In this Q&A, Sir Michael Hintze, chief executive officer and senior investment ofﬁcer of CQS, presents some of his thoughts on key investment themes for 2014.
CQS funds have seen another generally positive year in terms of performance in 2013. How do you see 2014 developing?
We have had a reasonable year across the firm on the back of a generally strong 2012. Having been constructive on markets for some time, I started becoming more balanced in my portfolios during the course of this year. As we look forward into 2014, I see more ‘pot holes’ than ‘black holes’. While Taper seems inevitable, central bank balance sheets globally will continue to grow as Quantitative Easing (QE) itself is not going away. It is the rate of growth of the balance sheet that is being ‘Tapered’. Markets have run a long way and expectations are high. However, I think the overall direction of markets is probably upwards, albeit at a more moderate pace than in 2013. Taper will also be a sign of confidence that the Fed believes the US economy has its own escape velocity and the financial system’s stability has returned. Having said that, a ‘pot hole’ arising from general market complacency around Taper, a miscommunication on forward guidance or renewed concerns around the Eurozone are all imaginable.
What investment themes are you looking at?
In terms of themes, we continue to see value both on the long and the short sides in several areas including:
• Credit spread versus all-in yield. I believe the risk lies in the risk-free rate rather than in the credit spread (given the benign default environment).
• Floating rate and/or short duration sectors of the credit market, such as structured credit, asset-backed securities (ABS) and senior secured loans, especially European loans.
• Fundamental analysis will assist in capturing futuredispersion given the current compression in credit spreads (especially in the US).
• Convertible bonds, especially European convertible bonds, which are well positioned to beneﬁt from increased corporate activity and have attractive event/takeover protection.
• European equities, where we see a durable dispersion in valuations due to a recurrence of mispriced assets.
It is clear to me that it is an advantage to be an active investment manager and that there are opportunities, but one must size positions appropriately.
What do you mean by ‘pot holes’ and ‘black holes’?
What I mean by ‘black holes’ is that I cannot see anything presently blowing up the markets. I sense no one else can see it either and that in itself is a potential danger. Policymakers and central banks have by-and-large put in place guidance and policies to mitigate many of the systemic risks out there over the last few years. For example, under Mario Draghi’s leadership the European Central Bank (ECB) has addressed the key structural challenges to the EU’s ﬁnancial framework (without spending a single euro). Could you see a ‘pot hole’ along the way, yes; but I do not see an imminent ‘black hole’ event in Europe.
Having said that, loss of faith in Draghi or his ‘magic’ could come close to being a ‘black hole’. Some of the ‘pot holes’ could occur as governments try to cope with their ﬁscal responsibilities. Others could come from the European periphery (Portugal and/or Greece), the Asset Quality Review, or the European parliamentary election in May. Such ‘pot holes’ will lead to opportunities.
There has been some progress in addressing international tensions with Syria and Iran. Conﬂict with Iran was always the most immediate risk to the Middle East region, if not the world. But remember, Egypt is still troubled as is Libya, Tunisia and Algeria, not to forget other areas of geopolitical challenge in Asia and Africa.
How do you see the major economies developing during 2014?
The overall picture is encouraging. In the US, the economic momentum continues and the longer-term fundamentals (cheap energy, self-sufficiency in agriculture, positive demographics and innovation) are supportive. The messaging on Taper created confusion, which has abated. Change at the helm of the Fed, whilst manageable, creates potential uncertainty. As a reserve currency, the US dollar provides a transmission mechanism creating risk globally and especially in developing markets.
In Japan, there is a clear political consensus to drive the yen lower. Following on from the first two arrows (fiscal and monetary stimulus), the third arrow (structural reforms) reﬂects the government’s determination. This is positive for Japanese markets in the medium term, although demographics weigh on Japan’s long-term outlook.
In the Eurozone, structural challenges to the financial framework are being addressed by Draghi and systemic risk has lessened materially. The UK economy is rebounding, the periphery seems to have turned the corner and overall, the European Union is no longer a drag on the global economy. Having said that, I also believe the EU recovery will be subdued. Fiscal proﬂigacy of many states is not being addressed and I feel complacency is a risk as the markets are not now focused on this.
Frankly, some of the most interesting and potentially important medium-term changes are happening in China. I believe the uncertainty surrounding leadership change has abated and this should be positive for GDP growth. The third Plenum set a reform agenda and is positive for growth, given the emphasis on free-market solutions, amendment to the one-child policy and the continued shift from manufacturing to services and further urbanisation. China’s importance to the global economy is reflected in its role as the marginal price setter in many natural resource markets. For example, some 50% of global demand for iron ore is from China.1
Could you expand on your thinking behind QE and Taper?
The messaging on Taper created confusion, complicated by change at the helm of the Fed. The market has been embracing the continuation of an accommodative stance, and I believe there is some complacency on this front. It is also important to remember that the US dollar’s reserve currency status creates transmission risk globally and especially in developing markets. I have heard it said that QE did more to stimulate downtown Mumbai than downtown Detroit. As Taper slows central bank balance sheet growth, the reverse could be true. Those developing economies that have restructured will be more resilient than those which have not. QE, Taper and Forward Guidance need to be considered in the context of overall monetary policy. The recent study by Vasco Curdia and Andrea Ferrero, published by the San Francisco Fed, shows that in 2012, QE2 combined with Forward Guidance added 0.13% to US GDP and 0.03% to the inﬂation rate, compared with 0.04% and 0.02% without Forward Guidance. At one level, perhaps it is not surprising that the impact is modest as QE’s original purpose was to assure the solvency of the banking system.
However, the important aspect here is that Forward Guidance has had such a statistically significant effect. When interest rates are close to zero, Forward Guidance becomes the key channel through which monetary policy is transmitted to the real economy. It is worthwhile recalling what Ben Bernanke said in October 2011: “Forward Guidance and other forms of communication about policy can be valuable even when the zero lower bound is not relevant. I expect to see increasing use of such tools in the future.”2
So what are the challenges the Fed faces in the context of global markets?
Consider the size of markets. The OTC (mainly swaps) market is about $670 trillion, the global bond market $83 trillion, the US bond market is $35 trillion, global equity markets are at about $54 trillion3 and global GDP is around $72 trillion. The direct influence that the Fed has is on the US monetary base. At $3.6 trillion,3 it appears modest in size relative to markets globally.
But how important is Forward Guidance to asset prices?
I recently reviewed a qualitative study put together by a team led by Paul Fisher at the Bank of England. See Fig.1 for this team’s view of what could happen with the Bank of England’s balance sheet once QE is withdrawn.
Of particular note is the path of real asset prices. When the balance sheet is shrunk they see asset prices deﬂating. I do not believe any central banks will shrink balance sheets in the short term, but rather that the growth of QE will be Tapered, although there is a school of thought that they may shrink naturally through ‘pay downs’. However, Taper will signal the direction of travel unless there is sufﬁcient economic growth. It is due to Taper and the risks associated with Forward Guidance that I have become more balanced in the portfolios I manage. Forward Guidance really does matter and it is no surprise there are and will be ‘Taper Tantrums’.
Parenthetically, if inﬂation does ever start to become a problem, I believe it will be more difﬁcult for liquidity to be withdrawn than any central banker believes or cares to admit.
What should the markets be worrying about with Ben Bernanke stepping down?
Given how important Forward Guidance is, any change in leadership can be unsettling. In fact, misunderstandings, as we had in May of 2013, can be unsettling. In my view, the biggest risk is that Janet Yellen will not be as good a communicator as her predecessor. However, she is experienced and during her conﬁrmation hearings she was measured, and I sense she could be Ben Bernanke Act II and there will not be much to worry about. Should there be another ﬁnancial stress event, I would be more concerned about the absence of a Hank Paulson-like ﬁgure at the Treasury.
So what does that mean for markets?
It highlights the ‘pot hole’ thesis. I believe the chances of the market realigning itself are high. These moves could be sharp, albeit not massive: 3% to 5%, rather than 10% to 15%. All this is in the context of major regulatory change across the ﬁnancial system affecting banks, insurance companies, ﬁnancial intermediaries and leveraged investors such as hedge funds, as well as the growth of ETPs, especially in less liquid securities. We also need to understand that Forward Guidance has had a significant impact on the risk-free rate and the Equity Risk Premium (ERP).
Do you subscribe to the view that in seeking to eliminate systemic risk, central banks are unintentionally creating greater risk?
Yes. There is no such thing as a free lunch. The views of the central bank are reﬂected in the market, rather than the diversity of views of market participants. Dampening volatility, and hence risk, builds stresses elsewhere in the system. In this instance the strong Forward Guidance from the Fed, the Bank of England and the ECB has created a clear risk-on objective.
It has squeezed out mass hedges; hedging is generally costly and more difﬁcult to effect. Let me clarify what I think is happening. QE has driven the risk-free rate down and, combined with asset purchase programmes, certain asset values (such as ﬁnancial assets) up. In so doing, central banks have ‘driven’ the market into the same trade. The bell-shaped probability distribution curve has been squashed from the sides; the bell has been elongated upwards (see Fig.2).
Forward Guidance has led to a lessening of the uncertainty and reduced the volatility of asset prices for now. But it actually makes the market less stable in the long term. Importantly, Forward Guidance and central bank interference decreases market resilience; everyone is thinking the same and being driven into the same trade. The unintended consequence will, at some point, be to ‘normalise’ the probability distribution curve. It might even ﬂatten too much in the other direction and broaden the tail the other way before regaining normalcy. Shifts when moving from one state to another can be difﬁcult and abrupt. It is not healthy to have a ‘rigged’ market.
Looking at the Equity Risk Premium, does a ‘normalised’ risk-free rate suggest the equity market is overvalued?
Not necessarily. Very simplistically, the Equity Risk Premium = Earnings Yield – Inﬂation-Adjusted Risk-Free Rate. The key drivers are the earnings level and earnings growth, the risk-free rate, and the rate of inﬂation. We have looked at a number of scenarios and even if you were to assume a ‘normalised’ risk-free rate 100 to 300 bps higher, the ERP, ceteris paribus, would not be far out of line with recent levels and still above the long-term average. That said, unless there is a strong growth signal, equities could react badly to a signiﬁcant increase in the 10-year risk-free rate.
And if rates backed up, what would that mean for credit?
If you look at a chart of the 10-year Treasury that dates from 1980 to the present (see Fig.3) you would see rates tightening from a high in 1981/2 of 16%, grinding to below 2% at the beginning of 2013. Rates have declined for three decades. I joined Salomon Brothers in 1982 when the Fed funds rate was 18% and what is interesting to me is that corporate credit spreads are actually similar today. The all-in US corporate investment-grade yield has moved from 9.2% in 1990 to around 3.2% at present.4 The credit spread (subtracting the risk-free rate) was 0.97% in 1990 and is 1.31% now.5 The risk lies in the risk-free rate, not the credit spread.
So what does that mean for the way in which you are investing in credit?
Foremost is fundamental analysis and identiﬁcation of idiosyncratic risk. This enables us to identify relative value both on the long and the short side. You also need to differentiate between the all-in yield and the credit spread. We continue to believe there is value in moving into ﬂoating rate instruments (out of ﬁxed) and shortening interest rate duration risk. In particular, we continue to find floating rate sectors of the credit market attractive such as structured credit, asset-backed securities (ABS) and senior secured loans, especially European loans. Importantly, there are supportive technicals and improving fundamentals.
Is the cost of debt still lower than the cost of equity?
Yes it is, although the relative cost is beginning to narrow in the US. What this suggests to me is that we could see acceleration in corporate actions that take advantage of cheaper cost of debt compared to cost of equity. During 2013, we witnessed Apple’s $17 billion bond issue 6 to fund its share buy-back programme, many substantial LBOs and MBOs and acquisitions such as Verizon’s buy-out from Vodafone. I think the likelihood is that this will continue to be a major feature of US markets and an increasing one in Europe. There is more to come and that will afford us signiﬁcant opportunity through credit derivatives and convertible bonds, especially in Europe where convertible bonds have strong take-over protection which makes them especially attractive.
Last year, you spoke of both France and the South China Sea as being potential ‘Black Swan’ events. Tellingly, both topics have been keenly watched and reported on. You recently reiterated your concerns over France. Is this not a potential ‘black hole’?
In France, there are ﬁscal pressures, a stagnant economy, rising unemployment and growing social discontent, combined with a growing military campaign in Mali and the Central African Republic. Let’s remind ourselves why a potential problem with France is so important for the Eurozone. France is at the heart of the European project. There may be 28 members of the EU and 17 states in the Eurozone, but the reality is that (along with Germany) France is at the centre. My understanding is it would be politically, and I sense economically, impossible for either France or Germany to bail one another out. So a weakening France is of great concern and, in extremis, there is the potential for a systemic threat, but I think we are a way from that. The debate over France’s fiscal system is driven both by politics and economics. France’s GDP growth will struggle to hit 1%in 2014.7 Bernard Cazeneuve, the Budget Minister, recently admitted that the weak economy would result in a €5.5 billion shortfall in tax receipts and they are likely to fall despite a nominal rise in tax rates. Deﬁcits continue to plague France with debt: GDP is estimated at 92.5% in 2013 and greater than 94% in 2014 and government expenditures are at 57% of GDP and growing.7 With an all-time low approval rating of around 20%,8 Hollande’s ability to push through reform is increasingly limited. Furthermore, let us not forget that France voted against the Maastricht Treaty in its ﬁrst voting round. While the market’s confidence in France continues for the time being, it is important to monitor developments closely.
You have also spoken many times about the tensions in the South and East China Seas. What do you make of the current tensions between China and Japan?
In short it is worrying. But I am hopeful there will be a sensible diplomatic resolution. I have written on the subject at length before, so I will not dwell on it here. Both the East and South China Seas represent a potential source of tension as China seeks to assert itself in what it sees as its natural sphere of inﬂuence. China’s recent declaration of an air defence identification zone (ADIZ) has certainly moved things to another level. Suffice it to say that given 40% of the world’s shipped goods are transported through the Malacca Straits,9 should a situation develop whereby that trade route is blocked, there could be significant ramifications. The chances of an accident are not insigniﬁcant in my view.
What are the risks for Asian and other developing economies as Taper takes hold?
Remember when QE started there were massive capital inﬂows into Brazil, India and other developing countries. Conversely, it stands to reason that when Taper begins, the magnitude and perhaps the velocity of these ﬂows will change. Whilst it is very difﬁcult to be deﬁnitive and to quantify the actual currency ﬂow mechanism, what is very clear to me is that the US dollar’s reserve status creates transmission risk globally, especially to developing markets.
There has been a lot of discussion around the renminbi as a reserve currency. How soon could that be a reality?
The renminbi has over the last ﬁve years made dramatic progress in becoming a signiﬁcant currency for global transactions. This has often been via bilateral currency swaps. I believe this growth will continue as China’s global trade grows. The transition from a major transaction currency to a major reserve currency requires a lot more structural change in the economy. It also requires change to an economy’s management and in the structure of the country’s ﬁnancial markets, as well as the political will to surrender control. In effect, the Chinese authorities will have to give up a certain degree of autonomy to market forces, allowing global capital ﬂows and opening access to their ﬁnancial markets. There is also the view that because the reserve currency is the major provider of liquidity, a growing world economy will naturally demand a greater level of reserves. The provider of the reserve currency must, if necessary, be willing to run a current account deﬁcit in order to ensure adequate global liquidity. This may well happen over time but there is no inevitability about this outcome. However, we have seen similar debate around the possibility of the Deutschmark and yen gaining reserve currency status when Germany’s and Japan’s respective currencies were touted as having potential reserve status.
To summarise, what should investors be considering in 2014?
There is enough dispersion and/or compression in valuations in the various asset classes for good returns to be achieved in 2014. It will be difﬁcult. It always is, no matter how easy it looked in hindsight. Isolating the risk-free rate will, I believe, be increasingly important. We think floating rate and/or short duration instruments such as ABS, loans and structured credit, as well as convertible bonds and those equities with growth and/or high dividends should provide value. Idiosyncratic long-tail risks present substantial opportunity and I see substantial value and opportunities via credit derivatives. I continue to be positive about opportunities arising from the evolving structure of capital markets, regulatory, ﬁscal and geopolitical, and I believe global government interventions are creating both distortions and opportunity. The key is to be opportunistic and to size portfolios appropriately. The need to have downside protection is important and has grown cheaper as a result of Forward Guidance. We have the tools and we are doing our best to take advantage of the evolving landscape for the beneﬁt of our investors.
1. Bell Potter, ‘Stronger for Longer’, July 2013.
2. Chairman Ben S. Bernanke, at the Federal Reserve Bank of Boston 56th Economic Conference, Boston, Massachusetts, 18 October, 2011.
3. BIS, Dealogic, SIFMA, McKinsey Global Institute.
4. Bloomberg, as at 12 November 2013.
5. Bloomberg, as at 24 October 2013.
6. Bloomberg, 30 April 2013.
7. EIU, May 2013, INSEE 5 September 2013.
8. IFOP 17 November 2013.
9. Reuters FactBox, March 2000.