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Prologue December 2009

Prologue December 2009

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Published by: marketfolly.com on Jan 27, 2010
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09/18/2010

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This letter is for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instruments. All market prices, dataand other information are not warranted as to completeness or accuracy and are subject to change without notice. Prologue Capital LLP is authorised and regulated bythe Financial Services Authority.
December 22, 2009The Fund achieved a 0.60% return in November, is up an estimated 0.16% so far this monthand up approximately 12.5% year to date. The 12-month rolling return stands at approximately16.33% (all figures net). The Fund
 
s annualized volatility is 4.03% with a Sharpe ratio of 4.39
1
.Last month, we profited from short volatility strategies in the US, US curve steepeners, anddirectional US trading. In Europe, we profited from long Germany vs. Spain, short UK vs. Europe, longUK basis, and Shatz vs. Eonia spread wideners. Gains were also made in long gold calls. Losses camefrom long UK inflation, curve positioning in AUD and CAD, and European money market steepeners.
 
The global economy is ending 2009 with good momentum and the stage is set for furtherpositive growth surprises during the first half of next year. Looking further ahead, there isconsiderable uncertainty about the viability of the upturn. After all, significant imbalances remain, notleast on the fiscal side. Headline inflation will generally pick up early in the year and then drift downtowards lower core inflation levels. As the year progresses, we foresee significant departures ininflation performance among the G3 economies, a dispersion we aim to profit from.Most recently, the United States has had the most noticeable pickup in activity with theeconomy growing well above potential for the second quarter in a row. Part of the story isinventories, a positive tailwind that should last for most of next year, while final demand has comeback quicker and stronger than most observers expected. The latter should improve further as jobgrowth returns early next year. Investment is also improving and is set to add noticeably to GDP overthe next few quarters. Our base line scenario is for growth to continue to surprise to the upsidethroughout the first part of next year.The expansion during the first half will only create a small dent in the output gap. Overcapacity remains a dominating force, not least in the labor market, and will continue to exert
1
 
12 month average of the 12 month rolling Sharpe ratio using the effective Fed Funds rate as the risk free rate.
 
 
This letter is for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instruments. All market prices, dataand other information are not warranted as to completeness or accuracy and are subject to change without notice. Prologue Capital LLP is authorised and regulated bythe Financial Services Authority.
downward pressure on core inflation. Although our profile suggests that headline inflation willincrease close to 3% early in the year courtesy of base effects and energy prices, we are confidentthat core inflation will continue to trend down. Our proprietary inflation framework indicates that coreinflation should trough around +0.5% year on year by the summer and stay around that level for therest of the year. Inflation running that low may re-ignite deflationary fears should the growth stall inthe second half. Consequently, the investment environment has the potential to look very different inthe second half of the year compared to the first.With no inflation pressures in sight and balance sheet vulnerabilities still present the FederalReserve will keep its main policy rate unchanged for some time. The market is nevertheless likely totest policy makers resolve as the economic data continues to improve and several of the FederalReserve
 
s non-conventional measures roll off in the first quarter. Another key issue that will weigh on Treasuries next year is a significant supply-demandimbalance caused by large scale issuance and diminishing public demand. For example, DeutscheBank estimates that the
 
demand gap
 
for Treasuries will be around $580bn. The US Treasury hasalso indicated that it wants to increase the average duration of its issuance, a factor that willcontribute to keeping the term structure steep.The Gilt market should experience an even greater supply-demand imbalance when Bank of England
 
s Quantitative Easing (QE) program ends. Estimates vary but somewhere between £80bn and£140bn of Gilts need to find new buyers. The key issue then becomes when QE will end with readydecided purchase finishing in late January. Judging by the noticeable improvement in economicactivity, upward revisions to past data and upward pressure on inflation argue against an extension of QE. Importantly, the rhetoric from some MPC members supports the notion that QE will not beextended. That said, it has been extremely difficult to second guess Bank of England
 
s strategy in thiscycle so we will carefully evaluate our expectation of an end to QE in light of the data that will bereported in January.One key reason why we expect QE to come to an end is the aforementioned deterioration inthe inflation outlook. Our investors are well aware of our long held view that UK inflation will runnoticeably above inflation rates in the rest of the developed world. Recent developments have furthercemented that view and we are confident headline CPI will be above the 3% letter writing territoryfor several months, starting in January.In Europe, the economic recovery is overshadowed by fiscal challenges and associated policyresponses. The dire Greek outlook has been the focal point so far but several other Europeaneconomies display similar fiscal problems. A central issue is the policy response to these challenges.Comparing Ireland and Greece is the clearest example of this. Key variables of fiscal distress are of similar magnitude but the two governments have displayed vastly different policy responses. Ireland
 
sattempt to clean up its fiscal mess appears credible while there are severe doubts to what extent theGreek government is willing to go down the right path. The financial market has respondedaccordingly and the outlook for the two countries is vastly different with the financial marketsassigning and pricing in almost twice the probability of a Greek default compared to the Irish. Thissort of dispersion is likely to become more accentuated next year for all Eurozone countries, includingthe core countries. For example, we expect the pricing between French and German bonds to start todiverge more meaningfully thanks to the relative deterioration of the French fiscal outlook.The European Central Bank began its normalization process with the indexation of the last 12month Long Term Refinancing Operation. The unwinding of non-conventional measures will taketime; already implemented and forthcoming scheduled measures will remain in the system untilSeptember of next year. Although technically feasibly our understanding is that there is considerableresistance among Governing Council members to adjust the refi rate until all fixed tenders have rolledoff. Put differently, a tightening of the main policy rate is unlikely until the fourth quarter of nextyear. There are fundamental factors to suggest that it may take even longer than that. For example,vulnerabilities in the banking system remains (as illustrated by the recent nationalization of Austria
 
s6
th
largest bank), inflation is likely to stay substantially below the target for the foreseeable future andthe labor market should face headwinds as emergency labor supporting measures roll off. That said,

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