Britain’s Chancellor of the Exchequer announced on 31 October the call of the 4% Consolidated Loan or Consol.[1]  While only £218 million face value, this utterly fascinating bond with no maturity date was originally issued in 1927 by then Chancellor Winston Churchill.  It actually consolidated various government debts all the way back to the early 1700s, including that of the infamous South Sea Company.  As such, this Consol is a big slice of financial history and a vast time series of the long term interest rate.

Founded in 1711, the South Sea Company lured investors with the promise of riches from trade with South America.  Investors in government debt were “encouraged” to swap into South Sea shares by the Chancellor of the day, John Aislabie, which then ran from £128 to over £1000 per share before collapsing in 1720.  The ensuing crisis wiped out a big chunk of GDP and Aislabie was jailed for his efforts.[2]  Most of the shares ended up at the Bank of England, then years later in this Consol.

In the wake of our most recent 21st century crisis, last month also saw the Fed end its asset purchase programme which once bought $85 billion per month of US Treasury and mortgage debt.  US Treasury yields have remained remarkably low since then.  Indeed, the over 250 year trading history of Consols suggests that the 1970s-1990s are actually an aberration and that long term rates are historically at or near current levels (Charts).[3]

LOWER FOR LONGER

So if rates stay lower for longer, and the Eurozone and Japan accelerate their QE, what are the implications for hedge fund strategy selection?

CONSOLS 1840-1938

Firstly, the emergence of clear policy divergences in the developed world increases opportunities for macro and CTAs. Already even under QE the emerging world exhibited policy divergences, with countries such as Brazil, Russia and Turkey raising rates whilst those in Poland, Chile and China cut rates. Now there is a real prospect of central banks moving in opposite directions. This may already be reducing correlation between, and within, markets. That improves the potential to profit from identifying individual market trends because there are plenty of idiosyncratic stories rather than the big risk on versus risk off trade.

Lower correlations between equities and credit instruments also improve scope for generating alpha from security selection, in strategies such as equity or credit long short.

A “GREATER FOOL” TRADE

Looking more specifically at QE, the most obvious trade is simply “front running” central bank asset purchases – and buying whatever the European Central Bank or the Bank of Japan is expected to buy next. The logical conclusion of this trade would be to indefinitely buy whatever the central banks are buying, which would then become a “greater fool” trade – buying simply in the expectation of being able to sell at a higher price, to a greater fool.

CONSOLS 1975-2014

As central banks are not generally profit maximising entities, they may indeed have a greater loss tolerance than other investors. But the danger here is that nearly all assets, including government debt, do entail some genuine risks. Recently, for instance, Greek government debt spreads blew out on fears that Greece may exit the IMF programme – and the impact of wider spreads has been all the more severe thanks to the maturity extension or “re-profiling” of Greek government paper.

If we look at corporate credit there have been defaults this year, and recovery rates have, so far, been zero for instruments such as junior debt of Portuguese bank Banco Espirito Santo. In general recovery rates have shown very wide dispersion, from zero in several cases all the way up to 80%. In a climate where credit investors receive less absolute yield as compensation for this default risk, robust analysis of default risk and collateral quality is more important than ever. Plenty of corporates are still offering attractive credit spreads relative to default risk. But now is not the time to be making indiscriminate purchases of credit index products. Indeed this sort of passive investment may prove the most foolish.

The best credit managers have sometimes been able to completely sidestep defaults, and their skills are worth paying for in this environment. It will take real discipline to jump off the bandwagon if QE compresses credit spreads to unreasonably low levels. There may even come a time when the risk reward favours short credit, as was the case in 2007 and 2008, so we generally want managers to have the flexibility to go short at some stage even if their short books may be very small today.

AN ANAEMIC RECOVERY

If we do expect monetary policy to remain accommodative for extended periods, we also have to ask why this might be. The answer is clearly that the economic recovery has been anaemic, at least outside the US and a few other pockets of strength – such as the UK. With China also now slowing, revenue growth is harder for companies to find, away from niches such as tech and biotech where valuations are already rich. This increases incentives for companies to merge and cut costs.

While the US crackdown on tax inversions may have prevented some mergers from being consummated, there are plenty of other reasons besides tax to merge. We expect mergers to continue, particularly in Europe where fears of a Eurozone breakup have receded and where a common banking regulator is keen to encourage consolidation. The savviest event driven and equity long short managers may be able to anticipate merger deals, and there are also smaller profits to be made from investing after deals are announced.

We also prefer a concentrated approach to equity investment which requires a contrary view of markets and today would include energy and emerging markets.  The point is to focus on securities rather than markets.  And to move as far away from passive indexing as possible, where inherent momentum and capitalisation biases have driven valuations, particularly price to sales ratios, to record levels.  The US small v. large cap premium makes the Russell 2000 a popular short.

The more sinister side of slower growth is that it may lie behind competitive “beggar thy neighbour” devaluations and could even lead to protectionism. Whilst these are not benign longer term forces for economies, a resurgence of currency volatility is something that some macro and CTA funds may be able to exploit, as they did in the 1970s.

BEWARE A DIFFERENT SORT OF QE

As the Fed winds down QE to a trickle of reinvested interest and principal, it is important to note that ECB and BoJ variants are not quite the same thing.  Currency weakness may be the most robust outcome in either instance.  And while Japan has at least made an effort to match monetary easing with rising effective demand, European consumption and investment spending is squashed under large German surpluses.  This does not augur well for corporate profits in Europe and acts to depress activity globally.  If avoiding mistakes like overvalued markets becomes as important as we think, then the most active management is the best placed for a low rate world.

Hamlin Lovell, CFA & Keith Tomlinson, CFA

[1] https://www.gov.uk/government/news/chancellor-osborne-to-repay-part-of-our-first-world-war-debt

[2] Homer, S and Sylla, R (2005). The History of Interest Rates. Hoboken, NJ: John Wiley & Sons. 151

[3] Time series data for this arcane security is hard to come by.  We have used readily available data for 2 periods which we think show the longer term trend.  This point is also picked up by Sydney Homer in The History of Interest Rates.

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