Q1 2016 Quarterly Letter

Location Date: 
April 8, 2016

Well that was quite the wild ride! The year started off with a big thud as equities and credit were sold hard post the Fed rate hike. By the end of the quarter virtually all of the losses would be recouped with some emerging markets posting huge gains. Your Fund managed to profit nicely from the volatility to produce a tidy gain of 5.51% in Q1.

Global Overview - The Big Picture
A recent article in the Lex column of the Financial Times1 on Irish debt is one of the best metaphors I have seen for the current economic and financial landscape. The Irish government recently issued a 100 year, euro denominated bond at 2.35%. Amazing, that a small country that only 6 years ago was on the brink of default, via an epic property bubble, can come to market at just over 2%! Incredible, that investors can be so sanguine about inflation and default risk for 100 years! And to top it off, denominated in a currency that has not been around for even 15 years which many commentators feel is doomed longer term! To borrow from John Lennon: “Strange days indeed”. 

This debt issuance is a good example of our primary global macro position that we continue to be in a “slower for longer” growth period characterized by high global debt levels, excess capacity and insufficient aggregate demand. We outlined this case in our year-end letter and we continue to manage the portfolio with this as our base case scenario.

So what, if anything, has changed in Q1?

The Fed blinked and went dovish

After raising rates in December and watching the U.S. and global markets tank in January, the Fed changed the dot plot to incorporate economic challenges faced by the rest of the world (“ROW”) – and there are many. The Fed turned dovish and decided not to raise rates and the reprieve was greeted by the now predictable “Pavlovian” global market rally.

And the U.S. dollar sank and markets rallied

After a big rally throughout 2015, the USD tumbled in March and is down roughly 4% for the year. As we have noted, the USD is one of the “pressure valves” of sorts – particularly with respect to emerging market assets (given the large USD denominated corporate debt) and commodities. As BCA has noted, the Fed is aware of the dynamic impact of their rate decisions. A dovish Fed eases global financial conditions via the USD, which in turn emboldens the Fed to become hawkish and then repeat the threat to raise rates. Until international growth returns this bizarre feedback loop will continue.

But wait, in ation is perking up

The Fed is charged with a duel mandate of full employment and stable prices. Based on the cycle low levels of unemployment at 4.9%, an increasing participation rate, elevated job openings and a rising quit rate, it would be fair to say that employment is on a good footing. So that box is ticked.

But what about inflation? U.S. core inflation rates are starting to rise, as they tend to do in the later stages of the economic cycle. As the figure beside shows, even the Fed’s preferred inflation measure, the core PCE rate is sneaking back towards the Fed’s stated 2% target. Our best guess is that the PCE will be through 2% well before year-end and that the Fed will have to tighten. The timing of the hikes is tricky and compounded by both the upcoming Brexit vote and the U.S. elections. There is clearly a chance that we see no further hikes this year.

So why is the U.S. treasury market rallying if inflation is picking up?

The bond market is always smarter than the stock market when it comes to economic forecasting. The U.S. 10 year bond yield continues to fall, and along with a fl attening of the yield curve (10’s – 2’s), is signalling further slowing growth. So what gives? Well, it appears that the bond market completely
agrees with the Atlanta Fed on Q1 GDP expectations and completely disagrees with the economics teams at the sell-side research fi rms and other regional Feds with respect to where the U.S. economy is headed.

Clearly, if the Fed continues to raise rates into a slowing economy then the economic and financial consequences will likely be bad to put it mildly. So the Fed is truly boxed in. Global economic growth is needed badly.

Kuroda goes negative and Draghi brings out the bazooka…

The BoJ in January unleashed negative rates (“NIRP”) and continued to buy equity ETF’s in their attempt to stimulate the Japanese economy and ignite inflationary pressures. Unfortunately this has had the completely opposite effect of what was intended. The yen surged up over 9% in the quarter (on repatriation flows) and inflation has fallen back close to zero as shown in the side chart. Not wanting to be left behind, the ECB finally opted to push rates even further into negative territory and to expand the size and scope of its QE program. The euro fell on the announcement but later rose to year highs after Draghi said rates need not raise any further. While European PMI’s have shown some recent strength, both Japanese and European financials are getting clobbered. With banks everywhere in rough shape and subject to much tighter standards, the necessary credit to fuel expansions seems lacking.

Central banks are losing their omnipotence

I enjoy reading the Epsilon Theory blog posts by Ben Hunt. He was one of the early commentators on the likely waning power and influence of global central banking. It appears that we are just about at the tipping point. Monetary policies like NIRP are now showing negative effects – especially in the financial sector. Pension funds, savers and of course the middle class are now the victims of what is colloquially termed “screwflation” brought about by such policies. Until we have addressed the global debt overhang (via write off , austerity or monetization) or see a real pick up in global GDP growth, this situation will not change and the commensurate tail risks will remain elevated. On another note, is it just me or does it seem that every single day there is a some regional Fed head or some global central banker on TV or pitching their book deals – rock stars, all of them!!

Here comes the new policy driven world - de-globalization

Larry Summers has been a leading proponent of the view that the world is in economic stagnation, the result of insufficient aggregate demand. His principal solution is for governments to take advantage of low rates and take on additional debt for large-scale infrastructure investments. Indeed, the newly minted Trudeau government in Canada is taking this approach with its first budget. We would not be surprised to see similar fiscal spending type announcements before year-end from Japan and importantly China. The U.S. will likely have to wait until post election. Depending on spending levels, multiplier effects and execution, this could help drive up international growth.

Clearly, many governments are engaged in a currency war in the battle for export driven growth – as we noted, it appears that monetary policy is now a counter productive force so it is not surprising to see trade issues arising – steel is always popular – the U.S. and now Britain looks poised to act against the dumping from China. All of the Presidential candidates are also for rejecting the Trans-Pacific Partnership (“TPP”) agreement. As Mr. Hunt notes, this actually creates a ‘negative sum game’ as retaliation begets retaliation and growth slows everywhere. But this is very consistent with what we are seeing with populist political agendas across the globe.

Finally, it appears that governments are getting more aggressive in their hunt for more cash. With the Allergan/Pfizer deal called off , inversion deals are done and so is the free tax carry. Drug pricing is coming under fire and based on the “Panama Papers”, good luck if you are evading taxes off shore or you have an undeclared off shore holding company – Uncle Sam, the CRA and others will be looking for you!

Recession watch in the United States?

Currently there is much debate on whether the U.S. is entering or will soon enter a recession. From our perspective, the real debate should be focussed on corporate profits. On this front, the situation in the U.S. does not look good. Profits and margins, even outside of the energy and materials sectors, have been contracting for two principal reasons. Firstly, as noted earlier, wages (expressed as unit labour costs) have been rising faster than final prices. Given the lack of final demand, this is not unexpected. Secondly, the strong USD has crimped the profits of U.S. industrials and technology companies. Whether the recent respite for the USD is enough to off set the margin compression remains to be seen in the upcoming quarterly results. Some will think that payroll and employment growth will help the U.S. economy grow again. In fact, these are lagging indicators, not leading indicators of future growth. As seen in the Atlanta Fed forecast, the economic trends do not look good.

The Portfolio Results


Equities generated approximately 80% of the P/L for the Fund in Q1.

Our macro positions, comprised of single country or industry specific ETF’s and futures, both long and short, produced the majority of the gains for the quarter. The biggest contributor was our positions in gold equities, which benefi tted from the weak USD and strong seasonal factors (as they did for us last year as well). We remain bullish on gold shares for reasons to follow.

On the international side, we remain short both Italian and Spanish equity markets which were profitable as valuation has not proven to be a catalyst versus a challenged European banking system. We also made solid gains in other shorts, especially the EEM and XIU. Our thesis for shorting markets impacted by China (by either a falling yuan or slower Chinese economy) has not worked well. However, our shorts in Korea, Taiwan and Hong Kong remain in our portfolio as we expect a substantial consumer slowdown in China in Q2 to adversely affect these markets.

Pair trades and long/short trades are very attractive right now and we made good gains in Q1. In particular, our healthcare and consumer long/short books did really well. Examples include Nobilis (long) and Valeant Pharma (short) and Michael Kors (long) and Coach (short). We remain short consumer discretionary broadly in the Fund – it marries up with one of our portfolio sub themes which is to be long “lower income” type companies (Walmart) and short “luxury or high income” type companies (Tiffany).

We remain very defensively positioned in equities with a net exposure of -12%. The combination of a very dovish Fed (“Don’t fight the Fed”) and what is now very constructive price action (e.g. rising breadth, high percentage of stocks over their 200 day MA etc.) is undoubtedly attracting the ‘sidelined’ cash. But poor corporate earnings growth and margin compression coupled with relatively high multiples, are not conducive to bull markets.

Bespoke Investment Group notes that falling profits have been a function of falling overseas profits for U.S. corporations (as opposed to domestic related) and poor results from financial firms (a function of extremely low rates). With overseas growth unlikely to materialize soon and U.S. growth on the verge of rolling over, you can see how challenging things may become for equities.

Fixed Income

Fixed income generated approximately 10% of our P/L in Q1.

We held a small long position (on a risk adjusted basis) in U.S. Treasury futures (10 yr and 30 yr) which yielded attractive returns as rates continued to fall in the U.S. We have since taken profits and are currently zero weight. Our positions now are in high grade corporate U.S. debt (LQD) and sovereign emerging markets (EMB and EMLC). EM debt in particular is also a decent hedge with positive carry to our broadly short exposure in EM equities.


We have substantially increased our commodities exposure with the focus on precious metals via gold, silver and platinum futures along with call options on the same. There is a possibility that the Fed may in fact do no further rate hikes this year if economic growth remains sub-par. In this scenario, the USD would break key technical support (93 on the DXY) and gold would likely rise further (it is up over 15% this year).

WTI crude prices and the XLE are now closing in on their 200 day MA’s. Technically oil appears overbought but with the upcoming OPEC meetings, there is scope for further gains. In particular, BCA’s energy team estimates that oil markets will be re-balanced by the 2H 2016 – one year earlier than the EIA estimates – and that prices should rise into the $50/barrel region. This is predicated on larger/faster production declines rather than a surge in demand. As the old adage goes “Nothing cures low prices, like low prices”. If this is the case, then the C$ is set to rise, along with EM equities and high yield debt. We remain very lightly invested in energy related commodities or equities but are willing to change course if BCA’s forecast appears more likely.

Elsewhere, we have traded around positions in cotton and soybeans – both charts look interesting and the fundamentals are improving. Perhaps we will discuss this further in next quarter’s report.

Foreign Exchange

Our foreign exchange positions refl ect one of three views:

  1. A relative value trade Short NZD/CAD or short GBP/SEK
  2. A general market hedge Short EUR/JPY
  3. A general trend Long USD/CAD

We have recently closed out our long USD/CAD trade and as we noted in our year-end letter, we are more focussed on relative value opportunities than trending ones given the “long in the tooth” duration for some (such as USD/CAD). We remain constructive on the USD dollar given the relative inflation outlook for the U.S. relative to other parts of the world. The move in the DXY from 100 back down to 94 is most likely a pause but we have a hard stop around 92 – much will depend on the Fed’s policy actions.


As equity markets closed out March on their highs and equity volatility collapsed, we decided to eliminate a number of our general market hedges, like the Russell 2000, EEM and XIU, in favour of put options where prices now reflect better value. We have reduced our short EUR/JPY position as well as it technically was very oversold. As you will see in our portfolio positioning, we remain net short equities (on a absolute and delta adjusted basis) allowing our portfolio to exhibit more negative correlation with stocks and more “alpha” from a relative value perspective.

Concluding Thoughts

While we are pleased with our Q1 results, we are not expecting the same performance this quarter. We have conviction in our relative value trades but because of our light use of leverage, we cannot produce large returns. Many markets from a technical standpoint are in “no man’s land” i.e. they are either bumping up against their 200 day moving averages (up or down) or they have crossed them but the trend is still not supportive. In this kind of environment, we try to remain patient and pick our spots. Any directional type ideas are now more likely to be expressed via the listed options market. As a small, nimble fund we still feel we can generate decent returns in this environment. All the best and we look forward to reporting back in July.

Jim McGovern

1  Financial Times, March 31, 2016, “Ireland: define normal”