Double barrelled tightening

Updated: Jan 21, 2019

Dear investors and well-wishers,


The Fund returned -3.3% net in November, while the ASX 200 dropped -2.8%.


This month our stocks were only down ~1%, but hedges and FX contributed the remainder. Both of these have moved favourably in the fund’s direction in December so far.


Apple was the largest negative contributor, as the stock sold down from a valuation of 11.6x in October to 7.8x as I write. Lundin Petroleum was mitigated by a short position in crude. We exited Country Garden, on the expectation of an increased credit crunch as highlighted below.


This letter will cover our views on the macro backdrop, which are driving markets at the moment, but please keep in mind we spend most of our time, and have historically generated the bulk of our profits, through long term equity investments.


Rates up, stocks down


2018 has been a year where policy has had an outsized impact on the market.


There are eery similarities to January 2016, although the policy responses are opposite. A few months prior, in August 2015, markets had sold off in similar fashion to the past few months. Emerging markets led the way, and a slide in oil prices put high yield bonds under severe pressure, much like the past few months.


Ignoring this, Janet Yellen raised rates (white line below), and shortly after Christmas markets fell 10%.




Fed Funds rate (white) and S&P500 (green). Covering the period from late 2014 to late 2016.


Yellen delayed any further rate rises for a year, and stimulus from China led to an extended bull run, with minor hiccups over Brexit and Trump. Central banks around the world coordinated a robust response, to ensure the first rate rise in the US since the crisis didn’t cause any further issues.


This year, in March and June, rate rises coincided with significant falls in the S&P500, and in our view, lifted the US dollar, and caused a series of currency driven emerging market crises, from Turkey to South Africa and Argentina. .


In September, when a considerable part of the world was already in a bear market, and multiple countries in a state of crisis, the Fed raised rates again, and this marked the annual high, almost to the day:





Fed Funds rate (white) and S&P500 (green). Covering the period from late 2017 to present.


There have been strong calls for further tightening, with calls for the Fed to play their traditional role and ‘take away the punch’.


Yet almost every asset class return this year has been negative. Manufacturing orders in the export giants of China and Germany are declining. Cyclical US sectors like housing, autos and financials are already in distress, and corporate credit markets have frozen: there has been no new high yield issuance in December, despite a number of attempts. At full employment, it’s not clear why auto loan delinquencies are rising.


What punch?


The Fed lifted rates again in Sydney time, in the face of buckling markets, growth declines in all major markets, and low inflation. We expect the next move in rates in the US, and Australia, to be down.


Quantitative Tightening


The other suspect for the rocky year is quantitative tightening. Most major equity markets, with the notable exception of those in the US, topped around January. This is when the Fed began reversing what was admittedly a successful program of Quantitative Easing, sucking $30 billion per month from markets since January, at an increasing rate (yellow line below).


There is now a $50 billion net seller of assets each month. The proceeds don’t rotate into any other asset class, they just cancel liabilities on the Fed balance sheet.




Fed Balance Sheet (yellow), S&P500 (green) and the Fed Funds rate (white). Note that the yellow Fed Balance Sheet begins to decline in earnest after Jan 2018.


Turbulence is likely to continue while this stays in effect, in our opinion. Sadly, there is some US$4 trillion to go. I’ve had to update this letter this morning, as Jerome Powell is staying the course here, where many expected some level of slowdown. It appears the Fed has a different view on the impact of QT. 


So in a global slowdown with even the US starting to crack, we have both QT and higher rates. In times like this old market sayings spring to mind, and one in particular. Don’t Fight the Fed.


There has been plenty of ink spilt on trade wars, but we see this as a red herring (unless, ofcourse, Trump actually does go through with 25% tariffs). To see the impact of picking a fight with your biggest trading partner take a look at the performance of the UK stock index, which is back to where it was in 1999:




It’s noteworthy that the FTSE 100 trades at a 31% discount to the S&P, given that they both largely consist of global conglomerates, and furthermore, the FTSE 100 should benefit from the lower pound sterling.


A 25% tariff might lead to a long bear market, as real costs would rise around the world. But contrary to what market commentary, in our view it’s monetary policy that has really been driving markets.


We had more evidence of that today, as mildly positive trade news was dwarfed by the news from the Fed, in particular, Jerome Powell’s comments that balance sheet reduction would continue at full steam. He dodged the prescient question as to why the Fed was even raising rates in the face of declining inflation data.


QT may also explain the market price action over the past few months. US equity futures have generally risen in Asian trading hours, only to sell off during US market hours. This would fit with a large net seller hitting the market every day in the United States.


There are a number of signals flashing red.


The challenge of the last 7-8 years has been to stay invested in the face of considerable risks, various eurozone crises, China scares, slowdowns, bond tantrums and so on.


Throughout this period, however, unemployment in the US was always tracking down. There were always a few more people working each month, a few more people buying products, and a little extra marginal demand.


In our view, the key question now is whether or not this reverses.


There are other somewhat ominous signs that suggest we are at market extremes. To pick a few:




The German 10 year vs Fed Funds rate




Fed Funds rate vs Libor. Crescat Capital bought these charts to our attention.


And debt funded corporate buybacks may prove as poorly timed as usual:  




Australian Dollar


FX detracted 0.7% from the fund in November, which was largely due to our ~40% USD holding. This reversed in the fund’s favour in December. We have maintained a high weighting to USD for three reasons:


1. The interest rate differential is widening. Typically the Aussie dollar is a carry currency: you earn yield to hold it and take the risk of a drawdown. Now, you earn yield to hold the reserve currency, which can generally be expected to rally in a crisis, particularly if commodities sell off. There are very few hedges with positive carry - this is one of them. The last time Aussie rates were so much higher than those in the US, the AUD fell to all time lows.


2. Housing is rolling over in Australia, and we believe the next interest rate move here is likely to be down, as lower household wealth begins to affect purchasing decisions. The housing decline is being led by extremely tight lending conditions, with prospective lenders being required to justify spending on Uber Eats and lunchtime kebabs. Whatever you think of the Royal Banking Commission, grilling middle managers on a national stage over their lending decisions is unlikely to increase lending. And that means more of us can’t get home and business loans. Overseas funding in the US also just became more expensive.We own US stocks, so holding US dollars reduces our financing cost. Our effective yield is higher than the differential between AUD and USD.


3. Yield differentials certainly seem to indicate fairly significant potential downside. The other key factor is commodity prices - something that would change our view would be a strong fiscal stimulus from China, however, as they are still trying to roll back the stimulus that boosted markets in 2016, this is unlikely, without further deterioration first.



AUDUSD (red) vs the rate differential between 2 year US and Australian government bonds. Note that the rate differential suggests a materially lower AUDUSD, and that this hints in 2012 and 2013 that the AUDUSD was about to reprice significantly lower. No indicator is perfect, but this appears noteworthy in any case.


So how are we positioning?


It’s worth noting that recessions aren’t the end of the world, and the worst economic data tends to mark market bottoms, rather than tops. As an example, in early 2009 the US started rallying in the face of news about job losses, GDP shrinkage, auto bailouts and the like. That rally in the face of negative news was a strong buy signal, (naturally with the benefit of hindsight). 


Both shorts and macro/hedging have been significant positive contributors to the fund this year, and we will make full use of them. Our largest error this year was to move into a period of double-barrelled monetary tightening with equity overweights in growth and Asia. This has meant our macro performance, while positive, was not able to counteract the falls in our equity portfolio. The playbook for our equity portfolio is exactly the same as it has always been: stay invested long term. 


The past few months there has been a strong bid for utilities and staples, which has made the moves in market indices seem muted relative to the movements in other sectors.


Despite this, and the relative underperformance of the sectors like tech and biotech, we believe the return prospects for innovative, growing companies are vastly higher than overvalued staples and utilities. Indeed, in the latest move down in equity markets this week, utilities and staples were among the worst performing sectors.


We have added shorts in firms like McDonalds and Coca-Cola that have shrinking revenues, and multiples well in excess of the market. We have paired up our remaining biotech positions with shorts in companies like Moderna, which just pulled off an $8 billion IPO with no clinically proven medicines - a valuation we believe is way out of line with the market and intrinsic value.


We have added high yield credit shorts through ETFs, which has performed so far, though the falls have been muted relative to movements in equity markets. Last night HYG, a high yield ETF, fell 1%, which shows that in a bear market high yield can move to the downside like equity. As a portfolio of bonds, the downside of being short is far less than equities. 


The freeze-up in US credit is very relevant to the near term outlook. In fact, we thought this might have been enough for a more market friendly update from the Fed, but that did not occur. We added upside optionality in long term treasuries, which have so far done well.


These trades were all too small, but we want a full portfolio of hedges, rather than to rely on any particular relationship.


In December so far we’ve realised a minor contribution from VIX hedging. Our leading hypothesis as to why this core strategy has not performed, and in fact has been a drag the past two months, is that markets haven’t really panicked.


As various moments over the past few years show, a single overnight move can be enough generate considerable returns, so we have maintained the position, and will reassess in January.


Long short opportunities


There are some excellent long/short opportunities at the moment. We have added Kering, which derives most of its profit from Gucci, growing at over 30% a year in a tough market.


Online sales are growing at 68% and the firm trades at a generous 12x EBITDA. We have paired this with a short in Fossil, a group with declining sales and net debt. We are considering adding shorts in comparatively struggling luxury brands to cancel out the exposure to luxury next year. 


We are also likely closer to the end of the sell-off, than the beginning. In November there was still bullish talk of Christmas rallies. Now, negativity may have finally swung to an extreme, and as I write this newspaper articles are publishing front pages with Great Depression era imagery.

Investors are now underweight technology, a rare occurrence. Rotating into cash or defensives provides short term mental relief at times like these, but comes at the cost of extended periods of underperformance in the mid to long term.


Hedge funds are also now overweight utilities, which hasn’t happened since 2008. Now, as then, we expect that positioning to be misplaced, and to be reversed in the mid-term.





It’s rare indeed to get the chance to invest in technology companies against the crowd.

With this new rate rise, we suspect emerging markets will again come under pressure, as their USD funding costs are higher and the US dollar is likely to rise. We have hedged out our EM exposure with indexes. This detracted from performance in November, but certainly helped in December month-to-date. We expect our stocks to outperform the index should this view prove incorrect, or if a bout of stimulus triggers a sharp rally.


Our approach right now is to harvest profits from our macro and hedging strategies, and incrementally invest the proceeds in our core portfolio. We have outlined a fairly bearish situation above.


But in markets when things look safest, they are most dangerous, such as the beginning of this year. Now we are approaching the opposite situation - valuations have contracted significantly, investors are underweight the most promising sectors, and sentiment has swung decisively negative. Each day our portfolio companies earn a little more profit, and create a little more value. This is tiny relative to the intraday moves we’re seeing right now, but over the long term, those tiny bits of value will outweigh the movements of the past few days, weeks and months. Our best periods of performance have generally been after periods like this. Volatility is never pleasant, but be assured I’m fully invested personally in the fund, and my family has added to their commitment.


Yours faithfully

Michael


Disclaimer

Frazis Capital Partners Pty Ltd is a corporate authorised representative (CAR No. 1263393) of Lanterne Strategic Investors Pty Ltd (AFSL No. 238198). The Frazis Fund is open to wholesale investors only, as defined in the Corporations Act 2001 (Cth). The Company is not authorised to provide financial product advice to retail clients and information provided does not constitute financial product advice to retail clients.


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 Contact: michael@fraziscapitalpartners.com

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