Hugh Hendry’s CF Eclectica Absolute Macro Fund commentary for the month ended March 31, 2017.
Since the end of 2013 we have been avoiding betting on really bad things happening, deeming the probability of a shock event systemic enough to potentially cause a decline of 20% or more in the S&P (our informal definition of what constitutes ‘really bad things’) as just too low. Our principal long volatility exposure instead has arisen from selective exposure to receiving global fixed income markets and our offshore renminbi trading.
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Our performance history reveals a series of returns with low correlation to any other asset class, at worst modest calendar year losses and convexity when bad things have happened to global markets. This kind of return profile can only be achieved by avoiding burning through capital with expensive hedges against risks which are not merely unlikely but implausible. We have therefore consistently, until now, resisted what were overpriced bearish European trades and this has helped our NAV tick higher in the absence of catastrophic events from the start of 2014 to the end of 2016.
However, since the fourth quarter of last year we have added a considerable quantity of long volatility like European exposure to our risk book as we await the outcome of the French Presidential election. Like everyone else we know there is an event risk that the French electorate could throw out the old political class and jeopardise the fragile equilibrium that is the European monetary system. We know the dates, we know that the result could produce considerable downside risk to global asset prices, much more so than Brexit given that the potential departure of one of the nations most fundamental to European integration would surely lead to the system’s demise, but we also know that the outcome is impossible to predict in advance.
Nevertheless, it is our contention that we have insulated our portfolio from such a known unknown. Success for Le Pen is currently deemed unlikely, but under such a scenario, where markets would need to grapple with the real threat of a Euro break up, our gains could be considerable. We think there is a significant probability of such a political upset, and believe our trade as detailed below offers a very attractive gain to loss ratio (5:1) should the probable path be upturned.*
How reasonable are these assumptions? Are we paying a considerable and unwarranted levy to make ‘bad things’ go away? I think not, so allow me to explain what we have done, expand on our thinking and allow you to decide on the appropriateness of our actions. We previously wrote to you likening quantitative easing as a form of extreme medical intervention comparable to chemotherapy which doctors believe is best applied early to offset the treatment’s nasty side-effects. However the peculiar status of Europe as a region bereft of political homogeneity has meant that the necessary fiscal or monetary policy has routinely been constrained or delayed by vested interests, convoluted regulation and a lack of public support. We welcomed the introduction of the ECB’s bond buying program in early 2015. But as the initial positive stock price response lost its momentum and prices began to slide once more we began to fear last year that the intervention had come too late and that we would all need to deal with those nasty side effects sooner rather than later.
You might reasonably ask, why now? There are at least two reasons.
First, Europe is caught in a severe pincer. On the one hand debtors are still being squeezed as households grapple with flat real incomes and a moribund jobs market making some resentful of the historically high influx in immigration. On the other, creditors, with their abundant pool of savings, are seeing their incomes squeezed by low or negative yields. In short, this is a fertile environment for populism. Furthermore, we believe the precedent from the UK’s decision to leave the EU makes the European project less robust as the subsequent benign trajectory of the British economy00 galvanises politicians in other member states who seek00 to pursue a similar path. Whilst noting the rejection of such populism by the Austrians in their Presidential election in December, we would again highlight the analogy of the UK’s departure from the gold standard in the 1930s and its successful pursuit of a nationalist economic agenda, which set in motion a chain of events that saw 75% of the prevailing gold standard members reject the system over the next two years.
Second, the persistence of super-easy monetary accommodation in Germany as well as the recent emergence of a synchronised global economic upturn and concomitant rising inflation seems to be awakening the hawkish old dogs that lie slumbering within the powerful constituency of the Bundesbank. Moreover, European QE is about to run into a serious political issue as the ECB runs out of German bonds to buy, meaning they either have to stop, or buy BTPs (for example) and not Bunds. The Bundesbank see this as a monetary transfer to the periphery through the back door (which it would be). So the only part of the European setup which has cleverly managed to circumvent political pressure runs into it hard next year as it simply cannot run for another three years without crossing the Rubicon of monetary transfers to the periphery.
How else is one to explain why, despite the muted economic recovery on the continent outside Germany, the ECB has already tapered QE and is in the process of winding it down altogether?
Should the bond buying program run-off over the next three years I do wonder what price the private sector will demand to finance the Italian government’s persistent and substantial debt re-financing demand. With outstanding stock of more than two trillion euros, a sum that expands every year so long as the economy fails to achieve sufficient GDP growth greater than the interest burden’s share of GDP, and an average maturity of less than 10 years, the Italian treasury needs to issue around a trillion euros of BTPs at least every five years. The ECB alone has been hoovering up almost 40% of this requirement with its bond buying program over the last two years, which has allowed it to control the price so far. However should they commit to a lower purchase level, perhaps with the eventual complete withdrawal of the scheme, I suspect that investors would find current 10-year BTP yields lack a sufficient margin of safety to persuade them to fill the void given the lack of structural reforms that would boost economic growth and stabilise Italy’s precarious debt balance. Put simply, does the constant currency 10 year additional return of around 20% from favouring BTPs over German Bunds provide adequate protection to private profit seeking investors to compensate for the ever present risk that the lira returns? I think not.
My best guess therefore is that the Bund versus BTP spread has recorded a long bottoming out period since 2014 and is now resetting higher as evidence emerges that economic growth is firming and fixed income participants reassess their inflation assumptions following the recovery in the oil price. Even without any political upheavals I would expect the ECB to continue to unwind their purchase programme and, as the private sector is required to fund more of Italy’s maturing debt, yields will continue rising.
As such we have a substantial position on the spread widening between the Italian 10-year bond yield and its German equivalent. We are fortunate that this spread has a long series of price data which has been subject to significant shocks and reversals over the last decade which makes it easier to draw some credible risk conclusions. For instance we know the highs and lows it has traded at. Prior to the seemingly irrevocable changes wrought by the financial crisis in 2008, the spread traded at just 30bps on the presumption of a seemingly permanent monetary union. In 2011, as the market feared the departure of Greece from the system, the spread was some 500 points wider. We also know that it has failed to break below 100 since the ECB began its great monetary accommodation back in March 2014.
The spread has doubled to around 200bps over the last year. We believe that the continent would have to change profoundly for it to breach 100bps. Such a reversal, should it occur, would indicate that the Germans had accepted a full blown monetary union with their southern neighbours; at present this seems most unlikely. However, to get there I would presume that the prevailing spread would first have to widen significantly in order to prompt such a dramatic volte face. Regardless this serves as our ultimate stop loss although I can assure you that risk reduction would have commenced much earlier and at higher levels.
The upside, however, is certainly not capped at the previous 2011 high. A Greek exit then would have significantly damaged the system but it would probably have endured. However should the French ultimately choose to leave, then the departure of one of the continent’s founding pillars would surely lead to the system’s demise and we would note that BTPs regularly traded at 10% yields prior to Italy’s membership as international investors demanded a significant risk premium to hold their paper.
That could have been the end of the story: a convex 5:1 potential payoff structure should the persistence of the Euro seriously come under question with a relatively modest ongoing negative carry cost. However we have gone further, adding a position which we think has a very high probability of delivering robust returns this year should the status quo of a European muddle through persist: we are long European senior financial credit and short the European bank stock futures.
This long credit/short bank equity trade has worked consistently since the ECB’s commitment to safeguardthe European monetary system back in the summer of 2012. There has been one dominant driver. Basel III rules written to capture the political prerogative of derisking the banking system post 2008 have required the European banking sector to raise a half a trillion dollars of capital over the last decade or so. However owing to a lack of profitability stemming from flat yield curves and the modest European economic recovery it has proven very hard to generate this capital internally from retained earnings. Instead the credit worthiness of senior debt tranches has been bolstered by numerous and very dilutive rights issues across the sector as typified by UniCredit’s latest €13bn capital raising which rises to €20bn when one factors in recent substantial asset disposals and was announced less than five years after their last dilutive €7.5bn share sale, which in turn was the third such capital increase in three years. Combining a position long the senior bank debt and short the equity has directly profited from this dynamic and has produced a consistent positive return over the last four years.
The pertinent question is whether this trade has run its course. The presidential election in America has been marked by a steepening of global yield curves which could restore the profitability dynamic of the banking sector and make the short equity position treacherous. The European bank sector rallied 60% late last year and re-rated higher to almost 1x book value on the expectation that profit growth would indeed accelerate; shorting the sector is now perhaps our most contrarian risk position.
To understand our logic you have to recognise the challenge policy makers face in attempting to push inflation higher. Their problem is that the markets ‘front-run’ their policy statements. For instance the prospect of pro-growth corporate deregulation and a significant tax cut policy from the new US administration has already encouraged the private sector to tighten monetary policy via pushing 10-year yields higher and strengthening the US dollar. Whilst inflation expectations have firmed, largely from the better performance of the oil price and the tightness of the US labour market, it still remains highly provocative to predict a meaningful pick-up in consumer prices.
But at least the Americans seem likely to support their economy with fiscal stimulus in the form of significant tax cuts, increasing the budget deficit. No such largesse seems likely from the core of Europe, whilst the most likely contenders for the next French president are vying with each other to promise further public sector spending cuts. This makes the European bank sector’s profit estimates seem too high to us; we reckon two 25 bps rate hikes are necessary by the ECB by the end of next year to allow the banking sector to earn the 10% return on equity demanded by a valuation at book value. Given the likely unfavourable impact this would have on the nascent economic recovery we favour the fixed income market’s reticence to price this eventuality and believe that the bank sector has run ahead of itself. We do however accept that the sector is now broadly recapitalised and that UniCredit’s rights issue and the Italian government’s proposed bailout of the other notable laggards is reminiscent of the final wave of stock recapitalisations in Japan back in 2003 under Koizumi. However we would note that with the Japanese bank sector’s balance sheet restored, cyclical economic upturns encouraged lenders to compete more aggressively and, in the absence of meaningfully steeper yield curves, the banks bid down their profit margins endlessly. For example, Japanese megabank MUFG has only been able to earn an average return on equity of 7% over the last five years. For us, something similar seems likely in Europe and we struggle to see the sector rallying strongly beyond last year’s highs making the credit/equity trade very compelling.
Combining this position with our sovereign spreads creates a zero-carry package matching two ‘bearish’ trades (the sovereign bond spreads and the bank stock futures short) with one ‘bullish’ bank credit receiving position, which we believe offers an attractive ‘crisis alpha’ like payoff profile.
Serious political shocks on the Continent are likely to lead to sharp widening in the sovereign spreads, with falls in the value of bank equity broadly offsetting losses on the credit position. Alternatively, curtailment of the ECB’s expansionary monetary policy would also tend to push sovereign bond yield spreads higher, with the likely negative impact on the economy in countries like Italy leading to more non-performing loans and hence weaker earnings in the banking sector. And in the scenario that Europe manages to stagger through and the status quo persists, we would expect profits from the bank credit/equity spread to offset modest downside from the sovereign spreads.
Hugh Hendry, George Lee, Tom Roderick
CF Eclectica Absolute Macro Fund – Performance Attribution Summary
- The Fund lost -3.5% in March as European equity markets surged higher.
- European bank shorts were the most significant drag on performance as the index jumped c. 9% during the month with political risk judged to be receding and amidst speculation that improving economic data could lead to tighter monetary policy and therefore increased lending margins. As discussed in our most recent commentary, with the sector having now rallied over 60% from last July’s lows, we struggle to envisage a scenario in which current valuations can be justified.
- Losses from our equity shorts were however cushioned by our European financial credit position as the cost of protection fell.
- In fixed income, losses on Chinese interest rate ‘payers’ and sovereign bond spreads in Europe outweighed gains generated from the steepening of the Korean yield curve which came about due to a combination of a periodic heightening of tensions with their neighbours to the north and the arrest of former President Park Geunhye on graft charges.
- Elsewhere, in FX there were profits from the Fund’s consumer versus producer RV, but losses from long US dollar positions against both the Japanese yen and the euro as markets questioned the Trump administration’s ability to deliver on their much hyped election pledges.