After earning 3% in 2010, Woodbine was off to a somewhat rocky 2011 start in January, down –2.53% net fees.
In its January investor update, Woodbine writes that it sees the global economy rebalancing taking one of two potential paths.
The first and most likely: the realisation of a soft landing in the emerging markets. IE slower growth and lower inflation in EM.
The second: inflation in EM, which would be a result of the rise in commodity prices’ encouraging speculative excess.
Woodbine is a relatively new global macro hedge fund. Two former Soros portfolio managers, Josh Berkowitz (former SAC and Goldman guy) and Marcel Kasumovich (former Goldman), founded Woodbine in 2009.
But despite being young, it’s huge and we suspect growing larger. The $2.5 billion fund recently hired Barry Schachter, a legendary quant who’s helped elevate Moore, SAC, and Caxton to become power houses.
Here’s Woodbine’s January update to investors:
Woodbine Capital returned –2.53% net of fees in January. We entered 2011 with a continued focus on cyclical exposure with hedges in the Euro area through a variety of currency, equity and interest-rate positions. We were long European short rates as a hike during potential bank problems seemed highly unlikely. Unfortunately Europe outperformed on all measures versus our cyclical exposure as the euro ended the month up 5% versus the Australian dollar and EuroStoxx up more than 5% versus the Nikkei. The shortage of liquidity in European money markets led to a sharp rise in effective and future overnight interest rates.
The synchronised downturn in 2008 was a healthy reminder that the world is an integrated place. Decoupling can occur for periods of time and stages of the cycle will differ substantially across regions. But correlations across asset markets and growth cycles will remain high by virtue of the fact that global economic supply chains and financial intermediation is increasingly connected. Yet, the market is again back to a decoupling thesis with the substantial outperformance of developed markets versus emerging ones. The story that markets want to tell is that economies with the most slack have the most room to grow and are therefore less at risk to a preemptive tightening in macro policies.
There are elements to truth in every story, and this one is no different. The broader measure of US unemployment is above 16% and trends in core inflation are less than 1%. It is not difficult to justify a long period of very accommodative monetary policy with those factors as your starting point. The case is less obvious for a country like Brazil. Capacity utilization is above the long-term average, the unemployment rate is at an all-time low, inflation expectations are higher than the central bank’s target, and credit growth is robust. It stands to reason that the risk premium in Brazilian assets would be much higher than those in the US, given the uncertainty on the timing of the tightening cycle.
The challenge with this line of reasoning is that the growth in developed market assets is integrated with the world economy. Roughly one-third of sales in S&P companies are to the emerging world, and that probably understates the importance of EM-related profitability. Consider Nike as an example. Emerging markets accounted for 18% of Nike brand sales in 2010. But the emerging world was responsible for 56% of the growth in earnings before interest and taxes. Clearly, the tightening in macro policies in the emerging world, to the extent that it is a risk to future demand, is quite relevant to corporate earnings. Likewise, Rio Tinto and Vale, two companies closely tied to the global metals cycle, are unlikely to diverge based on where the company is listed.
The biggest change in the macro outlook is how the global economy will rebalance. Last year, we were focused on exchange rates as a signal of an orderly, ordinary transmission mechanism. Emerging markets outperform, interest rates rise, developed markets lag, and purchasing power in the emerging world is enhanced by an appreciation of the exchange rate. The fact that we are not seeing the adjustment through exchange rates does not preclude it from happening. It is just a less traditional mechanism. There is more pressure on domestic income policies to achieve the rebalancing, and the uncertainty about those policies is much higher. We see two potential paths.
The first is the realisation of a soft landing in the emerging world. Much the way global policy focused on the US Federal Reserve achieving slower growth and lower inflation at the early stages of the previous expansion, that burden has been transferred to the emerging world. This is the most likely outcome. Already we have seen a material slowdown in leading indicators for China and Brazil, two leaders in the growth cycle, and the use of macroprudential tools is slowing excessive credit growth. Meanwhile, rate expectations in the developed world are playing catch-up to the pre-emptive tightening in the emerging markets. Expectations in the UK have shifted quickly from potential additional easing to the timing of pre-emptive hikes.
The second is a potential extension of inflationary pressures. While a soft landing in the emerging world may be the most likely outcome, the rise in commodity prices could easily encourage speculative excess with strategic buying. This is how inflation expectations become relevant for real economic decisions. In a low interest rate environment, companies may choose to strategically build inventory of goods whose prices are rising in anticipation of further increases in the future. This becomes self-reinforcing and is particularly risky for emerging markets, where it can be justified as a strategic use of bloated foreign exchange reserves. Given the sensitivity of raw commodity inputs to emerging market inflation, macro policies would need to tighten abruptly, and the risk of a renewed recession would rise. While an unlikely scenario, it is sufficiently damaging that it deserves attention.
Europe remains a lingering risk. We do not doubt the commitment of officials to provide a comprehensive package that minimizes systemic risk. But the path is still likely to be a bumpy one. European officials engineered a short- squeeze in peripheral assets last month, but pressure on bank funding and sovereign debt yields has yet to abate. Access to unsecured funding is limited, collateral for covered bonds is declining, and the timetable is running short. Some combination of a program for Ireland, Greece and Portugal as well as pre-emptive liquidity lines for Spain to ensure that bank restructuring can be funded would push European risks to the background for an extended period of time. The path to achieving that outcome is likely to be a bumpy one – it may take yet another funding scare to generate a political consensus.
The setup is far more supportive for the US dollar than it has been for a long time. This has the potential to feature more prominently in our themes in the period ahead: inflows into US equity markets, stronger US demand, and the prospects for a shift toward a less dovish posture from the US Federal Reserve. That has scope to ease some of the commodity price inflation. But it would also open the door for a decline in risk premium in emerging markets. Companies tied to domestic demand in Brazil, for instance, are down 20-30% since the start of November, despite ongoing signs of strong growth. This could also present opportunities to be long interest rates in regions where the yield curve has steepened considerably in response to the risk of an extended tightening cycle. The downturn in commodity-linked companies would be transitory with that in mind.
Our thematic risk is as follows:
1. Capital Goods Divergence
Our focus remains on commodity-based capital goods. Prices are strongly supportive of increased investment activity. We have increased exposure in the chemical and oil sectors.
2. China Rebalancing
Our exposure to China demand is concentrated in sectors where China is a price-taker and prices are less influenced by government intervention. Our exchange-rate exposure is indirect, in countries that export to China.
3. Mid-Cycle Policy
Our mid-cycle policy theme is geared to the use of non-interest-rate tools to generate the necessary tightening or easing in the stance of policy. US, Mexico, Brazil, and Poland rates stand out.
4. European Bank Restructuring
Europe’s sovereign and banking crises are now one and the same and will require further policy intervention. We have substantially reduced exposure geared to a long period of excess liquidity in the banking system. A positive policy outcome would be bullish for banks and German demand.
Long Spanish CDS funded through US homebuilders and long FX options for increased EMU stress funded through short USD-JPY volatility positions.