By Christopher Faille
Aureliano Gentilini and Massimo Maurelli, two managing partners of Mathema S.R.L., an Italy-based consultancy, have prepared a report on the Global Investment Outlook, as of December 2011 aimed at potential hedge fund investors, and broken down strategy-by-strategy.
The short version: they are positive on just two of the ten hedge fund strategies they discuss. One of these, and the only one on which they are unequivocally positive, is fixed income arbitrage. They believe that the recent longer-term refinancing operation (LTRO) of the European Central Bank will enable banks to “leverage lending activities to the European economy or, rather, bid on eurozone peripheral countries,” and that this and cognate developments, such as the U.S. Federal Reserve’s “operation twist,” will generate distortions in currency and yield curves. This in turn, they expect, will create ripe opportunities for plucking by sufficiently nimble hedge funds.
They are neutral-to-positive on MBS/ABS arbitrage, though they acknowledge that MBS’ “have underperformed compared to other risky assets” in 2011, and trading volumes are down.
Nonetheless, Mathema expects that there will be “arbitrage opportunities within different credit rating segments.” Further, the report notes that there has been recent trading activity by Appaloosa Management and Och-Ziff Capital that may signal the re-appearance of opportunities in this area.
Gentilini and Maurelli are neutral or negative on every other strategy included in their survey of the field. For example, they are bearish on global macro, a strategy that involves large leveraged directional bets, for much the same reason that they are bullish on fixed-income arb. The uncertainties that mean an opportunity for the latter mean danger for the former. In this context, the report expresses concern especially with the specter of a hard landing for China’s economy. China’s Purchasing Managers’ Index (PMI) fell below 50 in November, for the first time since February 2009. A PMI below 50 indicates contraction of manufacturing activity.
They are bearish also on convertible arbitrage, although they acknowledge that “the announced recapitalization of European financial institutions to meet new regulatory requirements might present attractive short-term investment opportunities.”
Their overriding concern, though, is that in the event of a market shock, convert arb funds could find their assets illiquid and “exit trades might be an expensive exercise.”
The report is full of cautions, and indeed adopts a quite generally gloomy tone. The markets, it tells us, don’t lend any credence to the political fixes that have been offered for the eurozone and especially for its peripheral players. If the fixes did have credibility, then the PIIGS’ 10-year government benchmark yields would have been falling significantly of late vis-à-vis the 10 year German Bund yield. But there has been no such fall.
Figure 2 in the report illustrates this point, graphing the spread of the yield on the sovereign debt of each of the periphery nations (and France) against the 10-year Bunds. The yield for Irish bonds, for example, graphed by the blue line below, ended the year vis-à-vis their German counterparts roughly where it began, with a spread a little above 6 percent. The Irish spread saw a spike in the middle of the year that took it to above 11 percent. That spike is long gone, but that fact is of little comfort looking forward.
France’s bonds, by contrast, were showing a yield spread of only 1.893 percent as of November 9. That was its peak for the year; it has declined a bit since. (This is presumably why Chancellor Merkel of Germany treats President Sarkozy of France as a partner in proposing those political fixes.)
U.S. Treasuries are serving as a safe haven given Europe’s difficulties. There is some irony in this, because as the report notes, 2011 saw the emergence of genuine concern that the U.S. could be exposed to its own sovereign-debt crisis, especially given the failure of the bipartisan “supercommittee.”
Irony notwithstanding, U.S. bonds still do look like a safe haven to many investors, and the resulting increase of demand for these instruments has pushed the U.S. Treasuries yield below 2 percent. “Unless the U.S. macro scenario deteriorates,” Mathema concludes, “gains in the U.S. bond and currency are expected to continue outpacing the traditional haven – gold, which continues to slump to fresh multi-month lows.”