For some people, Christmas comes in November. This was the case for market participants, who benefited from the anticipated “Santa-Claus Rally.” As mentioned in the October column, 2005 has been a tough year, save for a few event-driven funds (managers who invest based on corporate events such as mergers, spin-offs and restructurings) and global macro funds (managers who trade based on economic fundamentals and geopolitical analysis).
Thankfully, stocks around the world exhibited positive performance this past November. In the United States, the S&P 500 gained +3.5%; the Nasdaq +5.4%; and the Dow Jones +3.9%. In Asia, Hong Kong gained 3.8% while the Nikkei went on a tear and jumped 9.3%. As a side note, the Nikkei’s recent run has been fueled by non-Japanese investors, who are becoming more bullish about the country’s economy. Interestingly, domestic investors, still weary after a decade of deflation, are mostly sitting on cash and bonds. Should domestic risk appetite increase, it would translate into a well-sustained rally for the Nikkei.
But Japan wasn’t the only strong market in Asia this past month: The Kospi, an index representing Korean stocks, gained +12.0%. While the private equity community is complaining about recent moves by the Korean government to limit the access of foreign capital in some areas, the hedge fund and mutual fund communities are still enamored with the country-and for good reason as shown by the Kospi’s 2005 outstanding performance.
At this point, I’ll re-emphasize the fact that November was too good to markets around the world. Mexico, thanks to positive sentiment, stemming from low inflation, gained +6.8%. Russia, which along with Korea has been one of the best markets in 2005, was up a mind-blowing 13.6%. In recent months, global capital in search of a home has been knocking on the door of Russia looking for deals and investments. As you probably guessed, high oil prices favorably helped the trend.
Finally, our world tour wouldn’t be complete without a stop in red-hot India, where positive sentiment about the country helped the Sensex index gain + 11.4% (no explanation needed), and sunny Iceland where the ICEX 15, which is up 50% this year, gained +9.2%. So if you didn’t get the drift, investors everywhere experienced the Santa Claus rally.
On the currency front, the USD took everyone by surprise (well, almost everyone.hum, hum) by strengthening significantly against the majors (GBP, EUR and JPY). FX traders shifted their focus from the U.S. deficit to interest rates differentials after another telegraphed hike from the Fed. With ECB keeping short rates at a meager 2% (until a few days ago), the Bank of England lowering its benchmark rate and the Bank of Japan sticking by its 0% policy, U.S. short-term Treasury rates at 4% looked attractive. Hence, strong inflows into U.S. fixed-income securities (including corporates) helped shore up the dollar.
In commodities, crude oil retreated from $60 to around $57 and gold hit $500 per ounce for the first time since 1983 (interpreted by some as a sign of higher inflation expectations). But the most interesting commodities market proved to be copper. Drama and intrigue were in the cards, as copper prices jumped from $190 to $220 after rumors spread that a copper trader for the Chinese government had run massive losses by being short 200,000 plus tons of copper (roughly $800MM USD at current prices). Lin Qibing was bidding on behalf of China’s State Reserve Bureau (SRB) – a secretive organization-turned-metal-stockpiler. He went missing and was subsequently disowned by the SRB. The initial dissociation attempts by the SRB proved clumsy – Oibing was very well known by global traders and bankers in the metals market – and market participants wondered if the SRB would try to renege on the trades. The story is still unfolding.
Since this is the last issue of the year, I leave you with some things to ponder over the break. As you may know, the shape of the yield curve – a graph representing the various maturities for US Treasuries – is generally upward sloping. An inverted yield curve, where short-term rates are higher than long-term rates, historically has been one of the best predictors of recession. For example, the curve inverted in 2000, shortly before the downturn. It makes intuitive sense because an inverted curve shows that fixed income investors are bearish about future economic prospects. In addition, institutions that rely on a positive spread between short and long-term rates (like financial institutions) are unable to generate profits by borrowing at low rates and lending at higher rates in an inverted curve environment. Finally, inverted yield curves generally materialize in periods during which the Federal Reserve is raising short-term rates, which increases the cost of capital for business and consumers, hence slowing down the economy. In recent months, the yield curve had been flat but not yet inverted. However, in November, part of the curve did slightly invert for the first time: five-year rates went below two-year rates (-0.70bps), indicating expectations of high rates/high inflation in the near term and a softer economy in the long run. The overall curve is roughly flat, so there is still hope that it will go back to its normal shape once the Fed stops raising rates. But if it does invert – and the theory that long rates are low due to massive buying by Chinese and Japanese central banks proves false – it may make sense to prepare for economic headwinds.