Monday, April 11, 2016

Racing to the Bottom

After another week of high volatility and powerful currency movements (not to mention articles about active managers seriously underperforming the market) even the most hardened global macro manager will be sending out for cases of comfort food.  While it’s easy to fit their underperformance into the “passive is always better” narrative, even Jack Bogle might be tempted to cut his active colleagues some slack as the fallout from negative interest rates continues to take a toll on the markets with the S&P 500 experiencing three trade days last week with a greater than 1% movement not to mention the fact that real yields on the ten-year Treasury slipped into negative territory last week thanks to rising core inflation.

The truth is that investors are experiencing the consequences of past decisions and the fallout from the early experiments with negative interest rates.  At first glance it seemed so simple, negative rates would help spark inflation and with lower rates it would substantially reduce the true “cost of money” encouraging lending, spending and possibly curing male pattern baldness at the same time.  Instead it’s provoked a level of anxiety among professional money managers that even readers of Zero Hedge might consider excessive as the playbook that’s guided managers since 2011 has been officially tossed out the window.  But we’re wondering if in their haste to find something that works, they’re being a little too quick to get behind a new investment philosophy.

Some old rules still apply, starting with things that go up will eventually come back down as those who are long the dollar continue to discover their pain.  Not that many people are focusing on just the dollar although 2014’s big move in the PowerShares DB Dollar Bullish Index Fund (UUP) reminded more than a few people of John Murphy’s famous bump and run formation (or BARF) which usually ends in a major pullback and with UUP finally closing below $24.50, it seems like a trip back to $22.50 is in the offing.   But dollar weakness is old news and the Yen offers a much juicier story as more and more investors wager that the BoJ, like the ECB, can only make rates so negative which along with Janet Yellen’s uber-dovish stance helped send the CurrencyShares Japanese Yen Trust (FXY) surging over 3.2% for the week on volume more than 4X what you would see in a normal week.  The WSJ and FT are full of articles talking about traders hoping that the Fed continues to deliver the pain to the dollar but short covering was a more likely motivating factor as Yellen’s uber-dovish stance continues to cut the legs out from under those who hoped the dollar could repeat 2014’s success story which would explain the 21% drop in FXY’s assets last week along with a 20% drop in outstanding shorts.

Whether short covering or not, the end result was the same with hedged Japanese equity funds seeing a major drop in their ETFG Behavioral scores last week led by the WisdomTree Japan Hedged Tech, Media and Telecom Fund (DXJT) with a 37% drop on a 4.55% loss for the week although the tiny fund did manage to recover a large chunk of its losses with a nearly 4% gain on Friday.   It’s been a wild ride for DXJT investors over the last year; the fund was hovering close to $30 in mid-2015 before pullback in the run-up to the Fed’s rate hike plans later in the year sent the fund plummeting to $20 in February and a similar story has affected nearly every fund in WisdomTree’s Hedged Japanese equity fund line-up.  Turns out DXJT wasn’t the leader in a new trend but the last fund to feel the burns as the fund is now down over 13% in 2016 although investors should consider themselves fortunate compared to holders of the WisdomTree Japan Hedged Equity Fund (DXJ) which you won’t find on our list of biggest weekly movers as its behavioral score has long since backed off its highs as over $3 billion has been pulled from the fund in the last three months while losing over 17% in 2016.

Volatility and international equities are going to be a running theme here but while the media is fascinated by Japan and the Yen, investor interest in Latin American equity funds continues to wane.  Our ETFG Behavioral Top Scorers continues to be dominated for yet another week by the iShares MSCI Brazil Fund (EWZ) whose 6.4% gain on Friday was almost enough to push the fund back into the black after four straight days of losses.  The fact EWZ continues to dominate the Behavioral Lists isn’t terribly exciting, in fact it’s probably to be expected after years of double digit losses made it one of the most despised international funds in the market (and boosted its implied volatility) while its recent success has led to a major climb in its short interest ratio which kept the fund in the top spot despite its inability to get above $27.  What’s more interesting to us is that while EWZ might still be gathering headlines, waning price momentum has knocked nearly every other Latin American equity fund off our Behavioral list with the iShares Latin American 40 ETF (ILF) having fallen all the way to the #94 spot while the iShares MSCI Chile Fund (ECH) has dropped off the list and the iShares MSCI All-Peru Fund (EPU) was one of this week’s biggest behavioral losers.  If Latin American funds were one of the early winners of the breaking of the buck, does their lackluster performance now signal a bigger shift is ahead.

Ultimately, every winner in this latest rally depends on a weaker dollar and while Janet Yellen has done everything she can to help, the ultimate burden will be on other central bankers to weaken their own currencies in the race to the bottom.  Given the willingness of the Bank of Japan to intervene in currency markets and extensive history of doing just that, how willing are you to step in front of the BoJ even for just a day?

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