absolute return : investing through volatility
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absolute return : investing in a volatile environment
Summary
Volatility is back The combination of a sluggish recovery in the economy and concerns over the UK’s fiscal position and credit rating has weighed on UK asset markets over recent weeks. The rally in the equity market has lost steam, while UK bonds have underperformed their overseas counterparts and the sterling exchange rate has fallen sharply. Such concerns seem unlikely to dissipate and the recent hung parliament result of the general election has added to a feeling of instability.
Equity markets over‐priced the recovery and are now correcting (10/15%). Treasuries are low yielding given flight to quality and are unattractive at these prices in the long run because of associated inflation and default risks. In our view, commodities remain volatile and Gold is due for a correction, (surely gold plated ATMs in Abu Dhabi are a sure sign of a bubble). Besides, alternative defensive holdings, such as cash and gold, are not yielding. Inflation risk in medium/long term with negative real interest rates How then to invest for absolute returns? We believe the fixed Income from real estate offer low volatility, high yielding regular returns against rated Covenants such as Tesco Plc, UK Government, BT with in‐built inflation protection at a time when interest rates are low.
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Equities are volatile and have fully priced recovery with PE ratios overheated
Treasury yields are unattractive given associated inflation & default risks
Commodities look fully priced and remain volatile
The GBP is attractive for none UK investors against USD
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Zaggora LLP Zaggora LLP is a boutique real estate investment partnership focused on acquiring direct commercial property assets in the UK and Europe on behalf of private investors. The partners of Zaggora have a wealth of successful experience in acquiring, financing and managing commercial real estate assets and companies in the UK and European markets with a combined £5bn of deal experience. Investment Environment The combination of a sluggish recovery in the economy and concerns over the UK’s fiscal position and credit rating has weighed on UK asset markets over recent weeks. The rally in the equity market has lost steam, while UK bonds have underperformed their overseas counterparts and the sterling exchange rate has fallen sharply. Such concerns seem unlikely to dissipate and the recent hung parliament result of the general election has added to a feeling of instability. More broadly, the financial markets have begun to re‐price risk after the images of rioters in Greece protesting against austerity measures brought the realisation of the overwhelming size and scale of public sector deficits direct to the trading floor courtesy of CNBC. Key Market View In our view, we believe that investors should focus on yielding assets with inflation protection within a risk‐averse strategy that is uncorrelated with the volatility of equity and fixed income markets. Our view of the world is that;
Equity markets over‐priced the recovery and are now correcting with high volatility
Treasuries are low yielding given flight to quality and are unattractive at these prices in the long run because of associated inflation and default risks
Commodities remain volatile and are due for a correction
Alternative defensive holdings, such as cash and gold, are not yielding
Key Framework View This is within a framework view that;
Despite the MPC’s decision to pause quantitative easing, money market interest rates look set to stay at very low levels for a long time, as the weak recovery delays official rate hikes.
As a result, market swap rates are at an all‐time low and expect 3M Libor to remain between 0.5‐0.7% until at least Q1 2011. This enables low cost borrowing against real assets that offer inflation protection and real yield.
While fiscal concerns have pushed bond yields higher, the outlook for economic growth and inflation
suggests that yields will fall again this year. Not least given the flight to quality purchasing.
The lacklustre recovery has already poured some cold water on the rally in UK equities. But there is still a large risk that the recovery falls further short of markets’ expectations, forcing equities lower. There is a very real risk of ‘double‐dip’ to the extent the economy falls back into recession. This is not likely to be compared to the same ‘peak to trough’ declines as 2007‐2008, but may be meaningful nevertheless.
Sterling has been hit hard by fears for the UK’s credit rating. But a major fiscal tightening due to be announced in the emergency budget should ease some of the pressure on the pound.
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Equity Markets The lacklustre economic recovery has already poured some cold water on the UK equity market rally. The bull‐run that we have seen since March 2008, albeit from distressed levels, has been consistent across the worldwide exchanges as investors bought the recovery trade and the ‘bargain prices’ of both blue‐ships and secondary market listings. However, the market responded nervously to the debt woes of Dubai earlier in the year and saw this is the first sovereign debt cloud on the horizon. The continued rally in the equity markets came to an abrupt end with the announcement of civil investigations by the SEC of Goldman Sachs (GS) CDO trades, quickly followed by news of a potential criminal investigation of GS and other firms. This was followed by the request of Greece for an IMF bailout and subsequent riots on the streets in protest at austerity measures. The increasing volatility was represented in a spike in the Vix Index and a ‘flash crash’ of the NYSE on May 6th when the market fell 10%, before recovering 8%, all in the space of 8 minutes. It is no wonder investors have taken profits and re‐positioned their portfolio as a result of such volatility. Fundamentally, there is the risk that the economic recovery story continues to fall short of markets’ expectations, causing equities to fall during 2010, further correcting from here by a further 5‐10%. In addition, the rate at which investors discount future profits has fallen significantly as a result of actions by policymakers to boost liquidity in financial markets as well as signs that official interest rates are likely to be very low for a prolonged period. We know that the rally in the FTSE 100 has coincided with the drop in real yields on government bonds, consistent with our belief that equity markets would rally as long as interest rates remain low. However, the headwinds represented by the risks of sovereign debt default/re‐structuring or austerity measures to cut spending both lead to an outcome of instability and lower growth, now being priced by the market. The rally has also coincided with a sharp rise in confidence in the economic outlook. But the latter index has recently risen to its highest level in over 11 years. We doubt that such high expectations for the recovery will be met. Furthermore, while the prospects for economic growth are bad, the outlook for corporate profits looks worse. Forward‐looking indicators of corporate earnings, such as the CBI’s balance of manufacturers’ order books, are still consistent with further falls in corporate earnings over the next year. (See Fixed Income –Corporate Bonds). In addition, the large amount of spare capacity in the economy, combined with the recent sharp rise in firms’ unit wage costs, is likely to squeeze firms’ margins severely. We expect macroeconomic profits to fall by around 6.5% this year and to be flat in 2011. As a result, the drying up of dividend income could mean that investors switch to other asset classes. Indeed, they may already have good cause to do so – commercial property yields exceed the earnings yield on equities, while the gap between index‐linked bonds has also narrowed (see Real Estate)
We suggested in March that the equity market had over‐bought the recovery and out‐run the corporate earnings recovery. The gathering clouds on the horizon, first seen in the Dubai debt wobbles in February had clear implications for Europe. After reviewing the 12 months performance of the FTSE‐100 adjacent, what is the next move? We believe the market will correct further to the 4,600 in what will be a period of significant intra‐day volatility. 4000
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Fixed Income – Treasuries & Corporate Bonds While bond yields have edged a little higher since Q4 2009, the prospect of a major fiscal squeeze, sluggish growth and low inflation and interest rates should provide a more favourable backdrop for bonds later in the year. The recent rise in yields has reflected three factors. First, the rapid deterioration of the public finances and a hung parliament at the general election have raised concerns about the risk of sovereign debt default. The CDS premium on UK government debt – a measure of the cost of insuring against sovereign default – has risen alongside the rise in bond yields. Worries that the recent rise in headline consumer price inflation might prove to be rather longer‐lasting than the Monetary Policy Committee expects have pushed break‐even inflation expectations higher. The rise in yields has coincided with the easing in pace and (at least temporary) pause in the Bank of England’s bond purchases under its quantitative easing scheme. The previous narrowing in the spread between gilt yields and overnight index swaps – which had been attributed to the effect of QE – has recently been reversed. But we suspect that at least some of these pressures will ease later on in the year. For a start, the cross‐party consensus on the need to tackle the fiscal position suggests that, even under a hung parliament, further plans and action to reduce the budget deficit will emerge after the election. This may keep the rating agencies happy and are due to be announced in the emergency budget. Second, inflation concerns should also fade in time as the full disinflationary effects of the recession and the vast amount of spare capacity created become evident. And finally, while gilt issuance will remain very high over the coming few years, a further extension of the quantitative easing programme is yet possible. Meanwhile, new liquidity requirements requiring banks to hold more government debt should also help soak up some of the supply. Coupled with a fall in international bond yields as the global economic recovery disappoints and inflation elsewhere remains subdued, we still expect these developments to pull 10 year gilt yields back down to around 3% by the end of the year. Meanwhile, corporate bond spreads have continued to tighten over the quarter. But they may struggle to narrow further. Spreads are not much wider than during the 2000s credit boom. And the relationship between the growth rate of economic activity (as measured by the CIPS surveys) and corporate bond spreads hints that they may widen a little again. Commodities The commodities market has largely responded to the positive outlook for the recovery in line with the risk seeking trend of the equities market. The normally inverse correlation between gold and equity prices was broken some time ago as fears over currency levels have pushed investors into Gold, Silver, Platinum. As the equity markets have begun their correction, commodities such as crude oil have seen a correction.
We strongly believe that the gold market is due for a significant correction. The demand/supply factors behind the $1250 o/z gold price cannot justify this level. The development of gold plated ATMs, as first rolled out in Abu Dhabi, surely are clear signs of a bubble? However, shorts beware, markets can (and do) stay irrational longer than you can stay solvent.
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Money Markets Despite the Monetary Policy Committee (MPC)’s decision to pause quantitative easing, market interest rates look set to remain close to their very low levels for the foreseeable future, as the weak recovery prevents monetary policy from being tightened. Spreads of 1 and 3 month Libor over overnight index swaps have remained very tight over the last few months. Meanwhile, the MPC has continued to vote unanimously for Bank Rate to be held at 0.5%. We see little reason to think that the low interest rate environment will disappear soon. For a start, while the MPC voted to pause its asset purchase programme in February, the Committee has struck an increasingly dovish tone. The Bank of England’s quarterly Inflation Report showed that inflation was expected to be below target at the two‐year policy horizon, even if Bank Rate were held at 0.5%, largely due to the disinflationary impact of the spare capacity in the economy. In addition, the Governor has left the door open to further policy stimulus, stating that “it is far too soon to conclude that no more [asset] purchases will be needed.” A tightening of monetary policy therefore seems a long way off. In response to these signals, markets have revised down their rate expectations. But they still expect Bank Rate to rise by 150bps or so over the next two years, in line with expected hikes in the US and euro‐zone. In contrast, we expect Bank Rate to remain on hold for the foreseeable future. A key effect of such low libor and real rates is that fixed borrowing costs in the UK swaps market over 1‐30 years are historically low. Borrowers can fix 5 year loans at 2.5% and 30 year loans at 4%. Real Estate Following the collapse of Lehman Brothers and with it the financial markets, we have been analysing the real estate markets and seeking to understand their direction and true nature as well as talking to investors. Due to the central role of the asset price bubble in creating the financial crisis, real estate has been avoided by many investors since 2007, many of which are waiting for prices to fall further before looking at the asset class again. The opportunity exists to earn low volatility, fixed income returns of 10‐15% on equity annually (received quarterly) from acquiring UK commercial real estate assets let to excellent covenants (UK Government, Tesco leases) for 5‐10 years with 10‐15% annual IRR. We believe in the current, limited visibility environment this represents an extremely interesting low risk, real asset investment strategy. As a defensive play, the potential returns profile compares well to other defensive alternatives such as cash/gold/treasuries. The strategy offers investors low volatility, steady state returns with in‐built inflation protection at a favourable time to acquire GBP denominated assets relative to USD when GBP borrowing cost is 2.5% for a 5 year fix and 4.04% for a 30 year fix. Real assets offering the following investment characteristics;
8‐15% Fixed annual equity return (received quarterly) 10‐15% Annual IRR Fixed income with annual increases (RPI/CPI/Fixed) FRI Income (All costs, management, insurance, maintenance, paid by tenants) Strong residual value driven by quality of asset and location
The UK market structure and framework provides the strongest opportunity because;
Ultra‐Long leases 10‐20 years+ (without tenant break options) Upward‐only rents, if markets rents fall, tenants continue paying same rent FRI leases making tenants responsible for all management, maintenance and insurance costs Active lending market to secure leverage on modest basis (60%‐70% LTV)
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