The market environment in June was not much different from that in May – inflationary concerns and heightened interest rate expectations continued to dominate market events. This translated into a difficult trading environment across most asset classes – declining prices in the first half of the month and a rebound in the latter half. Consequently, most global indices had a flat to marginally positive/negative month in June, reflected in the performance of the composite Eurekahedge Hedge Fund Index (-0.5%)1, the directional Eurekahedge Macro Hedge Fund Index (-0.1%), as also most regional indices (refer graph below).
The above graph compares regional hedge fund returns, with North American funds posting a flat month while the other regions registered moderate losses. Latin American funds were the only exception in this regard, recording the month’s best returns (+1.9%), as Brazilian markets rebounded strongly, partly on news of the Fed’s dovish 25 basis point hike in interest rates, towards the end of June (the Brazilian real appreciated by 3.6% against the US dollar at June’s close).
Global Market Overview
Market movements in June took on a see-saw quality across asset classes. In the currencies markets, the US dollar rallied against most currencies in the first half of June (it strengthened by 3.5 basis points to 1.248, against the euro) on the back of higher US interest rate differentials, weakening emerging market currencies, and investors’ flight to quality. However, following a 25 basis point hike in the short-term interest rates by the Federal Reserve towards the end of June, accompanied by dovish comments regarding an end to the monetary tightening, the USD rally lost steam.
In the energies and metals markets, declining inventory levels and rising demand (and in the case of oil, continuing tensions in Iran) spurred a healthy rebound in energy and metal prices during the middle of June, after registering significant falls early in the month. For instance, from an intra-month low of US$556 a troy ounce, gold rebounded to US$615. Likewise, copper rose from US$6,400 to US$7,350 a tonne, during the second half of June.
This had a domino effect on equities, which also stabilised mid-June. For instance, the MSCI World (Equity) Index shed 6 percentage points in the first half of June, but recovered most of it and closed the month down just 0.2%.
As equities stabilised, inflationary concerns resurfaced, and the heretofore rallying bond markets (on the strength of demand for less riskier assets) had to contend with falling prices in the second half of June.
Most global hedge fund strategy indices too were in line with this trend, with largely flat returns (see graph below).
As can be seen from the graph above, arbitrageurs were the best performers for the month (+0.8%) and, along with multi-strategy funds (+0.2%), were the only strategies that reported gains for the month, as funds allocating to specific asset classes were hit by the month’s high-volatility markets across the board. CTAs (-1.5%) and equity long/short managers (-0.7%) were particularly hit by this trend, and shed the most during the month, as falling inventory levels and robust demand effected a mid-month rebound in metals, energies and equities.
Performance by Investment Region – Review & Outlook
North American funds closed the month of June virtually flat (0%), as the May sell-off in equities and commodities continued well into June, before a rally (owing to manufacturing strength, job creation and Fed’s dovish comments) towards the end of the month. Managed futures funds weathered the most losses for the month (-1%), as long commodity and short dollar bets were hit by the turnaround/volatility in those asset classes during the month. Macro (-0.5%) and relative value (-0.3%) managers too reported slight to moderately negative losses, as the markets lacked clear direction during the month.
On the positive side were primarily arbitrage funds, which welcomed the recent few months’ spike in volatility (there was in fact volatility in the volatility index, as it jumped from 16.4 at the beginning of June to 23.8 mid-month and dropped to 13.1 by month-end) and repeated their May performance (+0.7%), particularly in the convertibles space. Distressed debt players also had a moderate month (+0.5%) as the high yield market ended the month down just 0.4%.
Eurekahedge North American Hedge Fund Index
Inflationary concerns returned to the markets as energy prices turned around in the middle of June. The market outlook then hinges on the extent of the US interest rate hike, despite the fact that the dovish end-June FOMC statement regarding Fed policy on inflation has had a calming effect on the markets. Corporate earnings and balance sheet data are encouraging, and equity-focused and directional funds should get back into positive territory as stability returns to the markets.
Arbitrage funds were the best performers for the month in Europe as well, posting robust gains at 1.2%, yet again cashing on the opportunities afforded by volatility and reversals seen during the month.
Commodity prices moved more predictably (downwards) in the UK, with news of easing supply difficulties for the coming winter (such as progress on repairs of the UK’s main gas storage facility, construction of a new pipeline between Holland and the UK, etc ). In continental Europe, on the other hand, commodity price direction was less clear with political and regulatory uncertainty afflicting German and French utilities, while the Nordic market was bullish. As a result, European CTA/managed futures funds had a nearly flat month (+0.2%) during the month.
The rest of the strategies were in the negative, with event-driven funds bringing in the most losses (-1.4%) as some key M&A events suffered from delays of a political/regulatory nature. For instance, in the utilities sector, E.ON was awaiting approval from the Spanish regulator over its bid for Endesa and political debate surrounds the proposed merger of Suez and Gaz de France. This was in spite of a high level of M&A activity – Mittal steel made an improved bid for Arcelor, and Macquarie and a Goldman Sachs consortium were involved in a bidding war for Associated British ports, to name a few.
Multi-strategy and long/short funds were hit by the overall volatility and lack of direction in their respective markets.
Eurekahedge European Hedge Fund Index
Given the continued high level of M&A activity and cash-rich corporations, the region’s performance during the month could be put down to noise and lack of clear guidance. Some of the regional markets such as Russia also look promising – falling inflation coupled with robust production growth numbers for June suggests further appreciation of the rouble without hindering growth.
Japanese equities recorded modest gains for the first time in three months, as the Topix and Nikkei indices rose 0.4% and 0.2% in June, respectively. Market movements were in step with the rest of the global markets, with the small- and mid- cap indices closing the month slightly down. But this masks the severity of the intra-month decline – for instance, blue chip scrips like Toyota lost 5% in a day’s trading. The continued monetary tightening has taken its toll on Japanese markets, which were drained of over US$220 billion over the last few months. Compounding the problem were the insider trading charges levelled against an activist trader, Yoshiaki Murakami. And then, there was mid-month rebound triggered by a slew of strong economic data and a view that the market was oversold. As a result of these market swings, long/short managers recorded losses of 0.8% for June.
However, equity market neutral plays such as index arbitrage paid off during the month, and relative value managers ended the month in decidedly positive territory (+0.9%).
Many Japanese stocks are substantially overcapitalised, and their valuations are rather attractive given the backdrop of the equity market decline. Combined with the fact that domestic demand in Japan is solid (driven by bonus payments), this is bound to create lucrative opportunities for equity-focused managers in the near term.
Asia ex Japan
In emerging Asia, the general volatility and lack of clear direction seen in the developed markets was exacerbated by substantial investment outflows, as risk appetites shrunk globally. This drain of liquidity had a greater impact on the direction of currency, bond and swap flows than fundamental drivers. There were also some risk reduction trades triggered by concerns over Turkey, South Africa and Hungary (shuffling of the emerging-market-mix). Most regional currencies such as the ringgit, won and rupiah weakened by close to 2% in the wake of an over-4% drop in the yen’s value, recovering a little towards the end of the month. Relative value players (-2.5%) in the region were adversely affected by these reversals.
The Chinese yuan was the only currency that skipped the general trend and appreciated by 0.3% over the course of the month. China is going through an export-driven positive cycle (May’s trade surplus stands at US$13 billion – a 44% year-on-year jump), while capital pumped into infrastructure rose 30% for the year to May, far exceeding the target of 18%. IPO activities too have seen very strong demand, with bids for Bank of China Limited’s IPO reaching close to US$85 billion – 32 times oversubscribed. The superior returns generated in China partially explain the relatively better performance of multi-strategy managers (0.3%), and the broad Asian index too lost just over half a percentage point (-0.5%).
Distressed debt managers (-0.5%) had to contend with trying high yield markets, as the global markets were hit by a bout of risk aversion and US treasury yields were moderately high.
Asian equities too had to weather a fair bit of noise, not quite showing in the 2.8% drop in the MSCI Far East Index. The May sell-off continued well into June across most of the regional equities. As a result, long/short managers shed 1% during the month.
Eurekahedge Asia ex-Japan Hedge Fund Index
Given the extended six-week sell-off in most regional markets and across asset classes, the case for bargain-hunting undervalued securities is rather persuasive, and this should bring the stock-pickers back into these markets, both driving and driven by the gradual stabilisation of the markets as the uncertainty clouding global inflation and interest rates clears up.
Furthermore, the Chinese markets look very attractive, with strong fundamentals, growth and return potential (the country is sitting on US$1.9 trillion in household savings), as do infrastructure stocks in India.
One positive development in this volatility-ridden month was that market players became more prudent and fundamentals-driven in their allocations to the emerging markets. Chile, Brazil and Hong Kong saw good rebounds but Turkey, Taiwan and Hungary continue to be avoided. For instance, the Turkish lira depreciated significantly against the US dollar whereas the Brazilian real appreciated 3.6% against the US dollar during June. Although Latin American equities went through the same dip and rise routine as the other equity markets and had their fair share of volatility, the markets recovered strongly in the latter half of June, as evidenced by a 4.1% rise in the MSCI Latin American Index for June.
In regional news, the Mexican election results are going in favour of a (financial) conservative, boding well for business opportunities in and with the country. Brazil’s external debt continues to shrink, and its sovereign credit rating has been upgraded. This is in step with Brazil’s treasury’s plan to convert USD denominated debt (of up to US$4 billion) into local debt, as it announced a debt buyback. As a consequence, spreads widened both between local and US treasuries.
Almost all Latin American hedge fund strategies posted robust gains, with the exception of event-driven funds which were in slightly negative territory (-0.4%), assisted by the strength of the mid-month rebound.
Eurekahedge Latin American Onshore Hedge Fund Index
Brazil is a favoured market as its central bank could cut rates by half a percentage point in July, and more rate cuts are expected in the remaining part of the year as the economy is in a disinflationary cycle. In a broader sense, the fundamentals for growth remain intact – rising domestic savings, solid trade surpluses, healthy earnings growth, etc – with low inflation and interest rate figures in emerging markets such as Brazil and Mexico.
In short, the month’s market movements were dominated by inflationary fears and volatility. Global markets are looking towards the US market to stabilise for guidance, although global emerging markets are much better positioned in the event of a slowdown in the US economy, fundamentally speaking. If the Fed’s less hawkish statements towards the end of June are anything to go by (as they well are), this could help liquidity return to the equity markets and drive out the current volatility.
Taking even the purely technical stance that equity prices reflect the present value of projected earnings discounted at a projected interest rate (projections being on a medium-term basis), on the earnings front, net estimates continue to be revised upwards and bode well for equity price stability as the Fed tightening cycle pans out.
It is also encouraging that the re-shuffle in emerging markets allocation is more fundamentals-driven as opposed to the speculative liquidity inflows that built up into highly overbought positions in these markets and triggered the recent sell-off.
In terms of hedge fund strategies, to reiterate what has been pointed out in earlier reviews, economic and corporate data continue to be robust in most markets and equity-focused, opportunistic and market-neutral strategies should do well in the coming months.
1 Based on 51.41% of the NAV returns for Jun-2006 as at 13-Jul-2006.
2 The Eurekahedge Japan Hedge Fund Index is a separate index and derives its value not only from the actual performance of the listed strategies for the investment region but also from the strategies which are not listed (due to strict Eurekahedge indices guidelines) but having the same investment mandate.