in 2013 has largely been due to multiple expansion as earnings have grown less than 5% and throughout the year companies have generally lowered guidance. Meanwhile, high yield, loan and convertible bond issuance have boomed returning to levels last witnessed prior to 2008. In addition, underwriting standards have declined with so-called covenant-lite deals accounting for almost 50% of new issues this year. In simple terms, it seems hard to find ‘cheap’ or good value in liquid securities. Lastly, it seems evident that QE dampens market volatility and leads to higher correlation in equity prices, thus robbing investors of avenues of diversification while inducing complacency from lower volatility.
Hedge Fund Outlook
Along with QE, another new reality is the increased regulatory burden that creates issues for financial institutions and in certain cases, opportunities for private capital like hedge funds.
Increased regulation and stricter capital requirements has resulted in less liquid markets, causing the following:
• Market anomalies to last longer.
• Market making rents are available.
• Longer term finance structures are also well rewarded, especially where there is additional complexity.
The benefits of these factors are most prevalent in the structured credit universe.
Structured credit continues to be an interesting place to invest. Much of structured credit was the toxic waste at the center of the financial crisis which continues to scare away certain investors. Not surprisingly, much of the new regulatory burden targets structured credit further impeding bank activity in the sector. A prime example is new capital requirements for mortgage servicing rights (“MSRs”) and capital retention rules for securitizations in general. Banks have become forced sellers of MSRs to the benefit of REITs and private capital.
The most asymmetric opportunities are in less liquid alternative credit. Since 2008 market participants have placed a relatively high price on liquidity, leaving excellent rents for those willing to take illiquidity. The net result is a variety of opportunities that share the following traits:
• Returns that offer significant premiums to corporate credit of a similar maturity;
• Excellent asymmetry, as investments have a limited and defined downside, and equity-like upside; and
• Often generate regular cash flows.
Credit instruments have been driven to expensive levels with little excess spread remaining. One could argue this is true from Treasury bonds to high yield corporate paper. Clearly there is little value in high grade OECD securities and high yield bonds that not only trade at all-time low yields but are being issued with increasingly loose covenant patterns. Given this environment, it makes sense to focus on funds with a demonstrated capability of the short side, and we generally regard negative carry on a portfolio as a positive.
There is general belief that Central Banks will intervene in markets during periods of market stress, which increases rotation into riskier assets. Still, there is a law of diminishing returns and it seems that we are approaching the limit of Central Bank activism on stocks. Increasingly, equity returns will require earnings growth. At 19 times trading earnings, the S&P 500 is not cheap; on a price-to-sales basis, the market is 60% above the post 1960 median valuation.
In 2013, correlations have moderated and stock picking has been rewarded. Both implied and realized equity volatility is very low with levels not seen since pre-2007. Unlike in 2012, the skew is flattening along with the term structure. This implies a lot of complacency and apparently a decline in the interest in tail funds. One benefit of a low volatility regime is that it allows equity long short funds that use options to create more asymmetry in their positions. Going forward, there is a good chance long/short managers will outperform long-only managers.
Central Bank activity dampens volatility, and tapering appears to increase volatility; therefore a long volatility bias is preferred and important.
In addition, the general increased regulatory burden of doing business has reduced market making capital and liquidity. The reduction in liquidity implies increased volatility especially during periods of market stress. This should provide opportunities for hedge funds to both capture market making rents and also to benefit from dislocations caused by increased volatility.
Brian Walsh is Chairman and Chief Investment Officer at Saguenay Strathmore Capital, a global wealth manager focused on customized fund of hedge fund portfolios with US$2billion in combined assets under management and advice. Previously he co-founded Saguenay Capital in 2002 to manage bespoke alternative portfolios for a client base of international institutions and family offices. Brian has over 30 years of investment banking, international capital markets and investment management experience. He had a long career at Bankers Trust culminating with his appointment as co-Head of the Global Investment Bank. Prior to that, Brian served as Chairman of Bankers Trust International where he ran the global derivatives business.
After leaving Bankers Trust in 1996, Brian focused solely on investment management for clients including the Bass Family of Fort Worth, Texas and a major Canadian pension fund. He then founded hedge fund management operation Veritas Capital Management prior to Saguenay Capital.
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