Hugh Hendry’s CF Eclectica Fund commentary for the month ended August 31, 2015. Hendry was hurt more by his bets on European equities than his long China positions, although they too were hit. See the full letter below.
Discretionary Global Macro
The investment objective of the Fund is to achieve capital appreciation, whilst limiting risk of loss, by investing globally long and short mainly in quoted securities, government bonds and currencies, but also in commodities and other derivative instruments.
Hugh Hendry's CF Eclectica Fund - Performance Attribution Summary
- The Fund lost -7.1% in August, reducing the year-to-date gain to +2.7%.
- Equities were responsible for the large majority of losses, costing -7.1% in aggregate as global stock markets dropped in dramatic fashion.
- Thematic European exposure was the main driver of negative Fund performance with a -4.1% return. Elsewhere, our remaining Chinese index futures lost a further -2.1% before being closed out completely.
- FX positions gave back -0.6%, of which -0.5% stemmed from our long CNH options strategy as we found ourselves on the wrong side of the renminbi devaluation.
- Fixed income holdings disappointed, losing -0.9% in total. A tactical 4bps DV01 position in the US 30 year Treasury not only failed to offset the negative returns from the equity book but added to losses as yields pushed higher.
Hugh Hendry's CF Eclectica Fund - Manager Commentary
August was all about the markets’ reaction to a surprise shift in the management of the renminbi, with the Chinese authorities bowing to short term capital pressures and a desire to be included in the IMF’s SDR framework. Officially, the currency will now be set using market prices alone; unofficially, this being China, the “market price” will in our view still include a significant amount of government intervention. The previous regime had resulted in a huge build-up of leverage in being long the renminbi versus the US dollar and short volatility. We agreed with the bullish narrative on the currency, but thought the volatility was cheap, and hence began the month with a 150% NAV notional exposure long the renminbi versus the dollar through options. Thankfully owing to swift hedging and the low entry price of the options we kept losses to a minimum despite the currency initially selling off as the bullish renminbi positions were unwound.
Having underestimated the amount of deleveraging this would cause, the Chinese authorities were then forced to intervene heavily in the market once more. This opened up an opportunity to reinitiate our successful payer position from last year; as the PBoC buys renminbi from the market, there is less liquidity for the offshore money market, pushing short-term interest rates higher. Profitable opportunities such as this opened up by the PBoC’s persistent need to intervene in markets make us continue to focus on China as an area of strong macro opportunity.
Chinese stocks on the other hand proved more costly. Further sharp falls in August cost the Fund -2.1% for the month and the position was closed. Time will tell whether we were wrong or just early, but it is worth highlighting that despite our bullish stance and dramatic recent losses in Chinese stock markets, Chinese equities have cost the Fund less than 1% for the year. Losses have been kept in check by buying early and by being mindful of the very high volatility which prevented us from running a more significant exposure.
However the spill over into European equity markets was unexpected. Up until August, Chinese stocks had been an idiosyncratic asset class waxing and waning independently of other global markets. This changed abruptly with the currency devaluation. Pandora’s Box had been opened. Was the Chinese economic slowdown so severe that it prompted the currency intervention? We don’t think so but other investors are less sure and the aftershocks reverberated through almost every financial market from US Treasuries to European stocks which fell over 9% during the month and have now almost given back all the gains following the enactment of QE earlier this year. With a 50% exposure to European equities this proved our costliest exposure for the month.
So where are we now? Today’s environment seems analogous to the greatly mistimed bout of bearish sentiment that enveloped markets from 1983 to mid-1984 and marked the end of an especially dark decade for bond investors. As economic data began to show a US economy recovering from the Volker induced interest rate shock the fixed income market, conditioned by the inflation of the 1970s, panicked and sold treasuries once more pushing the 10-year yield back up from 10% to 14%; the S&P fell 15%. Today the fear is almost the reverse: that the Chinese economy is set to suffer a growth slump and generate similar deflationary forces to those experienced in 2008 with evident and profoundly negative repercussions for global equities. But as we have noted previously with the S&P 500 having lost 80% of its value relative to Treasuries over the last 15 years (and even more so for the DAX and the Nikkei relative to their domestic bond markets) there is an argument that we are approaching the end, not the beginning of a dark period for stocks relative to bonds, and that we should be wary of reinventing the deflationary ghosts of the past decade.
For now, it is likely that the Chinese economy will be the principal determinant of global equity prices. On the one hand we think this is a positive as it will provide cover should the European or Japanese monetary authorities wish to boost their economies further. But on the other hand, the immediate return from global equities will likely be constrained to the upside until Chinese economic data stabilizes. Thankfully there are many ways that you can make money from a macro book without relying upon binary wagers on higher or lower stock index values, and I believe we have introduced a good blend of trades in FX, corporate credit and EM rates that will help us stay the course should the tumult gather pace and return to making money. So let us review another idiosyncratic opportunity…
Hugh Hendry's CF Eclectica Fund - Sector Insight: German Property
We are long the German residential property sector. Our narrative has three legs - a macro bias nuanced by a fundamental local property story and a compelling yield play. The macro is simple. If Europe is to persevere with a fixed exchange rate then we would suggest that domestic-prices (and hence competitiveness), not the external currency value of constituent members, must change to balance the system. European monetary policy is now set at a level which is at long last arguably appropriate for the less productive nations such as Spain and Italy but certainly too loose for more productive countries like Germany. This means that German asset prices should appreciate relative to other European assets. With the uncertainty of Chinese growth, domestic German assets such as property would seem a better play at this point than the huge car and chemicals exporters that dominate the DAX.
The German property market is changing as the population moves away from rural and eastern areas, in favor of large cities and the industrialized parts of North Rhine-Westphalia. Vacancy rates are low and falling in these areas, and so pressure on housing stock means that prices are finally rising from a low base. Historically the local authorities built cheap subsidized housing for “workers”, a social group comprising half the population who earn household net incomes below €20,000 per annum. This may sound surprisingly poor, but wages have been suppressed in the last two decades as part of Gerhard Schroeder’s mercantilist deal to keep the export regime running. As with China, the household sector has done well but could have prospered even more if, like the UK or the US, these people had been showered with cheap consumer credit to inflate asset values. Instead, the quid pro quo was a secure job and cheap residential rents. Even relative to these low wages, rents are cheap: a typical house is 65sqm and the rent is €5/sqm/month, or €325/month.
There are so many ways to consider the potential upside for such stocks. The sector typically is priced off a 7% rental yield and operates with a 50% LTV. To keep it simple, the property is valued at 100, the NAV is 50 and the market cap is currently around 70 as stock market investors are willing to front run Germany’s surveyors and accept a lower implied yield of 5.8%. However, with 10 year bund yields at just 0.7%, you can argue for just about any magnitude of upside. For now let's just say that 5% is a more appropriate capitalisation rate and that existing rents remain unchanged. Under such a scenario, the lower capitalization rate boosts the property value by 40% to 140, debt remains 50 and the NAV would rise to 90. It is likely that the stocks would trade closer to this higher asset value, in which case there would be c.30% upside to current stock prices.
With the property market facing shortages, the authorities have reacted to rising prices by the time-honored imbecilic policy of rent caps for existing tenants; accordingly rents on average are crawling up at just 2-3% per annum. The problem however is that the German economy desperately needs new houses and with new supply costing something like €2,000/sqm to bring on, you need rents of €8-9/sqm/month to get a return of 5% on a new property investment. In other words, rents really need to go up 60-80% to incentivize new supply. So what happens if rents re-price to the level required to bring on new supply? Under this scenario you could get 150% upside to the existing companies in their current corporate structure without doing anything too daring to the balance sheet, calculated on the basis of a 60% rise in the starting rental income capitalized at 5% and assuming that stocks trade on a price-to-book value ratio of 1x.
But what if we were really Gordon Gekko greedy? Remember the typical German property stock has a property portfolio presently marked at 100 and a market capitalization of 70. And I’ve argued that if we are right and rents need to rise to the level that encourages new supply and that 7% capitalization rates are simply ludicrous when the 10 year bund yields just 0.7% then the property portfolio is worth at least 224. Just imagine if we could convince a European bank to lend us 50% of the higher property value? We would have debt firepower of 112 versus the present enterprise value of 120. So we would need to put in equity of just 8 which could be worth 112, a humble 14-bagger. On a spreadsheet this could almost work from today as rental income of 7 would drop through the P&L minus operating expenses and some maintenance capex and just about cover interest of 2% on 112, especially if revenues grow at 2-3% per annum and they can hold those operating costs flat or better. Sadly the days of such accommodating banks are most likely over, but it does illustrate just how cheap these stocks are.
But for now we would be looking for sub-5% capitalization rates and LTVs of 70% or more to act as a red light for the time to sell, which implies there is probably another leg higher for the German property sector at some point in the next year or two.