The Horatius Fund Newsletter - November 2019
The Horatius Fund returned +0.03% in November, compared to an average for our three benchmarks of - 0.55%. That brings a year to date return delivered to our investors of 9.32%, compared to an average return for our three benchmarks of 6.35%.
November saw a continuation of several of the trends which have characterised the year to date. After the latest Fed rate cut at the end of October, and with growing optimism for at least a successful ‘Phase One’ deal between China and the U.S., we saw a marked distinction between emerging and developed markets. Both EM equities and credit posted negative returns for the month, whilst high yield and developed market equities gained, the S&P increasing by over 3%, on its way to what looks like being its strongest year since 2013.
This divergence between DM and EM is interesting for various reasons. Firstly, because, as we have discussed previously, future returns are significantly driven by one’s entry point; valuations matter. Since 1930, in every year except one that the S&P has gained by more than 25%, the subsequent year has seen returns fall by more than 10%, and in most cases by a lot more: outsized returns in consecutive years are a very rare phenomenon.
Secondly, the levels of correlation, respectively, within developed markets and emerging markets, are very different. Whereas DM equity market returns (other than the UK, for obvious reasons) are heavily clustered around the 20-25% return range, in emerging markets there has been much greater dispersion. While certain markets have produced strong gains - China A shares +24.5%, Brazil +26% - others have fared poorly this year: Ukraine -8.7%, Nigeria -15.5%, Lebanon -22%. This is a helpful reminder that so- called emerging or frontier markets are a far from homogenous group. This is both a risk and an opportunity. Finally, the pattern is yet another reminder of the continued role of central bank policy as one of, if not the, most important driver of today’s financial markets. In 2019, it was the U.S. Federal Reserve that dominated the headlines, returning to their dovish stance with three rate cuts from 2.25% to today’s 1.5% and also the ECB who, in September, recommitted to a further round of stimulus. It is true that a number of key EM central banks were also in an accommodative mood. However, it was the change in expectations – the Fed’sreturn to rate-cutting mode was far from the consensus view until the middle of the year – that ensured that the easing in the U.S. and Europe had the greatest impact. This is interesting for us because, looking forward, it is across the emerging world where we see the greatest prospect of further stimulus, whereas the Fed is currently expected to make either no change or just one further cut in 2020.
The other feature which has become increasingly evident within EM, is the divergence between corporates and sovereigns. Whereas the very low default rate in EM corporates of 1.5% seen in 2019 is expected to remain at a similar level next year (ex-Argentina), there has been an increasing number of sovereigns trading at stressed or distressed levels. As well as the obvious case of Argentina, bonds in Lebanon, Ecuador, Tajikistan and Surinam have all experienced sharp declines (although Ecuador has since rallied back impressively).
On top of this, Latin America, not long ago the top regional overweight, has recently seen country after country (Chile, Colombia, Uruguay & Bolivia) experiencing social unrest and political instability, with a material impact on bond spreads. Whilst there have, of course, been idiosyncratic corporates which have experienced difficulties, they have been fewer, have tended to be in smaller credits and have caused less contagion: this view is likely to be reflected in the relative exposure that the fund takes to the two parts of the asset class respectively.
Returning to the subject of valuation, and the importance of one’s entry level as a determinant of future returns, EM credit illustrates the dilemma of today’s investor. While yields are towards the lower end of their range of the last couple of years, spreads – the excess return relative to the underlying risk free (treasury) rate are still hovering around their widest levels of the same period. This begs two questions: what is the risk and which one is ‘right’?
We believe that the primary risk is that underlying yields rise. U.S. 10 year yields have declined from 2.66% in January to 1.84% today, reflecting the 75bps of easing from the central bank and this has clearly been one of the primary drivers of the year’s strong returns for fixed income investors. If, or rather when, we see a significant reversal in yields, this will present a material headwind, albeit that even today’s spread levels DO provide a degree of insulation.
However, our current view is that next year is likely to see most major economies struggling for growth, let alone inflation. We see growth in the U.S. as remaining around the current 2% level while China and Europe could well experience continued disappointing numbers that actually see further loosening of policy next year. 2020, then, does not appear to be the moment when inflation suddenly resurfaces. Turning to the second question as to which one of yields or spreads provides the best barometer of how credit trades going forward, it is necessary to first ask why, with yields having declined as they have this year and stock markets at all-time highs, have spreads not followed suit?
There are multiple factors which explain this: the drag effect of assorted, underperforming sovereigns (Argentina, Turkey, South Africa), relative positioning in the central bank-easing cycle: tighter spread levels have typically taken longer than the current mere six months since the Fed started easing again and, on a related note, the outlook for inflation and central bank policy as well as for default rates and the general health of credit markets. Our view is that 2020 is likely to see a continuation of the current low inflation/low rate environment and indeed that certain governments may now also seek to stimulate via the route of fiscal policy. We therefore derive considerable optimism from today’s starting point of spreads as having the potential to underpin healthy returns over the next twelve months.
On top of this, the other main source of volatility during 2019 has been the concern that the U.S and China might fail to find a working ‘agreement’ in their terms of trade. The recently agreed Phase One deal has seen the resulting relief drive markets, equities in particular, on to new highs. The discussion is now likely to progress to the more thorny questions around technology and security but, with the U.S. election set for November, any potential flashpoint is likely to be deferred until at least the very back end of next year. Similarly, 2020 sees a material reduction in the number of key elections compared to the last year. Whilst markets will always throw up surprises, it is at least the case that the scheduled number of possible geopolitical shockwaves is lower than it can often be. Just as the starting point of valuations makes a huge difference to eventual returns, there is a similar point to be made for the geopolitical backdrop: as the year draws to a close there have actually been a helpful number of problematic political situations around the globe. Whilst some of these can, and probably will, get worse, it does at least reduce the proportion of potential NEW sources of risk and, even in those where situations have begun to materially deteriorate, much of this is already in the price. The prime example, and an important one, is Argentina, where it is still too early to tell how new President Alberto Fernandez and his government will work with the IMF, but there are already signs (Ecuador, Ethiopia, Pakistan) that the Fund, under new leader Kristalina Georgieva, is prepared to work collaboratively with nations who are prepared to attempt to make the necessary adjustments.
Although of slightly less impact globally, the situation in the U.K. around Brexit has also served to ensure that uncertainty remains elevated. This has, to a degree, now been reduced by the scale of Boris Johnson’s recent victory. As even those sceptical of the PM have observed, there is now at least someone driving the UK bus. The mood amongst those in the real economy in the UK is one of intense relief that the threatened Marxist agenda has been resoundingly outvoted. However, Scotland is likely to prove a thorn in the side of the administration (subject to how broadly the ripples travel from the Alex Salmond case). More importantly, thePM’s plan for a full exit from the EU by the end of 2020 has raised again the spectre of a ‘no-deal’ Brexit. However, we believe that this more likely implies that a deal WILL be done but only at the most basic and cursory level, and in relation to goods, not services. This means the critical issue relating to passporting has also been kicked down the road. So, despite the extremely constructive mood in the UK as we come into 2020, the uncertainty in relation to sterling is likely to persist.
The constantly evolving landscape of international relationships, perhaps particularly in a world which seems, for the moment at least, to have passed ‘peak globalisation’ and which is now characterised by an increasingly populist, inward-focused sovereign-level mentality will necessarily create winners and losers, at both a country and a regional level. We are particularly excited by certain south-east Asian economies which look set to benefit from the changing dynamic in the region from China’s diminishing role as the world’s manufacturer of cheap goods and as supply chains adapt accordingly, certain economies in central Asia with stable governments and where national champion businesses are now beginning to access international capital markets, high-growth African countries not overly reliant on commodity exports and certain Latin American countries where populist sentiment is unlikely to displace governments that do ultimately grasp the benefits of working with the IMF and other agencies. Conversely, we have concerns in the Middle East for Saudi Arabia and Bahrain, Latam countries which cannot bridge the gap between solving the middle-income trap and satisfying the demands of fiscal responsibility and nations with high twin deficits and which are heavily exposed to the exporting of one or two commodities.
There are also a number of technical points, the significance of which should not be underestimated. Net issuance of sovereigns (new, gross issuance – redemptions of existing bonds) is projected to be around $21bn next year (a four year low) while for corporates the number is a mere $4bn. At the same time, EM debt now represents a little over a quarter of all global debt. Amazingly, though, the recent ‘European Asset AllocationSurvey’ by Mercer notes that only 18% of (European) investment plans hold EM bonds and, of those that do, the average holding is just 5%. Similarly for U.S. insurers, who hold just 2.3% in EM debt. Taken together with the fact that the world’s stock of negative-yielding bonds is close to $12 trillion (down from $17tn but still way above the last five years’ average of c. $8tn) this implies a) that investors are hugely under-invested in EM bonds and b) that the relative value appeal of the asset class is still very high. This dynamic suggests that global investors are hugely incentivised to continue their quest for excess yield – and that EM credit is an obvious place to find it.
In conclusion, whilst markets as a whole will lack the significant tailwind of substantial fiscal stimulus and so equities in particular are unlikely to repeat the returns of 2019, the key drivers of emerging market credit –background geopolitics, global fiscal policy, corporate and sovereign fundamentals and market technicals – all point towards a 2020 where the Horatius fund should be in its element and well-positioned to deliver another year of very attractive returns for investors.
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