Global Allocation Fund commentary for the month of March 2020, discusssing that the level of leverage in the financial system is unsustainable. Translated from Spanish using Google translate.
Q4 2019 hedge fund letters, conferences and more
When it comes to value investing, one strategy that's often used is seeking out companies which have sizeable moats against competition. In a presentation for the Value Investing Club at Google earlier this year, Connor Leonard of the Investors Management Corporation explained two ways of looking at moats and how value investors can benefit from Read More
As many of you know, our GA fund was waiting for a crisis to materialize in 2020. As we always say and repeat, to make it really a crisis, it would materialize mainly in the credit and financing markets, although also in the stock markets.
Unsustainable Leverage In The Financial System
We have long believed that the level of leverage in the financial system is basically unsustainable, derived from also unsustainable monetary policies that have based the bulk of their work on the "wealth effect", leaving aside sustainable growth.
In this way, the prices of financial and real estate assets are being sustained and artificially increased, mainly, based on lowering interest rates to even negative rates in the case of Europe. Without a doubt, the most worrying aspect of this policy. monetary policy, establishing a "saving that favors, thanks to the additional purchases of bonds by the European Central Bank (from the most inefficient governments) These have seen how they have not had to face the structural changes in their economies, and have continued to increase gradually your debt.
Aside from social or other problems stemming from growing inequality, one of the most serious consequences of these policies has been the negative effect on the income accounts of the main European banks, followed by an excessive increase in the future obligations of the plans. , pension funds, both public and private, that basically make this type of policy have touched its ceiling, or rather, its soil.
The fund's positioning is based on the effects that the triggering of a crisis usually entails in the markets, within the restrictions imposed by the strict rules of management of the regulated funds UCITS. We understand that these consequences are basically an increase in risks of credit in the main countries and companies in the region, as well as a demand for liquidity by companies and individuals in the face of a sudden increase in the risks perceived by the markets.
This fact is usually decisive for increasing interest rates, especially as the term to which we want to obtain that liquidity increases.
Thus, our main risk is options sold on the 50-year interest rate (swap rates, equivalent to the interbank rate), on negative interest rates Specifically in strikes 0 3 and 0 5 and with a term of 5 years Technically, our greatest risk it would be to obtain financing by charging within these terms Charging for us to be lent For these options we have received premiums that we have “in which this situation disappears, that is, buying options in case interest rates rise drastically, as well as the pending ones of these interest rate curves will reflect the greatest uncertainty over time.
In any case, as the Covid 19 storm unleashed with the general collapse of the stock markets, the markets opted for “as they usually do when the risks to equities in fixed-income assets suddenly rise, and, especially, thinking that The performance of the Central Banks will be no other than doing more of the same than they have been doing for too many years. By the way, without achieving, in any case, the desired effects.
This massive purchase of bonds (German 30-year bonds have come to quote at returns of 0 50 That is, a sure loss of around 15 in the next 30 years, with a potential risk of "more than 50 has dragged initially at interbank rates at these terms, raising the value of our options sold, not only because the price of financing has reached these levels, but also due to the exorbitant increase in volatility, which also causes these options to rise of price All of this has caused us intense valuation losses, as well as the price of the options we had bought, which have also dropped in valuation sharply. In the latter we have reached a point where their valuation can hardly go down any further, assuming a very small percentage in the portfolio, and concentrating the possible further decrease in our net asset value only on the risk that it financed it n these 50-year terms) continue to decline.
The enormous price differences between the options bought and sold, as they are operations "made to measure" with different investment banks and as they are always "very prudent" valuations for our counterparties, they would prevent us from replicating the same positions at the moment due to the price differences between the valuations of our positions and the sale prices to increase them Because we expected this to materialize at some point, last year we decided to close the funds to new money inflows, as this situation would now benefit same in a very notable way to the new participants against the old ones On the other hand, the few capital outflows that we have had during these months do nothing but benefit the old participants, who are increasing their positions at practically zero costs of the portfolio of options bought As we have seen in the final section of this week, it is po It is possible that they will finally begin to recover their value very quickly.
In any case, with current equity or even lowering a little more, we can endure much more market stress, understood by even more negative rates of 1 in 50 years, which in itself means that practically money loses half of its value in this term, or that things (shares), can be bought at a very significant discount when using interbank financing, as well as allow us to make derivatives markets.
Hedging Position In Precious Metals
For this reason, we maintained a very relevant hedging position in gold, silver and mining, which we understood that they should benefit intensely from this financing opportunity at these terms, since they cannot have negative interest rates.
This correlation seemed to work until many of the accounts that were invested in stocks, also had mining companies in their portfolio or directly gold as protection, have suffered in such a way and in such a short time, that they had no choice but to make cash. in their positions in these assets to protect the rest of their positions, making this protection useless, especially on the worst days.
Thus, as soon as we saw this fact clearly, we substantially reduced these hedges from 85 in the portfolio to 30 and thought of raising them again when we see that this crisis finally turns into a credit crisis that is difficult to solve, at which point we think these assets can work better again
In any case, after the appearance of Christine Lagarde this week recognizing her scarce abilities to solve the immense problem we are in right now, and transferring that responsibility to the part of fiscal policy, that is, increased spending by governments, the portfolio had an intense rebound in valuation, precisely one of the worst days of all the other assets, not only of the stock markets, but also of the bonds, which saw their prices drop sharply. Bonds have remained or have been accentuated in the subsequent rebound of the stock markets, and we understand that the “effects of the markets that we anticipated for a few months have already begun.
No Credit And/Or Bank Crisis
In no case do we see a credit and / or bank crisis compatible, with the banks themselves lending money at negative rates in these terms, but rather the opposite. We anticipate an increasingly important stress on these assets, where there are currently 15 and 20 trillion USD in bonds trading at negative rates, and which will certainly bring losses to their holders. These assets have been enjoying “due to the constant price increase they have had in the markets. In other words, they have had positive returns due to the revaluation. of prices, but they will have certain losses to maturity. A little the opposite case of the positions that we maintain in our portfolio.
The stress of these days is mainly attributed to the demand for coverage by some major insurers, which also have this crossroads in this type of long-term returns, and hence there has even been panic on the part of some of them trying to “The minimum possible long-term losses. That is, they are trapped, and their solution has been a kind of suicide. With a great deal of feeling, we believe that soon we will begin to see some of these companies with serious solvency problems.
Therefore, the overconfidence of many market operators in the ability of the ECB to push negative interest rates to infinity or beyond is hit hard by reality. On the one hand, the difficulties of banks and insurers, and On the other, due to the exorbitant increase in the need for funds to alleviate the effects of this crisis. We are increasingly confident that it will trigger a credit crisis, affecting the bond market, undoubtedly the most important due to its size and function as a transmission. of financing to companies, families and especially governments, which are going to have, we think, serious difficulties in accessing these resources. In fact, we expect the fall in bond markets, amplified by the effect of the greater differential that credit has already begun. in a very violent way to collect, it will cause large reimbursements in all types of funds based on these assets, putting liquidity in fixed income funds in trouble We do not rule out the possibility of some closings of funds, a kind of "
Global Allocation Fund Closed To New Investors
It is also for this reason that we anticipated last year, that our fund will be closed to new investors, but open to anyone who needs liquidity. Right now over 50 of the equity, without counting the assets in gold and silver that are also very liquid and easy to convert into liquidity.
In any case, these days we have had conversations with various institutional investors, who have asked us to enter the fund, knowing well the positions and the strategies we maintain in the portfolio. Only in a highly improbable or extraordinary case would we decide to open it to new investors. As I say, only to protect the old and / or strengthen them, thereby improving their return with those tickets.
Due to the amount, in nominal terms, of exposure that we have in purchased options, the time we have for these options to finally come into value (between 1 5 and 4 5 years for the most important ones), and the low value that they supposedly have Now, we anticipate that right now, in the event that we finally have the correct criteria on the events that we expect, the profitability of the fund can assume high or very high figures. They can make us multiply the assets of the fund several times, within a reasonable period of time. one and four years This strategy has been implemented respecting the concentration limits required by ESMA and compliance with these limits is being monitored on a day-to-day basis, so that if at any time these limits are exceeded, the deadlines imposed will be met. by the regulator to reduce such exposures.
In between, I reiterate, only if we see that we are able to replicate without added costs the same strategies or other positions that we see more appropriate to the evolution of the markets, the fund will remain closed to new investors, especially so that those returns are for all those that you have been placing your trust in us for a longer time We hope not to disappoint you.
The facts seem to begin to prove us right. The last NAV published on March 18, 2020 Global Allocation FI recovers a 37 55 with respect to the low of the day 10 03 period in which the Euro Stoxx 50 has fallen by 17 89.