Euro Zone

Cairn Capital is one of the world’s largest alternative investment managers with assets under management of over $21.95 billion. The fund based in Europe is a credit  and a fundamentally oriented.

They think a Greek exit from the Euro is under-priced by the market and they expect a correction shortly.

In their January letter, they told investors to expect a brutal 2012 due to the Euro-Zone crisis.

Below are some highlights from the CIO Graham Neilson.

The recent hiatus in structural Eurozone stress came hand in hand with a more positive cyclical backdrop during Q1 2012. The “Methadone Method” of policy response had its third major installment in three years and this time it is global.

The corrective market phase they have been have been expecting has started to play out, but still see opportunities in credit.

Some further commentary below:

Q1 2012: CYCLICAL POSITIVES AMIDST A STRUCTURAL HIATUS

 The first quarter saw a decent positive shift in the former and a hiatus in the latter. There has been some unravelling of this more recently but we believe markets are a long way from the stress of last year.

Chart: Structural proxies (France, Italy and Spain CDS spreads) v cyclical proxies (CDX HY and MSCI World Equity Index)

The cyclical forces have been reasonably predictable on a global (ex-Eurozone) medium term basis.

IMPRESSIVE CREDIT AND EQUITY RALLY HALTED…

Six months ago we were focussing internally on catalysts for being more positive. Now markets are recoiling from another liquidity-driven risk chase.

Late in the first quarter, our focus began switching towards catalysts for being more cautious. Some of these catalysts started to twitch…Recent news flow from various sources has not been so positive: US ISM and job data; rising oil prices; China, Europe and Australia growth disappointments; and expanding deficit targets in Spain. Further evidence of market hyper-vigilance is seen in very steep equity volatility skew, abnormally large flows into Vix ETFs and the heavy volume of reminders from investment banks of which “tail hedging” strategies have worked in the past. And now many leading equity and credit indices are in the process of giving back up to half of the positive move of the first quarter.

…BUT THE THIRD PHASE OF THE CYCLICAL SWING IS NOT YET COMPLETED
Whilst hyper-vigilance and a correction is understandable, I have been ranting about a three phase rally analogy internally and in investor meetings since earlier this year. The phases are:

ONE: Headline markets become technically stretched (evidence of phase 1 is all around, particularly in major equity markets and headline credit indices. A more corrective range trading period has begun).

TWO: Asset allocations move longer risk and growth expectations move higher (evidence of phase 2 arrives in the form of higher economic and earnings growth expectations and a shift in asset allocations as a result. This can be seen more recently from private and official sectors regarding economic growth and in recent asset allocation and credit surveys from numerous sources).

THREE: Cyclical vulnerability starts to rebuild and markets “self-harm” (phase 3 is a period where the shifting sands beneath markets need to be watched closely). All in all, I think markets are struggling now with phase 1 and there are increasing signs but not extreme danger regarding phase 2. Phase 3, however, is only in its adolescence.
So the key from here is to watch out for cyclical vulnerability rising with the following:
1) Higher safe haven yields
2) Higher commodities across the board
3) Extreme allocation biases
4) Extreme equity and credit valuations
5) Signs of genuine downward data surprises (chart below)

Chart: Economic surprise indices: turning over but not outside the “comfort zone” yet

 

EUROPEAN SOVEREIGN STORY APPEARS TO BE MORE OF THE SAME…

I don’t think the structural Eurozone issues have altered markedly and I assume we are seeing a reversion back to longer term sovereign spread trends without a sharp re-emergence of severe stress for now.

The structural sovereign debt overhang has not been solved by short term liquidity measures and the sensitivity of long term sustainability to growth means long term sovereign risk premia can easily escalate when growth expectations for late 2012 and 2013 are forced down again.

My fundamental dislike for peripheral corporate and financial risk remains in place although does not appear to be as mispriced as last year given sovereign spreads reside at levels significantly wider than a year ago.

Chart: Sovereign and corporate benchmark index spreads: Sovereign spread trend unchecked

I think the risk of a Greek exit within a twelve month timeframe tends to be priced too low and hope for domestic or EU political ability to avoid such an end game seems too high again.

…AND SO THE CURRENT CORRECTION IS PROVIDING OPPORTUNITIES

For the current quarter I expect more range bound credit spread movement where volatility can stay at lower levels than H2’11. The same read can be made for corporate, financial, loans and ABSm credit spreads and, to a lesser degree, high yield which are more sensitive to growth expectations.