GMO is a global investment managing firm founded in 1997 with assets of $97 billion as of Dec. 31, 2011. They believe European issues are creating investment opportunities, their highest quality holdings performed the best, and going into 2012 their strategy is to look for high quality at low valuations, as always:
Global Market Review
After a summer swoon, markets regained some of their poise in the fall. Although the initial sell-off had been broadly indiscriminate, the recovery was somewhat more discerning. In particular, markets began to focus more intently on the problems facing the eurozone and the securities most obviously exposed to the unfolding sovereign debt troubles. Perhaps not surprisingly, U.S. markets were perceived to be somewhat of a safe haven, with both risky U.S. assets and the U.S. dollar the main beneficiaries.
At the end of September, the specter of a Lehmanstyle event centered in Europe propelled the VIX index back above 40. The apparent inability of European Union politicians to react to the spreading contagion let alone try to manage it sent markets rioting. The resulting mess was enough to unseat Italy’s longest-serving post war leader and dissolve the Greek government. The remaining leaders reached for their tried and tested playbook and called for yet another summit. Despite the shortening half-life of the effectiveness of European summits, market participants seemed more willing to trade on anything that appeared to be positive news and markets began to rebound. By the time the summit had concluded in early December, markets, in characteristic fashion, decided to focus on the short-term liquidity measures rather than the absence of any meaningful plan to deal with the longer-term internal imbalances. To be fair, the liquidity measures amounted to a quasiquantitative easing policy and managed to stabilize, if not completely heal, peripheral bond markets. Rather than buy European bonds directly, the European Central Bank preferred to extend its back door bailout program by offering generous longer-term financing terms for the banking systems of various troubled countries. In addition, the summit produced an agreement to strengthen the fiscal compact but stopped short of offering actual fiscal transfers.
Despite being welcomed by the markets, the summit failed to satisfy the minimum conditions necessary for giving the euro a chance of medium-term survival: the creation of a fiscal union, along with ECB lending to bridge the gap between the required multi-year political timetable and a market timescale measured in weeks or months. Despite the self-congratulation among EU politicians about their “fiscal compact,” the fact is that Germany vetoed the most important characteristic of a true fiscal union: some degree of joint responsibility for sovereign debt. Since Germany refused even to discuss Eurobonds or a vastly expanded jointly-guaranteed European Stability Mechanism, the summit did nothing to reassure the savers and investors in Club Med countries that their money will be protected from either devaluation or default. For the currency union to thrive longer term, political leaders must find a mechanism to address Europe’s internal imbalances that does not rely exclusively on deflation as the cure. As in all of the previous summits, the only truly definitive decision was to have another meeting in three months' time, when a new agreement would supposedly be conjured up to resolve all of the controversial issues left undecided.
The recovery in the S&P 500 began almost immediately and, apart from a pause from mid- November to mid-December, the index almost never looked back. Improving economic data and a hope that the U.S. would be somewhat protected from the slowdown in Europe translated into a gain of 11.8% for the quarter and left the index unchanged on a price basis for the year. The recovering sentiment helped value indices recover a little more than growth, with the Russell 1000 Value index ending at +13.1% and the Russell 1000 Growth index rising 10.6%. Smaller companies also benefited, but the recovery was not enough to erase the dramatic falls seen in the last quarter. There was little to distinguish between value and growth in the small capitalization indices as all small cap returns clustered close together. The Russell 2000 ended the quarter with a gain of 15.5% and the Russell 2000 Value and Growth indices rose 16.0% and 15.0%, respectively.
The performance of international developed market equities, however, diverged significantly from the U.S. In local terms, the EAFE index was up a paltry 4.1% as investors remained spooked by the ongoing bedlam in the eurozone. The recovery in the dollar translated into a gain of 3.3% for the same index for dollar-based investors. Having avoided the worst of the previous quarter’s sell-off, the Japanese market continued to trade independently, falling 3.9%. Although investors were willing to believe the U.S. would remain decoupled from the rest of the world, emerging market investors were not so lucky and emerging equities finished in line with developed markets with a gain of 3.9%.
Despite the modest recovery in equity markets, bond investors seemed somewhat more circumspect. Yields initially rose as sentiment recovered, but fell back to their earlier lows by the end of the quarter. The U.S. benchmark bond yield ended the year under 2%, as did the U.K., Japanese, and German yields. The J.P. Morgan U.S. Government bond index returned +0.9% while the J.P. Morgan Non-U.S. Government Bond index fell 0.2% over the same period, due mostly to a strengthening greenback.
Credit markets recovered somewhat with the Barclays U.S. Aggregate index posting a gain of 1.1%. The recovery in the municipal bond market continued apace with the Barclays Municipal Bond index returning +2.8%. The biggest beneficiary from increased risk appetites, however, was the J.P. Morgan EMBI Global, which gained 5.1% for the quarter.
Asset Allocation
Review
October witnessed global rallies that set a few records as virtually all markets responded strongly to a combination of signs of economic recovery in the U.S. and at least a sizable “relief rally” from indications that Europe might dodge, at least short term, a liquidity bullet. Reality settled in during November and December as the harsh future and likely painful restructuring necessary in Europe sobered up the brief celebration of October. But by the end of the quarter, equity markets had recovered slightly from what had been a terrifying summer and third quarter.
The performance of international developed market equities and emerging equities, however, diverged significantly from the U.S. In local terms, the EAFE index was up a paltry 4.1% and emerging rose only 3.9% (vs. a positive 11.8% for the S&P 500, for example). The debate going forward seems to revolve around whether a recovery in the U.S., however modest, could withstand the likely economic doldrums of Europe – basically, how untethered is the U.S. to the prospects of Europe.
Strategies
All this talk of gloom and doom in Europe, however, presents a contrarian firm like GMO some interesting opportunities. So, if there was movement in our strategies during the quarter, it would have to be characterized as classically contrarian. Contrarians “run into burning buildings,” if you will, and by any definition it appeared that “Rome was burning.” Our strategies, therefore, tended to move, incrementally, into Europe. Selectively, slowly, prudently, of course, but the general belief is that markets have overreacted, and this always presents some opportunities. This is by no means a “call” on the bottom of possible European corrections or crises, but valuations are such that bad scenarios are already baked into some prices.
Our broad strategies are:
ï® Maintain Quality bias. Quality gave back a bit of its outperformance this quarter, but the game is in the early innings still. High quality stocks still trade at attractive levels, and the general defensive posture of quality still remains appealing given all of the uncertainties surrounding global prospects, dysfunctional governments, and horrific bond yields.
ï® Bias toward Value in EAFE. We’ve also begun to bias our international portfolios toward Value. One cannot characterize this as a “big bet,” but valuations are such that we are beginning to see attractive spreads between Growth and Value in international equities.
ï® Reduce exposure slightly to emerging markets. We funded some of the flows into EAFE both through cash proxies and from Emerging equities. Continued concern surrounding China’s economic bubble and a likely inability to deflate it without contagion effects gave us pause.
ï® Continued bearishness on bonds. We are literally running out of superlatives to describe how much we hate bonds. Yields are pitiful, dangers of even a slight recovery that could wreak havoc for long-duration portfolios loom, and monetary policies globally certainly have added to the specter of rising yields.
ï® Invest in conservative absolute return strategies, where available. Ideally, absolute return strategies are often a pure play on manager skill. Therefore, the return streams should have little correlation to the movements of the markets. Such investment instruments can provide equity-like returns, while helping to diversify other parts of one’s portfolio.
Performance Review and Outlook Global Quantitative Equities Market Review
Global equity investors entered 2011 optimistic after a strong 2010, only to shift into fear mode mid-year as Europe’s sovereign debt woes took a turn for the worse. While the source of fear was local to Europe, the ensuing sell-off in risk assets swept around the world, sparing few. And though efforts to resolve the European crisis stabilized markets somewhat in the fourth quarter, positive absolute returns for the year in full were the exception rather than the norm. GMO’s Global Quantitative Equity Strategies posted generally strong relative performance during the year. To understand the sources of relative return, an examination of the themes of 2011 and their impact on our quantitative investment tools is helpful.
Safety Was the Dominant Theme in 2011
As in past periods of investor fear, safety was the dominant theme for global investors in 2011. U.S. stocks outperformed International stocks. International stocks beat Emerging Markets stocks. The trend toward safety was also evident within markets. The S&P 500 posted a +2.1% return in 2011. But the index’s Utilities sector registered a 14.8% gain for the year while Financials posted an 18.4% decline. The safety spread was also evident in International developed markets. The MSCI EAFE index lost 9.4% in 2011. But the index’s bestperforming sector, Health Care, notched a positive return of more than 2%, while its Financials component dropped more than 20%.
High Quality and Low Volatility Led the Outperformers
The safety theme wasn’t limited to economic sectors. Among investment factors, high quality and low volatility stocks posted exceptional relative returns in U.S. and International markets. Within EAFE, the best 25% of the market based on GMO’s quality definition – high, stable profitability and low leverage – and the lowest 25% of the market based on stock price volatility each outperformed the market by approximately 15% in 2011. In the U.S., the relative returns for quality and volatility were similarly strong, with low volatility faring a bit better, owing to a significant weight in the Utilities sector.
Quality Also Helped Implicitly
GMO’s quality factor also played a significant role in many investment models where our definition of quality is an input. For example, one of GMO’s simple value models compares market price to a number of financial metrics (e.g., book value, earnings, etc.) to find cheap companies. We include an adjustment based on company quality, which helps the model avoid low quality companies that trade statistically cheap for good reason. 2011 was a tough year for simple value models, which piled into a raft of cyclical, low quality companies and were penalized for this positioning in the flight to safety. Including a quality adjustment, however, spared much of the pain.
A Word on Momentum
One of the fundamental risks in running a price-based stock selection metric like momentum is the possibility that market themes can shift quickly and leave you holding a portfolio full of the last theme’s stocks. Momentum metrics experienced such a fate in mid-2011, when the flight to safety left them holding significant exposure to firms levered to rising commodity prices. As investors sold off riskier, more economically exposed companies amid the Europe-induced spring sell-off, momentum lagged.
Volatility Creates Opportunity
The quick rule of thumb for understanding GMO Global Quantitative Strategies’ relative returns in 2011 was: the more quality a portfolio held, the better the performance. While a flight to safety certainly helped produce strong 2011 results, it’s important to remember that our positioning stems from valuation, not a broader economic view. This is particularly relevant as we enter 2012. In the U.S., we continue to hold significant exposure to high quality stocks in many of our strategies. Quality’s 2011 outperformance came on the back of two years of poor relative returns, and U.S. quality’s fundamentals held up exceptionally well relative to the market. We continue to find U.S. high quality stocks representing an exceptional value opportunity. The story is different Internationally, where the European sovereign debt crisis has now been underway for more than two years and quality stocks have delivered exceptional relative returns. Since the beginning of 2010, the best 25% of the International market based on GMO’s definition of quality has outperformed by more than 14%; during that same period, the best 25% of the U.S. market based on our quality definition has underperformed by 1.5%. Given this recent performance, it’s not particularly surprising that the relative valuations of International high quality stocks aren’t as attractive as their U.S. counterparts. The good news is that volatility frequently creates opportunity. While quality stocks as a group have become more fully valued, traditional bottom-up value opportunities are becoming more plentiful in International markets in the wake of the sovereign credit crisis.
Looking Forward
We enter 2012 with our International and U.S. portfolios exhibiting a different implementation of the same fundamental principle: buy value. In the U.S., our value orientation leaves us with a heavy dose of high quality. In International, we’re letting our bottom-up value models do more of the heavy lifting. Our positioning continues to stem from the attractive values we find in any market, not a “top-down” view on market direction. We continue to be interested in the market’s short-term swings only insomuch as they offer us attractive opportunities to purchase stocks for less than they’re worth. On this front we continue to stand, as always, ready and waiting.
Emerging Market Equities Market Review
The fourth quarter found investors still tuned into the European debt crisis and, unsurprisingly, caught up in their two-step dance of hope and disappointment. Fortunately, there was positive news on the U.S. front with the unemployment rate dropping to 8.6%, its lowest level since March 2009. Country performances over the quarter were as diverse as a 12.5% rise in Peru and a 15.7% fall in Turkey. Among sectors, the spreads were narrower, ranging from a gain of 9.7% for Consumer Staples to a fall of 3.2% for Health Care.
Russian stocks climbed on the back of a rally in commodity prices. The jump in commodity prices is a major boost for the country, given its heavy dependence on oil and metal exports. Toward the end of the quarter, the market was spooked by protests against Prime Minister Putin’s government. Tens of thousands of protesters gathered in Moscow to raise their voices against the alleged electoral fraud in the parliamentary elections of December 4. Our overweight in Russian Energy, the largest country/sector bet in the portfolio given its enticing valuations, boosted performance. Hungary was hammered by fears of contagion from the eurozone’s debt crisis. Investors worried that growth in the emerging European economies would slow and that lenders would pull back. Another source of weakness is that 60% of Hungarian household mortgages are denominated in foreign currencies. When the Hungarian forint comes under pressure, it renews concern on the health of the financial sector. Investor sentiment was not helped by the government’s efforts to reduce the independence of its central bank. Our overweight in Hungarian Financials, driven by low valuations, detracted from performance.
The Indonesian central bank forecast the economy to expand 6.5% this year, the fastest pace since 1996, even as global growth slows. Domestic consumption is cushioning slowing exports without sparking fears of inflation. The central bank cut its benchmark interest rate to a record low of 6% last month as inflation eased for a third month. Further cheering sentiment was a credit-rating upgrade to investment grade by ratings agency Fitch. Our overweight in Indonesian Consumer Discretionary contributed to performance.
India’s benchmark dropped as the debt crisis in Europe and the biggest series of interest rate increases on record hurt corporate earnings and curbed growth. Facing inflation higher than 9% for the past 12 months, the central bank increased its benchmark interest rate to 8.5% in 13 moves since March 2010. The 6.9% rise in the gross domestic product in the three months through September was the weakest expansion since the second quarter of 2009. The government’s efforts to stimulate growth have been hampered by corruption scandals that have stalled legislation for a year. Our underweight in Indian Financials helped performance.
China’s stocks rebounded on speculation that the government would continue to lower lenders’ reserve requirement ratios and further ease curbs on credit.
Foreign direct investment dropped for the first time since 2009 and money supply grew the least in a decade. Europe’s debt crisis has significantly impacted Chinese exports and growth while also releasing some of the pressure on the overheating economy. Our underweight in Chinese Financials negatively impacted performance.
Stock selection detracted from performance in Brazilian Financials but contributed positively in Russian Energy. Overall, country/sector selection detracted 0.6%, while stock selection lost 0.1%.
Outlook
Emerging markets underperformed their developed counterparts in 2011. This was at odds with their relative macroeconomics – healthy balance sheets in most instances for emerging economies vs. worrisome leverage in many cases for developed markets. Emerging economies have therefore made a lot more progress than their developed counterparts in regaining their pre-crisis growth trends.
Early in 2011, this healthy growth had led to the decidedly unhealthy side effect of rising inflation. Food prices, in particular, have experienced a significant jump and were a key driver of fears that the world would revisit food shortages last seen in 2007. Throughout 2011 and especially in the latter part of the year, emerging markets were also buffeted by the European sovereign debt crisis. The waves of risk aversion emanating from the Mediterranean reached far enough to depress investor sentiment (and prices) in emerging markets. However, the effect was not an unalloyed negative.
Global growth was downgraded as the European sovereign issues went unresolved, helping to ameliorate the pressure on food prices and inflation in general. Another factor behind lower food-based inflation was the highly mean-reverting nature of food prices.
Given the twin developments of slower growth and lower inflation, emerging market central banks begin the year significantly more open to monetary easing than has been the case for quite some time. This is one of the reasons we are positive on the asset class this year. The other reason behind our optimism is valuations. After dropping about 20% over the course of the year, emerging markets enter 2012 significantly cheaper than their historical averages.
While we are bullish on the asset class, our optimism does not extend to emerging market small caps. They are not cheap relative to history (see, for example, “Capturing Domestic Demand in Emerging Markets: Neither Small Caps nor Multinationals Are a Good Proxy” at GMO’s website). In our opinion, they are not ideal on either a stand-alone basis, nor are they a good way to indirectly play the emerging market consumer theme. We continue to be fully on board with this secular theme but believe that the optimal investment vehicle is a direct one.
Fixed Income
Review
Bonds had a good quarter, particularly emerging debt, as yields fell nearly everywhere; however, the U.S dollar’s rise weighed on foreign bond returns. U.S. Treasuries returned +0.9%, slightly underperforming the broader USD Barclay’s Capital U.S. Aggregate index, where tightening sector spreads contributed positively. USD Emerging debt (EMBIG series) returned +5.1%, thanks to spread tightening on the asset class. Foreign government bonds, both from advanced countries and emerging countries, produced positive returns. However, U.S. dollar strength dented overall returns. The dollar’s rise was clear relative to emerging currencies, which fell 1.4% using the basket associated with the J.P. Morgan GBI-EMD local debt index. For the GBI ex-U.S. associated with advanced economies, the foreign currency decline was a bit less at -1.0%.
Government bond markets rallied across the board during the quarter: in local currency J.P. Morgan Global Bond index terms, gains were the highest in the U.K. (+5.5%) and lowest in Japan (+0.5%). Setting the stage early in the quarter for a rally in the U.K. bond market, disappointing economic data put downward pressure on gilt yields in October. As Standard & Poor’s put 15 of the eurozone countries on watch for possible downgrades and European Central Bank loans were unable to calm eurozone debt markets, investors bought gilts instead. Australian bonds (+3.5%) rallied on growing concerns of a slowdown in China, coupled with the initiation of a rate-cutting cycle by the Australian Reserve Bank. In other bond markets, Sweden (+2.0%), the eurozone (+1.9%), Canada (+1.8%), Switzerland (+1.4%), and the U.S. (+0.9%) also reported total return gains.
In terms of yield levels, interest rates fell in most markets for a third consecutive quarter. Among advanced countries, New Zealand, U.K., and Australian yields fell the most, and Norwegian the least, the declines ranging from 3-50 basis points for 10-year yields. Among emerging countries, Indonesia and China were the biggest decliners, although here we take 5-year yields. Only in Turkey, Hungary, Singapore, and Mexico did rates rise.
The U.S. dollar’s performance was mixed versus emerging and advanced country currencies during the quarter. In emerging currencies, more than half extended losses sustained in the third quarter, and those that didn’t registered only relatively modest gains. Hungarian forint continued to post steep losses, down a further 9.8% this quarter, as two major rating agencies downgraded the sovereign to junk, a move that requires the country’s bonds be removed from investment grade bond indexes. The three other EUR crosses suffered in the shadow of the ongoing, unresolved difficulties in the eurozone, where the euro fell by 3.2%. Czech crown and Polish zloty underperformed even the euro, -6.2% and -4.2%, respectively, although Romanian leu outperformed, -2.5%.
Indian rupee also witnessed a second consecutive quarter of uncharacteristically large losses, -7.8%. The Reserve Bank of India is grappling with twin deficits and inflation above target, while policymakers’ attention is caught up in political disputes.
On the top side, Peru new sol outperformed, +2.8%, despite a cabinet reshuffle and an apparent end to President Humala’s post-election honeymoon. Korean won was next, +2.2%, amidst fairly persistent dollarselling intervention, particularly following the death of North Korean leader Kim Jong Il. The Chinese reniminbi took third. Interestingly, the U.S. Treasury’s semiannual report on currency manipulation singled out just the renminbi and the yen as possible offenders, although both held top spots for the calendar year.
Among advanced countries, Australian dollar, Canadian dollar, and New Zealand dollar had outperformed by quarter’s end, +5.5%, +2.3%, and +2.1%, respectively, given the bounce in commodities prices off of the September lows. Meanwhile, the Swiss franc declined in line with the euro, -2.9%, as the Swiss central bank’s policy continued to target EURCHF. The Norwegian krone also fell by 1.6% as Norges Bank was the most aggressive in cutting its policy rate, dropping the deposit rate by 50 basis points to 1.75%.
In credit markets, emerging debt spreads (EMBIG series) tightened by 39 basis points to 426 basis points during the period. The eurozone continued to dominate headlines, as economic slowdown made fiscal adjustment even more challenging to achieve, and banks were hit by the extension of sovereign risk beyond the PIIGS. A round of EU summits plus the G20 did not succeed in reassuring investors. In the fourth quarter, Italy (A rating from S&P) continued to experience difficulty tapping the markets due to its high sovereign debt level, and its CDS widened by 9 basis points to 484 basis points. This spread was wider than that of Lebanon (B rating), increasing concerns that the European bail-out fund would not be large enough to contain the crisis. The Greek voluntary private-sector restructuring initiative was not implemented as market pricing overtook the proposed haircut.
Liquidity improved in the emerging cash bond market and the average bid-offer spread fell by 24 basis points to 95 basis points at the end of the quarter. New issuance rose to $59 billion in the fourth quarter from $32 billion in the third quarter, but it was less than in each of the preceding four quarters. Emerging currencies lost 1.0% against the dollar, with most of that coming from the European ones.
The biggest index gainers were Belarus (+22.7%), Venezuela (+14.3%), Uruguay (+12.7%), and Argentina (+9.0%). With the exception of Uruguay, these are lowrated, high-yielding countries that benefited from carry and spread compression due to a general reduction in risk aversion. Belarus devalued its currency to fair value and got balance-of-payments support from Russia in exchange for selling strategic energy assets to Russian companies. Venezuelan bonds still have the highest spread in the index (1,258 basis points or just 16 basis points less than Pakistan) and oil prices stayed high enough to ensure continued debt service. Uruguay is a different story, an improving credit with solid
fundamentals contributing to strong economic growth. Political uncertainty declined in Argentina after the presidential elections, and the government announced a reduction of subsidies that weigh heavily on the budget.
The worst performers of the quarter were Egypt (-10.4%), Hungary (-4.0%), Pakistan (-1.9%), and Ukraine (+0.4%). Egypt and Pakistan are convulsed by religious and social tensions, and their governments are barely functioning. Hungary, on the other hand, has an elected government that is using its parliamentary majority to increase the power of the prime minister and his party at the expense of independent institutions like the Central Bank. Political risk is also the main factor driving spreads in Ukraine, where the government has alienated its citizens and well-wishers in the EU and IMF, while resisting the Belarusian solution of turning to the Russians.
Asset-backed markets were unchanged other than a small widening in student loan bonds. According to J.P. Morgan, student loan spreads rose from 50 basis points to 55 basis points during the quarter, credit card spreads were flat at 16 basis points, and auto spreads were flat at 30 basis points. The ABX subprime indices declined modestly, with prices flat to down a few percent in the 2007 vintage.
Strategies
Fixed income strategies were mixed during the quarter: developed markets currency positioning, developed markets interest-rate selection, and emerging debt exposure performed very well, while emerging markets currency positioning and asset-backed holdings suffered.
In advanced country currencies, the cross-market strategy was successful, mainly given underweight positions in the euro and Swiss franc relative to the Australian dollar.
In advanced country interest-rate markets, opportunistic positions led gains. A yield-curve position moved in the strategy’s favor; in addition, some longdated interest-options increased in value. The yield curve slope strategy also contributed positively, aided by flattening yield curves in most markets. Tactical duration overlay positions added value during the quarter as the strategy maintained a slightly long duration in the front end of the U.S. curve.
In external emerging debt strategies, country and security selection added value, as did spread tightening on the asset class.
As in the second and third quarters, emerging local debt strategies benefited from instrument selection and country selection, while currency selection detracted. The U.S. dollar’s rise hurt overweight FX positions in emerging currencies. The main contributors to negative performance were overweights in Hungarian forint, which the models have signaled as cheap for a while, and Indian rupee, where the currency is fair and the carry is relatively good. The out-of-model underweight in Czech crown was helpful, while the two developed markets’ hedges were a push (the euro underweight positive, the Canadian dollar one not).
Finally, the asset-backed securities reported negative excess returns for the quarter.
Outlook
At year-end 2010, we and others highlighted the European situation as the central uncertainty facing world markets. Specifically, we said: “Unlike an emerging country crisis, which tends to play out on a more compressed time scale, the Europeans are slowly moving along the Kubler-Ross five stages of grief: they’re mostly past denial; clearly in the midst of anger; and engaging in a protracted bargaining. What’s left is depression and acceptance, which may begin with the forthcoming Greek write-down (which may or may not be “officially” declared a “default”; see “denial”). The good news is: Greece’s default is hardly a surprise, and the current bargaining efforts are aimed squarely at limiting the contagion and fallout from it, whether it be to other challenged sovereigns or their banks.”
Fast forward to end-2011, the characterization of “protracted bargaining” seems especially apt. As we see it, the Europeans made two grand efforts at political solidarity – once in late July and again in early December – then immediately adjourned for summer and Christmas holidays, respectively. Little was actually done, and we even enter 2012 with no completed Greek debt writedown.
Meanwhile, the list of Knightian uncertainties1 grew longer. Uncertainty distinguishes itself from risk by being unmeasurable, challenging financial markets intermediated by VAR-based institutions. Among the uncertainties: What if the EUR breaks up (a possibility suddenly thrust from the editorial sphere to the political with the shocking proposal for a Greek referendum on staying in the EUR; public discussions by French and German (but not EU) leaders of the same; and, more ominously, the failed EFSF auction and an announcement by CLS (settlement system for 70% of FX trades) that they’re making just-in-case preparations)? What if I’m forced to exit positions sooner because of a sudden downgrade to my company’s credit, or my counterparty’s, or Basel III, or simply because I’m fired (a thought front and center with MF Global’s demise)? What if China is having a hard landing (the probability of which is difficult to discern given very heavily managed, opaque public statistics)? What if tensions in Syria and Iran escalate (if the difficulties with the U.K. and France are any indication)? Why did the central banks need to re-institute the swap lines? Was a bank about to go under? Difficulty cuffing the odds of these things and then propagating reasonable scenarios to accompany them drive this Knightian uncertainty. Once again, evidence of all of this was wide bid/offered spreads, reduced volumes in currencies and bonds, dysfunctional money markets, and dire market color reminiscent of 2008.
In long-only space, on the positive side, certain valuations are better. For example, with emerging debt spreads wider and emerging currencies lower, prospectively these two areas offer healthy returns. On the negative side, certain valuations are worse, particularly government bonds from highly-rated countries, where yields are at multi-decade lows. In fact, for highly-rated countries, real yields on inflation-protected bonds are negative out to the 5- and 10-year point. Meanwhile, for those same countries, nominal government bond yields are at levels that imply inflation near the country’s target or forecast, leaving little room for positive inflation surprises. Of course, if deflation is the future, then it will have been a mistake to call either overvalued. Given this landscape, we prefer to rely more on alpha than beta in an opportunistic style.
On the strategy side, interesting new alpha opportunities are presenting themselves. Deleveraging by our counterparties has meant the markets have become less efficient (and less liquid). Patient investors can therefore buy and hold undervalued securities. This is also true in interest-rate markets, where anomalies in curves are left to the non-dealer market to cure. Currencies have presented more of a challenge lately. Among advanced nation currencies, the yield dispersion is low, and momentum has been low recently. Among emerging currencies, value has been a poor predictor of recent performance. We believe these facts are transient, however, and the likelihood that they persist indefinitely is low. We have tilted our risk budget away from currencies toward rates and bonds as a result, something we’ll revisit over time.
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Global Market Review
After a summer swoon, markets regained some of their poise in the fall. Although the initial sell-off had been broadly indiscriminate, the recovery was somewhat more discerning. In particular, markets began to focus more intently on the problems facing the eurozone and the securities most obviously exposed to the unfolding sovereign debt troubles. Perhaps not surprisingly, U.S. markets were perceived to be somewhat of a safe haven, with both risky U.S. assets and the U.S. dollar the main beneficiaries.
At the end of September, the specter of a Lehmanstyle event centered in Europe propelled the VIX index back above 40. The apparent inability of European Union politicians to react to the spreading contagion let alone try to manage it sent markets rioting. The resulting mess was enough to unseat Italy’s longest-serving post war leader and dissolve the Greek government. The remaining leaders reached for their tried and tested playbook and called for yet another summit. Despite the shortening half-life of the effectiveness of European summits, market participants seemed more willing to trade on anything that appeared to be positive news and markets began to rebound. By the time the summit had concluded in early December, markets, in characteristic fashion, decided to focus on the short-term liquidity measures rather than the absence of any meaningful plan to deal with the longer-term internal imbalances. To be fair, the liquidity measures amounted to a quasiquantitative easing policy and managed to stabilize, if not completely heal, peripheral bond markets. Rather than buy European bonds directly, the European Central Bank preferred to extend its back door bailout program by offering generous longer-term financing terms for the banking systems of various troubled countries. In addition, the summit produced an agreement to strengthen the fiscal compact but stopped short of offering actual fiscal transfers.
Despite being welcomed by the markets, the summit failed to satisfy the minimum conditions necessary for giving the euro a chance of medium-term survival: the creation of a fiscal union, along with ECB lending to bridge the gap between the required multi-year political timetable and a market timescale measured in weeks or months. Despite the self-congratulation among EU politicians about their “fiscal compact,” the fact is that Germany vetoed the most important characteristic of a true fiscal union: some degree of joint responsibility for sovereign debt. Since Germany refused even to discuss Eurobonds or a vastly expanded jointly-guaranteed European Stability Mechanism, the summit did nothing to reassure the savers and investors in Club Med countries that their money will be protected from either devaluation or default. For the currency union to thrive longer term, political leaders must find a mechanism to address Europe’s internal imbalances that does not rely exclusively on deflation as the cure. As in all of the previous summits, the only truly definitive decision was to have another meeting in three months' time, when a new agreement would supposedly be conjured up to resolve all of the controversial issues left undecided.
The recovery in the S&P 500 began almost immediately and, apart from a pause from mid- November to mid-December, the index almost never looked back. Improving economic data and a hope that the U.S. would be somewhat protected from the slowdown in Europe translated into a gain of 11.8% for the quarter and left the index unchanged on a price basis for the year. The recovering sentiment helped value indices recover a little more than growth, with the Russell 1000 Value index ending at +13.1% and the Russell 1000 Growth index rising 10.6%. Smaller companies also benefited, but the recovery was not enough to erase the dramatic falls seen in the last quarter. There was little to distinguish between value and growth in the small capitalization indices as all small cap returns clustered close together. The Russell 2000 ended the quarter with a gain of 15.5% and the Russell 2000 Value and Growth indices rose 16.0% and 15.0%, respectively.
The performance of international developed market equities, however, diverged significantly from the U.S. In local terms, the EAFE index was up a paltry 4.1% as investors remained spooked by the ongoing bedlam in the eurozone. The recovery in the dollar translated into a gain of 3.3% for the same index for dollar-based investors. Having avoided the worst of the previous quarter’s sell-off, the Japanese market continued to trade independently, falling 3.9%. Although investors were willing to believe the U.S. would remain decoupled from the rest of the world, emerging market investors were not so lucky and emerging equities finished in line with developed markets with a gain of 3.9%.
Despite the modest recovery in equity markets, bond investors seemed somewhat more circumspect. Yields initially rose as sentiment recovered, but fell back to their earlier lows by the end of the quarter. The U.S. benchmark bond yield ended the year under 2%, as did the U.K., Japanese, and German yields. The J.P. Morgan U.S. Government bond index returned +0.9% while the J.P. Morgan Non-U.S. Government Bond index fell 0.2% over the same period, due mostly to a strengthening greenback.
Credit markets recovered somewhat with the Barclays U.S. Aggregate index posting a gain of 1.1%. The recovery in the municipal bond market continued apace with the Barclays Municipal Bond index returning +2.8%. The biggest beneficiary from increased risk appetites, however, was the J.P. Morgan EMBI Global, which gained 5.1% for the quarter.
Asset Allocation
Review
October witnessed global rallies that set a few records as virtually all markets responded strongly to a combination of signs of economic recovery in the U.S. and at least a sizable “relief rally” from indications that Europe might dodge, at least short term, a liquidity bullet. Reality settled in during November and December as the harsh future and likely painful restructuring necessary in Europe sobered up the brief celebration of October. But by the end of the quarter, equity markets had recovered slightly from what had been a terrifying summer and third quarter.
The performance of international developed market equities and emerging equities, however, diverged significantly from the U.S. In local terms, the EAFE index was up a paltry 4.1% and emerging rose only 3.9% (vs. a positive 11.8% for the S&P 500, for example). The debate going forward seems to revolve around whether a recovery in the U.S., however modest, could withstand the likely economic doldrums of Europe – basically, how untethered is the U.S. to the prospects of Europe.
Strategies
All this talk of gloom and doom in Europe, however, presents a contrarian firm like GMO some interesting opportunities. So, if there was movement in our strategies during the quarter, it would have to be characterized as classically contrarian. Contrarians “run into burning buildings,” if you will, and by any definition it appeared that “Rome was burning.” Our strategies, therefore, tended to move, incrementally, into Europe. Selectively, slowly, prudently, of course, but the general belief is that markets have overreacted, and this always presents some opportunities. This is by no means a “call” on the bottom of possible European corrections or crises, but valuations are such that bad scenarios are already baked into some prices.
Our broad strategies are:
ï® Maintain Quality bias. Quality gave back a bit of its outperformance this quarter, but the game is in the early innings still. High quality stocks still trade at attractive levels, and the general defensive posture of quality still remains appealing given all of the uncertainties surrounding global prospects, dysfunctional governments, and horrific bond yields.
ï® Bias toward Value in EAFE. We’ve also begun to bias our international portfolios toward Value. One cannot characterize this as a “big bet,” but valuations are such that we are beginning to see attractive spreads between Growth and Value in international equities.
ï® Reduce exposure slightly to emerging markets. We funded some of the flows into EAFE both through cash proxies and from Emerging equities. Continued concern surrounding China’s economic bubble and a likely inability to deflate it without contagion effects gave us pause.
ï® Continued bearishness on bonds. We are literally running out of superlatives to describe how much we hate bonds. Yields are pitiful, dangers of even a slight recovery that could wreak havoc for long-duration portfolios loom, and monetary policies globally certainly have added to the specter of rising yields.
ï® Invest in conservative absolute return strategies, where available. Ideally, absolute return strategies are often a pure play on manager skill. Therefore, the return streams should have little correlation to the movements of the markets. Such investment instruments can provide equity-like returns, while helping to diversify other parts of one’s portfolio.
Performance Review and Outlook Global Quantitative Equities Market Review
Global equity investors entered 2011 optimistic after a strong 2010, only to shift into fear mode mid-year as Europe’s sovereign debt woes took a turn for the worse. While the source of fear was local to Europe, the ensuing sell-off in risk assets swept around the world, sparing few. And though efforts to resolve the European crisis stabilized markets somewhat in the fourth quarter, positive absolute returns for the year in full were the exception rather than the norm. GMO’s Global Quantitative Equity Strategies posted generally strong relative performance during the year. To understand the sources of relative return, an examination of the themes of 2011 and their impact on our quantitative investment tools is helpful.
Safety Was the Dominant Theme in 2011
As in past periods of investor fear, safety was the dominant theme for global investors in 2011. U.S. stocks outperformed International stocks. International stocks beat Emerging Markets stocks. The trend toward safety was also evident within markets. The S&P 500 posted a +2.1% return in 2011. But the index’s Utilities sector registered a 14.8% gain for the year while Financials posted an 18.4% decline. The safety spread was also evident in International developed markets. The MSCI EAFE index lost 9.4% in 2011. But the index’s bestperforming sector, Health Care, notched a positive return of more than 2%, while its Financials component dropped more than 20%.
High Quality and Low Volatility Led the Outperformers
The safety theme wasn’t limited to economic sectors. Among investment factors, high quality and low volatility stocks posted exceptional relative returns in U.S. and International markets. Within EAFE, the best 25% of the market based on GMO’s quality definition – high, stable profitability and low leverage – and the lowest 25% of the market based on stock price volatility each outperformed the market by approximately 15% in 2011. In the U.S., the relative returns for quality and volatility were similarly strong, with low volatility faring a bit better, owing to a significant weight in the Utilities sector.
Quality Also Helped Implicitly
GMO’s quality factor also played a significant role in many investment models where our definition of quality is an input. For example, one of GMO’s simple value models compares market price to a number of financial metrics (e.g., book value, earnings, etc.) to find cheap companies. We include an adjustment based on company quality, which helps the model avoid low quality companies that trade statistically cheap for good reason. 2011 was a tough year for simple value models, which piled into a raft of cyclical, low quality companies and were penalized for this positioning in the flight to safety. Including a quality adjustment, however, spared much of the pain.
A Word on Momentum
One of the fundamental risks in running a price-based stock selection metric like momentum is the possibility that market themes can shift quickly and leave you holding a portfolio full of the last theme’s stocks. Momentum metrics experienced such a fate in mid-2011, when the flight to safety left them holding significant exposure to firms levered to rising commodity prices. As investors sold off riskier, more economically exposed companies amid the Europe-induced spring sell-off, momentum lagged.
Volatility Creates Opportunity
The quick rule of thumb for understanding GMO Global Quantitative Strategies’ relative returns in 2011 was: the more quality a portfolio held, the better the performance. While a flight to safety certainly helped produce strong 2011 results, it’s important to remember that our positioning stems from valuation, not a broader economic view. This is particularly relevant as we enter 2012. In the U.S., we continue to hold significant exposure to high quality stocks in many of our strategies. Quality’s 2011 outperformance came on the back of two years of poor relative returns, and U.S. quality’s fundamentals held up exceptionally well relative to the market. We continue to find U.S. high quality stocks representing an exceptional value opportunity. The story is different Internationally, where the European sovereign debt crisis has now been underway for more than two years and quality stocks have delivered exceptional relative returns. Since the beginning of 2010, the best 25% of the International market based on GMO’s definition of quality has outperformed by more than 14%; during that same period, the best 25% of the U.S. market based on our quality definition has underperformed by 1.5%. Given this recent performance, it’s not particularly surprising that the relative valuations of International high quality stocks aren’t as attractive as their U.S. counterparts. The good news is that volatility frequently creates opportunity. While quality stocks as a group have become more fully valued, traditional bottom-up value opportunities are becoming more plentiful in International markets in the wake of the sovereign credit crisis.
Looking Forward
We enter 2012 with our International and U.S. portfolios exhibiting a different implementation of the same fundamental principle: buy value. In the U.S., our value orientation leaves us with a heavy dose of high quality. In International, we’re letting our bottom-up value models do more of the heavy lifting. Our positioning continues to stem from the attractive values we find in any market, not a “top-down” view on market direction. We continue to be interested in the market’s short-term swings only insomuch as they offer us attractive opportunities to purchase stocks for less than they’re worth. On this front we continue to stand, as always, ready and waiting.
Emerging Market Equities Market Review
The fourth quarter found investors still tuned into the European debt crisis and, unsurprisingly, caught up in their two-step dance of hope and disappointment. Fortunately, there was positive news on the U.S. front with the unemployment rate dropping to 8.6%, its lowest level since March 2009. Country performances over the quarter were as diverse as a 12.5% rise in Peru and a 15.7% fall in Turkey. Among sectors, the spreads were narrower, ranging from a gain of 9.7% for Consumer Staples to a fall of 3.2% for Health Care.
Russian stocks climbed on the back of a rally in commodity prices. The jump in commodity prices is a major boost for the country, given its heavy dependence on oil and metal exports. Toward the end of the quarter, the market was spooked by protests against Prime Minister Putin’s government. Tens of thousands of protesters gathered in Moscow to raise their voices against the alleged electoral fraud in the parliamentary elections of December 4. Our overweight in Russian Energy, the largest country/sector bet in the portfolio given its enticing valuations, boosted performance. Hungary was hammered by fears of contagion from the eurozone’s debt crisis. Investors worried that growth in the emerging European economies would slow and that lenders would pull back. Another source of weakness is that 60% of Hungarian household mortgages are denominated in foreign currencies. When the Hungarian forint comes under pressure, it renews concern on the health of the financial sector. Investor sentiment was not helped by the government’s efforts to reduce the independence of its central bank. Our overweight in Hungarian Financials, driven by low valuations, detracted from performance.
The Indonesian central bank forecast the economy to expand 6.5% this year, the fastest pace since 1996, even as global growth slows. Domestic consumption is cushioning slowing exports without sparking fears of inflation. The central bank cut its benchmark interest rate to a record low of 6% last month as inflation eased for a third month. Further cheering sentiment was a credit-rating upgrade to investment grade by ratings agency Fitch. Our overweight in Indonesian Consumer Discretionary contributed to performance.
India’s benchmark dropped as the debt crisis in Europe and the biggest series of interest rate increases on record hurt corporate earnings and curbed growth. Facing inflation higher than 9% for the past 12 months, the central bank increased its benchmark interest rate to 8.5% in 13 moves since March 2010. The 6.9% rise in the gross domestic product in the three months through September was the weakest expansion since the second quarter of 2009. The government’s efforts to stimulate growth have been hampered by corruption scandals that have stalled legislation for a year. Our underweight in Indian Financials helped performance.
China’s stocks rebounded on speculation that the government would continue to lower lenders’ reserve requirement ratios and further ease curbs on credit.
Foreign direct investment dropped for the first time since 2009 and money supply grew the least in a decade. Europe’s debt crisis has significantly impacted Chinese exports and growth while also releasing some of the pressure on the overheating economy. Our underweight in Chinese Financials negatively impacted performance.
Stock selection detracted from performance in Brazilian Financials but contributed positively in Russian Energy. Overall, country/sector selection detracted 0.6%, while stock selection lost 0.1%.
Outlook
Emerging markets underperformed their developed counterparts in 2011. This was at odds with their relative macroeconomics – healthy balance sheets in most instances for emerging economies vs. worrisome leverage in many cases for developed markets. Emerging economies have therefore made a lot more progress than their developed counterparts in regaining their pre-crisis growth trends.
Early in 2011, this healthy growth had led to the decidedly unhealthy side effect of rising inflation. Food prices, in particular, have experienced a significant jump and were a key driver of fears that the world would revisit food shortages last seen in 2007. Throughout 2011 and especially in the latter part of the year, emerging markets were also buffeted by the European sovereign debt crisis. The waves of risk aversion emanating from the Mediterranean reached far enough to depress investor sentiment (and prices) in emerging markets. However, the effect was not an unalloyed negative.
Global growth was downgraded as the European sovereign issues went unresolved, helping to ameliorate the pressure on food prices and inflation in general. Another factor behind lower food-based inflation was the highly mean-reverting nature of food prices.
Given the twin developments of slower growth and lower inflation, emerging market central banks begin the year significantly more open to monetary easing than has been the case for quite some time. This is one of the reasons we are positive on the asset class this year. The other reason behind our optimism is valuations. After dropping about 20% over the course of the year, emerging markets enter 2012 significantly cheaper than their historical averages.
While we are bullish on the asset class, our optimism does not extend to emerging market small caps. They are not cheap relative to history (see, for example, “Capturing Domestic Demand in Emerging Markets: Neither Small Caps nor Multinationals Are a Good Proxy” at GMO’s website). In our opinion, they are not ideal on either a stand-alone basis, nor are they a good way to indirectly play the emerging market consumer theme. We continue to be fully on board with this secular theme but believe that the optimal investment vehicle is a direct one.
Fixed Income
Review
Bonds had a good quarter, particularly emerging debt, as yields fell nearly everywhere; however, the U.S dollar’s rise weighed on foreign bond returns. U.S. Treasuries returned +0.9%, slightly underperforming the broader USD Barclay’s Capital U.S. Aggregate index, where tightening sector spreads contributed positively. USD Emerging debt (EMBIG series) returned +5.1%, thanks to spread tightening on the asset class. Foreign government bonds, both from advanced countries and emerging countries, produced positive returns. However, U.S. dollar strength dented overall returns. The dollar’s rise was clear relative to emerging currencies, which fell 1.4% using the basket associated with the J.P. Morgan GBI-EMD local debt index. For the GBI ex-U.S. associated with advanced economies, the foreign currency decline was a bit less at -1.0%.
Government bond markets rallied across the board during the quarter: in local currency J.P. Morgan Global Bond index terms, gains were the highest in the U.K. (+5.5%) and lowest in Japan (+0.5%). Setting the stage early in the quarter for a rally in the U.K. bond market, disappointing economic data put downward pressure on gilt yields in October. As Standard & Poor’s put 15 of the eurozone countries on watch for possible downgrades and European Central Bank loans were unable to calm eurozone debt markets, investors bought gilts instead. Australian bonds (+3.5%) rallied on growing concerns of a slowdown in China, coupled with the initiation of a rate-cutting cycle by the Australian Reserve Bank. In other bond markets, Sweden (+2.0%), the eurozone (+1.9%), Canada (+1.8%), Switzerland (+1.4%), and the U.S. (+0.9%) also reported total return gains.
In terms of yield levels, interest rates fell in most markets for a third consecutive quarter. Among advanced countries, New Zealand, U.K., and Australian yields fell the most, and Norwegian the least, the declines ranging from 3-50 basis points for 10-year yields. Among emerging countries, Indonesia and China were the biggest decliners, although here we take 5-year yields. Only in Turkey, Hungary, Singapore, and Mexico did rates rise.
The U.S. dollar’s performance was mixed versus emerging and advanced country currencies during the quarter. In emerging currencies, more than half extended losses sustained in the third quarter, and those that didn’t registered only relatively modest gains. Hungarian forint continued to post steep losses, down a further 9.8% this quarter, as two major rating agencies downgraded the sovereign to junk, a move that requires the country’s bonds be removed from investment grade bond indexes. The three other EUR crosses suffered in the shadow of the ongoing, unresolved difficulties in the eurozone, where the euro fell by 3.2%. Czech crown and Polish zloty underperformed even the euro, -6.2% and -4.2%, respectively, although Romanian leu outperformed, -2.5%.
Indian rupee also witnessed a second consecutive quarter of uncharacteristically large losses, -7.8%. The Reserve Bank of India is grappling with twin deficits and inflation above target, while policymakers’ attention is caught up in political disputes.
On the top side, Peru new sol outperformed, +2.8%, despite a cabinet reshuffle and an apparent end to President Humala’s post-election honeymoon. Korean won was next, +2.2%, amidst fairly persistent dollarselling intervention, particularly following the death of North Korean leader Kim Jong Il. The Chinese reniminbi took third. Interestingly, the U.S. Treasury’s semiannual report on currency manipulation singled out just the renminbi and the yen as possible offenders, although both held top spots for the calendar year.
Among advanced countries, Australian dollar, Canadian dollar, and New Zealand dollar had outperformed by quarter’s end, +5.5%, +2.3%, and +2.1%, respectively, given the bounce in commodities prices off of the September lows. Meanwhile, the Swiss franc declined in line with the euro, -2.9%, as the Swiss central bank’s policy continued to target EURCHF. The Norwegian krone also fell by 1.6% as Norges Bank was the most aggressive in cutting its policy rate, dropping the deposit rate by 50 basis points to 1.75%.
In credit markets, emerging debt spreads (EMBIG series) tightened by 39 basis points to 426 basis points during the period. The eurozone continued to dominate headlines, as economic slowdown made fiscal adjustment even more challenging to achieve, and banks were hit by the extension of sovereign risk beyond the PIIGS. A round of EU summits plus the G20 did not succeed in reassuring investors. In the fourth quarter, Italy (A rating from S&P) continued to experience difficulty tapping the markets due to its high sovereign debt level, and its CDS widened by 9 basis points to 484 basis points. This spread was wider than that of Lebanon (B rating), increasing concerns that the European bail-out fund would not be large enough to contain the crisis. The Greek voluntary private-sector restructuring initiative was not implemented as market pricing overtook the proposed haircut.
Liquidity improved in the emerging cash bond market and the average bid-offer spread fell by 24 basis points to 95 basis points at the end of the quarter. New issuance rose to $59 billion in the fourth quarter from $32 billion in the third quarter, but it was less than in each of the preceding four quarters. Emerging currencies lost 1.0% against the dollar, with most of that coming from the European ones.
The biggest index gainers were Belarus (+22.7%), Venezuela (+14.3%), Uruguay (+12.7%), and Argentina (+9.0%). With the exception of Uruguay, these are lowrated, high-yielding countries that benefited from carry and spread compression due to a general reduction in risk aversion. Belarus devalued its currency to fair value and got balance-of-payments support from Russia in exchange for selling strategic energy assets to Russian companies. Venezuelan bonds still have the highest spread in the index (1,258 basis points or just 16 basis points less than Pakistan) and oil prices stayed high enough to ensure continued debt service. Uruguay is a different story, an improving credit with solid
fundamentals contributing to strong economic growth. Political uncertainty declined in Argentina after the presidential elections, and the government announced a reduction of subsidies that weigh heavily on the budget.
The worst performers of the quarter were Egypt (-10.4%), Hungary (-4.0%), Pakistan (-1.9%), and Ukraine (+0.4%). Egypt and Pakistan are convulsed by religious and social tensions, and their governments are barely functioning. Hungary, on the other hand, has an elected government that is using its parliamentary majority to increase the power of the prime minister and his party at the expense of independent institutions like the Central Bank. Political risk is also the main factor driving spreads in Ukraine, where the government has alienated its citizens and well-wishers in the EU and IMF, while resisting the Belarusian solution of turning to the Russians.
Asset-backed markets were unchanged other than a small widening in student loan bonds. According to J.P. Morgan, student loan spreads rose from 50 basis points to 55 basis points during the quarter, credit card spreads were flat at 16 basis points, and auto spreads were flat at 30 basis points. The ABX subprime indices declined modestly, with prices flat to down a few percent in the 2007 vintage.
Strategies
Fixed income strategies were mixed during the quarter: developed markets currency positioning, developed markets interest-rate selection, and emerging debt exposure performed very well, while emerging markets currency positioning and asset-backed holdings suffered.
In advanced country currencies, the cross-market strategy was successful, mainly given underweight positions in the euro and Swiss franc relative to the Australian dollar.
In advanced country interest-rate markets, opportunistic positions led gains. A yield-curve position moved in the strategy’s favor; in addition, some longdated interest-options increased in value. The yield curve slope strategy also contributed positively, aided by flattening yield curves in most markets. Tactical duration overlay positions added value during the quarter as the strategy maintained a slightly long duration in the front end of the U.S. curve.
In external emerging debt strategies, country and security selection added value, as did spread tightening on the asset class.
As in the second and third quarters, emerging local debt strategies benefited from instrument selection and country selection, while currency selection detracted. The U.S. dollar’s rise hurt overweight FX positions in emerging currencies. The main contributors to negative performance were overweights in Hungarian forint, which the models have signaled as cheap for a while, and Indian rupee, where the currency is fair and the carry is relatively good. The out-of-model underweight in Czech crown was helpful, while the two developed markets’ hedges were a push (the euro underweight positive, the Canadian dollar one not).
Finally, the asset-backed securities reported negative excess returns for the quarter.
Outlook
At year-end 2010, we and others highlighted the European situation as the central uncertainty facing world markets. Specifically, we said: “Unlike an emerging country crisis, which tends to play out on a more compressed time scale, the Europeans are slowly moving along the Kubler-Ross five stages of grief: they’re mostly past denial; clearly in the midst of anger; and engaging in a protracted bargaining. What’s left is depression and acceptance, which may begin with the forthcoming Greek write-down (which may or may not be “officially” declared a “default”; see “denial”). The good news is: Greece’s default is hardly a surprise, and the current bargaining efforts are aimed squarely at limiting the contagion and fallout from it, whether it be to other challenged sovereigns or their banks.”
Fast forward to end-2011, the characterization of “protracted bargaining” seems especially apt. As we see it, the Europeans made two grand efforts at political solidarity – once in late July and again in early December – then immediately adjourned for summer and Christmas holidays, respectively. Little was actually done, and we even enter 2012 with no completed Greek debt writedown.
Meanwhile, the list of Knightian uncertainties1 grew longer. Uncertainty distinguishes itself from risk by being unmeasurable, challenging financial markets intermediated by VAR-based institutions. Among the uncertainties: What if the EUR breaks up (a possibility suddenly thrust from the editorial sphere to the political with the shocking proposal for a Greek referendum on staying in the EUR; public discussions by French and German (but not EU) leaders of the same; and, more ominously, the failed EFSF auction and an announcement by CLS (settlement system for 70% of FX trades) that they’re making just-in-case preparations)? What if I’m forced to exit positions sooner because of a sudden downgrade to my company’s credit, or my counterparty’s, or Basel III, or simply because I’m fired (a thought front and center with MF Global’s demise)? What if China is having a hard landing (the probability of which is difficult to discern given very heavily managed, opaque public statistics)? What if tensions in Syria and Iran escalate (if the difficulties with the U.K. and France are any indication)? Why did the central banks need to re-institute the swap lines? Was a bank about to go under? Difficulty cuffing the odds of these things and then propagating reasonable scenarios to accompany them drive this Knightian uncertainty. Once again, evidence of all of this was wide bid/offered spreads, reduced volumes in currencies and bonds, dysfunctional money markets, and dire market color reminiscent of 2008.
In long-only space, on the positive side, certain valuations are better. For example, with emerging debt spreads wider and emerging currencies lower, prospectively these two areas offer healthy returns. On the negative side, certain valuations are worse, particularly government bonds from highly-rated countries, where yields are at multi-decade lows. In fact, for highly-rated countries, real yields on inflation-protected bonds are negative out to the 5- and 10-year point. Meanwhile, for those same countries, nominal government bond yields are at levels that imply inflation near the country’s target or forecast, leaving little room for positive inflation surprises. Of course, if deflation is the future, then it will have been a mistake to call either overvalued. Given this landscape, we prefer to rely more on alpha than beta in an opportunistic style.
On the strategy side, interesting new alpha opportunities are presenting themselves. Deleveraging by our counterparties has meant the markets have become less efficient (and less liquid). Patient investors can therefore buy and hold undervalued securities. This is also true in interest-rate markets, where anomalies in curves are left to the non-dealer market to cure. Currencies have presented more of a challenge lately. Among advanced nation currencies, the yield dispersion is low, and momentum has been low recently. Among emerging currencies, value has been a poor predictor of recent performance. We believe these facts are transient, however, and the likelihood that they persist indefinitely is low. We have tilted our risk budget away from currencies toward rates and bonds as a result, something we’ll revisit over time.
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