In this Q&A, Sir Michael Hintze, Chief Executive and Senior Investment Officer of CQS, presents an update on the risks and opportunities he sees in markets in 2016 and beyond.
Q&A with Sir Michael Hintze
Q: It has been a decent first half in performance terms for CQS in what is proving to be a volatile and challenging year for markets thus far. At the end of 2015 you expressed caution. Are you still concerned?
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Sir Michael Hintze: I continue to be cautious and mindful of ‘potholes’. There are uncertainties created by global geopolitical turbulence, rising populism, and political uncertainty in the US ahead of November’s Presidential elections. In Europe, the UK voted to leave the European Union (EU). Looking into 2017, there is a pretty heavy electoral calendar in Europe, including German parliamentary and French presidential elections, as well as Czech, Hungarian and Norwegian elections, all of which are likely to add to the debate around what kind of Europe EU citizens want. Across Asia, the macroeconomic picture is weaker. China’s growth rate is moderating and its economic structural adjustment is ongoing, while the government has to balance concerns around possible unemployment, social unrest, rising debt levels, forex outflows, and tension around maritime issues. In Japan, Prime Minister Abe received a resounding new political mandate, but growth remains constrained by an economy and stock market that have been slow to respond to progressive monetary easing. It now looks like Japan’s government will undertake further fiscal policy responses to stimulate the economy. In contrast, the US economy appears to continue to grow, labour markets are tightening and the Fed is considering a more hawkish monetary policy.
Offsetting geopolitical and economic uncertainty from a market perspective is that monetary policy, particularly Quantitative Easing (QE), is supportive of valuations, especially in developed markets. Emerging markets (EM) have benefited and while it has not been drained from the system, in the absence of renewed stimulus, its effect on EM appears to be diminishing. Add to that, the US dollar has shown renewed strength of late. Credit easing in China and QE from Japan and other parts of Asia clearly helps, but it is not as universally supportive as US QE.
With the world’s major economies slowing, central banks globally are likely to err on the side of caution and monetary policies should generally continue to be supportive.
I believe that in such an environment, the ‘P’ part of ‘P/E’ is unlikely to rise and the ‘E’ part seems more likely to flatten or decline. Consequently, I think equity markets will find it challenging to make much headway from recent valuations. Conversely, in a lower growth environment, I favour spread product and I like corporate credit.
Q: How do you see the rest of 2016 shaping up?
Sir Michael Hintze: To look forward, you need to look back. What happens in the past informs future outcomes. At the beginning of the year there were concerns about systemic risk resulting from a weak oil price combined with a China slowdown and ‘debt bubble’, and their effect on the natural resources complex.
As Figure 1 illustrates, from mid-2014 credit spreads had been widening and this accelerated in December 2015. It could well be that there is more fragility in the system and there is certainly more volatility as banks’ ability to allocate capital to proprietary trading desks to absorb volatility has diminished materially. However, at the beginning of February markets, and in particular corporate credit, bounced back sharply.
The key driver of this was an understanding on the part of investors that the world hadn’t ended; that the decline in the energy complex didn’t mean a collapse in the US high yield market; that continued QE by the ECB, Bank of Japan and credit easing by the People’s Bank of China meant that a benign environment was to continue; and, importantly, that China looks less like a bubble about to burst and more like an unwind. There will be volatility and potholes which will create opportunities. To be effective, asset managers will need to price risk, to be nimble and to capture volatility, as well as ensuring the liquidity held in a portfolio matches the portfolio’s liquidity terms.
Q: What are negative yields telling us? What does it mean and should we be concerned?
Sir Michael Hintze: Negative rates and yields are mainly, though not exclusively, a European and Japanese issue. I believe there’s a massive distortion caused by highly motivated, price insensitive central bank buyers out there. There are those who say it reflects investor concern about European and Japanese economic growth and confidence. There is an element of that sentiment, however, I believe the aberration is largely caused by central banks. The ECB may extend QE beyond March 2017, but I believe it may be extended well beyond this date, should economic conditions in the EU remain relatively weak. In Japan, stimulatory measures will, I believe, continue. Conversely, the US is experiencing stronger growth, and its asset purchase programmes have ended for the time being. The consequences of this will be played out in the currency markets and I expect the yen to weaken appreciably against the US dollar. I also sense there could be deflationary tendencies as QE seems to encourage investment into financial assets rather than into the real economy via capital expenditures.
Q: What does that mean for corporate credit?
Sir Michael Hintze: I’m constructive on credit, although I am expecting rising default rates. Nevertheless, the current environment is challenging and my present focus is on shorter duration exposures, typically of less than two years. There is significant volatility and markets are buffeted almost weekly by geopolitical events, and these dynamics are further complicated both by central bank and government intervention.
In such an environment, sticking to your investment philosophy and to a disciplined investment process are all the more important. Detailed and rigorous credit work should enable us to identify the right credits or asset pools, and trade the right asset class in the right geography at the right time. Sizing one’s positions for ‘surprises’ is an important part of risk management. This approach enables us to retain conviction to hold our positions, increase exposures when we see opportunity in a volatile market and in some cases reduce hedges.
Increased volatility provides trading opportunities and one needs to be nimble and have a flexible mandate from investors. The current environment lends itself to a multi-asset approach to credit investing, by allowing us to allocate to different parts of the credit spectrum as and when the prices of credit sub-asset classes swing.
Q: How do you see the relative value and opportunity set in US vs. European credit?
Sir Michael Hintze: I believe that the overall global search for yield favours US credits given current spread levels. The Fed has brought its QE asset purchase programme to an end for the time being, whilst the ECB’s is in full swing. Consequently, there has been substantial yield compression in EU credit. If you look at Figure 2, you can see that relative value playing out.
The ECB’s Asset Purchase Programme (‘APP’) has changed the context of investment in EU corporate credit. It has resulted in €4tn of negatively-yielding debt (which includes sovereign and corporate), or a 48% share of the market and 10.7% of EUR corporate bonds2. It is interesting to me that heightened geopolitical risk, in particular Brexit, has resulted in expectations of further stimulus and monetary easing, especially in the EU. The search for yield remains strong and in this context we are currently finding better relative value in US credit.
Q: You touched on default rates. Where in the default cycle do you believe we are?
Sir Michael Hintze: It is worthwhile recalling that spread = the probability of default x the loss associated with default + a liquidity/volatility premium. As can be seen in Figure 3, spreads in the US had already widened in anticipation of a distressed cycle. In the US, the distressed cycle is very much under way with default rates reaching six year highs at 5.1%3. The default wave, however, has thus far been driven by the natural resources space and we estimate that more than 75% of defaulted debt will come from the energy and metal & mining sectors4. Contagion has been fairly limited as a function of a benign macro backdrop and accommodative fiscal policies.
The situation is different for Europe. The broader economy has struggled to grow since 2008/9 as the EU continues to fight hard to cope with sovereign, financial and corporate debt burdens which in many instances are tightly interlinked and inter-owned and as a result cannot be tackled stand-alone. Corporate leverage (especially in the midcap space) remains high, with most corporates amending and extending their debt incurred prior to the 2007/8 market crash, rather than seeking to reduce it through a restructuring process. As a result, Europe remains home to many zombie companies which are barely cashflow positive and continue to survive simply because they are on life support courtesy of QE. If and when that stops, we anticipate the overall breadth and length of the European distressed cycle will be significantly more pronounced than the US one.
Q: …and where do you see the investment opportunity for distressed credit investors?
Sir Michael Hintze: My sense is that overall the distressed market has been lulled into a sense of security by central bank-administered liquidity. That said, tension in the global system has been building for some time, with leverage ticking up as a function of aggressive forward assumptions, valuations and cheap financing. Similarly to the 2007/2008 burst of the leveraged buyout bubble, if and when liquidity dries up and financing costs increase, we could see 0companies that are burdened with cheap but inappropriate financing structures looking to restructure. This would usher in the next global distressed wave.
Q: Where do you see the best relative value?
Sir Michael Hintze: Taking a step back and reviewing the overall context is important. There is no change to my view that there is a secular change and a structural opportunity due to the combined effects of regulation and central bank intervention. Bank disintermediation is here to stay and it will continue to provide an illiquidity premium for more patient capital. Figure 4 illustrates the growth in the US and European high yield markets. Since 2008/9, there has been an increase in the number of issuers and diversity of investment opportunity.
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