Marked Up June 29th
Touching the void
“Touching the void” is a climbing movie where in the absence of any hope one climber chooses to cut the rope that is used to hold his climbing partner. The partner falls into the crevasse below, falling into the void.
The United Kingdom has cut the rope attaching it to Europe; it is not yet clear who is falling, the EU or the United kingdom.
The void in this instance is a political one. The British Prime Minister has announced his intention to resign, and the opposition leader has lost 12 of his front bench to resignation.
Boris Johnson is the early favourite to leader the Conservative party and he will try to fill the gap in leadership.
The problem seems to be that even the exit camp didn’t believe they would win. If they did then presumably there would have been a plan.
In the absence of a definitive plan others will fill the space, step in Nicola Sturgeon, the First Minister for Scotland.
Sturgeon is an articulate engaging politician, who has advised that Scotland may be able to veto the referendum and that Scottish independence is back on the agenda.
By making the involvement in Europe an electoral issue the Conservative movement has provided a platform for many and one of the many is volatility.
What do we know today
The vote was contrary to the pollster opinion polls. It seems a divide has opened up between young and older members of the community.
The difference in opinion is also geographic. London, Scotland and Northern Ireland all wanted to remain and the rest voted to leave.
Central Banks are ready to provide liquidity in an attempt to ensure there is not another Lehman’s experience.
Currency volatility has seen the Japanese Yen and USD rally on safe haven basis. Sovereign bonds have also rallied as clients look for liquid assets that provide some return.
There is no leadership that can answer investor questions.
Europe hasn’t been asked for its opinion of Britain, the conversation and politicking has all been around Britain’s view of Europe
Europe will have the first opportunity to collectively respond after Tuesday’s meeting in which Mr Cameron will present the outcome of the vote and then be asked to leave the room and the Europeans will consider their position.
Extraordinary behaviour
The Fed Blinked, luckily for markets
When the Fed declined to lift rates in June they referenced volatility in markets as a consequence of a potential Brexit. Prior to the June meeting many of the Fed Governors had detailed the belief that June was a live meeting.
St Louis President Bullard said in reference to Brexit “even if the U.K. decides to leave, “the next day nothing happens” and the country will enter into departure negotiations bound to go “very slowly.”[i]
Mr Bullard is right and he is wrong, nothing happened but everything changed.
Which brings back into focus the lower for longer theme?
Mr Bullard predicts it will take years to implement a transition what does it do for the expected trajectory of interest rates?
Can anyone see a situation where rates are higher in 2017? Or for that matter 2018, 10 years after the GFC!
The global central banks are prepared to extinguish the risk of liquidity crisis’s and sustained volatility spikes. They are not yet prepared to lift rates in an environment that is seeing fragile global growth challenged by even more fragile political alliances.
So rates don’t look like going up, markets have been sold off is this the black swan event that makes it a buy?
Black Swans
A Black Swan is “An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict.”[ii]
We are clearly watching a “Black Swan” event, there are going to be many who will claim the result of the referendum was obvious but the “Black Swan” in this instance is the deviation in prices.
The “market” didn’t predict the result and that is why the deviation is so significant.
Now that prices are lower investors are pondering if it is a buy.
It may help to first look at the reaction in context of the capital stack. We often mention that senior bonds are less volatile than subordinated bonds which are again less volatile than equities.
The following chart shows Lend Lease senior fixed rate bonds with the green line, CBA subordinate bonds in white line and NAB equity in yellow.
I don’t know if either of these assets are a buy but the chart goes to highlight what the market thinks of them.
The CBA subordinate debt is trading at a margin of approximately +270 over BBSW.
The implied return will be the BBSW rate for the period + issue margin of 2.65% and the difference in price of 99.0455 and the $100 CBA will pay at redemption.
The key driver of this graph isn’t the return, it is the response.
For customers escaping political driven black swans moving up the capital structure at least potentially reduces the velocity of the volatility.
What does it mean for Australian investors?
Without a plan, you are without a hope. The people agitating for leaving the EU do not seem to have a plan.
Investors need to recognise some investing disciplines in volatile times.
Keep on top of pricing, instigate tight stop losses, deal in what you know or less risky assets than you usually deal in.
No matter how much is written about what will happen it is clear no one yet understands the ramifications of a change of this size.
Clients may ponder that attitude of some of the better professional fund managers and that this is an opportunity to build a portfolio of high quality assets.
If the goal of investors is to build a portfolio of high quality assets at the lowest price, that is a different matter.
There is no guarantee that we are seeing the lows at the moment, the prices are lower that is all.
Investors should not discount the impact of volatility; the importance is to recognise volatility prior to the investment.
The defenders of Brexit remind everyone that world has not ended, the relationship between two trading partners has.
Which is true but what most impacts investments is the behaviour of the consumer and on that score no one is certain of the outcome.
Early indications are that the angry responses by both sides could negatively impact consumer confidence and behaviour.
The hybrid market
The hybrid market is a developing market. Primary issuance has been strong locally, and ANZ launched a USD issue recently.
Hybrids are not appropriate for everyone.
Recently an institutional investor spoke with me about his equity risk premium above the risk free rate. His premium was 5.00%, that isn’t to suggest that everyone should use 5.00%, what we are encouraging customers to consider is what is their premium for certain types of risk assets.
The following chart is the major bank hybrid curve based on trading margins.
A trading margin is the assumed return once a security has been redeemed at $100 plus the agreed coupon payable on the security.
As an example a security that has a coupon on +400 to BBSW and is trading at $105 assumes a loss of $5.00 at maturity and a consistent coupon of +400.
A security trading at $95 assumes a gain of $5 plus coupons over the period.
Investors should consider at what price they buy the bond and how that will impact their YTM, given the pull to par effect at maturity.
The dotted line is the normalised curve.
Charts should trigger questions, such as:
- Why does CBAPC trade below the line
- Why does NABPD trade higher that WBCPF when there doesn’t seem to be much difference in maturity
Nab is a large participant in the hybrid market, our focus in the post issuance market is to encourage clients to stay engaged with their investments.
In the same way Mr Boris Johnson from the leave camp cannot assure you of the future, we are unable to deliver guarantees but we can pose questions that will hopefully help provide clarity in your investment strategy.
Cash Rates
Economists are starting to predict a cash rate of 1.50% by the end of the year due in part to low inflation and post Brexit reaction.
Investors in cash will not be pleased by a lowering in the cash rate.
Clients who have invested in cash may need to have a strategy to satisfy one of the following criteria.
- Does cash meet existing liabilities on a predetermined basis
- Will the cash be used to invest in future opportunities?
The fact that investors have escaped some assets to invest in cash only means that they will be subject to the deteriorating impact of the lower for longer, now possibly being much lower and much longer.
Be in cash because it has a role not because it is a home.
Please remember this article is not investment advice. No one but you or your advisor knows (or hopes to know) what is best for you. We want you to understand the risks. If you’re unsure then don’t act.
[i] Bullard Doesn’t See Brexit Chance Affecting Fed Policy” Bloomberg News May 23 2016
[ii] Investopedia “Black Swan”