Hakan Kocayusufpasaoglu: We did have a few prevalent views about commodities last year. The first had to do with gold: Most people look at gold as an inflation or recession hedge but the main driver of gold according to our research of the gold price over last 100 years is real interest rate levels. When real rates turn negative and are expected to remain there for long periods of time it usually creates a gold rally, while the opposite causes the gold price to fall. As we have stated in the media, we believed that QE reduction is in effect a reduction of negative real interest rates and that the gold price would be falling from the highly elevated prices of US$1900/oz. This materialised as we got closer and closer to the Fed’s tapering efforts.
Additional to the gold trade argument was also that tail risks in the world were being priced out which supported downward pressure on gold. We also generated revenues from relative value trades in commodities, like the WTI-Brent trade, where a similar quality crude was trading substantially below the other European crude. The price differential was substantially higher than transportation costs and was caused by logistical issues which over time should be alleviated. The rule is that all logistical issues typically get solved when a large profit potential is involved and so it was with this trade.
Hakan Kocayusufpasaoglu:We have analysed the probabilities of EMs entering a crisis, ie the contagion risk. There are two major issues at work. At first glance when one compares the situation of EMs to those in the previous EM crisis of ’99 for instance, we see that EMs are in a much better position than they were then. They are larger, more powerful and have a stronger underlying economy. EMs are now around 40% of world GDP and will exceed 50% in a few decades. Their GDP per capita is rising steadily and so is their standard of living.However, there is a second worrying issue that is at play this time that is different than in the past. A huge number of US$ has entered into EMs from the developed countries since the 2008/09 crisis, around 4 trillion US$. This money has entered into the EMs taking their credit risk and currency risk. In the past foreign funds entered EMs only taking credit risk, as they invested in $s or hedged their FX risk; whereas now they have entered into the EMs in their local currency making them more sensitive to FX movements in EMS than ever before. Local currency government bonds went from around 600bn$ in 2008 to 2.5tr$ of foreign funds in 2013. The key danger is that foreign investors have big EM FX risk and may run to the exit doors at the same time, finding that the door is too small.
Evaluating both the above points one positive, one negative we have reached the conclusion that some EMs will suffer, but that an overall crisis will probably be avoided this year. That is that EM central banks will realize (some already have) that they have to raise rates more and by doing so have to keep their FX stable at higher levels, so that any depreciation of their currency happens in an orderly fashion. The EMs experiencing strain and difficulty are to our calculations around 10% of world GDP and hence probably too small to affect the path of developed markets in any grave way this year.
Despite our relatively benign outlook we are, however, making investments which should be successful in either scenario. For instance we are bullish the US$ especially when we get closer to short term interest rates rising in the USA at the start or middle of 2015. Any EM crisis will assist this view as the US$ is the main safe haven currency of the world. We also believe that Eurodollar contracts (3-month interest rate contracts in the US) are pricing in rate rises when none will happen. Again an EM crisis will assist this trade.
Hedge Fund Insight:Is there more money to be made being short the Yen this year? Which currency would you take for the long side, and why? If there is money to be made short the Yen, what do you want to see from the markets as a set-up?
Hakan Kocayusufpasaoglu: Please see above for the long US$. The yen will weaken to the 120-125 levels over the next years, but it is the EM contagion risk that is keeping the yen anchored at the moment. If as we believe that gets priced out in the next few months, then the yen will enter another weakening leg. We are still waiting for that moment and watching the yen carefully.
Hedge Fund Insight: Gold seems to be in the process of bottoming. What is your view, and if it is can you make any money from an instrument bottoming rather than going up in price?
Hakan Kocayusufpasaoglu: Gold, like the yen will strengthen if the EM risk talked above materialises, but we are being prudent in limiting ourselves to trades in both macro and relative value that are not binomially dependent on these two scenarios (as described two questions above).
Hakan Kocayusufpasaoglu: We still see upside in the equities markets especially in the US. We believe that on relative valuations, on macro economic projections and on money flow data that the US equity market is still relatively well positioned for further upside. Most people are worried that equities will dive since higher interest rates may mean that equity valuations will be lowered. Though this is ultimately true it is not so at the start of an interest rate rising cycle. In fact during the first 6-9months of a rate cycle equities perform quite well. If we see tapering (i.e. the reduction of easy money by the Fed) as real interest rises, and we use the Taylor Theorem to translate the 10bn$ per month of tapering into interest rate rises then we see that the Fed in effect is raising rates by around 0.7% each month. Tapering can hence be viewed as the start of an interest rate cycle. In effect at the start of this cycle we expect US equities to perform quite well. But as we get closer to the end of the year and tapering is taking its toll on the economy, and people begin to focus on the Fed funds rate rises on the horizon, then equities will begin to correct in our view.
That said, we see each major correction as a longer term opportunity in equities. The reason for this bigger picture view is that we see the 2008-09 crisis as significant as the Great Depression in the 1930s and believe that it was pro-active central bank action that has helped to avert a similar outcome. If the central banks of the world had not reacted in unison (with the Fed as the leader) then we believe we would have had a replay of the 30′s and instead of being called the ‘Great Recession’ the last crises would have probably been called the second ‘Great Depression’. With this background in mind we do expect equities to show strong performances for years to come. Of course they will have corrections and big ones especially when we get closer to the end of tapering and Fed funds rate rises, but in the larger scheme of things we believe we will see a multi-year rally in equities from today.
When it comes to portfolio construction we are much more concerned with correlation risk, rather than RV trade vs Macro trade risk. Both strategies generate a decent return over time and we are as eager to take advantage of one type as we are of taking the other. It is the market environment that determines which trades are more prevalent at any given moment in time. However, it is vital to us that our trades are not correlated to each other, since then we are in effect putting on the same trade in just larger size. As long as our trades are uncorrelated and fit our risk parameters we are willing to take them whether they are RV trades or Macro trades.