We don’t try and forecast events as we’re simply not clever enough. Usually, by the time we think we have found an event on the horizon or something will happen it’s already reflected in the price. An example of this is how well the stock options markets can price earnings day moves well ahead of the earnings day. Real events that move markets on good volume are rarely found in investors’ calendars, and so as an investor I do ask myself how I can protect client capital against such events?
Over time, it’s become clearer to us that real asset moves are caused more by an asset’s vulnerability than the particular nature of any triggering event. Finding vulnerabilities tends to be easier than predicting future events. In our experience we have found that it doesn’t take much of a trigger to expose a vulnerability and the longer it takes to expose the bigger the unravelling move.
External factors can contribute both positively and negatively to asset vulnerability. Post the Global Financial Crises, Global Central Bank Quantitative Easing programmes are a valid example where unprecedented purchasing of securities has meant that downside vulnerability has been reduced. However, as these programmes are now coming to an end it should be noted that the tradable universe for global bond markets has more than doubled since the Global Financial Crises. Is this a problem? We’d ask;
1 – Who has issued all of this debt?
- Developed market governments
- US and European lowest rated corporates within the high-grade universe
- Emerging Market Corporates
2 – What did the issuers spend the money on?
- Growth has been very slow coming out of the GFC and CapEx as a percentage of GDP has been far from impressive globally. However, a considerable percentage of government bonds trade at negative yields and governments own record levels of equities.
- Unprecedented levels of own stock bought back by corporates. Corporates have been hiring which is getting us close to productivity capacity. Have low-rated corporates been extended credit that they didn’t deserve simply due to easy conditions and the subsequent hunt for yield? Without mentioning issuers, it should be noted that the European Central Bank owned bonds in the multi-billion dollar mattress company failure that markets witnessed recently.
- EM corporate debt is at alarming levels (bigger than GDP) and an additional issue is that some of this debt has been issued in USD as opposed to local currencies meaning that dollar strength increases the debt and cost of servicing the debt; a multi-variable and self-fulfilling vulnerability.
3 – If the Central Banks stop buying, who will step in?
- There’s no shortage of bond investors but the Central Banks have become bigger and bigger players in terms of market share whilst at the same time regulation has meant that the Banks no longer hold large inventories. It’s not obvious who will take the Central Banks space and it looks like there is a vulnerability fast building on the bid side.
Being a European-based equities player, we are best positioned to benefit from the vulnerability of the low rated European corporates and are actively seeking to find over-levered corporates that we believe are vulnerable to a normalisation of the bond markets. We are also monitoring companies that have bought back large amounts of their own stock, coupled with large ownership from Central Banks; particularly where earnings per share growth has come from a large reduction in the stock count whilst RoA has actually fallen. Such companies where the asset base has increased using debt funding is of particular interest. We believe it’s only a matter of time before these vulnerabilities become exposed and strong risk adjusted returns can be made from the inevitable unravelling. Perhaps more importantly, we seek to structure our positions such that we have little non-linear downside if the vulnerability takes a long time to be exposed.