Originally published by Narrow Road Capital
Risk asset returns were mixed in November with divergent results in different markets. Equities in Japan (3.2%), the US (2.6%) and Australia (1.0%) did best whilst China was flat (0.0%) and Europe fell back (-2.8%). High yield credit saw a minor pullback but investment grade credit was unchanged. Iron ore (16.4%), US oil (5.0%) and US natural gas (4.5%) all jumped with gold (0.4%) eking out a small gain and copper (-1.4%) taking a small loss.
Loitering Around the Lifeboats
Imagine it’s 1912 and you find yourself on the Titanic’s maiden voyage. You know that the ship is going to sink but you’re sketchy on when it’s going to happen. What should you do? This scenario is similar to the current predicament for investors where almost all asset classes are expensive when using standard valuation techniques. The answer for both situations is the same; you should spend your time loitering around the lifeboats.
The Current Environment
In recent months many have called out the predicament faced by investors. Global price/earnings ratios for stocks are high and the quality of earnings used in those ratios is questionable. Credit spreads are low for both investment grade and high yield debt in pretty much every jurisdiction. Commodities have performed well this year, in large part due to the credit inflated economic growth of China. Emerging markets can look cheap, but their continued growth could be threatened by a weaker China, a stronger US dollar or domestic instabilities. Returns on cash and short term debt instruments are profoundly negative after tax and inflation in Europe, Japan and the US. Investors seem trapped everywhere they turn.
The Temptation to Just Keep Dancing
The former CEO of Citigroup's (NYSE:C) infamous comment that “as long as the music is playing you’ve got to get up and dance” highlights a major behavioural impediment to solid long term returns. The temptation is to ignore the risk right in front of you and buy investments that hold out the prospect of a quick win. Institutional fund managers are measured quarterly or monthly and can feel pressure to constantly outperform, especially if they charge substantial fees. Individual investors can lose focus when their friends and neighbours brag about how much they have made on the latest fad investment. We all struggle to keep the disciple and focus needed in these exuberant times.
Don’t Play Pick the Trigger
Many investors spend their time speculating what will be the trigger that starts the next downturn. The theory is that if you pick the trigger you can sell out prior to others, capturing all of the upside and none of the downside. In practice, the trigger for market peaks is rarely knowable in advance, most times the trigger event is a narrative created after the event to fit the facts. Rather than focussing on potential triggers, investors should focus on the risk/return characteristics of what’s in their portfolios. Stock prices and credit securities follow earnings and cashflows over the medium term. Time spent on detailed earnings and cashflow analysis (which increasingly few do) will be far more fruitful than time spent analysing the widely known economic, political and geopolitical risks.
The Lifeboats in Credit
In my home ground of credit, loitering around the lifeboats means staying short in credit duration and staying senior in the capital structure. Fortunately, making these shifts is often easy to execute when markets are exuberant as the increase in yield for taking extra risk is minimal. For instance, the gap between spreads on BB rated and B rated credits is currently low as is the gap between senior secured leveraged loans and subordinated high yield bonds. Going against the trend will cost a little in the yield achieved now, but that gap can be made up ten times over when the next downturn occurs. If correctly implemented, in the next downturn an investor will have cash from maturing assets to redeploy into bargain credits rather than a portfolio of distressed debt with substantial mark to market losses.
The Lifeboats in Equities
Equities is a tougher sector to implement a loitering around the lifeboats strategy as there is more potential upside to be missed by keeping a conservatively positioned portfolio. Stocks that are based on hope and hype rather than fundamentals, like Netflix (NASDAQ:NFLX) and Tesla (NASDAQ:TSLA), have the potential to push much higher before correcting. Greater discipline is required to persist with a value orientated approach when growth stocks are shooting the lights out.
In this regard I look to the equities managers I respect most, who all have a track record of long term outperformance of benchmarks. Whilst they each have slightly different approaches, there are consistent themes in their recent commentaries. First, they are all holding higher than usual cash levels. Second, there’s a willingness to push beyond the large capitalisation benchmarks in order to find cheap stocks. Third, there’s a strong focus on finding companies that are savvy in their deployment of capital, shown by consistently high returns on equity. Fourth, their preferred stocks have a low market capitalisation relative to their future earnings. This might be a low P/E for a mature company or an average P/E for one with above average growth prospects. Lastly there’s minimal exposure to cyclical stocks.
Conclusion
The innate human desire to want to keep up with the Joneses is an investor’s worst enemy in bullish markets. Ultra-low cash rates and quantitative easing have helped markets to continue to post gains beyond what company earnings and GDP growth support. Investors are increasingly all-in, having become numb to risk in a time of record low volatility.
By implementing a loitering around the lifeboats strategy, investors will likely miss out on some late stage gains. However, the potential pay-off is far larger than the missed gains if the overdue correction occurs. The more investors believe that markets are unsinkable, like the Titanic, the more likely it is that an iceberg is dead ahead.
Credit Snapshots
High Yield Pullback
The pullback in high yield credit had more than a few people excited, but it was a very tame affair. As the graph below shows, it was nothing compared to the pullback in early 2016 which was led by energy companies suffering as oil prices fell under US$30 a barrel. This time around the pullback has been focussed on a small group of credits with particularly weak fundamentals. Tesla is the most high profile example, a company that burns cash fast but produces cars slowly and whose future products are based on major technological advancements yet to occur. It’s as if investors have woken and realised that negative cashflow companies aren’t good borrowers. This sentiment hasn’t just applied to US high yield credit, sovereigns like Puerto Rico and Venezuela have been hit as well.
Puerto Rico
This month the realisation of how bad things are for Puerto Rico finally hit home. The territory has asked for $94 billion in post-hurricane aid, which if approved could come in the forms of loans rather than grants. This new debt would likely rank senior to the existing debt making existing debt close to worthless. The local government has also flagged that it may need a five year moratorium on principal and interest payments. US legislators are working on a bill that would see the existing debt completely written off. Without extraordinary generosity from the US federal government the bulk of Puerto Rico’s existing debtholders are staring down the barrel of a 0-20% recovery.
Venezuela
The only surprise about Venezuela’s default this month was that the country chose to make payments for so long when the situation was clearly hopeless. Conspiracy theories are being tossed around, the funniest one being that the government is pushing down the bond prices in order to buy them back. That scenario only works if the government has sufficient reserves to repurchase debt, which it clearly doesn’t. Venezuela is so broke it is demanding oil from its joint venture partners for domestic consumption, reducing its only meaningful source of foreign revenue. The first creditors meeting was a shambles, with the few attendees given bags of goodies after sitting through hours of lecturing about the evils of Donald Trump from an alleged drug dealer. Several hedge funds have sold out of their holdings pushing the bond prices down further.
China
After previous warnings turned out to be head fakes, the post-plenum period might hold some real reform for China’s debt markets. Interest rates have been allowed to tick higher, pushing up funding costs for all. Conglomerate HNA has sold one year debt at 8.875%, the highest ever rate for short term US dollar bonds. Investors continue to ignore government warnings that wealth management products can suffer losses, a belief that could soon be tested. Amongst many sectors, poor credit investing is showing up in rail debt, micro lending in rural areas, perpetual debt and even US CLOs where leverage is being applied to juice up returns.
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