Spanner in the works

Do not get too comfortable. The global economy is by no means out of the woods yet. And hedge funds are facing one of their most challenging years, not in terms of ability to outperform, but to survive the vagaries and interference of politicians and regulators.

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Some of the things that could throw a spanner in the works include too early/too high interest rate rises and quantitative easing, over-eager regulation that is ill thought-out and incoherent, the threat of sovereign default and another major banking crisis, this time in China.

First, interest rates. The eurozone may think it has made a soft landing out of recession but this could prove illusory. The recovery may be real and sustained. However, there are quite a few pressures on the zone that could derail the recovery train.

The European Central Bank’s (ECB) optimism may result in a rise in interest rates that is too much and possibly too soon. Fears over the possibility of inflation seem to be over-riding what others outside the eurozone fear more: a sovereign debt default. There are several candidates for this. Greece, Spain and Italy are still on wobbly ground. Ireland was in a similar shape but seemingly in control. Any of these could trigger a crisis within the union.

It is difficult, however, to see how the ECB can enforce its rules let alone ensure its members implement and follow budget cutting and re-financing measures. Domestic concerns vary across the zone. One could argue that the convergence of the currencies prior to forming the union was somewhat forced and that the economic differences between members remains too great to guarantee a stress-free eurozone.

At present ECB and eurozone member states seem intent on putting the heat on the errant member states, content to make them sweat (a lot). This approach may help them avoid a moral hazard issue but it is unsettling to markets and potentially could end in tears for the still young currency grouping.

This is the first major test of its ability to cope with the widening disparities between euro members. How it confronts this challenge will colour the way the grouping is viewed in future. A positive outcome will further enhance the euro’s growing popularity and build confidence in the ECB as a leading international player.

If, however, the zone runs into even more problems, it is unlikely to destroy the currency union – something that would ultimately also have the potential to demolish the EU itself but rather could destroy confidence in the currency and in the ECB’s ability to govern the group.

As the recent poll result on the Hedge Funds Review website shows, a good majority believe the risk of a eurozone member defaulting on its debt is a real possibility. As with many other things in the financial world, perception can count for more than reality. If it perceived that the default could happen, there is the risk of that becoming reality.

In the UK the May general elections are putting the country into a limbo state that could make a still nervous market even more jumpy and volatile. Speculation that the election could result in a hung parliament (something that probably is less likely than a slim majority or the need for a whichever party that ‘wins’ to form an alliance with the Liberal Democrats in order to have a working majority) is not helping sterling. Speculation that a hung parliament would cause a run on sterling is not making it easy for the government to manage the currency while tackling the whopping budget deficit, but this is probably wide of the mark. However, there is a danger that the ruling Labour party may try to win votes with the introduction of rash policies or promises, while the want-to-be-in-power Conservatives seem to lack a clear, coherent and workable plan to reduce Britain’s debt without slowing growth to near zero.

Meanwhile, there are concerns that the Bank of England might ease quantitative easing before the economy is in a full recovery state. The bank is aware of the dangers. Whether it can steer a sensible and correct path in the face of political turmoil remains to be seen.

On the regulation front things have become even more confused and uncertain. With US President Barack Obama’s push for radical banking reform, the government looks like it is heading into Glass-Steagall 2.0 as well as emulating the EU’s clumsy attempt to regulate alternative investments.

The US and EU proposals share two common themes that does not augur well for the future of regulation: confusion and lack of detail. Both Obama’s reforms and the EU’s draft alternative investment fund managers (AIFM) law start from rather confused premises and wander off into even more perplexing language. Both initiatives also plunge the hedge fund world (among others) into limbo territory. Until the detail is spelt out, the parameters defined and clarity given to the way these pieces of legislation will be implemented, no one can be certain of their effects.

This is not a good way to start 2010. Continued and prolonged uncertainty in too many parts of the financial system makes for continuing nervousness in areas where stimulus and a degree of tranquillity would be more conducive to promoting economic stability and growth.

Meanwhile, while money looks set to pour into emerging markets, there are questions being raised over the health of China’s banking system. Again, perception may be more relevant than reality.

Like in the developed countries, transparency and clarity would be welcomed. A more see-through view of the true relationship and extent of government involvement in the banking sector would be welcome. As long as it remains opaque, rumours will persist.

Despite all these potential disasters in the making, the hedge fund industry has started 2010 on a buoyant note. Launches are increasing and there is anecdotal evidence that start-up funds are finding it slightly easier to boost assets under management from the beginning. As more cash enters the system, launch sizes could rise, although few expect to see the majority of funds able to begin life with $100 million or more.

The preference of managed accounts continues as does the pressure on funds of hedge funds to prove their worth.

As the industry becomes more institutionalised, investor pressure to transparency, better liquidity and substantial operational risk control will dominate choice of fund as much as performance potential.

The debate over regulated versus unregulated and onshore versus offshore may be causing a lot of talk but does not yet seem to be causing a real change in behaviour among managers and promoters who still favour the more flexible structures found offshore.

Wherever 2010 ends it is likely the road will not be a straight one and certainly not without a few speed bumps to negotiate.

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