Is Athens Burning?
With no undue modesty, we are rather proud of our investment track record – punters following our advice over the years, as well as a few faithful clients, should be gratified by their performance. Inter alia, we were among the first Western source crazy enough to recommend more recently, Russian and Kazahk bank subs, as well as our Axis-of-evil trades (Belarus, Cuba-serviced, Venezuela PdVSA, and now, cautiously, Argentina).
While we managed a few good trades in Russian small-caps, latterly, we have been increasingly chary of equities as an asset class, preferring emerging market debt .
None of this, of course, has prevented our making a few spectacularly bad calls ...
The issue of the Euro crisis has been sufficiently dissected in the media (W. Munchau has done a very competent job in his FT columns) so we can safely skip over the details. Suffice it to say that – as noted previously –the basic assumption had been that a failure to provide sufficient financial support to prevent a Greek default would trigger a widespread loss of confidence, with financial contagion causing borrowing rates for any European sovereign seen to be potentially distressed to spiral out of control, causing a cascade eventuating in... exactly what we are seeing today.
It seemed so obvious. A few tens of billions of dollars spent early on in the crisis could have forestalled losses ranging into the trillions (though, of course, the opportunity would most likely have been wasted as governments continued their profligate ways). The outcome is still frighteningly uncertain, but we already draw three fundamental conclusions:
- First, while some of the more clueless commentary has focused upon the “democratic deficit”, the problem is precisely the opposite – a “democratic surfeit” if you will. Cutting wages, pensions and social benefits is a sure-fire vote loser; for politicians, to speak painful truths is often enough a career-ending move. Providing financial support to the profligate Greeks creates fury in the German heartland; removing long-cherished job protection and social benefits is deeply undemocratic; an economist or two will always be found to explain why pleasurable measures (ever- increasing stimulus) are to be preferred to unpleasurable ones (austerity). Finally, even the ability to comprehend the potential second- and third-order consequences of a disruptive sovereign event requires a fairly sophisticated understanding of financial markets, something totally lacking in most readers of the tabloid press – whose deeply held opinions are thus nothing more than ignorant prejudice.
- As noted by Prosperity Capital’s brilliant Liam Halligan (yes, Liam, you were unarguably right about the Euro – and long before it was fashionable to be; but now, most you rant so?) the broad Euro experiment was faulty – monetary union in the absence of hard fiscal convergence could not work. Alas, that was then, and now is now, and there is no way to unwind it without risking totally unforeseeable consequences. Personally, we would much preferred the more diverse Europe we knew as a child – but that too is now history, the Rubicon has been crossed, with only two possible outcomes: either fiscal/political unification or severe economic/political disruption with potentially disastrous consequences. Although we are reticent to make any further predictions regarding the efficacy of the European political process in dealing with financial crises, we would prefer to assume that the system is not fatally broken, and that the sole viable alternative – true fiscal/ economic union, is now ineluctable. Hope dies last!.
- While most commentary has focussed on the failure of the Euro project, the truth may be quite the opposite. It is not inconceivable that monetary unification was conceived in a secret attempt to force through a “United States of Europe” – in the knowledge that, sooner or later, a crisis would eventuate and, with no way back, Europe would be forced to adopt a federal model implying dilution of sovereignty of the component nation states. Perhaps linguistic unification comes next. Ich bin ein Berliner.
Beware the Bear...
The market currently offers a truly extraordinary opportunity! There is only one problem–we have absolutely no idea whether it is a buying opportunity or a selling opportunity...
All considerations of fundamental risk and value currently pale before the fierce waves of disruption from the macros. With the financial world having shifted entirely to a risk-on/risk-off model, assets are now worth either a great deal more, or a great deal less, than current pricing.
No sentient being is entirely sure what would happen were Greece to exit the Euro; the fact that the Lehmans debacle was not expected to create the degree of havoc that it ultimately did does not necessarily imply that a Grexit would do the same – much of the money that a Greek meltdown would “cost” has already been spent, and we would assume that markets have had time to prepare; that said, these are totally uncharted waters, and T&B would prefer not to see some of our hypotheses tested.
What does look fairly certain is that in the wake of a Greek default, we would see some truly extraordinary buying opportunities in a wide variety of financial instruments, as panicked investors dumped whatever they could for whatever price they can get, only then pausing to figure out what it was that they sold. It would be a wonderful time to have some free cash...
Our baseline scenario remains that some sanity ultimately prevails, and that Merkel abandons her hostility to desperately necessary Euro-wide measures – hopefully in return for the acceptance of some hard fiscal constraints by Germany’s neighbours. In this case, current pricing would seem very attractive, including for some of our favourite debt assets which have traded off with the rest, although far less than would be expected given the violent decrease in risk tolerance elsewhere in financial markets.
Emerging Markets Debt (EMD) has greatly outperformed emerging markets equities – which have once again been hammered by a wave of risk-off. While this relative outperformance is gratifying, caution is called for. Were the situation to deteriorate further – and there is certainly no shortage of tinder – investors would likely be panicked out of their remaining winning positions en masse, leading to a short, sharp sell-off in bond markets.
Given the macro uncertainties, all trading calls should be considered as subject –beware of leverage and keep some powder dry !
Equities
Of the many valuable lessons that investors have learned from the great John Maynard Keynes, perhaps there is none so useful as the admonition that, in the short run, markets are voting machines – in the long run, weighing machines. Over a short time horizon (the only horizon remaining in modern casino markets) what is vital is the perception, which you ignore at your peril.
At Investlogic we remains suspicious of equity markets, given their ability to deviate from their fundamentals for a prolonged period, and their extreme dependence upon sentiment and mood. The recent sell-off in emerging equity markets was almost entirely unrelated to any fundamental economic factors (indeed, such drivers are usually invented ex-post-facto – to explain what has just happened).
Therefore, if somehow, Greece and the EU find some temporary stability, a powerful rebound can be expected, at least until the next Eurocrisis strikes (apparently, it is unrealistic to hope that European policy makers actually take the proactive measures necessary to deal with the next phase of the crisis, before it eventuates).
Given the increasingly assertive foreign policy stance of the Russian government, we can expect Western press coverage to remain unremittingly negative10 (the Pravda-model of “independent journalism”) and, thus, for Russian equity (but not debt) markets to continue to suffer from the disaffection of foreign investors. This is, of course, largely a self-inflected problem; the solution would be not a craven foreign policy, but rather, for Russia to develop her own pools of domestic long-term, institutional capital, as well as encouraging popular equity ownership, perhaps via another bout of pensions reform.
Whilst recent moves to unify the RTS and Micex exchanges, establishing a single custodian, and improving settlement procedures are all very helpful, further improvements in Russian corporate governance and an end to the constant stream of “surprises” (inter alia, the recent suspensions of Vimpelcom and TNK-BP dividend payments) would be most welcome. Investors in Russia must still expect the unexpected, and while, in almost all cases the story is ultimately resolved with limited or no real damage, event-fatigue ultimately sets in.
Therefore we remain underweight equities – both Russian and non-Russian, with zero exposure to the US and European markets. Of the Russian assets, we continue to have a strong preference for the remaining high-dividend resource stocks. We expect substantial volatility going forward and would prefer to capture cash flows, rather than rely upon hypothetical price appreciation.
Fixed Income
The recent volatility in the wake of the Greek electoral circus probably constitutes a good buying opportunity for unleveraged players. Our fixed income portfolio has again performed very strongly this year, and we reiterate our trading calls; that said, the timing is currently tricky and we would not be in any hurry to increase positioning, keeping leverage to moderate levels given the risk of a European implosion.
Our long-standing Axis-of-Evil trades – in particular PdVSA and Belarus – shot the lights out. Belarus was the best-performing EMD asset this year, with PdVSA a close runner up. At present, we are a bit more nuanced in our strategy; having taken some profits as PdVSA yields dropped towards 10% (reasonably close to fair value) we are cautious of general market sentiment, and the risk of a further short term sell-off in oil. We remain entirely comfortable with the mid-term credit fundamentals, and we would be looking to increase positions in the shorter end of the curve, once some sanity returns to global markets; for now, we see little reason to hurry.
The fundamental story remains unchanged – China is taking an increasingly important role in the Venezuelan economy, and those hoping for a right-wing government to replace Hugo Chavez are likely to be disappointed (if holding PdVSA bonds for the eventuality – best to hit the bid). That said, Chavez has severe, indeed potentially fatal health problems and the plans for a possible succession are by no means clear; there is a very high likelihood of continued Chavismo in one form or another, but with the potential for considerable disruption. We wish him good health and a long life!
-Belarus enjoyed a spectacular recovery as Lukashenko was forced to recognize economic reality – allowing a maxi-devaluation, briefly hiking interest rates as high as 70%, and negotiating a huge financial package from Russia, with sale of the Belarusian oil transmission infrastructure and commitment to further privatisations (by which only Russian buyers are likely to be tempted).
Russia’s gains were facilitated by spectacularly incompetent European “diplomacy” that scored a marvellous own-goal, forcing Lukashenko to abandon his long-standing struggle to maintain equidistance between Russia and Europe.
A charter member of the Eurasian Customs Union, Belarus should now be seen as a future province of the Russian Federation (indeed, the justification for the separation of Belarus from Russia was never self-evident). In the near term, the danger is that, with the noose loosened, rather than privatizing and maintaining credit restrictions Lukashenko resumes his previous economic mismanagement, throwing increasing quantities of credit at fundamentally non-viable government-owned entities. Even this worst- case scenario simply accelerates the process of economic unification with Russia; the current >11% yield on the bonds is an anomaly, largely attributable to the current risk-off mood in markets.
Ukraine we would handle with great care. During our recent trip to Kiev, we were struck by a macroeconomic policy apparently based more upon hope than upon any rational analysis, with the government intent upon playing for time – although time was very clearly not on its side.
We have said so before, and will say so again – Ukraine is living on expedients, and needs to cut a deal with someone, either the European Union or Russia. Whilst the EU is very attractive to the Westernized denizens of Kiev – it is rather less so to the Russian half of the population. There is another slight problem while it can offer market access and much inspiring language, the EU currently has no money – for that, one needs to turn to Russia.
The politics are particularly fraught, but our best guess is that typically incompetent European diplomacy drives Ukraine into the arms of Russia – much as it did Belarus, with the sale of the Ukrainian gas transmission system (a wasting asset, in any event) and, possibly, accession to the Eurasian Customs Union.
That said, Ukraine has performed better than expected in the recent sell-off.
We would not be complete without a recommendation for the USD Eurobonds of Russian private banks, in particular the subordinated debt of Alfa, Bank of Moscow and Promsvyaz, as well as the senior debt of Russian Standard Bank. To this litany, we would add the new issue of Nomos 2019. Although we generally shy away from such long duration, the 11% YTM appears quite compelling.
Given the relatively conservative positioning of Russian retail banks, and the unstinting support of the CBR, they are about the closest we can find to “free money” in this market. Spreads have drifted out in recent weeks due solely to the Greek fiasco, which, of course, has absolutely no fundamental impact upon Russian bank solvency. For those requiring a bit more yield (and excitement) we continue to like selected Kazakh assets – KKB subs, and for those willing to position for the long-term, and to accept illiquidity in return for high yields, the perpetual bonds of ATF, BCCRD and KKB.
Finally, risk-tolerant investors might take advantage of the current market turmoil to position in Argentina, in particular Provincia de Buenos Aires which is yielding almost 25% – largely on the back of investor hysteria following the nationalization of YPF. We might also consider repositioning in the Argentina GDP warrants: currently pricing at about 9, a December 2012 payout of 6.5 cents based upon 2011 growth essentially means that patient investors can acquire a 20-year option on Argentine growth for 2.5 cents (after the coupon), with a theoretical potential payout some twenty times as large. No, markets are not always rational...
When the pundits start to gang up on any given company or country, one can usually assume that some serious mispricings are lurking about. Provincia de Buenos Aires is not for the faint- hearted or the over-leveraged, and considerable volatility can be expected; seen as a high-risk trade with a non-zero default risk, at a yield to mat of 25%, one is getting well paid to assume the risk.
Argentine macroeconomic policy is wildly unorthodox, with in particular the currency control regime becoming increasingly repressive and unmanageable. Like the previous attempts at a neoliberal model the current leftist model may well end badly, but that is almost certainly a problem for the medium term – at present, we see no immediate threat to debt sustainability, and despite all of the dire warnings, the Argentine economy has actually done quite well since its last financial crisis. Furthermore, nationalizing YPF may prove to be one of the several things that the Fernandez government has done right – the majority owner, Spain’s Repsol, was using Argentina’s main oil company as a cash- cow, milking it for very high dividends while underinvesting as oil production cratered.
Oddly enough, after acquiring YPF in a deal sanctioned by Kirchner, Repsol quickly sold 25% of the oil company to Petersen Co, owned by the billionaire Eskenazi family, in a deal in which the Eskenazi received one-quarter of a very valuable asset essentially for free; the entire purchase price was debt-financed, partly by Repsol itself, partly by a consortium of banks. The loans were guaranteed by the shares only, with interest and amortization serviced by the very high dividend flows (~90% of profits) generated by YPF itself... a wondrously attractive deal for the acquirer, though one which begs some fairly obvious questions regarding what was behind the deal.
Currencies
While from a fundamental standpoint, we continue to see the dollar as an accident going somewhere to happen, it is currently favoured by the risk-off trade. Given that we think it only a matter of time before the US either spirals back into recession or engages in further debt monetization, we are trimming our Euro/dollar and Euro/SGD shorts but certainly not going long the Euro. It has been a good trade.
On the other hand, our long-standing short- USD/long RMB is performing rather less well than expected. The Chinese currency is currently treading water; Beijing has shrugged off diplomatic pressure for a faster appreciation, and as the currency trades more freely, it is slightly affected by the same factors which have tanked emerging currencies in general – while the RMB is about 1% off its highs, the Brazilian Real and Rouble are off a good 10% - we would continue to own RMB as a store of value.
There are some great trades lining up as the risk-off pushes currencies away from their fundamental values. At some point, the AUD/NZD will once again become very fashionable as China plays – the BRL will come surging back, as will selected Asian
assets. We would bide our time until there is some clarity as regards the European situation. While we think that the worry about China is misguided, certainly, Greece and the other PIIGS constitute a greater challenge.
Rates – When no Greater Fool is to be Found...
While noting that negative real rates for 10- Year US treasuries (much less paying to lend money to the Swiss or German governments...) were the mother of all bubbles, We would not try t to call a top. At below 1.5%, we must be getting near. Although we would NOT short the bonds outright – panicky markets make widows and orphans – but we think that out-of- the-money option strategies for a blow-out in yields 12-18 months down the road make a great deal of sense.
Happy Trading!
