After yet another month of stagflationary pressures in July – inflationary concerns coupled with fears over a possible slowdown in the economy – the Eurekahedge Hedge Fund Index fell (-0.4%1) for the third consecutive month (albeit at a progressively flatter rate). Global equities were characterised by volatility similar to June’s market movements – falling during the first half of the month and recovering in the latter half – with the net effect of closing the month nearly flat. The MSCI World Equity Index was up 0.6% for the month, while the S&P 500 was up 0.5%. Commodities and currencies also saw similar sharp reversals mid-month. Funds also suffered from the rebound in international bond markets, as investors anticipated a pause in the cycle of rate hikes in European and American short-term interest rates.
A wave of fundamental scenarios during the month shaped market movements and played catalyst to the month’s volatility. The month saw a rise in geopolitical risk owing to North Korea’s long-range missile testing and growing tensions in the Middle East. These factors coupled with uncertainty over US monetary policy, contributed to the dip in equities during the initial half of the month. This was followed by comments from the Fed sparking expectations for a pause in its tightening cycle, and a market rebound ensued. On the other hand, the afore-mentioned geopolitical variables, coupled with supply disruptions, sent crude oil prices upward, while unprecedented heat waves in the US and Europe triggered a surge in energy consumption and natural gas prices soared in the last week of July. Given these scenarios, concerns over an economic slowdown outweighed positive earnings data and strong M&A activity during the month, and were exacerbated by high gasoline and oil prices.
Amidst this backdrop, regional hedge fund performance has largely been flat as well, with the exception of Japan (refer to graph below). Japanese hedge funds were the worst-hit among all regions, with returns at -1.7% on average, as the mid- and small-cap markets had to contend with deteriorating supply and demand conditions (largely owing to the unwinding of margin positions), and failed to recover during the latter half of the month.
On the strategies front, hedge fund performance patterns in July were, for the most part, similar to those seen last month. Returns have gotten progressively better over the past three months across the board, with some strategies even breaking into positive territory. The only exception was CTA/managed futures funds, which returned -2.4% for the month (against June’s -1.3% and May’s -0.5%), as the commodity markets were particularly affected by the month’s events. On the positive side of the global strategy returns spectrum were the usual suspects – arbitrage (+0.8%), relative value (+0.5%) and fixed income (+0.6%). Distressed debt (+0.5%) players did well as the high yield markets saw healthy activity levels. Directional macro (+0.3%) and multi-strategy (+0.4%) funds, understandably, also ended the month in moderately positive territory.
Performance by Investment Region – Review & Outlook
The Eurekahedge North American Hedge Fund Index returned -0.4% for the month of July. Most strategies had a nearly flat month too, with the most positive returns coming from arbitrage and fixed income players (+0.5% each) and the biggest negative returns coming from CTA/managed futures (-3.2%) and macro (-1.8%) hedge funds.
In addition to the general volatility of the markets, market participants continued to bid up convertible securities, and this presented good opportunities during the month for convertible arbitrage players. Fixed income players saw spreads reversing the previous two months’ trend and rebounding inward in July. And spurred by the Fed’s comments mid-July and the resulting anticipation of a pause in the rate-hike cycle, fixed income trading in July reached record volumes with little price movement.
On the negative-returns side in equity-focused strategies, investments in large-cap stocks registered small gains but small- and mid-cap allocations struggled (NASDAQ lost 3.7% and the Russell 2000 lost 3.3%, in July). The currency sector declined in July as the Fed’s comments hinting at a pause in the rate-hike cycle triggered a weakening of US dollar-denominated assets and long US dollar positions endured a mid-month trend reversal. Commodity prices, especially crude oil and natural gas prices, witnessed a particularly sharp reversal upwards. These movements proved detrimental to macro players in general, and CTA/managed futures players in particular.
Eurekahedge North American Hedge Fund Index
European hedge funds too had a relatively calm month (+0.3%), with the bulk of the month’s returns, again, coming from fixed income (+1.4%), distressed debt (+2.3%) and relative value (+1.6%) managers.
On the fundamentals front, robust economic and corporate data corroborated the markets’ business momentum, as the economy entered its third quarter. Industrial production is on a strong uptrend, and demand and inventory conditions remain favourable. Although high oil prices are pushing up headline inflation, core inflation remains contained at about 1.5%.
The number of M&A transactions also remains quite high. A case in point is the massive buyout of hospital company, HCA in the US by private equity funds for US$33 billion. The global geopolitical situation did not affect current deals (for instance, the closing of the Mittal Steel/Arcelor deal) and event-driven funds generated stable returns.
Eurekahedge European Hedge Fund Index
Japanese equity-focused managers such as long/short and opportunistic players continued to struggle in July, with the Eurekahedge Japan Hedge Fund Index posting its fifth (fourth consecutive) month of negative returns year to date. The TOPIX has changed directions five times (on a monthly basis) in those seven months. The bearish trend in small-cap equities accelerated in July, with the TSE Mothers Index down a whopping 19.6% during the month.
While event-driven and merger arbitrage funds in Japan have not had the best of runs for the year to date, M&A activity in Japan is set for further growth in a general (surge in M&A activities worldwide) as well as a specific (higher M&A activity levels are expected among Japanese corporations; for instance, a traditional Japanese manufacturer entered the fray with a hostile bid in July) sense. Also, with private equity funds displaying a strong appetite for financing management buyout deals in Japan, the number of such deals is also likely to rise.
Multi-strategy funds (which were the only ones in Japan in positive territory for July at +0.3%) did profit from their opportunistic plays in the M&A space, and are poised to increase their allocations to the same.
Market movements in emerging Asia (and emerging markets in general) were broadly in line with, although somewhat more pronounced than, elsewhere globally. The rally in the regional fixed income markets that began in late June after the Fed’s dovish comments, gathered momentum in July. Further encouraging comments from the Fed in July provided a boost to market sentiment. Local currency markets also rallied amid expectations that most of the region’s central banks will follow the Fed’s lead in their monetary tightening policies.
Among the regional markets, China continues to surge on with its economic growth. The government has taken some measures, such as imposing restrictions on the foreign purchases of property and directing banks to slow down loan growth. On the exports side, there has been a gradual appreciation of the reminbi and a slight raise in the minimum wages.
In Hong Kong, H shares were flat. Liquidity in this market remains abundant and retail consumption and confidence remain strong as well. The rise in the market seems to be dependant on two big players, HSBC and China Mobile.
In Australia, the equity market and individual security volatility remains high. A significant event would be the merger between the Australian Stock Exchange and SFC Corporation.
The Korean markets, on the other hand, seem to be stagnating amidst fears and insecurity regarding the missile testing carried out by North Korea in early July. Deteriorating current account balances and weakness in the economy have led to the interest rates remaining unchanged.
Markets in India were fairly active too. This was despite rises in interest rates and the Mumbai bombings. India exhibited very strong corporate profits, mainly from companies such as Infosys, India Hotel and Tata Motors.
In the other parts of the region, Thailand still faces political problems despite upcoming elections to solve the issues. Consumer confidence and corporate investment continue to be weakened and the banks have demonstrated poor results for lending. Taiwan has also experienced slow growth, but only in particular sectors. These include the technological sector, which has worsened by poor cross strait relations.
Amidst this market backdrop, the Eurekahedge Asia ex Japan Hedge Fund Index closed the month of July fairly flat (-0.2%), with most strategies posting moderately negative to slightly positive returns. The exception was event-driven funds, as consolidation continued to pick up in various industries in key markets, and special situations continued to deliver.
Eurekahedge Asia ex-Japan Hedge Fund Index
Equity price movements in both the Brazilian and Argentinian markets were in step with equities globally, but at a more pronounced rate, and closed the month up slightly above 5% each. The markets appear to be more sensitive to US market events and less sensitive to domestic political events. This was reflected in the relatively poor performance of long/short funds (-1.1%) among Latin American strategies. Barring that, it has been a positive month for hedge funds in the region across the board, contributing to a 0.6% return for the Eurekahedge Latin American Hedge Fund Index.
Among the other strategies, fixed income players benefited from the fact that, as with emerging Asia, the regional bond markets too saw a return to optimism following dovish Fed comments.
Healthy corporate and economic data has also helped opportunistic players during the month (+2.6%) as the domestic economies continue to be fundamentally sound with strong output and tame inflation.
Eurekahedge Latin American Hedge Fund Index
To summarise, the winners for the month were, in the main, fund managers who were either contrarian or opportunistic, or those expressing their macroeconomic bets through relative value strategies.
However, going by the progressively improving returns and indications that the Federal Reserve is finished raising rates up until end-July, the market correction of the past three months appears to be on course to correcting back. And with the Fed confirming the general market perception on rates in its early-August meeting, concerns over an economic slowdown (the housing market has been cooling down and the unemployment rate has been inching up) seem to have trumped over concerns about the upsurge in inflation. Despite the fact that the comments came qualified (that it may hike rates if inflation went higher), the Fed Chairman, Ben Bernanke, is counting on the economy to slow down enough to bring down inflation to more acceptable levels. The basic forecast of slower growth, but no recession, has a good chance of coming true, and should lend a sense of stability to the markets in the coming months.
In the specific context of hedge fund performance, as the US economy slows and the Fed takes a pause, company fundamentals will become more important and should lead to clear winners and losers. Hedge fund portfolios are poised to benefit from falling US and global treasury yields, rising energy prices, strong deal flows and weaker equity prices.
1 Based on 51.65% of the NAVs for Jul-2006 as at 13-Aug-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.