This investment note provides an insight into the Fund’s performance, dating back to the start of the 4th quarter of 2018. The last ten months have been a particularly turbulent period for financial markets, with significant swings in the price of risk assets in the midst of growing geopolitical tensions and a slowing global economy. Following the ‘about-turn’ in central bank policy, from quantitative tightening to quantitative easing, the environment we find ourselves in today poses a stark contrast to the autumn of 2018. We discuss the impact this has had on positioning within the Fund as well as the future outlook.
A period when economic growth forecasts were robust. The expectation of rising interest rates and quantitative tightening posed a threat to that economic growth and, therefore, bond and equity valuations. The Fund was positioned accordingly, it rose as markets fell.
Casting our minds back to the final quarter of 2018, the rhetoric from central banks focussed on quantitative tightening; the Federal Reserve had embarked on a path of interest rate rises and the European Central Bank (ECB) had started tapering asset purchases.
The Fund was positioned to benefit from this quantitative tightening and the risks that this posed to financial markets. The view within the fund management team was that rising interest rates would put a strain on less financially strong companies or ‘zombie companies’ which had been able to survive due to the proliferation of low interest rates. We believed this could cause significant stress in the corporate bond market, with valuations suffering. Rising interest rates also posed a threat to the valuation of ‘growth’ companies that rely heavily on discounted future cashflows.
We held a number of strategies that were designed to deliver a return if the scenario outlined above came to fruition; strategies that focussed on ‘bottom-up’ analysis or what we define as micro strategies. Whilst we structure these investments with the aim of delivering a positive return regardless of the direction of markets, a number of the strategies had a bearish bias, meaning the return potential was greater in a ‘risk-off’ environment, such as the one we witnessed in the period. This explains the positive performance of the Fund in a quarter that saw a significant fall in both equity and corporate bond valuations.
Following the fall in markets we cut back the Fund’s bearish positioning. Central banks, particularly the Fed, indicated a looser policy and markets reacted by recovering sharply. This proved a headwind for performance and the micro strategies were unable to compensate.
Given the substantial worsening of credit conditions, we decided to reduce our bearish position in corporate bonds, locking in value following the market moves. This proved timely given that early in the quarter the Federal Reserve surprised financial markets as it moved to a more dovish stance in an effort to reassure investors that they were not on autopilot; that the outlook of any more rate rises would be dependent on the economic conditions and outlook. This proved to be a shot of adrenaline to risk assets, with a sharp ‘V-shaped’ recovery ensuing, corporate bonds and equities quickly recovered their Q4 losses.
The defensive positioning within the Fund and the bearish bias of a number of the strategies meant the sharp recovery in risk assets was not a backdrop that would lead to positive performance. The decision to reduce a large portion of the bearish position in corporate bonds helped to stifle the drawdown.
Whilst the macro environment proved to be a headwind to performance in the quarter for a number of bearish strategies, we would have expected offsetting positive performance to have been delivered from the core micro strategies that do not take market directional risk. Unfortunately, the required catalysts within these strategies did not occur, an example would be our Pershing Square strategy. This strategy sits within our Discount Opportunity theme, where the goal is to take a position in an asset or company that is trading on a discount to its Net Asset Value (NAV) whilst also hedging our exposure to the underlying portfolio. These two opposing positions mitigate market risk and ensure the return of the investment is derived from the size of the discount to NAV. During the quarter the discount to NAV actually widened out because the performance of the underlying portfolio NAV outstripped that of the share price. Whilst this caused a negative return for the Fund for the quarter it also provided the opportunity to increase our exposure at a better level to one of our high conviction micro strategies. The desire of both the Pershing Square manager and the Board to narrow the discount, coupled with the improved sentiment to the trust after a period of strong performance act as catalysts for the discount to narrow in the future.
Corporate bond markets had rallied to levels where it was attractive to re-instate the bearish positions. Selected micro strategies were also topped up. In May investors took fright over trade wars and markets fell, the Fund again delivered a positive return in that month.
The strong rally in corporate bonds in the first quarter of the year, as credit spreads tightened beyond the lows seen at the start of Q4 2018, encouraged us to renew a number of bearish strategies. The move looked overdone, in our view, given the softening global economic data and more negative outlook for earnings. We were also able to top up our positions in Sanditon Investment Company and Boussard & Gavaudan at attractive discounts to NAV as their value biases were considered less appealing by investors. We continue to favour the underlying strategies of these companies while also seeing the potential for a number of catalysts leading to narrowing discounts.
May was another ‘risk-off’ month as increasing trade war tension spooked equity and bond markets that were already facing the prospect of a more synchronised global slowdown. The Fund performed well in May, relative to risk assets, delivering a positive return. This demonstrates the defensive nature of the Fund and the ability to perform when other asset classes are struggling.
A rapid change in central bank policy in major economies resulted from weaker economic growth expectations. Bond yields fell sharply. The macroeconomic driven moves were a headwind for the Fund.
With the softer global economic data now looking more like a synchronised slowdown central banks performed an about turn and made it clear to financial markets that they would start to ease monetary policy again, doing what was necessary to prolong the economic cycle. This was a significant shift in stance given the ECB had only started tapering (Quantitative Tightening) 6 months before following 10 years of a monetary easing cycle.
This caused a sudden and sharp fall in interest rates and a significant improvement in credit conditions as investors resumed the hunt for yield, looking through the worsening economic data under the assumption that central banks would be able to steer the economy through the tough period.
The Fund was not positioned for this sudden change in stance from central banks and the shift from believing the soft data would be transitory to the idea that we were in the midst of a synchronised global slowdown. We also underestimated the willingness of investors to look through the worsening economic data and worsening outlook in their hunt for yield; instead we were positioned to benefit from a shock to risk assets caused by the fear of a global recession. In reality, credit spreads tightened even though the macroeconomic data and outlook had significantly worsened.
Our belief is that markets have become highly complacent about the ability of central banks to revive the global economy and prevent a slowdown. They have significantly less ammunition in their armoury this time round and traditional monetary easing has already proved ineffective in delivering sustained economic growth.
These macroeconomic moves proved to be a serious headwind for a number of our bearish micro strategies. For example, the Global Equity Market Neutral Strategy was a negative contributor to performance. This long/short strategy uses a combination of screening and fundamental analysis, with a valuation bias, to select a number of diversified pairs.
The Fund’s positioning on interest rates was adjusted following the policy shift, but the bearish stance in corporate bonds was maintained with the view that they were “priced for perfection”, that is; all the good news was in the price and any bad news wasn’t.
In response to the dovish shift from central banks we reduced our responsiveness to falling interest rates but maintained our bearish position in corporate bonds. We believe this market is ‘priced for perfection’ with a complete complacency that central banks will be able to prevent the economic environment from worsening. Corporate bond prices have risen significantly in response to the dovish central bank tilt and we believe this asset class is most susceptible to a rerating should central banks under-deliver or should we see economic conditions continue to deteriorate. We also believe that there is little central banks can do about the “event risks” of a hard Brexit or full-blown trade war.
We see an increasing disconnect between the technicals and the fundamentals with the hunt for yield driving corporate bond prices up on the belief there will be significant central bank support. At the time of writing the market value of bonds with negative yields has breached US$16 trillion and is still climbing.1
Along with the risk to corporate bond valuations, a significant risk we see to the bond market is the liquidity risk. There is a liquidity mismatch with the evolution of ETFs and funds that provide daily liquidity at a time when the number of market makers is dwindling. Regulation now prevents banks and market makers from holding significant inventory or plugging the gaps as bond prices fall. This makes bond prices increasingly susceptible to avalanche-like drops in pricing if everyone runs for the exit door at the same time.
We continue to actively manage the portfolio and recently closed a Relative Valuation micro strategy at a healthy profit. To open the strategy we had bought the FTSE 100 and shorted an investment company investing in UK small cap equities that was trading at a premium to NAV. We believed the investment company share price was not reflecting the illiquidity of the underlying portfolio. This worked well for us as the FTSE 100 outperformed and the investment company discount to NAV widened out significantly.
Investors have become increasingly worried about global economic growth and there is much talk of recession, equity markets have sold-off and government bonds / safe haven assets have benefitted. The levels of risk have heightened and fear is taking hold. The Fund has performed well and as expected in such an environment.
The end of July running into August has seen a growing ‘risk-off’ environment, August is generally a month with lower liquidity which can lead to significant shocks to markets and we’ve already witnessed large daily swings in bond and equity prices.
Financial markets are quick to react to newsflow with the moves in asset prices exacerbated by lower liquidity. The surprise announcement by the US of a further tariff levy of 10% on $300bn of Chinese goods caught everyone off-guard and led to significant rerating of both bonds and equities.
The Fund again has performed well in this environment demonstrating the importance as a genuine alternative. In the last three ‘risk-off’ scenarios (Q4 2018, May 2019, August 2019) the Fund has generated a positive return as credit conditions worsened and equities fell. This is particularly relevant when the correlation between equities and corporate bonds has been positive this year, meaning a traditional portfolio would not benefit from perceived diversification.
The Fund remains focused on investing in micro strategies which can produce positive returns in their own right through different market conditions. Other positions will be taken subject to market conditions and opportunities. The fund managers remain of the view that we are approaching the end of the economic cycle and that risks in most asset classes are rising. It is therefore appropriate to reflect this in the investment strategy. The Fund’s objective is to provide positive returns over rolling 36 month periods. It remains focused on that and aiming to protect capital in challenging market conditions.
Robin Willis and Daniel Hughes
Premier Asset Management
1Source Bloomberg, as at 14.08.2019
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