The Effects of US Monetary Policy on UAE Investors and Borrowers

Written by Zachary Cefaratti – Risk Officer at Dalma Capital Management Limited, a DFSA regulated hedge fund manager in the DIFC.
What is really driving the DFMGI index?

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The DFMGI (Dubai Financial Market General Index) has been one of the best performing indices globally in 2014.  As of June 16, 2014 the index was up 88% year-over-year.  This outperformance is driven by a combination of factors, many of which are influenced from abroad.
The continued historically low interest rates in the US and a strong rebound in domestic economic growth following the 2008-2010 financial crisis can be viewed as the main drivers of the recent rally in the index.  Additionally, the UAE has been a major beneficiary of private capital flows due to its political stability following the Arab Spring.

According to the Institute of International Finance (IIF) real GDP growth in 2014 is forecast to be 4.2%, driven by growth in tourism, transportation and trade.  Hence, in comparison to the developed world, the UAE has benefitted from a more robust recovery post 2010.  This strong underlying economic recovery has translated into a rebound in asset prices for both equity and real estate markets.  Furthermore, the completion of previously stalled projects and preparations for the World Expo in 2020 provide a compelling backdrop for economic growth in the coming years.
The other primary driver of asset prices has been the maintenance of exceptionally low interest rates in the developed world, which has caused investors to search for yield in the faster growing frontier/emerging markets.  With the 10-year US Swap rate currently hovering below 2.8%, investors are implicitly assuming that the United States Federal Reserve (the Fed) will remain accommodative in terms of interest rate policy.  With such low yields available, foreign investors have been attracted to valuations in emerging markets – the DFGMI is no exception.

Figure : 10 Year USD Historical Swap Rate

Figure : USD Swap Curve

Why the US Fed Funds Rate matter for UAE borrowers?

Due to the currency peg between the US Dollar and UAE Dirham, the UAE effectively imports the monetary policy set by the US Federal Reserve.  Although there are many benefits to pegging the UAE Dirham to the world’s reserve currency, a major repercussion of the peg is that the UAE central bank cannot maintain independent monetary policy.
The currency peg forces local interest rates to follow those in the US, even when the economy economic outlooks of the two countries diverge.  The optimal monetary policy of the United States is not necessarily that of the UAE – GDP growth in the UAE has outstripped GDP growth in the US by a large margin and is expected to continue to do so for the foreseeable future.  The combination of strong GDP growth and ultra-loose monetary policy imported from the US has resulted in a strong increase in asset prices.  Given the inability of the UAE central bank to raise interest rates independently of the US, local regulators are forced to rely on macro-prudential regulation, such as limiting borrowing capacity to control overall credit growth in the economy.
“Given the robust outlook for economic growth in the UAE, our view is that the major risk for the local stock market remains a normalization in US interest rates,” notes Elliot Carol, portfolio strategist at Dalma Capital, “The issue of rising interest rates is not a question of ‘if’ but ‘when’.”
When will interest rates rise?

Following the 2008 financial crisis the Federal Reserve has maintained extraordinarily accommodative interest rate policy as measured by the Fed Funds rate.  With the Fed already reducing their monthly purchases of bonds through quantitative easing, effectively making monetary policy ‘less loose’, the next question facing investors is when they will begin tightening and normalize interest rates.

Figure : Effective Federal Funds Rate

The Federal Reserve has publicly stated that they are targeting a long-term inflation rate of 2%.  The most commonly used measure of inflation that the Fed utilizes is Personal Consumption Expenditures (PCE) as measured by the Department of Commerce.  The Fed uses the PCE index because it covers a wide range of household spending.  The chart of the current year-over-year change in PCE demonstrates that the Fed’s key measure of inflation is well below the target of 2%.

Figure : Personal Consumption Expenditures Index y-o-y % change

“Despite inflation remaining below the Fed’s target, the discussion of the normalization of interest rates has recently been discussed in the Fed minutes,” comments Ryan Mahoney, portfolio manager at Dalma Capital, “Current Eurodollar futures point to a 2.1% Fed Funds rate at the end of 2016 and a 2.9% rate at the end of 2017.  Although the tightening cycle will not likely start in 2014, local UAE investors must prepare for a rising interest rate environment.”

The inevitable monetary tightening will probably be the trigger for earnings multiple contractions in equity markets.  Over 60% of the price gains seen in local stock markets over the last year are the result of earnings multiple expansion – meaning local markets would suffer in an environment when earnings multiples are contracting.  Higher interest rates also translate into higher borrowing costs for UAE companies and ultimately lower profitability.  Additionally, higher interest rates would make corporate bonds and sukuks more attractive relative to equities as the equity risk premium is reduced by higher bond yields.  Although there is limited risk for an immediate normalization in US interest rates, prudent local investors will undoubtedly begin considering the exposure of their portfolio allocation to rising rates.

The Dubai Financial Market: Bear Market or Correction?

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited – a DIFC Hedge Fund Manager
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July 1, 2014
 As of July 1st, 2014 the Dubai Financial Market General Index (DFGMI) is down 24.3% from its recent peak of 5,374.11, which was reached on May 6, 2014. Clearly, the market has corrected significantly but the question as to whether we have now entered a bear market remains debatable. Although there is no single definition, many market participants consider a correction of more than (20%) over a two month period to be a bear market. Based on this definition, it would appear superficially that DFGMI is now in a bear market.

However, the DFGMI is still up 23.33% on a year-to-date basis and up 83.1% on a y-o-y basis. From our perspective, the current downturn is simply a correction following an extremely strong period performance by the index in 2013.

We continue to believe that the underlying growth outlook for the UAE is positive. The economy continues to grow due to strength in the tourism, trade and real estate sectors. The DFGMI posted a blistering 108% increase in 2013 due to a combination of factors. However, inclusion in the Emerging Market index by MSCI was one of the primary catalysts for the strong price performance of the market as a whole.
“From our perspective, valuation levels were overextended especially in comparison to other emerging markets” notes Ryan Mahoney, portfolio manager at Dalma Capital, “Ultimately, corporate profitability and economic growth will be the key drivers of the market going forward.“
Why Valuations Matter?
We continue to believe that the outlook is positive for the DFGMI. The recent correction reflected a normalization of valuation levels. In general, we view price multiples such as the P/E ratio to be mean reverting. In a sense, valuation levels are like a pendulum. Periodically valuations levels will overshoot their historical average and conversely undershoot, but will ultimately return to their baseline level.

Observing valuation data, we can see that at the beginning of 2013 the TTM (Trailing Twelve Month) P/E ratio for the DFGMI (blue line) was far above that of the MSCI Emerging Market Index (MXEF) (grey line). However, as the DFGMI marched upward throughout 2013 and the first half of 2014 the valuation premium became excessive. The overvaluation of the DFMGI becomes even more apparent when comparing directly to the Abu Dhabi Securities Market General Index (ADSMI, orange line).
“Although a valuation premium for the DFGMI relative to the MXEF is warranted, the discrepancy became too large to be sustainable,” observes Elliot Carol, portfolio strategist at Dalma Capital, “Given the recent correction in the market, we view the DFMGI as being much more attractively valued at current levels”
What are the future prospects for the Dubai Financial Market?
The IMF is currently forecasting that the UAE will achieve 4.75% GDP growth in 2014. The growth backdrop is positive with both the tourism and hospitality sectors performing strongly. While Abu Dhabi’s economy is supported by public spending projects, Dubai’s services sector has been the main driver of the rebound.
While the performance of the DFMGI has been exceptional, the recent correction will bring valuation levels back in alignment with other emerging markets. Overall, we maintain a positive bias on the UAE economy and the DFGMI, although we did view the rapid rise of the market in 2013 and the first half of 2014 to be unsustainable from a valuation perspective. We believe the market will consolidate at current levels and expect improved corporate earnings growth to be the catalyst to drive the market higher as opposed to an expansion in valuation multiples.

A Demystification Of Hedge Funds And The Risk For Investors

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited – a DIFC asset manager specializing in Hedge Fund management.

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A demystification of hedge funds and the risk for investors

As investors in the GCC become increasingly sophisticated and continue to institutionalize there have been pioneers, early adopters and latecomers in the development of an alternatives (hedge funds) portfolio.  The region’s pioneers have been the sovereign wealth funds, with ADIA as the world’s largest single investor in hedge funds.  Some large and sophisticated family offices have followed the prudent lead of the Sovereign Wealth Funds along with a handful of corporates, foundations and wealth management firms – but regional allocations to the asset class still ominously lag their western peers at a time when the world’s institutional investors are increasing their hedge fund allocations.

Why sophisticated investors are selecting hedge funds?

The year 2014, which we previously proposed would be the ‘year of the hedge fund’ is already seeing large flows into the asset class and in 2015, the industry may manage more than $3.3 trillion according to a report by Boston Consulting Group.  The forces compelling inflows today are the same as those driving flows to hedge funds historically – they are primarily related to risk management.

10-15 years ago, the impetus to invest in hedge funds was to diversify overweight allocations to equities as valuations were historically high and expected returns withered.  Hedge funds provided uncorrelated returns that were expected to mitigate exposure to expected market downturns.  Historically, hedge funds best relative performance was generated when markets faired poorly.  Investors seeking to protect gains from the equity bull market of the 90’s sought hedge funds to manage risk and protect their downside.

Today, expensive bond markets combined with increasingly ‘dear’ equity valuations create a similar – yet in some ways starker backdrop as expected future returns on stocks and bonds fall in step.  Inflows and allocations to hedge funds are therefore likely to be best explained by investors seeking to protect their downside as uncertainty grows amid expensive stock and bond markets.

Risk Matters

Risk is often defined as volatility, but it is certainly not perceived this way by private investors.  The probability of losses, particularly large losses, is a more pragmatic definition of risk for the individual investor – as losses destroy the rate at which capital compounds.  To maintain a portfolio with long run growth, investors must achieve positive return asymmetry – this is where hedge funds excel.

Asymmetric Returns

A marketing phrase often used by hedge funds is that ‘hedge funds produce equity-like returns on the upside and bond-like returns on the downside’.  This statement may be an exaggeration and oversimplification, but it is not entirely untrue based on historical performance of hedge fund indices.  Hedge funds typically generate more modest returns during protracted equity bull markets, but outperform strongly during bear markets delivering a long-run return profile that is more positively asymmetric than the market index.

The key to maintaining superior long-term returns and positive compounding is positive asymmetry, which is achieved through robust risk management and avoidance of significant losses, as losses destroy the rate at which capital compounds.  Positive asymmetry is where hedge funds have delivered for investors by reducing the relative downside investors inevitably experience as financial markets ebb and flow.  The end result is relative outperformance by hedge fund indices on both a risk adjusted an absolute basis compared with major equity indices, such as the S&P 500®.

Risk Management

Hedge funds typically manage risk based on the premise that superior long run returns can be generated through strategic selection of assets.  Most hedge funds seeks to buy assets that they believe will outperform the market and sell/short assets they will believe will underperform.  Short positions and derivatives held by many hedge funds might be considered on a standalone basis to be risky and speculative, but as part of a typical hedge fund portfolio – these assets serve to offer protection or a ‘hedge’ against market downturns or volatility – often reducing risk for investors.

Empirical evidence demonstrates the effectiveness of this approach – with Hedge Fund indices posting long run out performance on both an absolute and a risk adjusted basis when compared to most market indices and other asset classes.  By reducing market correlation and mitigating downside risk – hedge funds have emerged as an essential component of the prudent investor’s portfolio.

Zachary Cefaratti

Zachary Cefaratti is a Risk Officer at Dalma Capital Management and a director of the Dalma Unified Return Fund. He has over 10 years of professional experience in financial services and specializes in quantitative and computational analysis of asset returns. Zachary Cefaratti's primary responsibility is to maintain, update and ensure adherence to the Comprehensive Framework for Prudential Risk Management (CFPRM). Concurrently, Zachary Cefaratti graduated with a Double BA from Franklin University Switzerland in International Banking & Finance and International Business Management, with undergraduate and post-graduate work at in portfolio mathematics, accounting and economics at the London School of Economics (LSE), Foster School of Business and the University of Pennsylvania, respectively. Zachary is a US Citizen who is resident in Dubai.

Dalma Capital Management provides services to professional and/or qualified clients only. The Company does not currently open or make available its unified return investment models or the Dalma Unified Return Fund to third party investors. Past performance cannot be relied upon as an indication of future results. Dalma Capital Management Limited is a DFSA regulated asset manager operating in the DIFC: the company’s core business is hedge fund management. Zachary Cefaratti is responsible for back and middle office functions at Dalma Capital Management and supports the CEO in business development within the DIFC, GCC, Cayman Islands, United States and Europe.

Zachary Cefaratti, risk officer at Dalma Capital Management Limited, a DFSA regulated hedge fund manager in DIFC, said the decision by MSCI to upgrade the UAE and Qatar to Emerging Markets status from Frontier Markets status is likely to have profound, positive effects on domestic equity markets.