people in motion

people in motion

vendredi 24 février 2012

INVESTLOGIC STRATEGY  : The Bear Smiles... How To Trade It?

What strategy would we favor in the coming months and how shall we invest to cope with the financial and economical turmoils ? We can only reply that it made precious little difference – depending upon one’s time zone, personal proclivities, and astrological sign one could play the risk-on scenario via Russian stocks, Venezuelan bonds, Italian banks, Shanghai equities... or, for that matter, pork-bellies and Brazilian Real.
As we have been specializing in EM we shall continue to focus on these areas, more particularly to East and Asia.

The markets now move in a coupling mood as an amorphous lump; thus, if the party does continue, we would expect only the “safest” assets” – yen, dollar, US treasury and Bunds – to underperform. As noted in a previous issue, global financial markets have become a casino where all of the tables have been shut down except for the roulette... and the numbers have been off the wheel, too. Basically, you can bet on either red or black: risk-on or risk-off. Rien ne va plus!

Given the extreme pessimism with which the financial world entered the New Year, the market was overdue for a bounce; the excuse was provided first by the ECB (turning on the taps), then by the Fed (promising free cheese for as far as the eye can see).

Now that the Europeans have joined the Americans in massive monetary creation (the US via outright Fed purchase of government debt, the Europeans by ECB LBTO lending to the commercial banks which the employ the ECB cash to fund risk-free carry-trades on EU sovereign debt) the game will certainly last for another few innings. We are highly sceptical of any purported economic “green shoots”, which strike us as artificial in the extreme, driven solely by continued credit expansion. Note that the US has a structural deficit estimated at 7.5% and a current budget deficit of nearly 10%; the European blended deficit is a more modest 6%, mostly cyclical; alas, there are several notorious outliers with clearly unsustainable debt dynamics. Both blocs are being kept out of outright recession by accelerating monetization alone – never a comforting thought.

Vitally, neither the EU nor the US can roll over maturing debt under market conditions, and have thus resorted to overt monetization (despite the obviously unsustainable debt dynamics, the UST yield curve was flattened last year by massive Fed buying; European sovereign bonds have latterly joined the party, with yields coming in by as much as 50%). Not at all inclined to bet against the central banks, right now would currently tend to befriend the trend.

Of course, until and unless the laws of gravity are repealed, there is ultimately going to be a choice between massive fiscal drag or outright monetization with a severely inflationary outcome. But that is for later – and we get paid for making money now. Our best guess is that we will have a happy first two quarters of 2012, followed by a renewed storm in late Spring... if so, just remember to sell in May and go away.
Having happily sheltered in the emerging markets corporate fixed income space for the past six months, we are currently adopting a slightly more risk-friendly stance. Our preferred Axis-of-Evil (AOE) bond trade – Venezuela (PdVSA) / Cuba (serviced) / Belarus / Russia (private banks) – has worked out nicely indeed, with some of our assets up as much as 15 points (plus carry) since the October bottom. Argentina GDP warrants, arguably also associate members of the AOE, yielded about 60% last year, but still offer considerable value on a multi-year horizon.

We would now be looking to sell US dollars, buying Asian and commodity- currencies, equities (especially China, India), Russian roubles, commodities and emerging markets equities – in particular, Russia and China.

The China Syndrome As one of our basic investment themes, we shall continue to mock the China bears who have been warning of an impending collapse – since about 2003; meanwhile, the Chinese economy has more than doubled in size... Beijing had decided to downshift economic growth to just under 9%, and the last GDP numbers came in – at 8.9%; thus, the virtues of a properly- managed command economy. The Chinese financial system will need some restructuring, and restructure they shall, but without unwanted volatility. One can certainly choose to not play China – but one would be a fool to bet against it.

Fixed Income 
Our beloved PdVSA (Petroleos de Venezuela – Viva Chavez!) bonds are up as much as 15 points from their October lows, with some trading at or above their highs of the past five years. We are disinclined to chase them much above here. Belarus is surging back, and we would expect the bonds(now at 91, after seeing the low 70s) to enjoy further strength as Russia executes a successful buyout of her Western neighbour.

Russian bank bonds still offer free money – a good half-dozen points of yield pick-up with literally zero default risk. Our favourites remain RUSB (Russian Standard), Promsvyaz, and Alfa, to which we might add BOM, and for the truly adventurous, TCS. Your friendly VTB salesman will be able to guide you as regards relative value along the curve.

Elsewhere, the excitement is to be had in the more exotic neighbouring regions – Ukraine and Kazakh banks (we must here add a health-warning – something along the lines of “Don’t try this at home!” The yields are juicy but there are some very substantial risks).
Ukraine – often described as a joke which gets funnier each time you tell it – Ukraine is facing an unsustainable fiscal squeeze and has fallen squarely between two stools, managing to simultaneously antagonize both Russia and the EU. Given their unsustainable debt/current account/currency dynamics, we would assume that, in extremis, they will either agree a bailout with the IMF (requiring a 35% increase in domestic gas prices in the run-up to an election which is looking increasingly difficult for Yanukovich), or they will agree to a Belarus-type deal with Russia, ceding control of the gas pipeline system (a wasting asset, as competing routes – Nord Stream and soon South Stream – render it less critical for Russian export volumes), in return for a knock- down price on Russian gas imports.

It can be argued for most of the past decade that Nabucco was a pipe-dream not a pipeline – economic nonsense in the absence of a Transcaspian pipeline (vetoed by Russia and Iran). We have been amazed at their ability to keep the dream alive for as long as they have – but we reiterate our view that not a single molecule of gas will ever flow through it. Turkey’s recent agreement to allow the construction of Gazprom’s South Stream is probably the last nail in the coffin of what was always intended as a political luxury project that Europe currently cannot possibly afford.

Of course, this being Ukraine, there is also the possibility that they will dither until the markets lose patience and carry them out; all Ukrainian financial assets currently include a substantial sovereign risk premium. While we still like some of the dollar bonds, we would certainly not hold any local currency.

By far our preferred Ukrainian trade was Alfa Ukraine 2012 (restructured) – alas, this bond is now almost completely amortized, trading above par, and maturing later this year. This leaves Metinvest, in our view a credit substantially better than the sovereign which would be rated investment-grade were it not for the sovereign-ceiling effect; financial ratios are conservative, its sole vulnerability being its exposure to global steel prices.

As regards Kazakhstan, we think that the banking sector bonds offer substantial upside for moderate risk – the subordinated debt of KKB, ATF and BCCRD have been our preferred picks. ATF has performed poorly – the parent company, Unicredito Italia, receiving much unwanted attention as its share-price crumbled in the wake of the deeply discounted rights issue needed to repair its capital levels. That said, absent a European meltdown, we do not see is any meaningful risk of failure of Unicredito – which is TBF (Too Big to Fail) in Italy. Furthermore, as a stand-alone credit, ATF is holding reasonably steady and should continue to gradually amortize its NPL load.
Credit metrics of KKB and BCCRD are slowly improving – not at the pace which could have been expected with oil at $110 and the growing Chinese involvement in the Kazakh economy, but we see very limited default risk. We have at your disposal a full ppt presentation on the investments along the Silk Road, the opportunities and the development of Khorgos dry ports which opens a huge market between China, Russia and EU.

Those currencies which were worst beaten up during the extreme risk-off phase are now likely to outperform – NZD, AUD, KRW, RBL, etc. Which one you choose seems almost irrelevant – perhaps a basket approach would be best. Absent any further surprises out of Europe (always a risky proposition) the Euro should remain steady – but we can find more attractive alternatives.

Our top currency recommendation, indeed out top trade, remains what it has been for the past year – long Chinese RMB. We are increasingly enthusiastic about this call, which has performed remarkably well this year, RMB being essentially the sole major currency to have appreciated against the USD. As China liberalizes its currency regime preliminary to its assuming control over the entire visible universe, the NDF market, which until recently charged a premium of as much as 2.5% to buy RMB forward one year, is now actually offering forward RMB at a discount. Properly leveraged (6-1), assuming a 5% currency appreciation this year (mid-way between the bullish 6% and the bearish 4% calls), this trade should yield somewhere in the vicinity of 30% cash-on-cash. Best of all though, we see precious limited
downside – while the Renminbi might conceivably fail to appreciate, we are hard-pressed to envision a scenario where it would devalue outright.

While we admit that the highest-beta assets will likely outperform early in the year, our Russian equity positioning remains “conservative,” heavily biased toward “virtual fixed-income” e.g. the preferred shares of TNK-BP and Bashneft, with perhaps a side- order of Tatneft Prefs. But, according to Deutsche Bank Moscow, the best – Surgut Prefs, which DB expect to yield in the vicinity of 15%, offering both yield and capital appreciation; furthermore, according to Mr Quinn, even that baying hound Transneft may well become something resembling a public company, paying proper dividends and showing concern for investor relations.

Commodities “Risk-on” means what it says. Precious metals are likely to surge on pleasure-principal monetary policy, and even if Soros is right about gold being “the ultimate bubble,” one make a great deal of money on bubbles provided you remember to get out in time...
Uranium has been one of the worst-performing industrial metals – this was not improved by Fukoshima. At some point – though probably not this year – demand will further outstrip production, and prices will surge.

If the current flight from quality continues, then we would expect financial investors to come crowding back into the commodity space, with predictable consequences. We like energy and think some of the agriculturals are in for a strong bounce, but remain wary of the volatility. The PGMs, Palladium especially, are likely to see insufficient supply in the face of growing demand.
Where could we be wrong? We could be jumping the gun here, and have limited certainty as regards our bullish call – but at some point one simply must get up and dance.

Having once badly underestimated the Europeans’ ability to screw things up, we are cautious about falling through the same ice twice – and if tomorrow morning the reader learns that the Germans have blocked further LTRO loans, have decided to reintroduce the Deutschemark, then it’s game up.

Equally, were the US to suddenly stop talking about a balanced budget and actually attempt to implement one, we would not want to be anywhere near the risk assets. For now, all of these scenarios appear most unlikely 

Happy Trading!

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