Brevan Howard Global commentary for the month of May 2016.
Overview:
Brevan Howard Global Global Limited (“BHG”) is a closed-ended investment company, registered and incorporated in Guernsey on 25 February 2008 (Registration Number: 48555).
Prior to 1 September 2014, BHG invested all its assets (net of short-term working capital) in Brevan Howard Global Opportunities Master Fund Limited (“BHGO”). With effect from 1 September 2014, BHG changed its investment policy to invest all its assets (net of short-term working capital) in Brevan Howard Multi-Strategy Master Fund Limited (“BHMS” or the “Fund”) a company also managed by Brevan Howard Capital Management.
Brevan Howard Global was admitted to the Official List of the UK Listing Authority and to trading on the Main Market of the London Stock Exchange on 29 May 2008.
Brevan Howard Global Monthly Commentary
The NAV per share of BHG’s USD shares appreciated by an estimated 0.24% and the NAV per share of BHG’s GBP shares appreciated by an estimated 0.20% in May 2016.
Brevan Howard Master Fund Limited (“BHMF”)
The NAV per share of BHMF Class Z USD shares depreciated by an estimated 0.09% in May. Losses in interest rate trading from long positions in Japanese volatility as well as from long US directional positioning were partially offset by gains from directional trading in Europe as well as European swap spread and peripheral bond trading. FX gains from tactical and volatility trading in sterling were offset from losses in Emerging market currency trading. Trading across other currency pairs contributed small gains.
Brevan Howard Asia Master Fund Limited (“BHA”)
The NAV per share of BHA Ordinary USD shares depreciated by an estimated 0.16% in May. Modest losses came from long gamma positions in US interest rates as well as from US curve trading. Further minor losses came from curve trading in Korean rates. FX and equity trading generated small gains and losses respectively with little by way of themes.
BH-DG Systematic Trading Master Fund Limited (“BHDGST”)
The NAV per share of BHDGST Class Z USD shares depreciated by an estimated 3.99% in May. In May, gains were recorded in the bond and agricultural sectors. BHDGST realised its most significant losses in currencies which accounted for 87.5% of the total loss on the month. In bonds, the model generally increased its long positions on European and Australian sovereign debt futures. In short term interest rates, the model increased its shorts in Canadian banker’s acceptance futures and increased its longs in short sterling futures. In index futures, long positions in European index futures were increased while the highest frequency of directional changes happened in Asia. In FX, the model reduced its long stance on the Japanese yen, cutting its long versus the dollar and increasing a short versus the Australian dollar. With EURUSD, the model cut its long throughout the month and flipped to a small short in the final week. With the exception of a short in natural gas futures, longs in energies were increased. In agricultural futures, the model flipped a long in soybean oil to a short, reduced a long in soybeans and increased a long in soybean meal futures. In metals, the strategy substantially reduced its long in gold futures.
Direct Investment Portfolio (“DIP”)
The Direct Investment Portfolio (“DIP”) appreciated by an estimated 1.25% in May. The DIP generated most profits in credit and interest rates trading. In credit both the corporate & MBS books contributed to the gains. In interest rates, short exposure to USD interest rates when rates sold off mid-month generated the bulk of the gains. FX trading generated additional small gains from short exposures to GBP, ZAR & EUR against the USD. Long exposure to oil produced small gains, whereas equity trading was flat.
Manager’s Market Review and Outlook
The information in this section has been provided to Brevan Howard Global by Brevan Howard Capital Management.
Market Commentary
US
Growth improved in May while the labour market slowed, reversing the pattern seen since the start of the year. Real GDP growth is tracking above 2% (annualized rate) in the current quarter, a noticeable albeit unspectacular improvement on the soft patch seen in the last two quarters. The improvement has been driven by consumer spending and housing, two areas of strength in the economy. However, business investment and net exports continue to be areas of weakness.
Job gains disappointed in May, currently at their weakest pace since 2010, and the participation rate dropped abruptly for the second month in a row. The drop in the participation rate left the unemployment rate at a cycle low of 4.7%. However, broader measures of labor market slack were unchanged. Wage gains remain moderate, suggesting that there is still at least some slack even at such a low unemployment rate. The news could be read in two different ways. As the economy comes into full employment, job gains are supposed to slow. However, the slowdown in the last two months has been sharp and widespread, so the question is whether the labor market is facing downside risks. After all, business sentiment and capex have been poor for some time and the worry is that hiring is beginning to wane at the same time.
Inflation is low. After seeing a pick-up in core inflation at the start of the year, recent prints have solidified the run rate at 1.6% over the last year. If import and energy prices stabilise, then the prospects appear favourable for a steady improvement in core inflation in the second half of the year. However, such an outcome is highly dependent on the exchange value of the US Dollar. In May, the US Dollar appreciated more than 3% on a broad trade-weighted basis. Such appreciations put downward pressure on import prices and make it difficult to generate higher core inflation.
The developments in inflation expectations are cause for concern. Survey measures of long-term inflation expectations from the University of Michigan and the New York Federal Reserve Bank have been trending down. Indeed, the Michigan survey has been at a record low or made a new record low in four of the six months since lift-off. Similarly, inflation compensation in financial markets has been trending down. According to Fed calculations, the so-called 5-year/5-year forward breakeven inflation rate (“BEI”) is 25 basis points below where it stood at lift-off. The 5-year/5-year BEI had been following the path of crude oil prices for much of the year. However, in May crude prices rose to local highs while the 5-year/5-year BEI rolled over in sympathy with the appreciation in the US Dollar. In her most recent speech, Chair Yellen highlighted these negative developments saying, “The indicators have moved enough to get my close attention.” That’s a warning shot that these expectations have to improve for her to have confidence that inflation will move back to two percent.
At the recent FOMC meeting, the UK referendum on EU membership dominated discussions. If that uncertainty is resolved in favour of the status quo, then the upcoming Fed policy decisions will revert to being data dependent. If the UK votes to leave, all bets are off and US and global policy makers will shift into crisis prevention mode.
UK
Economic growth in the UK has slowed in recent quarters. GDP grew 0.4% q/q in Q1 of 2016, down from 0.6% in Q4 2015. The manufacturing sector remains subdued, with output falling 0.5% q/q in Q1, although it rebounded in April, helped by the weakening of the currency in the previous months. The construction sector also struggled, contracting by 1% q/q. Services output was resilient, growing 0.6% q/q attributable to buoyant household consumption. The impending referendum on EU membership has likely hampered investment decisions. Various business surveys have cited the referendum as having delayed business decisions, which would cause growth to slow. GDP is expected to slow further to 0.2% q/q in Q2. Retailing has moderated as well in recent months, though it remains relatively buoyant when compared to other sectors, with sales growing around 3.5% y/y in volume terms. Consumer confidence remains high relative to history, but has also moderated since the start of the year. Activity around the housing market has become more volatile than usual on account of the recent policy changes on buy-to-let properties. New mortgage lending in March doubled relative to the previous month as borrowers tried to finalize housing purchases before the policy changes came into effect in April. Consequently, net mortgage lending collapsed in April. New buyer enquiries, as reported by residential real estate surveys, have collapsed in recent months indicative of subdued activity in the housing market, which may follow through to slower house price inflation. Activity in the commercial property market has fallen sharply, and can be attributed to delayed investment decisions on account of the referendum. The unemployment rate was unchanged at 5.1% for the fourth straight month. Employment growth has slowed considerably, growing a mere 0.2% in the four months to March. Jobless claims fell by 2,300 in April, but only after rising 14,700 in March, the largest single month rise since 2011. This reflects how the uncertainty caused by the referendum has fettered hiring intentions. Wage inflation remains modest, only recording 2.1% in April (latest three-month average) still well below pre-crisis average levels. Core inflation fell back down 0.3ppts to 1.2% y/y in April. Similarly, headline inflation fell 0.2ppts to 0.3% y/y, still being weighed down by low commodity prices.
The Monetary Policy Committee (“MPC”) again unanimously voted to keep rates unchanged (at 0.5%) at the latest meeting in May. In the event that the UK remains in the EU, Bank of England Governor Carney said the next move in Bank rate was most likely going to be up. However, other members of the MPC have questioned the extent to which the recent slowdown can be attributed to the referendum. Moreover, there remains little price pressure to justify a rise in the Bank rate. If the UK were to leave the EU, Carney said the policy response would depend on the relative magnitudes of the fall in demand (via economic uncertainty) and the rise in inflation (through a lower exchange rate and lower labor supply). He added that there was on balance a lower probability of a rate rise should the UK leave the EU. The outcome of the referendum will largely shape the evolution of the economy in the medium term. If the UK votes to remain in the EU, then the economy is expected to recover in the second half of the year. If the UK votes to leave the EU, we expect the uncertainty around the exit process will further stall investment and hiring, which in turn may lead to the MPC lowering interest rates.
EMU
EMU GDP grew by 0.6% q/q in the first quarter, with domestic demand the main driver. However, this strong outcome was also due to some non-repeatable factors, stemming from the steep drop in energy prices due to unseasonably warm weather. Looking forward, a moderation of growth appears likely in the second quarter, with activity dynamics in a number of key sectors suffering from a negative statistical carry-over. While consumer confidence indicators have regained ground in May, the rebound in oil prices could weigh on consumer spending in the coming months. At the same time, business surveys remain generally stable with the May composite Purchasing Managers’ Index (“PMI”) at 53.1, broadly unchanged since February, although manufacturing orders appear to have weakened. Meanwhile, the labour market continues its gradual adjustment, with the unemployment rate falling to 10.2% in April, the lowest level since August 2011. Inflation in the euro area continues to hover below zero, but a base effect should gradually push it higher in the second half of the year. The Harmonized Index of Consumer Prices (“HICP”) inflation rate ticked up to -0.1% y/y in May from -0.2% y/y in April, led by a recovery in energy prices. Although core inflation gained 0.1 ppts during the month, it is still low at 0.8% y/y, failing to show signs of an upward trend. M3 slowed from 5.0% y/y to 4.6% y/y in April, while credit growth, albeit supportive, is insufficient to produce a strong impulse for the economic recovery.
The European Central Bank (“ECB”) is focusing on implementing its March easing package, from the new Corporate Sector Purchase Program (“CSPP”) which will start in early June, to the long-term loans (TLTRO-II) launching at the end of June. At its June policy meeting held in Vienna, the ECB revised its growth forecast marginally up for 2016 to 1.6% from 1.4% estimated in March, while keeping the 2017 forecast unchanged at 1.7%. Despite the rebound in oil prices and the effect of additional Quantitative Easing (“QE”), the HICP inflation forecasts were left unchanged in the medium term, at 1.3% for 2017 and 1.6% for 2018, still quite far from the ECB target of “below, but close to, 2%” with core inflation revised down along the projection horizon.
After weeks of negotiations, Greece and its main creditors found an agreement which paved the way for disbursement of the next EUR 10.3bn bailout tranche. As it stands, EUR 7.5bn will be released in June, with further payments contingent on clearing government arrears. Some small progress was made on debt relief with an agreement to ease Greek payments in the short term and potentially larger debt relief in the medium term in 2018 after the current bailout is completed. While this has not been finalized, it could involve extending the maturity of Greek bailout loans, repaying profits on bonds held by the ECB to Greece and buying out the more expensive IMF loans using leftover funds from the bailout. IMF participation in the financing program remains far from certain after the latest Eurogroup agreement.
China Activity data in China for April/May showed mixed signs, but supported a rebound of GDP in Q2 after the Q1 lull. In May, the official Purchasing Manager’s Index (“PMI”) came out slightly better than expected, but the Caixin PMI fell from its prior figure, with details less encouraging, as the new orders to inventory ratio softened. Industrial Production (“IP”) growth y/y in April fell to 6%, below the market consensus figure, partly due to a high base effect. In addition, fixed asset investments growth also slowed to 10.5% YTD in April, below expectations, while retail sales posted somewhat better figures than its prior reading. Export growth in May fell to -4.1% y/y from its prior figure of -1.8% and the weakness was broadly based across most domestic markets. Negative import growth has narrowed significantly to -0.4% y/y in May as commodity prices and import volumes of commodities recovered further. As a result, trade surplus recorded a decent figure of US$50bn. Consumer Price Inflation (“CPI”) fell to 2% y/y in May due to falling food prices, while core inflation is above its historical median.
Despite better data flows since March, the People’s Bank of China has maintained an accommodative monetary policy stance as the foundation of a solid recovery, especially for the second half of the year, has not yet been well established. The 7-day repo rate rose slightly to approximately 2.4% but has stabilized at this low level since then. Despite less encouraging credit data in April following a strong figure in March, total social financing growth since the beginning of the year remained strong in April. Investments in infrastructure and investments by State Owned Enterprises, both of which are a gauge of policy-driven growth, have rebounded notably in Q1 and in April, but there is little multiplier effect observed outside these sectors.
Japan
Prime Minister Abe announced a 2 1/2 year delay in the implementation of the second round of the consumption tax hike. The plan now is to raise the consumption tax rate by two percentage points in October 2019. The delay will avoid the risk of triggering a serious economic slowdown in 2017, as had occurred when tax rate was raised in the past. It remains to be seen how expansive fiscal policy will be next year. Prime Minister Abe has indicated that he will announce a significant economic package this autumn. It also remains to be seen what economic structural reforms will be proposed; early reports do not suggest major changes.
Real GDP posted a 1.9% increase at an annualized rate in the first quarter. While a solid outcome on the surface, a longer quarter due to the leap year can explain its strength. More generally GDP has been flat over the past 2 1/2 years, and the output gap has slightly widened over that period. Other data corroborate the soft trend. Industrial production has trended down at a moderate rate. The Shoko-Chukin survey of small and medium-sized businesses ratcheted down in the middle of 2014 and has largely moved sideways at a level just below the par line. The Tankan survey performed somewhat better, remaining at a decent level. In contrast, the Economy Watchers’ survey suddenly lurched down in the first quarter, and the reading for May was up only slightly over April.
The Bank of Japan’s re-inflation project has faltered even more. In the latter half of 2015, national consumer prices excluding food and energy had accelerated, but over the last eight months such prices have only edged up 0.3% at an annualized rate. Household inflation expectations have also slowed, unwinding all of the gains seen since the introduction of Abenomics. More recently, a daily price index that was previously produced by the University of Tokyo and now published by a private firm is slowing rapidly. These data, which are based on scanner data collected at the point of sale at grocery stores and similar markets, had been running at about a 5% annualized rate at the start of spring. Through the thirty days ending in mid-June the daily index is up only 1.4% at an annualized rate from thirty days previously.
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