Ruble, ruble, oil and trouble

"Double, double, toil and trouble; Fire burn, and cauldron bubble" - Macbeth

Early in the New Year, I tend to get into a contemplative mood and think about the year just past as well as my plans for the year ahead. 2015 is no exception, and in fact has provided me much to consider as acts of terrorism, a global pandemic, anemic economic growth, political battles, lack of regulatory clarity and the limits of central bank intervention all recently reared their ugly heads and cast trouble for risk assets.

It's natural to wonder if, like the three witches in Macbeth, the year's events are harbingers for additional strife and trouble. However, if one were to heed the negative headlines and "pack it in" for 2015, one is likely to miss the opportunities that currently present themselves as fear dominates the market psyche. Let's review some of these opportunities and their accompanying risks.

Russia presents a useful case study of different ways geopolitical risks can manifest themselves. The cost of insuring against Russian sovereign default tripled in 2014. The Russian ruble has tumbled, reaching levels not seen for 16 years, slipping past 60 per U.S. dollar. This reflects Russia's trifecta of troubles. First, its economy, highly dependent on one source of revenue, is likely to continue to be negatively impacted by lower oil prices. In addition to fundamental weakening of the economy, Russian companies are going to have trouble accessing the capital markets due to economic sanctions. A combination of weakening fundamentals and lack of financing usually result in challenges for businesses. In Russia's case, the third factor of increased risk premiums in emerging market bond markets further compounds its troubles.

Some have wondered if shorting Russian sovereign default risk is the way to go. While it can be part of a portfolio of trades, this is not the only way to benefit from volatility. The ruble has traded along with oil prices, and provides a liquid and deep market to express one's views on energy prices. Currencies of commodity/energy-driven countries offer some interesting opportunities as they price in the volatility of energy prices and market fears about the outlook for growth in China.

Looking ahead, terrorism remains the "known unknown" in the spectrum of geopolitical risks. Another risk factor is unexpected government intervention, such as the Swiss Bank's decision to remove the cap on the Swiss Franc, which led to a more than 20 standard deviation move on the currency in the span of hours. What we know is that when these scenarios appear, the market, already nervous about issues such as weaker growth coming out of Europe, will react quickly (and likely overreact). This can create buying opportunities that are brief and difficult to predict, along with periods of technically driven selling where mark-to-market volatility may diverge from changes in fundamentals.

One area in which there has been a real change in fundamentals is in the energy market. West Texas Intermediate (the U.S. benchmark for oil prices) recently fell to the mid $40s in the middle of January and many market participants see potential for a further slide. Previous $100/barrel oil masked many of the inefficiencies of many oil producers. In the long run, however, a lower oil price will likely weed out inefficient producers and delay or cancel projects that are less efficient. This should help increase efficiency into the exploration and production market and create long and short opportunities.

Whether one believes that the drop in oil prices is driven by an increase in supply (e.g., the U.S. shale revolution) or a decrease in demand (coming from slower growth worldwide), or both, what we certainly know for sure is that oil prices have fallen quickly and considerably. This has prompted investors to reduce their exposure to energy and anything that is even tangentially related to energy, including parts of the transportation sector such as shipping, industries where energy is an input such as petrochemicals, and consumer discretionary sectors such as retailers and leisure providers.

Many potential opportunities have surfaced in the energy sector. For example, in the high-yield bond market, there has been a dramatic divergence between the energy names and the rest of the index. In 2014, energy names posted a -7.3% return for the year vs. 1.83% for the overall high-yield corporate index, a dispersion of more than 9% in performance.

Nonetheless, a note of caution is warranted for bargain hunters in this sector. Capital structure matters, and matters more than ever. Firms that are highly levered will be hurt the most as the market sell-off hits the top line and potentially the bottom line as well. Energy names have been some of the most prodigious issuers of high-yield bonds, tapping into a yield-hungry market. As a result, energy has become a large slice of credit indexes, anywhere from 16% to 20% for key indexes. Some key differentiators among energy sector opportunities include differences among fixed-price contracts, geological exposure and ability to be the low cost producer as well as idiosyncratic factors such as which assets are mission critical (i.e., the company will do everything in its power before defaulting on that particular asset). Similarly, those who are exposed to marginal/swing capacity are likely to be vulnerable.

Opportunities also exist in other sectors that benefit from lower energy price, such as the consumer and transportation sectors. For example, in the consumer sector, there are opportunities in goods for which demand will increase on the back of consumer savings, such as retailers and restaurants, thanks to lower oil prices.

The recent focus on oil prices have taken investors' eyes off of other risks looming next year. The first is the possibility of the Fed rate hike, although weak growth in Europe and reduced inflationary pressure coming from lower energy prices increase the probability that the Fed will start with a token hike. Another risk factor is lack of growth in Europe, where the market is still anticipating a bolder policy move from the European Central Bank, potentially with some fiscal easing from core member countries, particularly Germany.

It appears that the troubles facing us as we begin 2015 are likely to persist throughout the year. Encouragingly, there are opportunities for diligent investors. Stock selection and execution are key to turning good ideas into good investments. Furthermore, it is more important than ever for long-term investors to have steady nerves, as fear can lead to sub-optimal portfolio decision-making. I wish you clarity of vision and a profitable year ahead.

Putri Pascualy is a managing director at hedge funds-of-funds manager Pacific Alternative Asset Management Co. LLC.