THE COUNTDOWN TO YEAR END / PRUDENTBEAR.COM

The Countdown to Year-End

Doug Noland 

December 6, 2013


With about three weeks to go until year-end, things are turning more interesting.

December 6 – Bloomberg (Saijel Kishan and Kelly Bit): “The $2.5 trillion hedge-fund industry, whose money managers are among the finance world’s highest paid, is headed for its worst annual performance relative to U.S. stocks since at least 2005. The funds returned 7.1% in 2013 through November… That’s 22 percentage points less than the 29.1% return of the Standard & Poor’s 500 Index, with reinvested dividends, as markets rallied to records. ‘It has been difficult for hedge funds on the short side,’ said Nick Markola, head of research at Fieldpoint Private, a $3.5 billion… private bank and wealth-advisory firm… Hedge funds, which stand to earn about $50 billion in management fees this year based on industrywide assets, are underperforming the benchmark U.S. index for the fifth year in a row … Billionaire Stan Druckenmiller, who produced annual returns averaging 30% for more than two decades, last month called the industry’s results a ‘tragedy’ and questioned why investors pay hedge-fund fees for annual gains closer to 8%.”

Let’s talk the markets. There are now only about three weeks to go to wrap up an extraordinary 2013. One wouldn’t think the calendar should be much of an issue for the markets. Yet market closing prices on Tuesday, December 31st, will determine the compensation for thousands of hedge funds that control Trillions of positions (not to mention year-end bonuses for tens of thousands of market professionals worldwide).

The traditional standard has been that hedge fund operators take 20% of a fund’s return for the year. Often it’s a case of receiving a cash payment for “paper” (unrealized) portfolio gains. For a decent number of funds, market performance over the coming three weeks will significantly impact 2013 returns. A major move in the markets might prove a case of life or death for struggling firms. For the fortunate ones, a big year ensures financial security for years to come. 2013 market gains will add to the already inflated number of global billionaires.

As noted in the Bloomberg article above, hedge fund industry returns have struggled again this year. Shorting stocks has been a nightmare. Long exposure in precious metals and commodities has been a nightmare. Playing the emerging markets (EM) has been dashing through minefields. In general, global fixed income has been tough. It’s not that much of an exaggeration to say equities have been the only game in town. Yet the yen short and yen “carry trades” (borrow/short yen and use proceeds to buy higher-yielding securities) have been huge winners. European periphery debt has also provided strong returns. But, basically, there’s just way too much (and growing) “money” chasing securities markets and mucking up the traditional game of market speculation.

Within the hedge fund community, there’s an unusually wide dispersion of performance. Some of the big “global macro” funds hit home runs with the central bank liquidity trade – short the yen and go long equities. At the same time, a notable percentage of funds have posted only modestly positive returns for the year. And, I’ll presume, there are an unusually large number of fund managers that have been pulled into the long European debt and global equities trades with a sense of trepidation. To be sure, it’s been a year where trend-following and performance-chasing dynamics attained unstoppable momentum.

Friday’s trading bolstered the consensus view that equities are poised for a strong year-end mark up. I have posited that the backdrop creates the potential for the emergence of a lot of weak-handed traders in the event of an unexpected market reversal. Fortunate managers might want to lock in their big years, while many others could be forced to impose aggressive risk management to safeguard evaporating 2013 gains.

Over recent weeks, market dynamics have unfolded that seemed to increase the probability of an unexpected bout of “risk-off” trading. In a replay of the May/June Dynamic, global yields have been on the rise. After declining to a low of 2.50% in late-October, 10-year Treasury yields ended Thursday at 2.85% - not far from the 3.0% level from early-September.

This week saw the MSCI Asian Pacific equities index drop 1.8%, the biggest decline since August. Australia’s main equities index was hit for 2.5% and New Zealand stocks were down 1.7%. Australian 10-year bond yields jumped 21 bps this week to a 25-month high 4.44%. Singapore stocks fell 2.0%, and South Korea’s Kospi sank 3.2%. Turkey’s major equities index fell 3.1% this week. Argentina’s Merval stock index was hammered for 6.77%.

EM instability has returned – in some cases with a vengeance. Brazilian (real) yields closed Wednesday at a multi-year high 13.27%, up 190 bps from early September lows. Other EM problem children also saw bond yields spike higher. Indonesian 10-year yields ended the week at 8.64%, up from the October low of 7.0% and not far from September highs (8.93%). Indonesian yields began the year at 5.19%. The Ukraine has become another EM worry. Ukraine’s dollar yields jumped from 9.40% on November 25th to 10.38% on December 3rd (after trading at 6.86% in early-March). After ending October at 7.16%, Russian (ruble) yields jumped this week above 7.90%. After trading down to 8.20% in late-October, Turkey’s 10-year sovereign yields this week returned to 9.60%. South Africa saw 10-year yields jump from October lows of 7.30% to above 8.10% this week. Almost across the board, EM yields have risen over recent weeks.

This quietly emerging “risk off” backdrop took an interesting turn this week in Europe. Curiously, French 10-year yields surged 29 bps to 2.44%, the highest level since September. French debt has been a speculator community darling. Perhaps there is a large yen “carry trade” component in the French bond market. Shorting German bunds to lever in higher-yielding French debt has definitely been a huge winning trade – although less so after spreads widened a notable 14 bps this week. Italian and Spanish debt have also been 2013 winners, although these gains were also under pressure this week. Friday’s bond rally reduced what were mounting early-week losses in periphery European bond markets.

However, Friday’s equities rally didn’t make much headway on notable losses in European equities. Italian stocks were slammed for 4.7% this week, taking back about 30% of Borsa Italiana’s 2013 gain (11.4%) in only five sessions. Spanish stocks’ 4.4% drop cut year-to-date gains to 15.1%. The French CAC40 sank 3.9% (up 13.4% y-t-d), and Germany’s DAX fell 2.5% (up 20.5%). It’s worth noting that Financials led European stocks lower this week. And Friday from Bloomberg: 

“Corporate Bonds Suffer Biggest Weekly Loss Since June in Europe.”

ECB President Mario Draghi made an interesting comment during his post-meeting press conference: “If we are to do an operation similar to the LTRO (“long-term refinancing operations” - the ECB’s preferred liquidity-bolstering measure) we want to be sure it’s being used for the economy and that it’s not going to be used to subsidize capital formation for the banking system through carry trades.”

The “Draghi Plan” has proved a huge boon for speculators in periphery (particularly Greek, Portuguese, Italian and Spanish) bonds. Perhaps Draghi’s comment this week suggests the ECB is increasingly concerned about mounting speculative excess. A downside of the ECB backstopping European debt has been the huge speculative inflows that have boosted the euro currency at the expense of struggling periphery economies. The ECB is now in a difficult spot. It would prefer a weaker currency, but dovish talk at this point only feeds a speculative Bubble.

Here at home, the Fed as well confronts dysfunctional speculative dynamics. QE has fueled a year-to-date 29.1% total return in the S&P 500, with the small cap Russell 2000 and the S&P400 Midcaps returning 34.8% and 30.0%. Yet Treasury and MBS yields have marched higher in the face of the Fed’s Trillion dollar bond market liquidity injection operation. In spite of the Fed and Bank of Japan’s combined $160bn (or so) of monthly liquidity injections, global yields for the most part have jumped higher.

Thus far, cracks in the “periphery” of the global Bubble have only worked to bolster excess at the “core” – a destabilizing dynamic fueled by central bank liquidity injections, guarantees and backstops. The global leveraged speculating community has been right in the thick of this dynamic, as they flee underperforming markets to jump aboard inflating speculative Bubbles. U.S. equities and corporate debt, along with European stocks and bonds, reside today at the heart of increasingly unwieldy global Bubble Dynamics.

Friday’s stronger-than-expected U.S. non-farm payroll data add an exclamation point to what has been a batch of strong data. With surging stock prices, inflating home prices and about the loosest corporate Credit conditions imaginable, it would be surprising if the economy weren’t picking up some momentum. As such, our central bank is bringing new meaning to “behind the curve.” The case for further delays in tapering gets only weaker by the week.

If the Fed doesn’t begin articulating its tapering strategy on December 18th, it surely will by January 29. This would suggest ongoing “risk off” for the troubled periphery – especially the “periphery of the periphery” of troubled emerging markets. And after the way equities responded to the Fed’s retreat from September tapering, I expect Fed officials will be more hesitant to pamper a speculative marketplace next time around.

How will the global leveraged speculators game this? Play for further “how crazy do things get” speculative excess at the “core”? Push the melt-up dynamic in U.S equities for all it’s worth – squeezing the shorts and hedgers at each and every opportunity? Or does the unfolding “risk off” dynamic continue to expand, as was the case for much of this week? Are we in the early stages of a problematic de-leveraging throughout global fixed income, a predicament exacerbated by ongoing Bubbles in “core” equities and corporate debt?

As the marginal source of buying and selling pressure in many global markets, the now $2.5 Trillion hedge fund industry will undoubtedly set the tone. If the hedge funds get through year-end, they will then have January to contend with. They surely would like to avoid having to de-risk into a June-like backdrop of heavy mutual fund and ETF outflows. The current backdrop would seem to imply the return of unstable markets for some weeks to come.