We have some good news: we have found one more of the many, many hedge funds who bought into the biggest bandwagon trade of 2014, namely that the world is recovering and it is time - yet again - the short Treasurys. That fund is Crispin Odey's Odey Asset Management (which as Bloomberg reported recently had its AUM soar from $8.3 to $12.4 billion in 2014, leading to $271 million in profits to its LPs), which despite its massive growth generated just 5% in P&L, despite "having been on average 27% net long equities." The reason for the underperformance: the same reason most other hedge funds also were on the other side of one of the best trades of 2014: long Treasurys.
It was a frustrating year, where we felt we gave unnecessary performance away... the short 10-year Treasury (-4.87%) and Gilt positions (-2.95%) were costly and clearly a bad call given how things have developed. We don’t mind losing money when the market is just taking a different short-term view to us, in fact we quite like this, but we hate losing money when we are wrong.
The bad news: one of the biggest bulls of this particular central bank artifical-bull cycle is turning bearish, and in its latest letter is warning about what he thinks are the biggest risks underpriced by the market. Here is the breakdown:
6 years into a bull market, with multiples above their long-term averages, we do feel there are certain risks that are under-priced by the market:
- Sovereign QE not working in Europe
- Emerging market capital flight
- Political risk/popularist governments
- US wage inflation
- Increased currency volatility
- Insurance against natural catastrophes
1. It feels that the market has and is placing high hopes on Mario Draghi delivering a silver bullet with regards to European QE. To us, European QE is broadly a red herring apart from the weakening effect it has on the currency (which may in fairness be mainly what Draghi has in mind). For us the difference with US sovereign QE, in terms of its potential effectiveness, is stark. US banks were less leveraged and had cleaner balance sheets. Europe still has material unre-solved structural issues with regards to labour markets and encouraging investment that only governments can resolve. Bond rates were at a much higher level when US QE started: the 10-year rate on the US bond was 3.11% in November 2008, compared now to 0.45% on the German 10-year and 1.52% even on the Spanish 10-year. European equity multiples are higher than US multiples were at the time.
2. Although expectations of the first US rate rise have moved out, and bond yields have reduced recently, dollar strength could be a problem. Foreign debt to GDP in emerging markets is below the peak seen at the Asian crisis of 1997-8, but remains >40% of GDP (predominantly dollars). Meanwhile the dollar has appreciated 16% against the JPMorgan EM Currency Index since last May. The flip side of local currency debt is that developed market savers are taking on the currency risk, leading to potentially material losses from what is meant to be a ‘safe’ asset class. Below is the Ashmore local currency sovereign emerging market debt fund as an example of how disillusioned developed market savers could get.
On top of this, liquidity in emerging market bonds has dried up following the tightening of banking regulations (mainly due to leverage ratio constraints and the Volcker rule), so it may only take a small spook to cause a stampede. We have already witnessed on Oc-tober 15th a “six-sigma” movement in some portions of the US yield curve. Treasuries should be the most liquid asset class in the world.
3. Political and policy risk is often surface froth, but there are periods when its effects run deep and can change valuations of multiple asset classes. 2015 requires careful attention through this lens.
The electoral cycle brings instability to Europe, particularly in Greece, Spain and the UK. German domestic politics sinks its teeth into ECB decision-making. US politics is particularly important for the hardened stance it threatens to bring against Russia and possibly Iran, whilst a fight is engaged in Washington as to whether the US attempts to ring-fence the Middle East as a “quagmire” or gets more deeply involved there once again, with the impacts that could have on the oil price and terrorism back home.
Basic concepts are being challenged, yet to date QE has partially dampened potential instability. ISIS contests the concept of nation states; Mr Putin contests the West’s concepts of a multi-lateral and UN-focused world without spheres of influence; China’s rise continues to require further international ‘adjustments’; and the peoples of numerous countries want more independence, more identity politics, and are less content to belong to large political groupings. What we see in Greece and Spain we see in the UK.
The UK is in a moment of national, constitutional and party argument, where centrifugal and splinter forces test their strength against forces of stability and history. The General Election could go either way, very different economic and social policies could result, and even under scenarios offering continuity at the fiscal level, such as the permutations of a Conservative government, an EU referendum delivers instability as its counter-punch.
4. Although recent hourly wage inflation has fallen short of expectations, and the falls in commodity prices reduce the probability, there is a risk that US wage inflation accelerates, causing unit labour costs and rates to rise ahead of expectations. What is interesting is how differently private sector wages are growing in America for unionised labour forces and non-unionised.
This suggests that there is huge value in being in a union at the moment, and that non-union private sector workers in the US do not appreciate the negotiating leverage they have with companies. With unemployment falling almost every month at the moment, and currently sitting at 5.6%, there is a risk of a sharp catch-up in this ‘underpaid’ dynamic. The chart below represents a margin threat to the S&P 500. The shape of the chart cannot be sustainable or else it ends with social unrest; certainly it fits Obama’s recent State of the Union speech on closing the ‘US income gap’.
5. Currency volatility has picked up markedly from historical lows. We have recently seen some extreme examples with regards to the Swiss franc, where companies such as Swatch, FXCM and Global Brokers have been caught out. With further dollar strength, internationally-exposed US companies will also face headwinds. First, they face the translation impact of lower revenues coming from outside the US. Secondly, it makes US companies less competitive. Thirdly there can be a transactional impact (margin squeeze) where there is a mismatch between a dollar cost base and international revenues. Lastly, where there is an asset-liability mismatch, such as US dollar debt matched against cash or revenues in a foreign currency. This last phenomenon is going to be more common this cycle for US companies which have taken on dollar debt with cash trapped offshore due to repatriation taxes. Amazing as it is, the market is quite poor at pricing in these movements.
6. Although insurance of natural catastrophes is a niche area, it is one we have taken a position in by shorting some of the insurance companies. After three years of rate reductions, real property reinsurance pricing has fallen to the lowest level in fifteen years post the 2015 January renewal season. Large cat losses have been very low recently (2014 and 2013 were 50% and 30% below the 10-year average), which has propped up reinsurers’ results. We believe the market is far too complacent on the sustainability of this level of earnings. Judging from historic patterns, current pricing supports a normalised, interest-rate adjusted, combined ratio of 105%. Therefore, we expect the 2016 normalised earnings for the large European reinsurers to halve from the 2013 reported numbers (EV/EBIT 2013 10.6x vs 2016E 17.0x).
Reinsurers’ earnings were also flattered by marking to market unrealised gains from falling bond yields – for example, around 20% of Munich Re’s TNAV is unrealised gains on fixed income assets (P/TNAV less unrealised gains is 1.4x vs 1.1x spot). When bond yields stop falling, this premium over par value starts to unwind: given a typical asset duration of 3 years, we expect a 10% book value drag per annum (pre-tax). It is only a matter of time before large losses normalise, higher bond gains drop away, and the severe deterioration of underlying margins is revealed.
... we see more risks to the market this year, and are currently about 20% beta-adjusted net long. We have materially reduced our short government bond positions given that the facts as we see them have changed and there is an increased risk that the downward pressure on inflation from commodities has more than a transitory impact.
That means that one of the two most crowded trades of 2015 (the other being the USD-long of course), the US Treasury-short, is just a little less crowded now. Which also means that when the epic short squeeze puke finally hits, it will be just a little less brutal.