The first quarter of 2014 saw increased volatility across equity markets and stronger performance in bond markets, a stark contrast to 2013. Fed Chairwoman Yellen reiterated the Fed’s stance on tapering and the importance of economic data while hinting at future rate hikes. International markets were shocked by inflation fears in emerging markets and reduced liquidity due to tapering in the US. Lastly, and most importantly, the Russian invasion of Ukraine caught international markets off guard.
Economic data came in below expectations during the quarter with unemployment figures and GDP growth disappointing. The lack of job growth was most concerning but many believe it to be a function of the very cold winter across the country. Expectations are that more normalized job data in March and April should provide greater clarity on the employment picture going forward. Yellen’s first press conference was relatively uneventful as the taper plan was unchanged: the Fed intends to reduce QE (Quantitative Easing) by $10 billion monthly until it ends altogether in October of this year. However, Chairwoman Yellen’s comments about raising rates six months after ending QE scared some investors that had not anticipated higher rates so soon after the end of QE. All that being said, Chairwoman Yellen reiterated that the economic data would dictate any and all future monetary policy.
In response to the ousting of the pro-Russian Ukrainian President in February, Vladimir Putin invaded the Crimean Peninsula to “protect” the largely Russian inhabitants. In a matter of weeks, Russian forces seized the area while positioning the territory for a referendum and ultimate annexation. While the Crimeans clearly had stronger ties to Russia than Ukraine, Putin’s illegal aggression towards the Ukraine is concerning in that it may be an indicator of a much bigger expansion plan. His stranglehold on the natural gas market and ambitions for world powers are dangerous factors for larger unrest across the globe.
Emerging economies, especially those that are commodity rich and export dependent, struggled with high inflation and currency devaluation during the quarter. The Argentinian peso lost nearly 20% of its value during the first month of the year while the Brazilian real suffered similar inflation related pressure. In early April, Brazil’s Central Bank voted to raise rates for the ninth straight time to 11%. Inflation in Brazil is estimated to be as high as 6.5% by the end of the year. South Africa and Turkey are in similar situations with stubbornly high inflation and weakening growth. Lower expectations for developed market growth combined with continued deleveraging in the US and Europe caused investors to withdraw capital from these countries contributing to higher current account deficits.
After starting the year at new highs, equity markets across the globe experienced a pullback in early February with the S&P 500 declining nearly 5%, the NASDAQ declining nearly 10% and some emerging markets dipping 10-15%. Volatility spiked significantly during the quarter giving investors an opportunity to rebalance after a strong 2013 and reinvest amidst a brief (but dramatic) pull back. Many domestic markets went on to reach new highs again later in the quarter before giving back some of those gains at quarter end. Many domestic growth and momentum stocks experienced a major correction during the quarter with the high flying biotech sector declining more than 15% from peak to trough. Last year’s second worst performing S&P 500 sector, utilities, was the best performing during the first quarter of 2014 rising over 9%.
Like domestic markets, international and emerging markets were punished mid quarter before recovering towards quarter end. The currency fears discussed above combined with the Russian/Ukraine conflict contributed to market volatility. Markets in Russia (-15%), the Ukraine (-16.9%), Japan (-10%), and China (-6.9%) were some of the notable decliners. Frontier markets generally outperformed emerging markets. Some of the positive returns in frontier and emerging markets were in the UAE (+32%), Indonesia (+19.5%), India (+9.1%), and Vietnam (+17.2%). There was a clear separation of strong and weak equity markets within emerging and frontier economies during the quarter. We believe that this trend could continue which would benefit active emerging and frontier managers with the ability to separate the most fundamentally sound companies from those that are sensitive to capital flows and commodity demand.
The following chart summarizes various equity market indices in the first quarter:
Bottom Line: Equities will continue to be a significant contributor to portfolio returns. Active managers will have a more fruitful environment to invest than previously as correlations decline and volatility remains in response to Fed tightening. While we are biased to domestic equities, developed international and emerging markets are cheaper on a relative basis. Should we see a greater variance in returns, we may shift equity allocations to increase exposure internationally.
Fixed Income Markets
The first quarter was strong for fixed income assets across the globe. The Fed continued its taper program and investors rebalanced out of equities after a strong 2013 into credit oriented instruments. Spreads compressed during the quarter with longer maturities outperforming shorter maturities and lower quality bonds outperforming higher quality bonds. Municipal bonds had an exceptionally strong quarter as new issuance remained low and demand picked up in response to a higher personal income tax environment. Municipal bond mutual funds saw net inflows during the quarter. While Puerto Rico was downgraded to junk by the three largest rating agencies in February, their issuance of $3.5 billion of 20 year bonds yielding 8.73% was 5.4 times oversubscribed. Clearly, demand for yield (and triple tax exempt yield) is very strong.
The following chart summarizes performance for various fixed income indices in the first quarter:
Bottom Line: Our outlook for traditional fixed income remains muted with low expectations for total return. However, opportunistic fixed income strategies and active traditional fixed income managers will have ample opportunity to deliver results in excess of broader bond markets as volatility returns to credit markets.
While most hedge fund strategies, as measured by the HFN Indices, were positive during March, it was one of the more difficult quarters as a whole. The reversal from many of the growth-oriented momentum trades to more quality-dividend-oriented strategies caught many managers off guard. The macro traders betting on a strengthening Nikkei were hurt as the index was down more than 10% during the quarter. The long/short credit strategies as measured below by the HFN Fixed Income Non-Arbitrage Index, generated the strongest returns as most fixed income markets rallied significantly during the quarter creating ample opportunity for trading oriented credit strategies to lock in gains. The following chart summarizes broader performance for various hedge fund indices in the first quarter:
Dispersion of returns across alternative strategies in the first quarter was the widest we have seen in quite some time. Across our long/short equity managers, the range of returns was -5% to +3% for the quarter. One of our market neutral managers, who had historically been one of the most consistent, low volatility strategies, experienced one of its worst drawdowns since inception during the quarter. Global macro strategies continued to have a difficult time while more commodities- oriented managers rebounded. Some of the better known global macro managers were down 6-9% for the first quarter. Distressed strategies had a very strong start to the year with many of these strategies posting positive returns during January when most equity indices were down. Many of the themes that were in place finally paid off during the quarter with the Lehman Brothers settlement representing the biggest winner in many portfolios. While the variability in returns might seem like a negative, we actually think it’s an indication that markets are no longer moving in lockstep which is good for active management and hedged strategies going forward. Volatility benefits managers that aim to generate alpha through long and short trades rooted in strong fundamental research on companies and markets.
Bottom Line: Hedge funds delivered good relative returns during the first quarter in response to increased volatility. Some short positions finally paid off and fundamentals were more responsible for stock movement. 2014 should be a good year for hedge funds as we return to more normal levels of volatility which create a fruitful environment for active management and fundamental research. We have been more selective recently about the illiquid opportunities as private markets have come to expect richer prices as public markets advanced through 2013. While we continue to like the illiquid opportunity set, it’s been harder to find new and exciting investment opportunities.
Conclusion and Outlook
We expect to be more active in rebalancing portfolios this year if volatility continues. Our disciplined approach to asset allocation dictates that we increase allocations to asset classes that come under severe pressure during times of stress. Patience and discipline will lead to better long term results.
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