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Hugh Hendry Details Big 5:1 Le Pen Bet
Hugh Hendry and his research team at the Electica Absolute Macro Fund have always been skeptical, if not bearish in their thoughts about central bank stimulus and the economic environment. But they have generally maintained prudent but not overwhelming hedges. The fund’s performance, which peaked near one year ago before down trending into the November US elections – where it sharply rebounded – is now looking across the European panoply of activity and sees risk that should be hedged on the horizon.
While he expressed bearish thoughts in the past, Hendry is now acting on them
Since the close of 2013, Hugh Hendry, George Lee, Tom Roderick and the team of risk-focused investors at Electica Absolute Macro Fund have avoided one negative bet against the stock market, as have other fund managers in the region.
Hendry has been a classic naysayer regarding central bank intervention into “free markets.” The quantitative magic they sprinkle upon markets generally works like trickle-down economics, benefiting the owners of stocks and to a lesser extent bonds. The London-based Hendry, having compared the European experiment “a patient dying of cancer” in previous investment letters, now thinks it is time to hedge – and anticipates such plays rewarding investors at this moment in history.
Since the start of the fourth quarter – and coinciding with a “populist” election result in the US – Hendry has “added a considerable quantity of long volatility” to the portfolio as French election results loom in April. (The letter didn’t mention the March 15 Dutch elections. Some are watching this not for its practical impact – even if populists win, they won’t be able to form a coalition based on recent press reports – but more as a gauge of real EU sentiment.)
Like everyone else we know there is an event risk that the French electorate could throw out the old political class and jeopardise the fragile equilibrium that is the European monetary system. We know the dates, we know that the result could produce considerable downside risk to global asset prices, much more so than Brexit given that the potential departure of one of the nations most fundamental to European integration would surely lead to the system’s demise, but we also know that the outcome is impossible to predict in advance.
Hendry thinks “bad things” could be ahead and is planning accordingly
While in the past Hendry has avoiding betting on the negative, as the probability was too low, now he thinks “really bad things” – defined by a 20% or larger price adjustment on the S&P 500 – is a possibility.
While the stock market is going to be the focus of headlines, Hendry is looking at a traditional measure of sovereign economic strength: government bond spreads.
Serious political shocks on the Continent are likely to lead to sharp widening in the sovereign spreads, with falls in the value of bank equity broadly offsetting losses on the credit position. Alternatively, curtailment of the ECB’s expansionary monetary policy would also tend to push sovereign bond yield spreads higher, with the likely negative impact on the economy in countries like Italy leading to more non-performing loans and hence weaker earnings in the banking sector.
One primary benefit of the EU is that normally “risky” sovereign bonds are less so, bringing down interest rates. If the EU breaks up, watch the spread between those prosperous economies – led by Germany – show wide differentials from the more debt-laden geographies.
Hendry, with a primary focus on France, thinks success of the populist Marine Le Pen is “currently deemed unlikely,” but there is a reasonable potential that has fat tail risk. Hedge accordingly.
“We think there is a significant probability of such a political upset,” the letter said, noting the asymmetric payoff of 5 to 1 “should the probable path be upturned.”
Specifically, Hendry says:
It is our contention that we have insulated our portfolio from such a known unknown. Success for Le Pen is currently deemed unlikely, but under such a scenario, where markets would need to grapple with the real threat of a Euro break up, our gains could be considerable. We think there is a significant probability of such a political upset, and believe our trade as detailed below offers a very attractive gain to loss ratio (5:1) should the probable path be upturned.*
How reasonable are these assumptions? Are we paying a considerable and unwarranted levy to make ‘bad things’ go away? I think not, so allow me to explain what we have done, expand on our thinking and allow you to decide on the appropriateness of our actions.
You might reasonably ask, why now? There are at least two reasons.
First, Europe is caught in a severe pincer. On the one hand debtors are still being squeezed as households grapple with flat real incomes and a moribund jobs market making some resentful of the historically high influx in immigration. On the other, creditors, with their abundant pool of savings, are seeing their incomes squeezed by low or negative yields. In short, this is a fertile environment for populism. Furthermore, we believe the precedent from the UK’s decision to leave the EU makes the European project less robust as the subsequent benign trajectory of the British economy galvanises politicians in other member states who seek to pursue a similar path. Whilst noting the rejection of such populism by the Austrians in their Presidential election in December, we would again highlight the analogy of the UK’s departure from the gold standard in the 1930s and its successful pursuit of a nationalist economic agenda, which set in motion a chain of events that saw 75% of the prevailing gold standard members reject the system over the next two years.
Second, the persistence of super-easy monetary accommodation in Germany as well as the recent emergence of a synchronised global economic upturn
and concomitant rising inflation seems to be awakening the hawkish old dogs that lie slumbering within the powerful constituency of the Bundesbank. Moreover, European QE is about to run into a serious political issue as the ECB runs out of German bonds to buy, meaning they either have to stop, or buy BTPs (for example) and not Bunds. The Bundesbank see this as a monetary transfer to the periphery through the back door (which it would be). So the only part of the European setup which has cleverly managed to circumvent political pressure runs into it hard next year as it simply cannot run for another three years without crossing the Rubicon of monetary transfers to the periphery.
How else is one to explain why, despite the muted economic recovery on the continent outside Germany, the ECB has already tapered QE and is in the process of winding it down altogether?
Should the bond buying program run-off over the next three years I do wonder what price the private sector will demand to finance the Italian government’s persistent and substantial debt re-financing demand. With outstanding stock of more than two trillion euros, a sum that expands every year so long as the economy fails to achieve sufficient GDP growth greater than the interest burden’s share of GDP, and an average maturity of less than 10 years, the Italian treasury needs to issue around a trillion euros of BTPs at least every five years. The ECB alone has been hoovering up almost 40% of this requirement with its bond buying program over the last two years, which has allowed it to control the price so far. However should they commit to a lower purchase level, perhaps with the eventual
complete withdrawal of the scheme, I suspect that investors would find current 10-year BTP yields lack a sufficient margin of safety to persuade them to fill the
void given the lack of structural reforms that would boost economic growth and stabilise Italy’s precarious debt balance. Put simply, does the constant currency 10 year additional return of around 20% from favouring BTPs over German Bunds provide adequate protection to private profit seeking investors to compensate for the ever present risk that the lira returns? I think not.
My best guess therefore is that the Bund versus BTP spread has recorded a long bottoming out period since 2014 and is now resetting higher as evidence emerges
that economic growth is firming and fixed income participants reassess their inflation assumptions following the recovery in the oil price. Even without any
political upheavals I would expect the ECB to continue to unwind their purchase programme and, as the private sector is required to fund more of Italy’s maturing debt, yields will continue rising. As such we have a substantial position on the spread widening between the Italian 10-year bond yield and its German equivalent. We are fortunate that this spread has a long series of price data which has been subject to significant shocks and reversals over the last decade which makes it easier to draw some credible risk conclusions. For instance we know the highs and lows it has traded at. Prior to the seemingly irrevocable changes wrought by the financial crisis in 2008, the spread traded at just 30bps on the presumption of a seemingly permanent monetary union. In 2011, as the market feared the departure of Greece from the system, the spread was some 500 points wider. We also know that it has failed to break below 100 since the ECB began its great monetary accommodation back in March 2014.
The spread has doubled to around 200bps over the last year. We believe that the continent would have to change profoundly for it to breach 100bps. Such a reversal, should it occur, would indicate that the Germans had accepted a full blown monetary union with their southern neighbours; at present this seems most unlikely. However, to get there I would presume that the prevailing spread would first have to widen significantly in order to prompt such a dramatic volte face. Regardless this serves as our ultimate stop loss although I can assure you that risk reduction would have commenced much earlier and at higher levels. The upside, however, is certainly not capped at the previous 2011 high. A Greek exit then would have significantly damaged the system but it would probably have endured. However should the French ultimately choose to leave, then the departure of one of the continent’s founding pillars would surely lead to the system’s demise and we would note that BTPs regularly traded at 10% yields prior to Italy’s membership as international investors demanded a significant risk premium to hold their paper.
That could have been the end of the story: a convex 5:1 potential payoff structure should the persistence of the Euro seriously come under question with a relatively
modest ongoing negative carry cost. However we have gone further, adding a position which we think has a very high probability of delivering robust returns this
year should the status quo of a European muddle through persist: we are long European senior financial credit and short the European bank stock futures. This long credit/short bank equity trade has worked consistently since the ECB’s commitment to safeguard the European monetary system back in the summer of 2012. There has been one dominant driver. Basel III rules written to capture the political prerogative of derisking the banking system post 2008 have required the
European banking sector to raise a half a trillion dollars of capital over the last decade or so. However owing to a lack of profitability stemming from flat yield curves and the modest European economic recovery it has proven very hard to generate this capital internally from retained earnings. Instead the credit worthiness of senior debt tranches has been bolstered by numerous and very dilutive rights issues across the sector as typified by UniCredit’s latest €13bn capital raising
which rises to €20bn when one factors in recent substantial asset disposals and was announced less than five years after their last dilutive €7.5bn share
sale, which in turn was the third such capital increase in three years. Combining a position long the senior bank debt and short the equity has directly profited from this dynamic and has produced a consistent positive return over the last four years.
The pertinent question is whether this trade has run its course. The presidential election in America has been marked by a steepening of global yield curves which could restore the profitability dynamic of the banking sector and make the short equity position treacherous. The European bank sector rallied 60% late last year and
re-rated higher to almost 1x book value on the expectation that profit growth would indeed accelerate; shorting the sector is now perhaps our most contrarian risk position.
To understand our logic you have to recognise the challenge policy makers face in attempting to push inflation higher. Their problem is that the markets ‘front-run’ their policy statements. For instance the prospect of pro-growth corporate deregulation and a significant tax cut policy from the new US administration has already encouraged the private sector to tighten monetary policy via pushing 10-year yields higher and strengthening the US dollar. Whilst inflation expectations have firmed, largely from the better performance of the oil price and the tightness of the US labour market, it still remains highly provocative to predict a meaningful pick-up in consumer prices.
But at least the Americans seem likely to support their economy with fiscal stimulus in the form of significant tax cuts, increasing the budget deficit. No such largesse seems likely from the core of Europe, whilst the most likely contenders for the next French president are vying with each other to promise further public sector spending cuts. This makes the European bank sector’s profit estimates seem too high to us; we reckon two 25 bps rate hikes are necessary by the ECB by the end of next year to allow the banking sector to earn the 10% return on equity demanded by a valuation at book value. Given the likely unfavourable impact this would
have on the nascent economic recovery we favour the fixed income market’s reticence to price this eventuality and believe that the bank sector has run ahead of itself.
We do however accept that the sector is now broadly recapitalised and that UniCredit’s rights issue and the Italian government’s proposed bailout of the other notable laggards is reminiscent of the final wave of stock recapitalisations in Japan back in 2003 under Koizumi. However we would note that with the Japanese bank sector’s balance sheet restored, cyclical economic upturns encouraged lenders to compete more aggressively and, in the absence of meaningfully steeper yield curves, the banks bid down their profit margins endlessly. For example, Japanese megabank MUFG has only been able to earn an average return on equity of 7% over the last five years. For us, something similar seems likely in Europe and we struggle to see the sector rallying strongly beyond last year’s highs making the credit/equity trade very compelling.
Combining this position with our sovereign spreads creates a zero-carry package matching two ‘bearish’ trades (the sovereign bond spreads and the bank stock futures short) with one ‘bullish’ bank credit receiving position, which we believe offers an attractive ‘crisis
alpha’ like payoff profile.
Serious political shocks on the Continent are likely to lead to sharp widening in the sovereign spreads, with falls in the value of bank equity broadly offsetting losses on the credit position. Alternatively, curtailment of the ECB’s expansionary monetary policy would also tend to push sovereign bond yield spreads higher, with the likely negative impact on the economy in countries like Italy leading to more non-performing loans and hence weaker earnings in the banking sector. And in the
scenario that Europe manages to stagger through and the status quo persists, we would expect profits from the bank credit/equity spread to offset modest downside from the sovereign spreads.
The banks have moved too far, too fast. No one knows the future, but it might be prudent to turn the noncorrelated dial up a notch, Hendry says.
This article was originally published in ValueWalk.
Photo: Pietro Piupparco