Heads, equities win; Tails, equities win
It’s funny how one can have a thought and suddenly discover that several strands of communication one has had over the previous few days all prove to have been pointing in that direction. Thus it has been with the increasingly vain struggle by fixed income investors to find returns which warrant the description.
Core guvvies have generated some fabulous returns on the back of quantitative easing but short of the authorities driving the curve to flatten further, the sense is that much of the juice is out of that market. Not only that but if, as and when the economies do begin to recover, the central banks are going to want to recycle their considerable debt portfolios back to private sector investors and who wants to be the one holding the baby when that occurs?
As total return is the sum of coupon and market performance, the prospects for Long Bonds with a coupon 2¾% or 30yr Bunds paying 2½% isn’t truly compelling in the medium term.
Like it or not, the equity market looks like a win/win from where I am standing.
My old chum Alex Moffatt in Melbourne put his finger on it this morning with in his “Obiter Dictum” in which he wrote: “It was nice seeing the Telstra dividend in the bank account yesterday and a cursory glance down the statement shows a number of others having arrived, all very welcome and the imputation credits make them more so. Rather makes the daily rise and fall of share prices more palatable when we see the magnitude of income compared to the line marked bank interest.”
It is clear that as strong management can control costs in the corporate environment a lot better than flaky politicians seem to be able to in the public sector. Hence, even if the economy continues to stagger along at best and as much as top line revenues might fluctuate, net earnings can be controlled and dividend streams upheld. The relative attractiveness of equities has to get stronger. If the economy improves, bonds go down and equities go up. Up the economy doesn’t improve and further easing follows, equities go up too. Like it or not, the equity market looks like a win/win from where I am standing.
However, I also had a conversation yesterday which dovetails with this issue. I was talking to a US based total return investor. I was having a bit of a moan about the paucity of business flow in my specialist areas of rates and credit. He apologised profusely and excused himself by blaming the unsatisfactory returns in both areas and explaining that it was his colleague in the structured credit space who was collecting all the new investment dollars. This particular investor’s universe is floored at single-A and the hunt for yield is pushing them back into areas which cost the previous generation of money managers their jobs. Of a sudden, after a gap of five years, new love has been found for the mezzanine tranches of structured credit transactions.
At this moment in time, the buy programmes are apparently still limited to relatively pukka RMBS deals but it surely won’t take long before returns on basic product are so skinny again that we will see such mainstream investors begin to dip deeper into the risk box. We’ve seen it before and I have few doubt that we will see it again. This particular company’s CFO was there - but not in that role - when one of his previous employers blew itself up with eye-watering exposure in structured credit in 2007/2008 and I am convinced that the move to higher risk will be one which will take place slowly and reluctantly. But I would be happy to bet that he, along with many of his peers, will argue that having been caught once, they know the tall-tale signs of a crisis and that may they might be forearmed to venture out there again. Me no like.
Core interest rates are low, credit spreads are tight, emerging markets and high yield bonds are sporting record low coupons and generating returns which exceed inflation is becoming harder and harder. Along with Moff, I quite like the idea of simply collecting dividends but I fear that the pull into structured credit has only just begun and I know that, when the horn is on, experience and rationale can quickly be forgotten.
One man’s island
On a slightly lighter note, I was watching pictures of Taiwanese trawlers joining in the fun concerning the argument over the ownership of the Senkaku or Diaoyu islands. It might not appear comical at first sight but I recall reading, many years ago, one of the funniest books written on the Cold War called “And to My Nephew Albert I Leave the Island What I Won Off Fatty Hagan in a Poker Game”, penned by Robert Forrest-Webb and David Eliades under the pseudonym of David Forrest. It is the riotous story of the Americans and the Soviet Russians disputing ownership of a rocky island in the middle of nowhere and one which I warmly commend even forty years later. I do hope it has been translated into both Japanese and Chinese and if it hasn’t, it should be, pronto.