Geopolitical tensions are at fever pitch throughout the West in the wake of the crisis in Ukraine. We have lived through numerous similar events, all of which gradually fizzled out. Many a cynic would be forgiven for saying “this time is no different.” The battle-hardened among us have grown accustomed to booms, busts, and things working themselves out. However, now, the largest Sovereign Wealth Fund in the world is warning that this time really is different. Although the the response from central banks is more of the same, what’s changing is the effectiveness of those stopgap policies.
Norway’s $1.3 trillion Sovereign Wealth Fund posted gains of over 14% in 2021; its best performance since 2018. Despite the decent performance, Nolai Tangen, the fund CEO, has cautioned that 2021’s gains may have formed the apex of their return capacity, for a long time to come.
Mr. Tangen told reporters:
”This tremendous increase we’ve experienced over the previous 25 years will not continue. Interest rates are at an all-time low, and equities are at an all-time high, so we’re in for more hard weather from here on out.”
— Nolai Tagen, Norwegian Sovereign Wealth Fund CEO
In times of uncertainty, actively managed funds have had a tendency to outperform their passive counterparts. Having said that, fund managers who were more responsive to the volatile nature of global markets also proved to be the best money management strategies throughout the pandemic.
Expectations of dismal returns in the equity and bond markets have become common across the board, due to fears of impending double-digit inflation. While sell-side reports from investment banks may often be taken with a grain of salt, when the CEO of the world’s largest fund issues bearish guidance, it is all the more credibly alarming.
Inflation continues to soar across the world. Price pressures in the United States reached their highest level in four decades in December 2021. It is abundantly clear that inflation has already begun to manifest itself, with the Consumer Price Index recently rising to 8.5%, potentially foreshadowing a further move northward into double-digit territory.
CRISIS AFTER CRISIS
Thanks to the concerted efforts of politicians and central bankers to subdue high unemployment levels and provide price stability, as per the mandate of the US Fed, a tsunami of freshly-minted money has thus far mostly culminated in higher valuations for stocks, bonds, commodities, and even cryptocurrencies.
47% of all money in existence was printed since the pandemic.
Monetary and fiscal stimulus has now begun to find its way across all industries and down to consumers, raising market competition for the limited assets and products. Buyers are finally emerging from a lengthy grapple with a global pandemic which disabled production capacities and slammed the brakes on consumer demand across most developed nations.
The rebound from lockdowns has seen producing nations greatly benefit from the return of consumers now facing limited supplies of goods, products and assets, coupled with exorbitant freight costs.
After the 2018 market setback, when the S&P 500 plunged by more than 6%, investors have been expecting an inevitable long-term pullback, which has yet to truly manifest. The impact of COVID-19 on the global economy has had a similar impact on the psyche of investors as did the “Credit-Crunch” recession of 2008, which led investors to seek safe-haven allocations.
”The homogeneity of hedge funds should be all the more concerning because correlations tend to increase even more during times of crisis.”
— Manas D. Kumaar, PWE Capital Group CEO
A notable aspect of the 2020-2021 saga has been the return of market inflows following 2020’s $68.5 billion outflow, according to EurekaHedge data. With the global economy slowly gaining traction after international trade and business activities were allowed to resume, investment capital has continued to flow back into active strategies, highly concentrated in North America. The US tilt was likely due to the relative attractiveness of higher US interest rates and the hawkish stance of the Federal Reserve, led by Chairman Jerome Powell.
An industry total of $1,634 billion worth of assets under management was reached, with most funds (76%) having a global investment mandate aimed at diversifying fund risks to individual regional shocks. Although the bulk of funds are internationally oriented, a large minority sought safety in the arms of Uncle Sam. Over 20% of allocations went to the domestic US market.
Indeed, funds with a North American mandate proved to be the best performing regional allocations through 2021, as indicated by EurekaHedge data. While the US dollar suffered significant losses in 2020, the global reserve currency outperformed all other currencies and later gained over +6% in 2021.
Although the “Safe Haven” plays – whereby investors have traditionally sought the safety of US government bonds, assets and dollars – has been the go-to strategy during periods of turmoil such as the 2008-crisis and COVID-19 global outbreak, it was however recently noted by Manas D. Kumaar, PWE Group CEO, that “The homogeneity of hedge funds should be all the more concerning because correlations tend to increase even more during times of crisis.”
Active currency market strategies are typically uncorrelated with other asset classes and hence provide appealing diversification benefits within most investors’ asset allocation frameworks as we previously highlighted.
Why then, are currency strategies so underutilised? The below charts depict the composition of the hedge fund industry, by Assets Under Management.
Over the past two years, Currency CTA fund AUM has grown by almost 70%, from $19.4bn in 2019 to $32.8bn by the end of 2021. Despite the vast inflows since the crisis, currency CTA funds only account for 0.46% of the industry. Some currency funds may fall into the ‘Other’ category, but that is also only 0.868% of the industry, according to BarclayHedge data. Fixed income has seen the largest inflows, along with traditional balancing between bonds and stocks. This flight to safety is all the more surprising given lacklustre yields. Is fixed income still the safe haven that it once was? Is earning a close-to-double-digit negative real yield, by investing in bonds of heavily indebted Empires in their death-throes, ‘safe’?
U.S. FED BALANCE SHEET
Prior to the 2008 financial crisis, the Fed’s balance sheet was about $800 billion, under the leadership of Chairman Ben Bernanke. However, following the events which led to the global financial crisis of 2008, the Fed’s balance sheet proceeded to balloon in excess of $7 trillion by mid-2020.
The years following the 2008 financial crisis proved that even reducing interest rates to zero was deemed insufficient support for collapsing economies. Time and time again the market has expressed niggling doubts about the unorthodox measure which the US Fed has resorted to over the years. Is this continued stance creating a moral hazard for the entire industry?
The evolution of Quantitative Easing as the Fed’s go-to instrument in times of crisis has resulted in an extraordinary volume of money in circulation, exacerbating the current inflationary pressures being felt across the globe post-Covid.
It is worth questioning, “is 2022 the year?” This is a reasonable question, especially considering the Fed’s previous attempt to wind down its asset purchase programme back in 2013. The 2013 policy shift provoked the so-called “’taper tantrum””, an event whereby Investors panicked and triggered a selling-spree in bonds followed by a rise in Treasury rates. The new round of monetary policy tightening under the Powell’s Federal Reserve bank may cause similar effects to those which led Asian developing markets to experience significant capital outflows and currency devaluation, pushing Asian central banks to raise their respective interest rates in order to defend their capital accounts against a flight back to the safe haven that is the US market. Back then, money inflows to the US helped to strengthen the US Dollar index and equity valuations, but now, US markets are none-too appealing. It seems as though there is nowhere left to hide.
Having been hard at work to support US stock markets since 2008 through the use of unorthodox monetary policies and measures, the delayed impact of the Federal Bank’s endless money printing programme now sees the potential risks from the combined US Economic Stimulus rescue packages, and extended period of low interest rates, threaten the US Dollar’s positions as the world’s reserve currency due to looming inflationary pressures at home.
Due to the fact such unorthodox economic measures have always been accompanied by the drastic risk of decreasing the international value of the US Dollar through hyperinflation, quantitative easing has always been regarded as a temporary measure that has now been long extended beyond its effectiveness, to now acting as the main ‘’life-support’’ for the global economy.
As the market continues to anticipate further rate increases, from March 2022 onward, and as communicated by Chairman Powell, volatility in the global equity, stocks, and bond markets, it is reasonable to expect that volatility ought to reflect levels reached during the “Taper-Tantrum” of 2013. Add to that the current tensions in Eastern Europe, and you’ve got a strong possibility of a new level of taper-tantrum, like never before.
With the global allocation of assets by fund managers being largely driven by the “Safe haven” US plays and perceived anti-inflationary assets such as gold and other commodities, the over saturation of fund movements back into the world’s largest economy may raise further systemic risks. Global allocations may once again become highly concentrated in a region that is anything but safe from inflationary pressures.
The US “Safe haven” play relies on expectations and confidence. It is founded on the premise that others will follow suit, which is akin to a “greater-fool” investment thesis. Indeed, modern Keynesian economic policies are largely based on influencing expectations. But what happens if the market utterly loses confidence in the Fed? Moreover, the US dollar is arguably the most overvalued asset in history. US consumption is effectively subsidised by the dollar’s reserve status and cheap imports. Both of those crutches are subject to change.
If the inflation persists, as predicted by the likes of Norway’s Tangen, it will also create opportunities. Inflation is one of the main determinants of currency exchange rates. Trends in inflation equate to trends in currency markets, which is a boon for active strategies that can accurately capture those trends. A key requirement for effective risk management for high returns will likely encompass the utilisation of currency hedging strategies throughout 2022 and beyond. If the US Fed embarks on its rate normalisation journey away from the “Zero-bound” in any meaningful way, it will dramatically alter the investment landscape.
DARK CLOUDS ON THE HORIZON
The recent surge in interest rate volatility and dramatic repricing of central banks’ near-term policy course has already claimed a few casualties. Norway’s Tangen strongly believes that the current rate of inflation will have a long-term negative impact on investment returns beyond 2022. 2021 already saw surprise rate decisions and recommendations from policymakers – ranging from Brazil to the United Kingdom – catching many investors off-balance.
Some of the world’s most prominent macro hedge firms sustained colossal losses following the recent market meltdown of September 2021 to January 2022. Many were caught off-guard by a burst of central bank’ miscommunication and the ensuing abrupt re-pricing of rate expectations.
Currency hedge funds will play a greater factor in the overall performance of fund returns as we approach the realistic possibility of hyperinflation in the years ahead, thanks to extensive periods of QE, profligate monetary policy and excess liquidity across the globe.
THE NEED FOR CURRENCY STRATEGIES
Another common objection to the current era of easy money is that such unorthodox policies act as a catalyst for moral hazard on the part of governments. The medicine can be worse than the cure, if taken excessively for extended periods.
Market discipline in the form of rising interest rates, in particular, can be utilised to compel governments to reconsider increasing deficit expenditure with “Shovel-ready jobs.” However, this is no longer the case when the US central bank now operates as a last-resort bond buyer and is willing to acquire government assets indefinitely – rendering market discipline near-impossible to achieve without serious repercussions.
Between 1921 and 1923, the German Papiermark, the currency of the Weimar Republic, experienced hyperinflation, most notably in 1923. The price pressures led to significant internal political instability in the country, an ensuing occupation of the Ruhr by France and Belgium, followed by overall suffering for the inhabitants.
100 years later, the world’s largest economy is once again following in the footsteps of the Ancient Greeks, the Romans, and every other civilisations that printed money until their inevitable spectacular collapse.
In 2022, uncertainty may be the only certainty. The good news is that active investors can expect large potential for Alpha generation as we enter an era of shifting sands.
Considering the above, it is now more evident than ever that a fund’s ability to correctly predict, anticipate and effectively manage their underlying currency risks will yield greater returns than traditional portfolios primarily focused on the diversification of their equity holdings. At the end of the day, the value they eventually return to their investors is denominated in currency.
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