Michael Kretschmer manages the Pelargos Japan Alpha Fund, a long/short relative value fund investing in Japanese equities. He was interviewed in April by Asia Pacific Intelligence but events since that interview warranted a return visit to see how his fund has fared through the recent volatility experienced in Japanese equities.
Kretschmer says: "The rally in the Japanese equities of the multi-decade low was extremely powerful and to some extent astonishing , not so much in the timing but certainly in the magnitude of the move. We had eight consecutive up months driven by heavy retail participation and foreign buying in the futures market." He doesn't feel that the 80% parabolic ascent was sustainable, "parabolics are never sustainable, and it was followed by a vicious sell-off to shake out the weak hands" he says. "I was surprised that the major indices actually reached such high levels and then again it was not a surprise that once buyers were depleted, the market crashed hard, especially the Japanese market which has a tendency to over- and undershoot."
Kretschmer finds it peculiar that investors tried to search for reasons why this sell-off occurred and that coinciding events, such as a poor Chinese PMI number, was chosen as causality. Kretschmer says: "Retail participation reached multi-year highs and with that margin debt, once the market direction turned the sell-off was reinforced by margin calls. Plus, to me it seems that a lot of ‘marginal' strategies were squeezed out."
Kretschmer explains that with very low interest rates of close to zero and the ability to use high leverage makes even low investment returns strategies profitable. "Once interest rates increased, many highly levered strategies are not profitable anymore, especially arbitrage strategies were impacted."
Kretschmer thinks that this sell-off is very healthy. "It shakes out the macro tourists and headline/event driven retail investor and once the dust settles the market will refocus on fundamental trends" he says. "Longer term the behaviour of the JGB market will be crucial to equity investors. Contrary to average opinion, I think higher interest rates are a good thing for an economy, it makes capital scarce and leads to more efficient capital allocation. However, a highly indebted system such as the Japanese needs a slow transition towards a higher interest rate environment. Anyway, interest rates below 1% are too low, but the holders of JGBs are risk averse and the current volatility is unwarranted for them. The BOJ finds itself in a paradox, it promised higher inflation, therefore it is rational to sell JGBs but at the same time the BOJ buys JGBs to lower the risk premium."
Kretschmer's fund lost 1% over May but is still up 18% for the year with limited volatility. "The whole buying frenzy prior to the crash was momentum driven and valuation was neglected, I think that once volatility has peaked good old fashioned value strategies will contribute positively again."
Looking forward, Kretschmer describes his base case scenario as that the initial crash will be followed by a period of volatile sideways trading and another move lower. "Bull markets are supposed to climb a wall of worry and a lot of froth needs to be unwound before the structural bull can continue. It's interesting to note, the ‘generals' of the bull move were the reflation trades such as REITS, real estate and banks. Once those sectors stabilize and start to outperform again is on a much healthier footing" he says.
This article was published in Opalesque's Asia Pacific Intelligence our monthly research update on alternative investments in the Asia-Pacific region.