Running the obstacle course

By Walter Molano, Guest Columnist

The shortening days and chilly mornings confirm that autumn is on its way.

It also reminds us that we are entering the fourth quarter, before closing out what has been a painful year.

With some of the most-storied hedge funds returning money to investors, it affirms the fact that the global macroeconomic environment has been difficult. Indeed, it has been virtually impossible to gauge.

What started as a promising year, with the European Central Bank backstopping the banks through the LTRO programme, turned into a morass of European political fumbling.

Greece was forced to restructure its debt. France had a major change in political direction, and Germany could not make up its mind on what would be its final position on the fate of the periphery.

At the same time, Spain came clean about the rot at its banks, and Italy put limits on what it would allow Monti to do.

All the while, the US economy continued to recover, but at a very slow pace. Now, people are waiting on the sidelines to see what happens next week with the German constitutional court.

Provided that the ruling is favourable, we believe that the market could be in for a rally.

There are plenty of reasons for optimism. After a lot of soul-searching, there seems to be a clear commitment by Germany to ensure the preservation of the Eurozone. The Germans are beginning to realise that they have the most to lose from the dismemberment of the common currency. The new DM will soar, exports will collapse and the unemployment rate will spike.

Likewise, there has been a lot of progress across the periphery. Fiscal deficits are lower, labour regimes are more flexible and exports are higher. Therefore, with a better outlook for Europe, there is no reason why investors won't want to come back into the water before winter sets in.

A lot of money has been sitting on the sidelines and people are hungry to put it to work. While there has been a bit of new issuance, most of it has been in higher quality names.

Emerging market CFOs are busy looking for alternative sources of funding away from European banks. These institutions are no longer lending as aggressively as they did in the past. There has also been quite a bit of improvement in the high-beta names, like Argentina and Venezuela.

Higher oil and grain prices helped both of them, as well. Nevertheless, there is still a great deal of value across the corporate and provincial landscape. This is going to become painfully evident, as investors realise the meagre returns they are receiving from investing in high-grade emerging market names.

Asset managers, particularly the larger ones, are reporting constant inflows.

One of the reasons for the inflows is the move by traditional institutional investors, such as university endowments, insurance companies and pension funds, to heed the advice of their consultants and increase exposure to the emerging world.

Now, with a better global outlook, the overall appetite for risk will rise and push the market higher.

However, two major problems are on the horizon. The first is the fiscal cliff in the US. The expiration of tax cuts along with the simultaneous imposition of mandatory spending cuts will push the economy into a recession, unless the congress finds a way to avert the crash. Unfortunately, partisan politics and the electoral agenda preclude any solution to the problem until after the New Year. Surely, this will add a spasm of volatility to the marketplace. Yet, a larger concern is the structural problems facing our industry.

There is a dangerous asymmetry that is building between the buy side and the sell side. On the buy side, the growing importance of large traditional institutions that have little to no experience in emerging markets is leading them to channel their funds into well-established houses.

With careers on the line, few fund managers will take a punt on a small, no-name, hedge fund—regardless of their track record. This is leading to an incredible concentration of assets, at the very moment when the sell side is providing less liquidity.

The end of prop trading, the need for greater collateral to trade risky assets and the need to shrink balance sheets left the markets with very little liquidity. So far, it has not been a problem because institutional investors continue to pour money into the asset class, instead of looking for bids.

However, when redemptions begin to arrive, there will be a great deal of dislocation due to the sell side's inability to support the market.

Fortunately, that day is still some way away, and it will probably coincide with a reversal of US monetary policy.

In the meantime, we can expect brighter days as fund managers try to lock in a decent finish to a lacklustre year.

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC. wmolano@bcpsecurities.com.