Q2 2016 Quarterly Letter
Another wild time in Q2 with the roller coaster ride associated with the “Leave” vote in the UK referendum on EU membership hitting quarter end.
We were pleased with our good fortune in generating positive consecutive monthly returns throughout the quarter ending with a solid gain of 5.61%.
Global Overview - The Big Picture
The announcement early in July that the current private equity owners of Hostess Brands, makers of Twinkies and Ding Dongs, were taking the once bust company public again, is a tidy metaphor for today’s world. The bankruptcy of Hostess in 2012 was the product of a debt bloated capital structure, large pension liabilities and an ‘inefficient’ 18,000 strong workforce. Hostess sold the Wonder Bread business to Flowers Foods, while the Twinkies/Ding Dong brands were sold for $410 million to Apollo and another private equity firm. Today’s Hostess is a shell of its former self. Automation has misplaced the once unionized workforce (roughly 2000 workers now) and margins are very healthy with adjusted EBITDA of $220 million! As noted by the FT’s Lex columnists:
“The elite making a pile on an esteemed brand while pensions and jobs disappear makes the Twinkies revival an ideal symbol for those who suspect something has gone badly wrong in the modern economy.”1
The Twinkies story shows the dynamism of the U.S. economy – could you imagine this happening in France or Italy? Not likely. But it is also a byproduct of the structural forces globally impacting and shaping today’s narrative with rising income/wealth inequality and defl ationary technological advances at the forefront. But this company and its, albeit smaller, workforce would be long gone if not for the capitalists. Therein lies the conundrum and the motivation for the growing role of government policy in our economic lives. Taxation and trade arrangements will be at the heart of future policy.
So what, if anything changed in Q2?
Brexit of course!
There has been too much already written on Brexit. For me the result is not a huge surprise as it is an extension of the well documented global issues of immigration, income inequality etc. What I did find interesting was the market’s “collective” wisdom that Brexit would in fact not happen. The failure of investors/traders to understand the well known limitation of classical statistics was amazing – simply, the standard error made these polls too close to call. As the markets rallied steadily into the vote, we established a short position in £/$ at 1.50 on the simple premise that the downside was far greater than the upside by a big margin. We were also short Italian and Spanish equities as the whole concept of the EU would be put at risk (in the short run anyways) with a Brexit vote. It doesn’t pay to be a contrarian all of the time and sometimes it is better to be lucky than good!
Speaking of Italy….it is Pasta its best (no pun intended)!
Long before Brexit, the garlic belt of the EU has remained under intense financial pressure. This quarter we want to address Italy in particular because the world’s seventh largest economy and third biggest bond market may be the next hot spot come this fall. Brexit did have a material impact on bank shares and credit supply, the result of the impact on rates and risk premia - and in particular on Italian bank shares as they are amongst the weakest in Europe. Italian bank non performing loans stand at €300+billion or close to 20% of GDP2!
PM Renzi is proposing a €40 billion bailout using public funds, something the EU (i.e. Germany) is technically against but which will likely be agreed upon in the backrooms. After all, given that 50% of the subordinated debt holders are retail investors, it would be political suicide not to bail them out. However, Renzi has also called for a vote on constitutional reform in October and is trailing in the polls to the Five Star Party (anti – EU); this adds additional political uncertainty. Clearly economic growth is desperately needed – aside from reforming the banking sector (consolidation, recapitalization etc.) – the low rates aff orded to Italian government debt gives Renzi the ability to boost fi scal spending despite having one of the highest (164%) debt to GDP ratios. Italy is clearly a must watch global hot spot as it, like Japan, is inching closer to the tipping point.
Helicopter Ben meets Helicopter Yen
Oh to be a fly on the wall during Mr. Bernanke’s recent visit to Japan. Abe certainly needs an expert on deflation given Japan’s decades long affliction. Monetary policy is effectively exhausted. A stronger currency (¥ at 102), a falling stock market (down 18% in 1H) and inflation falling again, have the markets expecting something much more than negative rates and perpetual QE - enter “Helicopter Money”. A massive stimulus plan (~$200 billion or 4% of GDP) fi nanced by the BoJ (likely via 0% perpetuals) is possible this summer – especially after Abe’s successful electoral win in the Upper House. This is likely to generate inflation but as we have argued before, Japan sorely needs more structural reforms. That being said, we do believe there is now a trade to be long Japanese shares and short the yen again.
One interesting lesson from Japan was the massive infrastructure spend post the property bubble bust in the early 90’s. The graph below highlights how much “room” other countries will have to reach the level of Japan if, as we suspect, aggregate demand remains well below equilibrium levels (given today’s interest rates).
And China’s Silk Road to nowhere?
Martin Barnes of BCA describes China’s current situation as a “High Wire Act”. After attempting to clamp down on corruption and rampant speculation, 2016 has seen much greater support for the economy via fiscal expansion and rapid credit growth. The results have been most evident domestically in the escalation of real estate prices once again. As noted in our last letter, the massive build up in corporate debt (145% of GDP) and a slowing domestic and global economy is a toxic combination. Declining profitability and ability to service the debt, especially by the SOE’s, is a real concern3. But given China’s relatively low government debt to GDP (40%), non-performing debt for equity swaps via the PBOC will be the order of the day going forward. Shadow banking associated with Wealth Management Products (“WMP’s”) is being replaced with Trust Beneficiary Rights (“TBR’s”) which transfer NPL’s to trust companies who act as the guarantor. Larry MacDonald notes “The genius is that the banks now get to report these non-performing loans as an asset on the balance sheet as it is a trust4!” Many market commentators are extremely concerned about the growth of debt and NPL’s. We share these concerns but feel there are still policy options to mitigate – at least in the short term.
Besides the defacto public sector recapitalizations of the state banks, the PBOC is also in the midst of a steady depreciation of the Yuan and continued cuts in rates. Economic growth continues to moderate despite all of these moves – falling growth and a weak exchange rate have large implications for markets outside China which we are trying to exploit.
The Portfolio Results
Equities generated approximately 6.77% for the Fund in Q2.
Our macro positions did not change much over the quarter however we were forced to trade aggressively as markets began to price in a bounce in global growth in Q2.
In particular, we have started trading from the long side select EM countries where we have predominantly been short – these markets include Brazil. The Brexit vote has put the FED on hold until December most likely which has allowed some breathing room for EM currencies like the Real.
We were fortunately able to benefit from the Brexit vote in late June with our short Italian and Spanish equity ETF’s. We reduced our shorts post vote. With the European bank stress tests coming in July and the Italian constitutional referendum in October, we will be looking to further trade around these core short ideas.
In Asia, we continue to be short markets that will be negatively affected by China’s slowdown and monetary policy. In particular, we remain short Australia, Korea, Hong Kong and Taiwan. These have been partially hedged by longs in Indonesia and Malaysia for idiosyncratic reasons.
Our individual security long/short portfolio continues to be thematic in nature. We remain net short a basket of consumer discretionary companies versus consumer staples. The biggest themes here are long “basic needs” versus short “luxury”. Within financial services, we are net short consumer finance, traditional asset managers and Canadian mortgage lenders. In basic materials, we remain long a portfolio of lithium stocks along with gold and silver shares and select zinc exposed companies. Finally, we are opportunistically trading energy shares with a bias to be long – especially natural gas focussed companies.
We remained defensively positioned in equities although less so then in Q1. At the end of Q2 we were 6.12% net long.
Fixed income generated 0.15% for the Fund in Q2.
We discussed last quarter the potential for rising inflation in the U.S. – core CPI and the PCE are still expected to rise to over 2% by year end. Pavilion notes that the Atlanta Fed’s “sticky” prices are rising faster than “flexible” prices indicating a pickup in broad infl ationary pressures.
Shelter and medical prices are running hot and U3 employment levels suggest limited slack in labour markets. So given marginal productivity gains, it requires more labour to maintain 2% GDP growth - thus xcreating wage infl ation5. In “normal” times, the FED would begin raising short term rates. As BCA notes: “FOMC members are more worried about making a policy mistake by tightening too quickly than they are about falling behind the curve on inflation6.” It also helps that Chair Yellen’s favourite labour statistic, the Labour Markets Conditions Index has also continued to fall in Q2. Of course all of this leads to real interest rates becoming more negative which is good for gold. Nominal rates (10yr & 30yr) are no longer attractive as either a hedge or as an outright investment and we clearly now prefer TIP’s.
We closed out our EM debt positions in Q2 given our more positive views on EM equities short term. We have established a 5% long position in Aussie 10 year bond futures. We expect the RBA to cut rates further this summer as the economy and inflation slows. The Australian real estate market appears to be rolling over as well.
Our focus in commodities remains gold. Yes it has performed extremely well YTD, but our view is it will be either the best (if USD breaks down) or the second best (if USD breaks out) currency in the world. Silver also remains attractive. Our portfolio includes futures and gold equities.
We remain conservative on energy markets. Oil prices have retreated off the $50 level and we expect a range bound market. We will look to get long in the low 40’s, partially as a hedge to our CAD short. Many companies are trading with implied $55-$60 oil prices already. Natural gas is interesting for structural reasons given the collapse of the coal industry in the U.S. We own a small portfolio of Marcellus shale (lowest cost) equities rather than natural gas itself.
On the agricultural side, we have a small position in grains as a portfolio diversifier. Prices have been hit recently so we will look to add to this position when the market stabilizes.
Our foreign exchange generated -1.26% for the Fund in Q2. YTD this bucket has been negative largely because the pairs are often in place for hedging purposes.
We have re-established a long USD/CAD position again. We are concerned by the lack of export growth in Canada outside of energy – especially given the low level of CAD. It is likely the BoC will ease before year end. We remain USD bulls and have positions short EUR, AUD, NZD, JPY and SGD against it. Whether the FED raises rates or not this year, we believe the market will continue to expect others to ease regardless of FED policy.
Technically, the U.S. equity market has “broken out” to the upside and all investors need to respect the collective wisdom. With rates expected to remain low and government stimulus on the rise, markets are expecting strong 2H 2016 profits growth. We are skeptical but net long equities and hedged via OTM puts on the S&P. Volatility has collapsed once again post Brexit. The CAPE is very elevated and the spread between GAAP and proforma reported earnings is especially wide. We are reminded that “when the going gets tough, the accounting gets cute!”
As we noted at the start of our letter, governments are going to play a critical role in infl ating the economy. How the market interprets and incorporates this into security prices appears to be tilting towards equities and away from bonds. We still want to be very hedged. The performance of bank shares, UST’s and the USD will be the key “tells” in the second half.
The second quarter was a solidly profitable one. Given the summer is upon us and the generally lower level of market participants that goes with it, we have reduced our gross exposures materially. There will be a number of important political and monetary policy decisions that will be magnified by the illiquidity. We are very happy with our YTD results and hope we can add some additional performance with low portfolio volatility and correlation in the second half of 2016.
All the best and we look forward to reporting back in early October.
1 Financial Times, LEX, “Private equity: the Twinkie defense”, July 6, 2016
2 LSR Daily Note, “Italian banks and Brexit Contagion”, July 13, 2016
3 Knowledge @ Wharton, “China’s Growing Debt: Are the Fault Lines Beginning to Show?” July 6, 2016
4 The Bear Traps Report, LGM Group, July 20, 2016
5 Pavilion, Global Strategy Note, “A new phenomenon: inflation”, June 20, 2016, page 2
6 Bank Credit Analyst, July 2016, page 8