G stands for Governance not Green

The explosion in demand for green bonds in recent years has left them looking expensive versus other fixed income securities, with better options available to investors outside this niche part of the market.

Over $100bn of green bonds have been issued so far this year, with the euro-denominated market leading the way after accounting for 43% of all issuance. Investors have been attracted in their droves to green bonds, with market conditions exceptionally favourable for the securities over the past 18 months.

As a result, issuers have generally been able to dictate the terms of new debt and thus rush to create green bond structures. The sector has become overvalued as a result.

We do not want to ruin the party, but we choose to avoid buying green bonds due to current pricing. Where an issuer’s long-term ability to pay is not backed up by the right business model or balance sheet, adding a green moniker to that issuer will not make us invest.

Investors must consider green bonds within the wider context of ESG, and ensure they drill down into the underlying drivers for each bond, rather than focus simply on the notion that they have some level of green credentials. In particular, investors need to be aware that the underlying risk from green bonds is not ring-fenced from other debt the company may have issued.

Our belief is that green bonds should be treated much like any other anomalies; we will seek to exploit them. Where we can lend to an issuer for the same length of time, with the same security, and support a green project – that is great. But we are not in the business of lending money to the disadvantage of our portfolios and clients where the cash raised by those issuers is fungible with the rest of their cash pile and our security is ranked along with all their other debt in the issuer’s general corporate purposes.

Green investing should be actively encouraged, but not at prices or in companies that could otherwise not pass investment scrutiny. A strong business model and good governance are key to our process and ESG success. That ‘G’ stands for Governance, not Green.

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A green opportunity, but at what cost?

Green bonds have grown in prominence over the last couple of years, with a company’s ESG (Environmental, Social and Governance) credentials assuming ever-greater importance for investors. The terminology used to describe green, or ethical, bonds – and the definition of investing ethically – can often be interchanged to such a degree that the end investor is left with an incorrect understanding of the difference, and perhaps a lack of appreciation of the risks.

Dedicated green or ethical bonds are sometimes issued by established blue-chip corporates (e.g. Lloyds and SSE have issued green bonds in recent times); the proceeds of such issuance is essentially ring-fenced by the issuer to fund socially responsible or environmentally-friendly projects. Liquidity in instruments issued by such well-established entities is typically as deep as would be the case with the rest of such an issuer’s capital structure.

Unfortunately the same liquidity is rarely as prevalent in green bonds issued by unlisted entities, regardless of how “green” the opportunity may be. The substandard issue size of such bonds (very often less than £100m outstanding), combined with the lack of disclosure limits the scope that such bonds can be bought or sold in the secondary market. It is this trade-off between maintaining liquidity in an investor’s portfolio, whilst maintaining their overarching desire to fund responsible and environmentally-friendly businesses that perhaps deserves greater attention than it is given.

One avenue that facilitates an efficient combination of the dual requirements of investing ethically without compromising liquidity is to invest in an ethical fund. At Kames we have managed ethical portfolios since 1989, with an independently administered “dark green” screen in place to ensure that the portfolio’s investments are consistent with the expectations of our client base. The end investor has regular disclosure on the nature of the fund’s exposures, whilst they can also sleep well in the knowledge that their investments have daily liquidity.

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Why a disorderly queue is worse than an orderly QE

The UK’s reputation took a further plunge as investors queued outside the Bank of England yesterday (see below) demanding payment in either gold or other hard currencies in exchange for the pound.

The currency took a further lurch lower in value after another frantic day’s trading on currency markets. Following the Governor’s refusal to bail out the UK’s major banks in 2008, the UK has failed to break from its cycle of recession after the catastrophic effects of the collapse of an effective payment system in 2008. The subsequent widespread economic hardship was exacerbated by The Bank of England’s refusal to allow Quantitative Easing (QE). The policy of QE has been aggressively pursued by other major central banks since 2009, leaving the Bank of England an outlier. The European Central Bank incrementally added its QE programme which saw a rapid solution to its “Euro crisis” in 2011.

This scene from yesterday, outside the Bank, is reminiscent of Northern Rock’s collapse 10 years ago, which saw then Chancellor Darling bail out that bank, but encouraged him and the Prime Minister to not support further bank rescues in 2008.

Yesterday’s demand was from a disparate collection of private individuals and investors, and marks the further increase in tensions as the currency slipped to further all-time lows against both the dollar and euro. As overseas investors continue to shun the UK government bond market, double-digit gilt yields further undermined equity market confidence.

Last year’s vote to leave the European Union only exacerbated the already weak financials. Conditions continue to worsen as net immigration to Europe and the rest of the world reaches levels not seen since the 19th century. The government aimed to reassure investors, but with an ounce of gold costing sterling-based investors over £10,000, it is difficult to see normal conditions returning to the UK anytime soon…

Or rather, is it just a queue of collectors keen to have one of the new Jane Austen £10 notes launched today?

My counterfactual history of events 10 years on from the financial crisis is clearly ludicrous. But whilst QE may be bad, it is like Churchill’s remarks on democracy: QE is the worst form of policy, except for all those other forms that have been tried from time to time.

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Nothing to fear except price itself?

Is the real challenge for fixed income markets solely their valuations? Most measures from the global real economy point to stronger PMI, lower unemployment or increased GDP – all suggesting that rates should be higher. So why are Treasuries at their lowest yields this year?

US rates are in the tug of war between bond bulls and bears, with bulls currently having the upper hand. There is little doubt that the 1% increase since the end of 2015 has done little to dampen the US economy; the counter to this is that the economy has not run away either, seemingly regardless of significant swings in the dollar’s value. Cheap debt has fed into all aspects of rates and credit markets as financial repression reduces yields across markets. Are we in a goldilocks scenario? Or should we fear more than price itself?

There are signs of individual sector stress that aren’t as noticeable at an asset class level. Carmakers, typically with higher credit quality, are selling fewer units, while online retailers are redefining valuations for second-tier shopping malls. Credit market quality is also a subject of debate. Looking back to 2005/06, many corporates have slunk to lower credit ratings. But for the most part debt serviceability is not materially impaired, and financials’ credit quality is demonstrably stronger.

Maybe North Korea offers the opportunity to shake things up? Spread widening reactions so far to missile tests have been measured in Richter scale numbers (single digits) rather than nuclear equivalent, tonnes (hundreds). This points to markets with lower volatility, but could be an implicit bull signal. Certainly if it is only a war of words and further sanctions achieve the removal of uncertainty, this could prove bullish for credit markets.

Of course central bankers are really key to whether we should expect more of the same or not. They have been hyper-proactive in support of monetary policy and balance sheets have grown dramatically. We are now headed into a period where a reverse is the case. The Phillips curve and other econometric models that tell us to expect inflation to materialise from current levels of unemployment and growth are being challenged. Central bankers are the pilots frantically tapping their instrument gauges, knowing they need to land but have to do it on their own as well as negotiate the crosswinds of investor sentiment.

Markets expect an orderly removal of stimulus over a long period of time – and that orderly process is captured in current market valuations. A disruption to this view could cause meaningful market volatility and a back-up in valuations.

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Back in the summer of… 2011

As fund managers interacting with our clients, the team often gets asked, “What’s the holding period for a trade”? And, given our strong belief in active management, we typically respond by explaining how we rotate our portfolios’ credit and rates exposure across issuer / sector / quality / currency to find the best value in the market. It’s not often we say “six years” and leave it as that.

But for those of you that have followed our strategic bond funds over the years, you will have noticed that we recently closed our long-held position in US Non-Agency Residential Mortgage Backed Securities (RMBS).

The aftermath of the great financial crisis created many opportunities for us as active managers. One of these transpired back in the summer of 2011, when we started to establish a position in US RMBS. These were bonds secured on pools of US mortgages that had been originated in the years 2006 and 2007 and were trading at very distressed prices (on average in the low 60 cents in the dollar). This reflected a US housing market still in a state of flux following the financial crisis, and an expectation that these bonds would experience losses as home owners defaulted on their mortgages.

At the time we believed that the pricing of the bonds reflected too pessimistic an outlook for the US housing market, pricing in significant further declines in average home prices. In our opinion, we were nearing the bottom of the housing cycle, and these bonds would perform well as the US housing market recovered. With the benefit of hindsight, we were six months too early in our entry point as US house prices didn’t trough until late 2011/early 2012. But as long-term investors and given the scale of the subsequent recovery, it is harsh to quibble about the exact timing.

Source: Bloomberg

We recently took the decision to exit this position. With average US prices now above the level they were before the financial crisis, we believe we have seen the bulk of the performance from the trade. That is not to say we believe there will be a downturn in US house prices, rather the bonds now more accurately reflect the outlook.

One of the skills we must have as active managers is the discipline to take profits on a successful trade. These bonds have been an excellent investment for our clients, with some positions generating an average return of close to 8% each year since our initial entry. They have also provided excellent diversification benefits for the funds, exhibiting very little correlation with other parts of the global fixed income market. In this case, it was well worth an extension to our typical holding period of a trade.

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Bank credit should be top of the list for income investors

The Global Financial Crisis (GFC) triggered fundamental changes to how the financial services sector operates. A slew of legislative frameworks ensued across most developed markets in an effort to prevent such a scenario from happening again. In the following years, the sector was subject to a plethora of new regulatory directives and frameworks on a global, regional and local scale. The common theme was ever higher capital requirements; the difference was how these would be met.

Fast-forward 10 years and most major global economies are in recovery mode (with varying degrees of activity picking up and unemployment falling). But the economic pain that followed the GFC is not forgotten – especially by the financial regulators. New and stricter rules require banks to hold ever more capital; it seems that each time the capital target is hit, the goal post is moved further away. From a credit investor point of view, this perpetuates a goldilocks scenario in bank credit: bank fundamentals are improving, but a large-scale redistribution of excess capital back to shareholders is constantly delayed due to the need to reach each new milestone, lowering the risk in bank credit.

As per the above, we are still in a regulatory convergence mode, and the end game is not yet in sight. What is certain is that banks’ fundamental profiles have strengthened significantly in the meantime. Most institutions now hold three times as much high quality capital compared to 2007, but this is not reflected in bond valuations. The spread on the junior-most capital layers of bank debt (the riskiest type) is five times more than senior unsecured bank credit (the safer layer), compared to just two times more in 2007. In terms of annual returns, the Bank of America Merrill Lynch Contingent Capital index achieved 5.8% in 2014, 6.9% in 2015, 7.3% in 2016 and 10.9% over 2017-to-date. The handsome yields on offer are also higher than bank equity, but with a lower volatility.*

As well as offering an attractive return profile, junior bank credit tends to have little discernible correlation to ‘traditional’ fixed income credits, as it is positively correlated to inflation and negatively correlated to interest rates. This offers investors significant diversification benefits using a building block fixed income approach.

Overall we believe that bank credit offers an excellent solution for those income investors that can look through short-term volatility and focus on annual total returns. As always, issuer and structure selection are key to avoid losses and capture the best income opportunities. At Kames we have a long history of successfully avoiding the losers in our high yield franchise, while our team combines over 30 years of fundamental bank analysis and research.

*Source: Bloomberg as at end July 2017, local currency returns. Bank of America Merrill Lynch Contingent Capital index ticker is COCO.Bank equity refers to EU Bank Equity Index’ dividend yield SX7P

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Prime time to checkout Amazon?

Amazon is a company that polarises opinion in the investment world. It has been variously described as the biggest not-for-profit organisation in the world to one that epitomises the new technology world we live in, a company that is at the vanguard of the equity-market-favoured “FAANG” quartet (comprising Facebook, Amazon, Apple, Netflix and Google).

Whilst there can be no disputing the incredible equity market performance it has exhibited this year (the equity is up more than 30% in 2017), it is fair to say that the credit rating agencies also have sharply differing views too – in their case on creditworthiness. It is not uncommon for Moody’s and Standard and Poor’s to perhaps differ by a notch or two in their assessment of an individual credit, but it is rare for them to diverge by four notches as they do in the case of Amazon. Moodys rate Amazon at Baa1, with Standard and Poors assigning one of its highest ratings for a corporation at AA- .

As part of its ongoing strategy to be a one-stop shop for all consumers, Amazon recently announced its intention to acquire Whole Foods Markets Inc, a takeover that would give the e-commerce giant more than 460 physical stores. This week saw the company issue a multi-tranche (7 dollar issues) deal to raise $16bln and help finance this acquisition. We viewed the 10 year tranche, initially to be priced at 110bps over the underlying US Treasury, as good value relative to the secondary market curve. However, spill over from equity market enthusiasm ensured the deal finally priced at spread of 90 over for Treasuries. A stretch too far for us; the deal left investors with little value and Amazon with a very competitive cost of funds.

The Amazon example is very representative of our investment style; we try not to be too dogmatic in our assessment of individual credits; we look to buy good investments, which is not always the same thing as buying a good company. We will leave “not for profit” investing to the experts – like Amazon.

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Masterly manipulation

“Masterly manipulation” it was called by J.M.Keynes in secret papers in the 1920’s. Today we call it QE. 

A fascinating and only recently discovered entry in old Bank of England ledgers revealed that in 1914 the Bank was forced to purchase Gilts for itself as there was insufficient demand for its new issue. The issue of the £350m “War Loan” in 1914 was reported as being a success; press articles of 1914 talk of demand ”pouring in” for the deal. Yet, £250m of the transaction was never sold and quietly shuffled away on to the Bank of England’s ledger – or balance sheet.

So what have we learnt from this historical discovery?

1) Just because the newspapers (social media, today) say it’s a good deal it doesn’t mean it is a good deal. Having some healthy scepticism is “stock-in-trade” for the Kames Fixed Income team, and we trust for our readers.

2) QE will happen in extremis but ultimately it is about delivering confidence. In 1914 it was about financing a European war and failure to be seen to be doing so would have had huge political ramifications. Similarly, in 2009 confidence in the financial system was shot and QE helped rebuild confidence in the system. Something had to be “done” and globally central bankers responded by tripling their balance sheets over the next eight years.

3) It has taken over 100 years for the “masterly manipulation” of War Loans to come to light. Despite some disquiet, Gilt purchases in the UK or purchases by other central banks have been done in an open, transparent and formulaic fashion. With today’s QE there is no obfuscation with the purchase process but QE’s unwind is less clear and a matter for public debate. Institutional transparency is a part of the confidence we have in our system. We may not like QE but it’s a whole lot more transparent than a hundred years ago.

(Thank you to the authors of the excellent bankunderground blog: https://bankunderground.co.uk/2017/08/08/your-country-needs-funds-the-extraordinary-story-of-britains-early-efforts-to-finance-the-first-world-war/#more-3230)

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Reports of my death have been greatly exaggerated – the Sterling corporate bond market continues to thrive

More than a year has passed since the Bank of England announced its £10bn Corporate Bond Purchase Scheme (CPBS). While the scheme was completed by April, much more quickly than originally anticipated, its positive impact on the market has been lasting.

Prior to the Bank’s intervention the importance of the sterling corporate bond market was under threat, in part due to poor secondary liquidity and a lack of supply from borrowers drawn to the depth, convenience and competitive pricing of the euro and dollar markets. Even UK-centric borrowers such as Royal Mail favoured the euro market over their home turf.

The backstop bid that the Bank’s scheme provided gave market makers the confidence to increase secondary liquidity through tighter bid/offer and larger size. There was concern as the scheme drew to a close in April that the improved liquidity would diminish but this hasn’t happened. Higher volumes have persisted and market participants are more confident trading larger blocks. A marked increase and greater variety of new issuance over the course of this year (gross issuance year to date has already surpassed full year 2016 volumes) has also helped to define market levels and encourage further secondary activity.

To this end, the Bank’s intervention has been a great success. A more dynamic market presents further opportunities for us as active managers to express views and add value to portfolios for the benefit of our clients.

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Does the unreliable boyfriend ever want to be Action Man?

The Governor of the Bank of England (BoE) has just said, as it released its Quarterly Inflation Report, that it expects to reduce stimulus more than the market is currently pricing.

Yet the bond market rallies.

The BoE reduced growth and wage expectations for next year, while still predicting above-target inflation three years out, and keeping alive the prospect for a rate hike. One way to square that circle is if it has lowered its assumptions about the potential growth of the economy – meaning that even if we beat trend growth just a little bit, we will be reducing slack in the economy, enough to warrant a reduction in stimulus. In other words, the UK has an even lower bar to beat. This could be seen to be hawkish.

Yet the first reaction of the market was one of scepticism, pushing out rate hike expectations even further. The Monetary Policy Committee (MPC) may now face a communication problem. It has to convince the market that it is serious about raising interest rates, after the hawkish noises heard earlier in the summer were not followed through in today’s vote (as per our earlier article, http://bondtalk.co.uk/macro/monetary-policy-soft-or-hard-approach-not-just-a-political-dilemma/ Haldane could have made it 5-3, yet the vote was 6-2).

Perhaps the best way for the MPC to communicate that it wants the market to price higher interest rates is to actually deliver and reduce the stimulus put in place last August – that will certainly get the market’s attention.

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Who Benefits from QE?

A report out overnight from the Bundesbank examines the impact of quantitative easing on the rate of interest German authorities pay to borrow money.

In 2007 the average rate for the government or a local authority to borrow was 4%, last year it was less than 2%. Over that period German authorities have “saved” €240bn in interest payments. Put it another way, that is €240bn of income investors have LOST out on as a result.

Bond prices globally have moved to ridiculously high levels as central banks manipulate the market and hoover up assets. Investors in all asset classes have traded lost long term income for short term capital gain. Unfortunately the history of most markets is that prices and yields normally move back toward longer term averages. As that happens who bears the losses? Well, not the government – it has locked in decade long low rates. Which leaves investors.

I’m a dyed in the wool capitalist, I believe passionately in regulated, free markets. I believe the system works best when the balance of risk and reward between borrowers and lenders is evenly spread. From 2001 to 2007 the balance tipped too far in favour of borrowers and we ended up with the global financial crisis as everyone “levered up”. We then spent 5 years trying to fix things with more regulation and capital controls. But since around 2012 we reverted to type. Hiding behind a smokescreen of “dis-inflation” (largely due to oversupply of commodities, where production was boosted by all the free money!) Central Banks continued to manipulate markets, boost asset prices and destroy long term value for investors by holding savings rates way below the rate of growth of G7 economies. Let us be clear – that boosted asset prices principally because borrowers had never had it so good. It disincentivised investment and innovation. It killed productivity. There is NO mystery behind that.

So if you intend buying an equity or a bond fund have a think about that. The German government has already made €240bn from your generosity. If and when prices reverse it is not they who will bear the losses.

A decade ago all the talk was of “debt socialisation” as the only means to get us out of the leveraged hole the financial and government sectors were in. Well, we need to WAKE UP people. Socialisation has happened. And if you are the one left holding the assets when the market turns, who is going to bail you out?

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Not just all talk, maybe some trousers?

Well now, a month ago I wrote a piece comparing the current mania for buying government debt to “The Emperor’s New Clothes”. Let’s all lend to the government for returns massively below the level of inflation and growth and pretend it’s all good. Individually we all know the guy is in the nude, collectively we just ignore the fact.

Within a matter of days, a series of emperors – central bankers globally – rushed to point out they were indeed naked! In itself not a pretty thought. Ridiculously overvalued bond markets did what ridiculously overvalued assets have done for 500 years – they fell in price. And with the merest whiff of QE removal in the air even that decade-long bastion of stability, the global equity market, had a little wobble too (short lived of course).

The reaction to a potential 180 degree turn from the ECB, Bank of England, Bank of Canada and (whisper it) Bank of Japan has unfortunately been all too predictable. Sellers of risk peddled the line that Yellen, Carney et al now recognise how STRONG the global economy is, that they would not DARE raise rates unless the recovery was self-sustaining. So, go out and buy that risk because the market is only going in one direction.

We do need to remember that risk valuations are often based on discount rates – in short, the lower the level of government bond yields, the easier it is for equities to look “cheap”. And of course the lower the cost of borrowing, the easier it should be for companies to fund earnings growth. Mind you, things are clearly so good now that raising the cost of borrowing really wont matter will it? It’s not as if those same risk managers have relied upon (and publicly thanked) central bankers for their decade-long largesse.

But wait, perhaps the party is not yet over. Since setting up the market with a coordinated “we are going to raise rates” message, ECB, Fed and BoE officials have been back peddling faster than a Tour de France cyclist going downhill in reverse gear.

Today at 3pm is the first test, the first time we will see whether the rhetoric is matched by reality. The Bank of Canada is widely expected to raise rates. It kicked things off a fortnight ago telling us how rates needed to go up. If it does raise, then this may signal co-ordinated deeds as well as words to further remove emergency monetary policy globally. If so, judging by historic standards we probably have three to six months of risk assets doing okay. After that – good luck.

Of course, no rates increase and the party can trundle on a bit longer – albeit with an Emperor no longer naked but wearing a very small pair of pants.

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Valuations Sour the Green Apple

This week saw the issuance of Apple’s second green bond, a $1billion 10-year transaction to help fund its goal of running 100% of the company’s operations on renewable energy. The issue builds on $1.5billion of green bonds sold by Apple a year ago, the biggest ever green bond issued by a US corporation. Whilst Apple has plenty of cash on its balance sheet the company’s issuance has helped fuel a surge in dollar green bond issuance last year, with 2016’s supply doubling 2015’s total issuance. This year so far, around $120billion worth of green bonds have been issued by corporations.

Apple has an agenda, epitomised by CEO Tim Cook attempting to persuade Donald Trump not to leave the Paris Climate Accord. Apple is committed to making the future iPhone solely from recycled materials but currently only a small percentage of the current iPhone is made from them. Apple has identified a number of materials used in their products which can be recycled and used in new products, for example aluminium that is used in the current iPhone 6 can be melted down and used in Mac computer cases.

December 2016 also saw Apple investing in four subsidiaries of China’s largest wind turbine manufacturer, Goldwind, taking 30% stakes. They are targeting directing power from the wind turbines to Apple manufacturers based in China. The company is currently using renewable energy in 96% of their stores and factories with the goal of increasing this to 100%. Apple scores very well in the E component of our ESG scoring but controversies still lie around their supply chain management, use of child labour and hazardous chemicals usage.

For investors the new green bond was fully priced at +82bps spread over the US Treasuries curve. Initial price talk at +95-100bps would have offered investors some value at launch but final pricing left little to excite. In the basket of Apple bonds this wasn’t necessarily the one to pick and, whilst the ‘green’ label is to be applauded, for a company the size of Apple corporate responsibility is more material than the odd billion of green bonds.

More HC Andersen: The Emperor’s New Clothes

2017 is the 180th anniversary of the publication of Hans Christian Andersen’s short story “The Emperor’s New Clothes”. For those not familiar with the tale, it is the story of how two conmen convinced an Emperor to part with money for nothing – by creating a scheme whereby those who challenged prevailing wisdom were made to seem stupid. Ultimately the scheme unravelled when an innocent, a small child, laughed at the stupidity of the situation.

My problem – I’ve borrowed a bit of money and can’t really afford to repay it, so in a giant Ponzi scheme that would make Bernie Madoff blush I’m going to get people to give me more at ridiculously low levels, such low rates of interest in fact I really don’t need to worry about how much money I get.

My clever scheme – the economy is in a mess and I can sell you something that is guaranteed to make you a tiny amount of money. I know the data suggests things are actually as good as they have been for 20 years, but we all know “experts” and “facts” are so 20th century. Trust me, I can make you rich.

German 10-year bonds yield 0.25%.
German (nominal) growth is around 3.5%.
You can lend money to Germany and get 0.25% back each year.
Germany makes 3.5%.
Do that for 10 years: you get around 3% total return, Germany over 40% (did someone mention compounding?).

Now replace Germany with the UK, US (to a lesser extent) and even Japan.
But are Mark, Janet and Mario the Emperors, the conmen or the children?

Hey, if you want to buy the beta of the bond market – if you want that return-free risk – go ahead. Who am I to stop you?

One final thing to note: 2017 is the 176th anniversary of the publication of Charles Mackay’s seminal work – “Popular Delusions and the Madness of Crowds”.

The Ugly Duckling by HC Andersen, as translated by DAJ Roberts

Once upon a time there was a little red duck called Jeremy. He was shunned by the other ducklings on the pond who were a nice shade of light red, almost pink, unlike the strong scarlet of Jeremy’s plumage. But it wasn’t just the colour. The other ducklings – Tony, David, Ed and even that nice little Gordon – just couldn’t quite understand him; perhaps it was the accent, or perhaps the product of a poor education system? At times he seemed to be speaking a language foreign to theirs!

One day after years of teasing Jeremy, the gang woke up and found that he had grown into a rather attractive swan! They looked in astonishment at Jeremy swimming serenely along. And not only was he calm above the water, he no longer seemed to need to paddle furiously beneath the surface either.

But suddenly – to the amazement of all in view – up from behind the bushes (where she had been sharing a moment of quiet contemplation with her bestie Phil) leapt farmer Liz.

Without a moment’s hesitation she emptied both barrels of her shotgun (always kept loaded; oh how she longed for those days when foxes were fair game) straight into poor Jeremy. Red feathers everywhere.

“What the deuce did you do that for old gel?” asked Phil.

“Well” replied Liz, “My swans are supposed to be white. I saw a black one once – a portent of doom – and did nothing about it.”

“What happened?” Phil quizzed.

“There was a terrible storm about ten years ago. My house nearly fell down (in truth I couldn’t afford the mortgage but the nice man at the bank, Mervyn or Eddie I can’t remember which one, had told me not to worry about it) and half my money was washed away in the flood.”

With that, Liz turned on her heel and walked quickly back to her modest country abode. At her heels was her ever-faithful dog, Theresa, with a smile on her face (if indeed Corgis could smile).

Little did Theresa know that Liz had long had a hankering for something bigger, perhaps with a shaggier coat. Indeed, that very morning she’d been to the pet shop in Windsor and had started to look kindly on a golden Labrador answering to the name of Boris. He’d been a bit noisy, but in truth Liz worried his bark was worse than his bite. Still, if she ever needed a guard dog to ward off any more red swans, surely to goodness he’d be more use than Theresa?

UK election positives

It is early days yet but it looks like Theresa May is going to be returned as prime minister as the Conservatives form a government with support from the Democratic Unionist Party (DUP). On first glance it seems a bit of a mess but taking a closer look at the results there are some positives.

Firstly, the share of the vote taken by the mainstream parties has risen as a proportion of the vote. Or putting it another way, the share of the vote taken by the extremes has fallen. The country as a whole has moved towards the middle. In England, from Right to Left, in Scotland from independence (as supported by the SNP) towards unionist, and in some places, from Anti-EU (Tory) to EU (Liberal Democrats).
What does this mean for policy? Perhaps the same – moving towards the centre, compromising on the issues that the UK faces, which could be a positive outcome.

So for example, the probability of a second independence referendum in Scotland has been reduced.  Many SNP seats were lost on this issue. Scotland is not usually prone to voting Conservative but in this election they represented the strongest voice against Independence.

Negotiations with the EU will have to be less extreme, particularly as the DUP does not want a ‘hard border’ with the Republic of Ireland. You could make the argument that a cross-party team could be appointed to lead negotiations in the national interest, but maybe that is too farfetched. However, with the decline of UKIP, it doesn’t seem likely that the current position can move any further anti-EU.

With regard to tax and fiscal policy, we can probably expect some movement towards the left, i.e. higher taxes and higher public expenditure; the Conservatives lost badly on this issue to Labour. We can probably expect the pledges regarding minimum wages being fulfilled and some of the cuts that were floated (e.g. school lunches) being abandoned.

What does this mean for UK fixed income? Probably very little, with easier fiscal policy being outweighed by reduced extremist political risk. And sterling? It could be positive depending on the Brexit negotiating stance. Monetary policy is likely to stay stable thus supporting fixed income, sterling has depreciated a lot versus both euro and US dollar over the last year, so this political event – as messy as it is – in my view is unlikely to push sterling to new lows.

Europe not Spain executes Popular wind-up

Banco Popular’s equity and subordinated bondholders have been wiped out today. To come to this end, the EU’s Single Resolution Board (SRB) has exercised its power to resolve the Spanish bank after the ECB stating last night that the lender is ‘failing or likely to fail’. The exact mechanics follow a €9.1bn provisioning and capital shortfall being identified which necessitated the writing down of equity and AT1, as well as conversion of T2 debt into Shares of Banco Popular while simultaneously transferring that equity to Banco Santander for a total consideration of €1.

Some market participants have surely been taken aback this morning by the abrupt and radical way of dealing with a failing financial institution. After all, this is the first time when the relevant resolution authorities apply the widely-advertised Bank Recovery and Resolution Directive (BRRD) rules so in essence this is the first real-world test of the new playbook. As a reminder the BRRD was put in place a little over three years ago with an explicit target to limit market and public sector implications that have in the past ensued from a failing systemic financial institution.

In that respect, albeit relatively early to say, we can observe that the first attempt of breaking (or at least loosening) the bank-sovereign nexus seems to have been a moderate success. At the time of writing, the yield on the 10-year Spanish government bonds has hardly reacted to the event. In addition, not only are there no early signs of a broader market fall-out, both within the AT1 subset as well as across peripheral banks, but the broader market tone is actually constructive, with peripheral bank AT1s leading the gains.

The muted to positive market reaction to what many feared would be a catastrophe for a nascent asset class only one year ago illustrates several key facts; 1) investors are now much better educated on the risks and mechanics of the AT1 instrument 2) the regulators have come some way to address broader market concern regarding risks in these securities and 3) the strict application of the new resolution tools gives confidence that these are not just on paper but will actually be applied as intended in a uniform way.

That last point is very important in my view in restoring the ability to price risk in future similar instances and should reduce risk premia across the capital structure going forward. We still have fresh memories of widely diverging approaches in what looked like similar instances in the past (SNS Reaal, ING/ABN/KBC bailouts, Monte Paschi). It may well be too soon to say that these examples are surely a thing of the past, but for the time being the market seems to be taking exactly that view.

Taxi Driver – the sequel

Sequels are rarely good as the first. In Robert De Niro’s original 1976 film, Taxi Driver, Vietnam veteran Travis descends into New York’s low life as sexual infatuation and delusion overtake him.

As the original is based on sex it’s no surprise that the sequel is about money. In this case the cost of being allowed to buy a New York cab licence, known as a “medallion”, and its implications.

New York cabs is a regulated market with around 13,500 medallions allowed. As New York recovered from the 2008 financial crisis, the cost or value of a medallion increased dramatically to $1.3m in 2013 being driven by a combination of this restricted market and cheap money.

And today? Medallions sell for $241,000 as Uber decimates the existing regulated taxi business. This is not without implications. Clearly the disruption caused by technology – Uber in this case – has destroyed the value of the incumbent market by 80%. No wonder taxi drivers are angry.

The figures from Capital One – the US lender – show why it’s a problem. Most cabbies don’t have the cash to buy a medallion, so borrow it. Capital One has $655m of loans to cabbies and the non-performing loan rate of that part of its lending is 52.7% – doubling over the last year. For Capital One it is a huge hit in a tiny part (0.25%) of its overall lending. Evidently chastened by large write-offs in small areas, Capital One tells us it is “building a tech brand”: reading through Capital One’s annual stockholders’ presentation and its key (basically only) theme is “disruption caused by technology”.

Lenders are starting to understand this to ensure they can effectively manage exposures to sectors under stress (e.g. cabbies) to ensure their profitability. The lesson here is that the negative effects of disruption emerge in unexpected places.

Taxi Driver the sequel has a less happy ending than the original. De Niro runs out of bullets to shoot himself but I suspect the sequel sees the cabbie succumbing to his debts. For Hollywood, the villains will clearly be bankers, but the real – and unseen – villain is surely technology.

And another thing Mr Carney…

A quiet weekend for me – my usual taxi-driving services not required. My 17-year-old son took himself off round a series of Universities, ostensibly checking them out ahead of deciding where to study next year. I note the perfect correlation between institutions on his list and places where he already has friends or relatives studying. No mug he – a week of free accommodation leaving the entertainment kitty fully stocked. I say ostensibly, for he long ago was offered and accepted a place for next year.

Having had time for reflection then, I remain irked by comments from the Bank of England and its Governor. Reading through the statement in detail, I share the incredulity of former MPC member Andrew Sentance at the focus on downside risks to the economy and indeed the apparent failure of the committee to model for all but the most benign Brexit scenarios. As a result the market is assuming no rate hikes until 2019 IRRESPECTIVE of economics. Paraphrasing the Pythons: other than inflation above target, growth around trend, a near 20% fall in the exchange rate boosting exports and tax receipts, stock prices at record highs, booming trading partners, record low unemployment, and an embargo on foreign workers likely to jack up average earnings, what have Brexit and record low interest rates done for us? Oh that’s right: renewed concerns at consumer indebtedness and a return to record house prices. And the Bank, along with most central banks, now admits to being worried at the level of consumer debt. A strange response this! ‘We are worried consumers are borrowing too much money, perhaps raising rates a little might curb that trend, but goodness me that might lead to a reduction in consumption and some defaults’. Now, when did I last hear that? 2008 I think. And that ended well…

Do you buy an alcoholic a bottle of whisky today so that he can avoid a hangover tomorrow, in the knowledge he’s more likely to contract cirrhosis in a couple of years’ time?

Sell gilts: UK high street inflation shocker!

I have just wandered to my nearest Starbucks for the bargain that was its “tall, black, filter coffee”. As others have paid £4 for their daily dose of vanilla-spiced, grande, half-fat frozen frappuccino, that august American tax-paying institution has been charging me the princely sum of £1 for real coffee. Indeed, this was actually 38p cheaper than the equivalent in my employer’s “subsidised” canteen.

Well as of 7am this morning that all changed. £1.25! 25% overnight inflation. The Scot in me is still wrestling with the conundrum – is the 13p residual saving versus a short trip to my canteen worth the shoe leather?

I wonder if Mr Carney and the rest of the MPC take their coffee black and, had they visited Starbucks this morning, would their monetary policy decision yesterday have been the same?

Like many people I am confused; not necessarily at the MPC rates decision, more with the accompanying rhetoric. Apparently the main reason for not raising rates was because UK consumers would face a squeeze this year from the impact of higher inflation, all of which was attributed to a weaker sterling. Eh, you’ve lost me there chief – the MPC cut rates post BREXIT in part to push the currency LOWER so that the impact of a weaker sterling would OFFSET some of the uncertainties of leaving the EU. If Carney is really worried about the squeeze on household income, firstly in part this is a situation HE created and secondly, by RAISING rates he could help reverse it.

Let’s be honest here. Central banks globally have expanded their balance sheets to nearly $18trillion in the past decade. That’s greater than US GDP. They have created the mother of all asset bubbles across most financial asset classes and now are sh*t-scared of unwinding. That and the ongoing need to fund ever-larger government deficits means they seek ANY excuse to keep rates as low as possible for as long as possible. Meanwhile, financial assets move ever-higher, the day of reckoning pushed further into the future, but likely to be all the more painful when it does arrive. Then again Carney, Draghi and Yellen can continue to manipulate markets longer than I care to work for. Good luck timing your exit.

UK election; early thoughts

It seems a done deal that the Conservative Party will win the 2017 General Election and will increase its majority in the House of Commons. The Conservatives are around 17 points ahead in the opinion polls and the Labour Party’s election campaign to date can best be described as unfortunate. Senior party members appearing to have little knowledge of basic arithmetic and the leakage of the manifesto before the official launch haven’t helped.

The gilt market and sterling are heading into this political event with a reasonable sense of calm; unusual in the context of the last three years of potentially destabilising political events, starting back with the Scottish Referendum in 2014. The expectation appears to be that an increased majority in the House of Commons gives Theresa May the negotiating power to negotiate a ‘better’ Brexit. Many have interpreted this as ‘softer’ i.e. closer to the EEA (European Economic Area) or EFTA (European Free Trade Area)-type arrangements, rather than the imposition of hard borders and resorting to WTO rules regarding trade. This has led to sterling strength against the euro and the US dollar in recent weeks.

Unfortunately it is not clear what her Brexit negotiating stance is yet. On closer inspection of the opinion polls, we see that it is the UKIP support that has collapsed and switched to the Conservative Party. The Conservative manifesto has not been published (or leaked) yet so we are still to see if the currency and bond markets have made the right assessment of a ‘better’ Brexit. What we do know is that Theresa May is firmly rejecting the idea of Free Movement of Workers, with her commitment to reduce immigration to less than 100,000 per annum. This concept is completely at odds with the pillars of free trade in the EU, EEA and EFTA.

Sterling has appreciated over 2% on a trade-weighted basis over the year to date. Gilt yields have fallen from 1.5% at the 10-year maturity to closer to 1.0% as concern over imported inflation abates.   It seems to me that although the outcome of the election is of little dispute, the outlook for Brexit and the UK remains uncertain, and the risks rise again on 8 June.

Starting the Final Lap

The final lap of the race for the French presidency has started. Emmanuel Macron with 23.75% of the votes and Marine Le Pen reaching 21.53% will compete for the second round of the French presidency on May 7. Voter turnout was 78.69% versus 80.42% in 2012.

French sovereign and corporate bond markets rallied on the back of the first round results and investor political focus will now move to the UK in June and Germany in September.

For the first time under the Fifth French Republic, neither of the two traditionalist parties (Socialists and Republicans) will be present in the second round. The magnitude of this political earthquake is amplified by summing all the extreme votes together, leaving an elevated dispersion in the French political landscape.

After the preliminary results, most of the political figures called to vote for Emmanuel Macron and to form a republican front to preclude extreme ideas reaching the Élysée Palace. Jean-Luc Mélenchon kept his distance and refused to call to vote for any of the candidates.

Emmanuel Macron is the clear favourite for the second round. The polls place him above 60% with a low uncertainty component for his voters (only 8% are not sure of their choice versus 15% for Marine Le Pen). However, his score should be lower than Jacques Chirac in 2002, the last time that the extreme right party reached the final round of the French election.

It is important to note that the polls were extremely accurate, with less than 1% difference for each candidate and the correct order. This is a strong positive for the second round as given the level of accuracy it is hard to imagine Emmanuel Macron losing 20 points to Marine Le Pen.

After the second round, the legislative election will be paramount as the country could end up tough to rule without a majority in parliament. This is the biggest weakness of Emmanuel Macron which could lead to an incapacity to reform the country with every initiative blocked by the opposition.

Official results: French election first round

The coupon’s round trip

A few days ago we wrote about the possibility of the US Federal Reserve not reinvesting maturing bonds in its QE programme. Over time this would see the Fed’s portfolio of bonds reduce to zero (a very long time). This debate is about the reinvestment of maturities, but of course ignores those tricky little coupon things.

There are a whole load of technicalities around the administration of this, but it is in governments’ interests that the QE unwind happens slowly.


Let’s look at the UK. With the Bank of England (BoE) owning £435bn of gilts, Her Majesty’s Treasury (HMT) pays £15bn to the BoE.

If the BoE kept those coupons, the amount of bonds would compound by about £15bn a year, which, over time, would exponentially increase the nominal amount of bonds held by the BoE. This would lead to the BoE in essence being dominated by that relationship – which is not ideal for a central bank tasked with delivering independent advice.

Thus, the £15bn of coupons are sent back to HMT; a “round trip” that in essence means HMT has more money in its pot – and all of the political implications around that large dollop of money.

It is odd that this receives such little attention. It should be a charged and political issue given its enormity, but it gets lost in the vastness of QE.

Brexit “no deal” would have major negative ramifications

It has been one week since the UK formally triggered Article 50. Here is my view…

The chances of negotiating a trade deal between the UK and the EU within two years are incredibly close to zero. An extension of the talks or some transitional (or “bridge”) deal to an eventual relationship are far more likely.

The “no deal is better than a bad deal” mantra is absolute lunacy and should be dismissed for the nonsense it so clearly is. If the UK reverted to World Trade Organisation (WTO) rules in a hard Brexit in March 2019 it would have major negative ramifications for the economy.

WTO rules deal pretty clearly with trade in goods, of which the UK is a net importer from the EU of about £100bn per annum; the normal rates are not too punitive but agricultural products have high tariffs. But the WTO hardly mentions services, which tend to be more responsive to unified regulations and standards than differentiated by tariffs, yet the UK exports about £20bn in services to the rest of the EU.

Regardless of the eventual outcome, the UK economy is going to face an extended period of uncertainty. So far the consumer has remained remarkably strong. Consumption has partly been driven by an increase in credit (growing at over 10% each year) and a decrease in the savings rate. As real incomes are squeezed over the next few months due to the lagged inflation impact of weaker sterling, I would expect consumption to slow. In the meantime, if negotiations falter, sterling could weaken further as international investors examine the UK’s twin deficits (fiscal and current account).

For the next few months the inflationary effects of weaker sterling should dominate and it is conceivable that other members of the MPC will join Kristin Forbes in voting for a rate rise – thus our strategy is to remain generally underweight UK duration risk.

However, later in the year when economic growth slows this positioning stance may have to be reversed as further monetary stimulus can be anticipated. The Bank of England is likely to wait this time for the hard data to show signs of a slowdown, having been publicly castigated by the hard-core Tory Brexiteers for acting (in their view) prematurely in response to the weak UK survey data. But if the economy does start to slow then there is very little impediment to further quantitative easing from the Bank of England.

Heed the lessons of the past

“Markets are highly correlated with historically low volatility. Central bank activity has created a “goldilocks scenario” where investors treat bad news as good and good news as excellent. As a result of low cost of debt, markets have been propelled to record highs. Investment grade spreads are well below historic norms, high yield defaults seem remote and Emerging Markets appear immune to historic cyclical patterns. Equity investors talk about re-ratings and multiple expansion as discount rates seem set to remain low; for most, it is not about whether to take risk or not, rather about how much risk to take!”

I didn’t write that today. I wrote it in a note to clients in 2006. At the time I was being urged to add more risk across my portfolio range. I resisted until the bail out of Bear Stearns (if you are under 25 you probably won’t remember that), which gave all of us a green light, that the US authorities would stand behind their financial institutions. And then: Lehman.

But everything is rosy, we have had 10 years of rising prices in financial assets and in the US at least regulation is (for now) much tighter. What could possibly go wrong? The Fed and ECB will each fail to tighten for a while yet, surely?

Why not ask yourself, with rising inflation, decent growth and near full employment would a Fed Chair steeped in 2007 events REALLY allow the economy to run THAT hot?

Sometimes it is right to sell everything. Just as ALL assets have risen in value since the advent of QE, so too can they fall together. Especially as monetary policy tightens.

My key thought for the rest of 2017 – “Markets are highly correlated with historically low volatility……heed the lessons of the past.”

PS: S&P 500 topped out in 2007 at 1576. Currently 2368, a nice 50% ABOVE the global financial crisis. I am often told equities climb a wall of worry. That wall must be pretty high, because they’ve been climbing it almost without a break for eight years.


On Tuesday we hosted a conference where we heard from our own team and a couple of economists. Chris Watling at Longview Economics takes a, well, long view. He is quite a proponent of Kondratieff. Who he? Starting at the end, he faced Stalin’s firing squad in 1938 at the age of 46. Prior to that he had held office in 1917 as deputy minister for supply before the second, October revolution of 1917 after which he moved to academia but ultimately falling foul of Stalin’s fanaticism and being sent to the gulag.

However, in 1922 he published his first book on the long cycle. A simplified explanation is that as capital is invested it creates monies which are reinvested in similar products that are produced more cheaply until this process leads to a loss of confidence and people hoard cash rather than invest. The long cycle is around every 35 years and the slide below suggests we are at a turning point, having seen new lows in government bond markets in 2016.

I don’t dislike this explanation of the world but it has its limitations as well as practical investment limitations. Bond yields may well be materially higher in the long term but as managers we are judged on monthly, quarterly and annual performance. As yesterday’s 10bps rally in 10 year US Treasuries AFTER the Fed rate hike proves, there are plenty of opportunities on the journey to slightly higher yields.

US 10 year bond yields – 1900 to present (showing Kondratieff cycles):

No fund manager should ever be bored at work

In a survey cited in the FTFM section of today’s FT it was stated that 68% of fund managers are bored at work. I would argue that it is practically impossible to be bored as a fund manager. In a rapidly changing world, keeping on top of all the developments occupies a large part of the day. Add to this the scouring of the markets for new investment opportunities, and the desire to search for any supporting or contradictory evidence surrounding macro and stock level positioning, and there are never enough hours in the day.

Whether you are digesting information out of intellectual interest or to gain a competitive edge, you have to be driven. The moment that you think you know everything, the markets will reach up and teach you a whole host of new lessons! The one question I always ask in interviews is “what outside of work are you passionate about?”. Within reason I don’t really care what the answer is, I just want to make sure the candidate has natural enthusiasm. In an industry rife with overcapacity I am genuinely surprised that so many people can be bored doing fund management. However, their lack of motivation must make it easier to outperform them over the longer term.