The Great Bubble

INVESTMENT LETTER #4
August 2016
The Great Bubble
“Success comes from curiosity, concentration, perseverance and self-criticism”, Albert Einstein – “and by
self-criticism, he meant the ability to change his mind so that he destroyed his own best-loved ideas”,
Charlie Munger
Dear Investment Partner,
As I am writing this investment letter, the Spanish 10-year sovereign bond dipped below 1%,
only 4 years after the pinnacle of the sovereign crisis in July 2012, when Spanish debt yielded
7.6%. One would imagine that the ability to finance the Spanish State budget with 10-year
maturities at rates below 1% would be a reward for good governance and prudent management
of the public finances. Quite the contrary! To start with, a caretaker government has been in
place for the last 8 months and public finances have been quite imprudently managed with a
budget well above the 3% limit defined by the Euro convergence criteria. Moreover, much
needed structural reforms, to make the country more agile, stimulate private entrepreneurship
and reduce Government interference in the economy, have come to a halt.
Unfortunately, Spain is not alone in enjoying fiscal mediocrity being rewarded with all-time low
interest rates. Its Iberian partner – Portugal – is also running a similarly irresponsible budget
deficit. As it was in Spain, the result from the last general election was inconclusive, with no
party achieving majority of the votes. I am puzzled as to how we can still regard a system in
which an estimated five million emigrants (in a country with 10.6 million residents) elect less
than 2% of the members of parliament as democratic. Despite finishing second, a socialist
Government is now running the country with a minority of MPs and is only able to pass laws
with the agreement of two left wing parties – and these still advocate that communism is the
way forward. Unsurprisingly, one of the Government’s first measures was to reduce the working
hours of public servants to 35 hours per week – in a country that urgently needs to improve
productivity! Needless to say, economic growth is decelerating sharply. Politicians don’t seem
to care, but as fiscal irresponsibility is being rewarded with low sovereign rates (10-year bonds
below 3%), the market is also not forcing their hand.
Although not as striking, the picture is
unfortunately not that different throughout
most of the southern Euro-zone countries.
And the ramifications of ECB’s QE are being
felt across the whole European space, with
Germany now issuing 10-year bonds at
negative rates (i.e. getting paid for
borrowing), and the Netherlands, France
and even Belgium likely to follow.
Source: Bloomberg
Financial markets are interconnected and this new illusion that negative rates are the way
forward has replaced the need for structural reforms and prudent fiscal policy. ”Good State
governance” is spreading into the corporate bond market. The latest ammunition of “Super"
Mario and his colleagues at the ECB go by the name of CSPP - Corporate Sector Purchase
Program - the ECB’s latest form of QE (quantitative easing). Although we do not know the precise
amount of corporate bonds that the ECB bought since June when the CSPP became effective
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INVESTMENT LETTER #4
August 2016
(some estimate €8-10 billion… a week), the repercussion in the form of negative rates is evident.
It is quite irrelevant how much the ECB has effectively bought of corporate bonds so far (say
€70-120 billion), more important are the effects that this policy is having on the financial
markets, which we try to address below.
Negative yielding corporate bonds
Gradually the "negative yield virus" is
spreading from the European sovereigns to
the corporate bond market. It is currently
estimated that around €600 billion of
corporate bonds with maturities longer than
12 months have negative yields and an
estimated €5 billion are trading at negative
rates of more than 40bps (-0.4%). Why should
investors be happy to pay a corporate issuer
for the "privilege" of owning their corporate
bonds? Although we are not fixed income specialists, we certainly do not consider this a
compelling investment proposition, even assuming that there is a zero probability of bond
default. Having been in the professional investment business for the last 25 years and having
lived through the last three investment "bubbles" and I venture to tag the current situation in
the fixed income market as potentially the biggest financial bubble of all. The consensus seems
to be that the current deflation situation will force ECB’s expansionary monetary policy for
longer, thus anchoring bond yields at low(er) levels, which is supportive of bond prices. With
hindsight, there is one rationale in common for every single one of the four bubbles (87’s Black
Monday, late 90’s Dotcom, ’06 US housing and current Euro bond bubble) referred to above:
“this time it is different” with the belief that prices keep going up indefinitely.
Liquidity squeeze
ECB's intervention in the corporate bond market is drying up liquidity, driving prices up and
“artificially” compressing bond yields even further. Merrill Lynch estimates that the unwinding
of negative yields (i.e. what happens if the global $12 trillion of negative yielding fixed income
assets moves to zero yield) would produce $200 billion of losses! Fixed income investors that
today are experiencing a false sense of security will eventually want to run away at the first signs
of a less supportive Central Bank monetary policy (not only ECB, but Fed and BoJ as well).
Investment logic will prevail and negative rates will reverse one day, with bond holders bearing
heavy losses.
Shift to higher risk debt instruments
In a context where sovereign and corporate debt is yielding close to nil or even negative returns,
it is only natural that investors reacted, by shifting towards riskier asset classes that provide
some yield: Emerging Markets and High Yield investments. While merits exist in a portfolio’s
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INVESTMENT LETTER #4
August 2016
allocation to such assets, there is a step up in the number of risks such as sovereign risk,
exchange-rate risk, volatility risk or credit risk, which the investor needs to understand… and for
which he needs compensation.
Shift to other asset classes
Some other asset classes have also been boosted by this fervent search for yield. Real estate
investments and listed property companies in particular have also been great beneficiaries of
the collapse of bond yields. In simplistic terms, a property company is a leveraged investment
of the underlying assets it owns. For example, German listed real estate companies have
performed remarkably well recently (over the last year, Vonovia’s price +30%, LEG Immobilien’s
+40% and Deutsche Wohnen +50%) and are trading at premiums to net asset values of between
20% and 30%. Investors in Germany struggle with Government bonds that are yielding negative
rates and are therefore being “pushed” into residential properties that offer yields, in many
cases, of only 1-2%. So far, residential rents in Germany have been rising steadily, a phenomenon
partially explained by the influx of refugees, amongst others. Such stretched valuations could
only be justified if one believed that rental growth of 3-5% could be sustainable for a long period
of time. We caution against German real estate because rental growth might disappoint once
new house supply (and there is plenty coming) enters the market. Remember the Spanish
housing bubble when listed companies’ valuations were also backed by rosy assumptions of
sustained property and rental price inflation?
Toxicity of negative yields is “killing” both banks and insurance business models (particularly
traditional life insurance)
Without wanting to become too technical, although recently the spreads of non-financial
companies have tightened (as you would expect in the aftermath of ECB's QE), bank spreads
have widened. This divergent behaviour between non-financial and financial companies is quite
unusual. Over the last 10 years it only happened after the fallout of Lehman Brothers and very
briefly in July 2014 when oil prices reached their lowest point. I struggle to understand how the
ECB intends to stimulate growth and bank lending when it is literally suffocating the business
model of the banks. Commercial banks traditionally make their money by having a positive
spread between what they receive from lenders and what they pay to depositors. In our opinion,
negative rates do not stimulate healthy lending and in fact only help to keep uncompetitive
companies afloat.
I disagree with ECB officials’ reasoning that the current low interest rate environment favours
corporate investment, thus contributing to economic growth. At W4i, we spend our days
meeting the management teams of companies that we potentially can invest in, their
competitors, suppliers and clients to have a complete picture of the value chains. So far we have
not come across any serious company that is using the current low interest rate environment
and negative interest rates to make long term investment decisions in new production capacity
that generates new jobs and ultimately stimulates sustainable growth. Quite the contrary,
prudent management teams are postponing new strategic investment decisions because of the
uncertainty and unsustainability that this ECB monetary policy is bringing, exacerbated by geoW4i Investment Advisory Limited. W4i.co.uk. Authorized and Regulated by the Financial Conduct Authority / 3
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political developments such as Brexit. New bond issuance is being used by good companies to
replace more expensive existing debt rather than to finance new capital expenditure.
We believe that the mechanism of transmission of monetary policy to the real economy in the
shape of higher corporate investment, households applying for new mortgages or anticipating
future consumption is failing to produce desirable effects. Instead the ECB is stimulating an ever
growing bubble in the bond market.
European Equities outflow
So far this year it is estimated that more than €60 billion has been reallocated from European
equities to bonds or other investment classes. This outflow from equities drove European equity
returns down (year to date, by more than 6%, as of August 26th), at the same time that bond
spreads have tightened to the delight of fixed income investors.
We believe that this shift away from equities, and European equities in particular, creates very
attractive investment opportunities. In order to make our point we will use a concrete example
of Unilever, the Anglo-Dutch consumer goods’ company. After the ECB’s CSPP announcement
last April, it issued bonds maturing in 2020 with a zero coupon rate (0.08% yield to maturity in
issuance). We asked ourselves a very simple question: Would we rather invest in Unilever’s
bonds with a maturity of 4 years that currently yields 0% or would we buy shares of the same
company that currently have a 3% dividend yield?
The relative attractiveness of equities in a low bond yield environment
Unilever has not cut its dividend for the past 50 years. The last time it kept the dividend constant
year on year was 21 years ago (1995). And the dividends’ long term growth rate is around 7.5%
a year, well above inflation. Of course we have no idea at what price Unilever’s shares will be
trading in 4 years’ time when the zero coupon bond matures. Unilever is currently trading at 20
times the estimated earnings for 2017 and there is no certainty of where the multiple will be in
4 years’ time. If the past is to be taken into account (we firmly believe that the more we know
about the past, the better prepared we are to understand the future), over the last decade,
Unilever delivered a return on equity in excess of 20% for shareholders. We believe that
consumers will continue to buy Unilever’s products by eating their ice cream on hot summer
days or cleaning their clothes with their washing powder. We have some difficulty in articulating
a scenario in which the earnings and dividends’ power of the company would be seriously
compromised.
So investors are left with a current dividend of around 3% and the prospects of recurring income
in the form of future dividends, which grow at potentially, 5-7% per annum. Conversely,
Unilever’s bond investor will be paid 0 (zero) during these 4 years and in the end of the period,
the maximum he can aspire to is the full payment of the principal. In simplistic terms Unilever
equity investors can afford a 15% drop in the price of Unilever shares in 4 years and still be better
off than the investors who bought the most recent bond issue. However, if the Unilever share
price drops 15% by 2020 and if the company is able to continue to deliver the same growth in
dividends as for the past 20 years, the dividend yield on 2020 would be 4.8% (for reference, the
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INVESTMENT LETTER #4
August 2016
maximum dividend yield Unilever ever got to in the past 20 years was 5.1% in 2009). We
personally do not believe in the sustainability of a deflationary world, therefore preferring to
continue to be invested in Unilever shares instead of running the major risk of owning its bonds
that deliver no income.
Currently we are amongst the minority as investors around the world are shifting their holdings
from “risky” equities (that pay growing nominal dividends) into “safer” bond investment (that
pay no nominal income). If you need evidence that this is the case, just look at the investment
portfolios of insurance companies or pension funds that have been reducing equity investments
even further, supposedly to mitigate the schemes’ volatility. Combining this lower expected
return on the assets (consequence of lower allocation to equities), with the ballooning of the
liabilities (result of the fall in yields), the result is a rapid increase in the pension deficits, which
necessarily raises doubts about their sustainability and the capacity to provide income to their
retirees.
But for us as equity managers, we thank Mr. Draghi for this immense arbitrage opportunity that
he has presented us with.
Our investment performance
During Q2 both the European Opportunities fund and the Iberian Opportunities fund
outperformed their benchmarks. As of the end of July, since inception on July 1st 2015, the W4i
European Opportunities Fund outperformed the MSCI Europe Total Return index (i.e. including
dividends) by 10.5% delivering +3.2% total return vs. -7.3% for the index. Over the same period,
the W4i Iberian Opportunities Fund outperformed the IBEX 35 Total Return index by 19.2%
delivering +2.9% total return vs. –16.3% for the index. While relative performance is
encouraging, we want investors to be assured that we are particularly keen on maintaining
absolute performance in positive territory, year-to-date and since inception, that being the
highest motivation to continue to put forth our best efforts in the day-to-day management of
investors’ and our own funds.
Looking ahead, we feel particularly happy with our portfolios, with a balanced combination of
structural compounders (post correction at more attractive valuations), cyclical opportunities
(in depressed end markets, but with tentative signs of earnings’ reversions) and special
situations, leaving us confident over the medium term.
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August 2016
Funds’ performance since launch
I renew my invitation for you to join us and allow us to invest your money alongside ours.
In the meantime, ¡Buen camino! and invest actively.
Firmino Morgado
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