Buy Fear and Sell Greed

Christopher Joye

In my AFR column I argue that Donald Trump's "tape bombs" are the tail wagging the global financial market dog right now, and this volatility begets opportunity (click on that link to read for free or AFR subs can click here for direct access). Excerpt enclosed:

"Donald Trump's "tape bombs" are the tail wagging the global financial market dog right now, and this volatility begets opportunity. Trump judges his own political performance by movements in the US equity indices, vocally cheering rebounds and any new high-water marks on his Twitter feed. This relationship appears to allow markets to act as a disciplining influence on Trump's more extreme proclivities. After the initial "shock and awe" in relation to North Korea, Trump softened his position in an attempt to reach a more reasonable comprise and, I would submit, assuage his billionaire business buddies. Michael Wolff's insider account of the Trump administration relays first-hand anecdotes of the property developer's obsession with securing the approval of a bevy of titans, such as Rupert Murdoch and Carl Icahn, whom he would call nightly for advice. After ramping up his trade war rhetoric against China in the final week of March, which triggered a savage 6 per cent sell-off in US shares, Trump's Treasury Secretary Steve Mnuchin was out giving interviews the following Sunday assuring investors that a deal would be struck to obviate the need for tariffs. And then the tough, one-month deadline for finalising negotiations with China was suddenly extended to two. Equities bounced back this week as Trump's economic adviser Larry Kudlow sought to calm concerns. We had another Trump tape bomb on Friday with threats of yet more tariffs, which will presumably be softened ex post facto via Trump's dramatically theatrical desire for grand bargains. In the background, the thoughtful Chinese have been quietly appreciating their exchange rate, which reduces its external competitiveness vis-a-vis the US, and forcing North Korea into line by cutting off virtually all its exports of petroleum, coal and other key products to that country. Unsurprisingly, the little despot is now towing the party line. The probabilities favour a market-friendly compromise that gives Trump a short-term political win while allowing the more strategic Xi Jinping – who without term limits is not bound by a myopic political cycle – to target triumphing in the long run. The lower probability counter-argument is that Trump's nationalist advisers convince him into a higher-stakes, tit-for-tat game of brinkmanship that crushes market sentiment until it is resolved. In March most asset classes were hammered. Aussie shares lost 4per cent of their value and are now down 3.6 per cent (inclusive of dividends) in 2018. Normally ultra-low risk and highly-rated senior-ranking floating-rate notes (FRNs) issued by Aussie banks fell 0.3 per cent as the spread, or interest margin, they pay above the bank bill rate increased on the back of several temporary shocks. Much higher risk sub-investment grade, or "high yield", bonds dropped by more than double this sum. The listed hybrid market fell 1.1 per cent, which while only one-quarter the loss suffered by equities would have been much lower were it not for a sudden $3 billion plus surge in new supply (via the Westpac and CBA deals) and Bill Shorten's (subsequently diluted) comments on eliminating cash rebates. One stand-out in March was fixed-rate bonds with long-dated interest rate bets embedded in them. As the sequence of random Trump tape bombs dented future interest expectations, portfolios punting on the hope rates will remain low-for-long via long duration fixed-rate bonds furnished strong returns. A case in point is the peculiar performance of the major banks' AA- rated senior-ranking FRNs, which are among the safest and most liquid assets one can hold. The spread on five-year major bank senior FRNs jumped from 74 basis points above bank bills in January to 100 basis points in March (on the so-called bid side). Concurrently, the three-month bank bill swap rate (BBSW) also soared from 25 basis points to 50 basis points above the RBA's 1.5 per cent cash. Ordinarily this would signal fears the banking system was blowing up. This phenomenon has coincided with a similar jump in the gap between the London Interbank Offer Rate (Libor) and cash rates in the US. Both Libor, which is set in the UK, and its equivalent, BBSW, here in Australia reflect the cost of unsecured, short-term borrowing for banks outside of the US Federal Reserve system. These rates have leapt for two reasons that are entirely unrelated to bank credit risk. First, US companies have been repatriating cash from overseas back to the US as a result of tax changes, which has forced offshore banks to offer higher interest rates to fill this hole. Second, the US treasury happened to issue about US$300 billion of short-term bills that temporarily crowded out bank money markets. These two shocks will fade over time and in April there has been evidence that funding costs pressures are abating with bank credit spreads contracting and BBSW and Libor stabilising. We bought the major banks' senior FRNs at the wides in March and have watched bid-side spreads compress quickly from 100 basis points over BBSW to around 85 basis points today. The blow-out in March was partly driven by banks selling their own bonds to build cash reserves as they approached their half-year reporting dates. (Cash balances had been depleted by the dynamic noted here: that is, US corporates transferring money back to the US.) In April we've also seen signs of a bid returning to the listed hybrid market with cash yields (before franking) very high at around 4 per cent to 4.5 per cent, which is miles above term deposit rates and interest rates offered by senior or subordinated bond. Including franking, which even under Labor all taxpayers and pensioners will be able to utilise (non-tax-paying pensioners keep their cash rebates), major bank hybrid yields are north of 6 per cent. That's above the 5.9 per cent (franked) dividend yield on the ASX200 index even though hybrids have historically displayed around one-third the volatility of shares and about half the maximum drawdown during the GFC. This shift in sentiment was helped by Morningstar's hybrids analyst, John Likos, who published a detailed report during the week arguing that "the recent sell-off has been overdone, presenting attractive opportunities". "We have upgraded a series of securities in recent days, including ANZ Capital Notes 4, or ANZPG, on the back of this widening," Likos said. In my own portfolios I've been happy picking up hybrids over February and March as spreads gapped some 80 basis points wider. Buying when others are fearful and selling when they get greedy is a decision-making maxim that tends to outperform over the long-term." Read the rest of the article here.


Christopher Joye

Christopher Joye is Co-Chief Investment Officer of Coolabah Capital Investments, which is a leading active credit manager that runs over $2.2 billion in short-term fixed-income strategies. He is also a Contributing Editor with The AFR.

Expertise

equities credit bonds Hybrids donald trump

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