Observations, Markets & News

Zombie companies in Trump's America are increasingly a headache. 

According to data published by Arbor Data Science (Arbor Research & Trading, LLC), the number of “Zombie” companies (those with EBIT/interest expense ratios <1) in the US is growing, and now rests at 18%. Low/declining real interest rates in the US have allowed companies to carry higher debt loads. The growing universe of zombie companies is yet another example of credit investors’ willingness to sacrifice security for yield. When the earnings cycle turns, expect a spike in credit defaults. 

Australian ten-year government bond yields have more than halved over the last twelve months to less than 1%, and this means the stock market remains relatively good value despite a strong start to the year. Falling bond yields obviously herald weak economic growth and we have concentrated our long exposures in stocks that are not dependent on the economy for growth. This includes technology stocks like Appen and Zip, but we have also increased our exposure to property trusts, which have very stable income and have only started responding to the fall in interest rates. We have concentrated our property exposure in office and industrial and are avoiding shopping malls where the trend to online retailing is causing mall vacancy to increase. We continue to like mining and mining services, which also have little exposure to the weak Australian economy, and which would usually benefit from a fall in the Australian dollar.

“There is no barrier for U.S. Treasury yields going below zero. Zero has no meaning, beside being a certain level.” said Alan Greenspan.[i] The Man in the Arena of Central Banking for longer than anyone else has hit a point: Sovereign bonds have lost their predictive power for growth and inflation. Inverted yield curves do not matter as much as they did in the past.

When capital no longer needs to earn interest for capitalism to work then there are unintended consequences. Chief among them is a wealth gap with lower and middle classes losing out. That’s the common factor between Brexit, support for European nationalists and even the Hong Kong protests. We witness a “Japanification” of the advanced economies. [ii]

Normally, global slowdowns are triggered by higher interest rates or high energy prices. Neither condition applies today.

The Implications of Negative Yields

A staggering $17 trillion, estimated to be 30% of all investment-grade fixed income securities globally, trade at a negative yield. [iii] Held to maturity these securities guarantee a loss. There are three other implications:

1 - low yields lead to higher bond price volatility: the lower the yield the bigger a price change when rates rise or fall; small changes in yields have a large impact on prices

2 - convexity declines as yields become more negative: the more negative the bond yield the more negatively skewed it should become, the greater the potential for its price to fall more rapidly than it rises

3 - higher volatility and lower convexity of fixed income are contaminating other risk assets: investors are forced to look for positive yields in other assets such as credit, equities, real and private assets. These assets have held up well despite weakening growth and trade and geopolitical tensions.

Responsible / Sustainable Investing

Bodenholm: Responsible investment is largely a matter of common sense. It is part of the duties of a portfolio manager to assess relevant risks and opportunities regardless of whether they are classified as ESG3) factors or, say, technological development and political risk. Making well-informed investment decisions is essential to our ability to achieve our goal of generating a good, sustainable long-term risk-adjusted return.

… to engage in dialogue with the companies on various ESG issues. In spring 2019, these dialogues touched on business ethical issues such as management compensation packages, information disclosure and transparency, internal controls, board composition and minority shareholder rights. Other matters that were addressed during the year included the development of organic products and recyclable packaging, and the sharing economy.

Our responsible investment policy is based on the six United Nations Principles for Responsible Investment (PRI). Bodenholm Capital AB has signed the PRI and is also a signatory member of the Standards Board for Alternative Investments (SBAI), which produces best practice standards for business ethics, corporate governance, information disclosure, and fund valuation.

Economies & Monetary Policies

Cheap energy nurtures economic activity.

So far, strong consumption has offset weaker manufacturing in the US. Further contraction could affect consumption and cause a recession.

Gemsstock: Our base case remains that the cycle most likely continues to trudge on. The simultaneous global central bank easing is clearly supportive for risk assets, data is mixed (manufacturing is soft but services and domestic data are still holding up) and we continue not to see the typical end of cycle excesses coming through. The caveat to this remains Trump and tariffs.

The current situation for sovereigns was compared to Prince Rupert’s Drop[iv] (“larme de verre”), in that what is perceived as a strong, balanced system one day could blow up the next.[v]

Karya: Our base case continues to be for an extension of the cycle. Self-preservation will convince global leaders to agree on a cease-fire or a temporary agreement to de-escalate tensions until the US election. The support from solid domestic demand, accommodative central bank policy and the Chinese reflation effort will turn the tide and stabilize global growth. This environment is supportive for risk assets. / Recessions generally occur as negative shocks interact with tightening financial conditions and underlying economic vulnerabilities. / Recessions are, by nature, nonlinear events often precipitated by a sharp decline in a relatively weak sector or a sovereign that magnifies economic and financial market stress. It is, therefore, important to identify the “weak links” that could prove to be accelerants that tip a slowdown into a downturn. Job market indicators are the most critical to watch. The risk is that businesses begin to reduce the pace of hiring more significantly. The data so far suggest that labor force trends remain strong and personal income continues to rise. / China skirmish / Poor liquidity conditions are manifested in wider spreads including cross-currency basis swap spreads. Due to the elevated currency hedging, and flat US yield curve, US Treasuries currently yield less than German Bunds or Japanese government bonds. Foreign investors who want to divest from the $17 trillion of negative yielding bonds can only buy very long duration US assets on an unhedged basis, contributing to the dollar’s rise. The lack of market liquidity has therefore been correlated with a stronger dollar, softer global growth, and weaker EM asset and FX prices. This adverse environment has accentuated the downside in Treasury yields and flattened the yield curve. / We are long call options on equities financed by short call options on corporate credit. This position is driven by the late cycle characteristics of equities versus credit. As the excesses of the cycle catch up to credit performance (leverage, poor business models), that sector becomes very vulnerable relative to equities which are the beneficiaries of financial leverage undertaken late in the cycle. Credit, while a superb carry instrument, will struggle in periods of heightened uncertainty due to its negative skew. This asset class offers little upside in the trade resolution scenario but shares all the equity downside under a recession tail. / Global equities will rally as some agreement is reached on trade and investors realize that a recession has been averted. Central bank efforts to ease financial conditions and stabilize growth will be particularly beneficial for international equity indices which, unlike US equities, are traded at depressed levels. We express this theme by purchasing call options on European and Japanese equities. / We are also positioned for an increase in inflation expectations, which have moved down sharply on recession fears. As the Fed eases and the yield curve steepens, we expect inflation expectations to move up 25 to 30 bp by year end.

Politics

SPX: The world is experiencing a political bear market, with populism of various kinds on the rise and a resulting reversal of the globalization process, which has fostered prosperity for many decades. 

Trade tensions have a debilitating effect. Still, Trump seeks re-election for which he needs a higher stock market and a growing GDP in about a year’s time.

Brexit will be center stage during September. Expect volatility. 

Equities

Momentum collapse

We have witnessed the largest momentum collapse in a decade, a monumental shift in fund flows and stock preferences. 

When the dividends of a company's stock yield higher than the corporate bonds of the very same company it makes logically sense to own the equity rather then the debt. This was one reason for value stocks to be purchased.

Monetary stimulus was only required because of the somewhat negative economic outlook, which in turn makes equities of those companies less attractive that depend on the economic growth cycle.

reuters: The massive U.S. market rotation into value stocks over the last two weeks is finally giving value fund managers a reason to be hopeful after years of underperformance.

Dividend and earnings yields compare favorably with ever lower bond yields. 

Withyields falling the stock market remains relatively good value despite a strong start to the year. Falling bond yields herald weak economic growth: Concentrate exposures in stocks that are not dependent on the economy for growth. This includes technology, but also sectors with stable income such as utilities, infrastructure or property trusts (REIT’s).

Themes and sectors we like include Ageing Population, Digital or Cyber Security, Digitization, Automation & Robotics, Artificial Intelligence & Big Data, Water, and Biotechnology.

Fixed Income & Credit

Remain underweight and expect a rising default rate, particularly among high yielding debt. 

Emerging Markets Currencies & Debt

Differentiation among EM is key in all asset classes. Favor countries that are pursuing integrationist policies. 

Another beneficiary of the turn in monetary policy are big debtors who are dealing head-on with their debt loads. The low rates make the cost of refinancing notably lower, their relatively high-yield status more of a draw to investors, and so their heavy debt loads become more sustainable. Indeed, one underlying objective of the low-rate policy is to enable debt-stocks to be digested and grown out of. Buying long-dated bonds that have significant credit spreads of debtors typically offers good rewards in such easy-money times.

Events in Hong Kong could herald a change of paradigm but it is too early to tell.

Commodities

Northlander: Carbon prices in Europe are starting to look like an interesting trade opportunity. During the summer, particularly in August, we have seen a strong correlation to global macro worries and Brexit concerns. This correlation will break as we go into the winter motnhs, as cooler temperatures and fundamentals should become more important. In oru view, Brexit is a small issue but its impact on prices recently has been substantial. 

Coal prices seem to have reached a low, despite continued global trade tension. We have seen signs of production curtailments in coal in some parts of the world as a result of low prices and we think that will underpin a stronger coal market going forward. Some careful optimism with respect to US Chinese relations could also be a bullish catalyst for coal prices. 

With bonds yielding zero equities are made to wear the brunt of return expectations in any portfolio. That’s a heavy burden to carry for such a flicker asset class. Precious Metals are a natural complementary asset class.

In physical gold there is a demand overhang. This is due to higher central bank demand and lower production. Gold is the one ‘thing’ a central bank can buy that cannot be manipulated by the Americans, hence net buying by the Chinese and Russians. 

Gold is the ultimate speculation since it has little industrial use and a slight negative yield. When most investment grade sovereign debt trade in negative yield gold is suddenly more attractive in relative terms.

The oil price has become a key predictor for US inflation. Fortunately, a rally in oil is a low probability due to a supply overhang especially because of the increase in US shale production.

Asset Allocation

Geopolitical and macro uncertainties create opportunities for agile speculators investing long and short. This is a time to add active strategies with uncorrelated returns and convexity. 

Overweight equities vs. fixed income. Stick to liquid asset classes to stay flexible and nimble without opportunity costs since the premium for lack of liquidity has been eroded anyway.

We are amidst a megatrend of technological disruption. As the world goes digital overweight the disrupters. In sector allocation consider healthcare, biotech and technology. 

Hold Precious Metals.

Roland Eberhard

October 1, 2019

Footnotes

[i] Liz Capo McCormick, ‘Greenspan Sees No Barriers to Prevent Negative Treasury Yields’, Bloomberg News, August 13, 2019: Interview with Former Federal Reserve Chairman Alan Greenspan; Quote: ‘He postulated that extended life expectancy and an aging population have caused people to value future consumption more than current spending. Greenspan, 93, said he views Fels’s thesis as very plausible and also a reason why more debt has a yield below zero. He doesn’t think it will last forever. “Why people continue to buy long-term Treasuries at such low yields may be also due to forces having altered people’s time preferences,” Greenspan said. “But there is hundreds of years of history showing the long-term stability in time preference, so these changes won’t be forever.” ‘

[ii] Speaking of unintended consequences: Danish Jyske Bank offers 
-0.5% negative rates on mortgages! It is paying people to borrow money.  If you bought a house for DKK1 million and paid off your mortgage in full in 10 years, you would pay the bank back only DKK995,000. Link: https://www.jyskebank.dk/bolig/nyheder/realkredit-med-negativ-rente

[iii] Negative-Yielding Debt by Country as of August 29, 2019 in USD trillion: Japan $7.3T, France $2.3T, Germany $2.1T, Spain $0.9T, Netherlands $0.6T, Italy $0.5T, Belgium $0.4T, Switzerland $0.3T, Austria $0.3T, Sweden $0.3T, USA $0.2T

[iv] Equinox Partners

[v] Wikipedia: “Prince Rupert's Drops (also known as Dutch tears) are toughened glass beads created by dripping molten glass into cold water, which causes it to solidify into a tadpole-shaped droplet with a long, thin tail. These droplets are characterized internally by very high residual stresses, which give rise to counter-intuitive properties, such as the ability to withstand a blow from a hammer or a bullet on the bulbous end without breaking, while exhibiting explosive disintegration if the tail end is even slightly damaged. In nature, similar structures are produced under certain conditions in volcanic lava.

The drops are named after Prince Rupert of the Rhine, who brought them to England in 1660, although they were reportedly being produced in the Netherlands earlier in the 17th century and had probably been known to glassmakers for much longer. They were studied as scientific curiosities by the Royal Society and the unravelling of the principles of their unusual properties probably led to the development of the process for the production of toughened glass, patented in 1874.”

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