No less surprisingly given a savage 100 basis point blow-out in their credit spreads after the ALP’s announcement on franking credits, listed hybrids were the second-best performing asset class in 2018 with an impressive 4.89 per cent return. This was followed by other corporate bond benchmarks. So cash was not king – bonds and hybrids were.
Loaded up to the gills with listed and unlisted equities,the median “balanced” super fund had a dog of a year, returning nothing at all. House prices fared worse, down 6.1 per cent in price terms, or 2.6 per cent lower after accounting for rents (but before costs). Worst of all was global equities, off a hefty 8.71 per cent in US dollar terms.
Yet within the parlous equities universe, there were some stand-out stock pickers who bucked the trend. Arguably the biggest winner in 2018 wasVGI Partners, the discreet global equities hedge fund run by Aussies Rob Luciano and Doug Tynan.
VGI’s Australian master fund delivered a stunning 16.9 per cent net return (its ASX-listed company VG1 was up 10.8 per cent), besting rivals including Magellan (up 9.8 per cent), Caledonia (down 4.2 per cent), Antipodes (down 7.7 per cent), Platinum (down 8.9 per cent), andL1 Capital(down 26.5 per cent).
Mercurial short-seller John Hempton’s boutique shop, Bronte Capital, also hit the ball out of the park with an outstanding 20 per cent return.
I make it my mission in life to try and engage with, and learn from, the brightest investment minds in the world and Luciano and Tynan are bona fide stars. They are the gold standard when it comes to the intensity of their due diligence processes, which I try and benchmark myself against. Who else sends their entire investment team to the US to be trained by CIA interrogators on advanced investigative techniques? Ask either of these obsessive characters what sports they follow, and they respond that they’re only interested in stocks.
Quizzed on their staggering outperformance in 2018, Tynan says VGI made an equal amount of money on both its individual company longs and shorts, which contributed 7 per cent to net returns. Another 10 per cent came from the Aussie dollar short position they’ve held since 2012.
These outcomes were especially impressive given VGI retained a very conservative 45 per cent portfolio exposure to cash. While it is not the firm’s largest annual return, Tynan says it is the highest-quality result because of the broad-based nature of the returns across a dozen longs and two dozen shorts.
Looking ahead over 2019, I believe that the passage of time will prove that equity and bonds are trading off circular and arguably inconsistent logic. The causality has run from stronger growth/inflation in the US (as we predicted) driving higher long-term interest rates, which have pushed equity values lower (as they should).
Yet this has then paradoxically compelled bonds to rally, shunting long-term interest rates lower with (in our view) no real fundamental changes in the original growth/inflation outlook notwithstanding the normal business cycle volatility and a temporary blip induced into global manufacturing activity by Trump’s trade war.
It is clear that the equities market story in 2018 was a “discount rate drama”. The big 8 per cent to 10 per cent intra-month losses suffered by global shares in February, October, and December were demonstrably based on fears of rising interest rates, which were being driven by US economic strength.
In February and October it was surging wages and 10-year government bond yields, while in December it was concerns around the Federal Reserve not being dovish enough and dropping its previously-proposed three hikes this year (it had the audacity to keep two hikes in its projections).
The discount rate drama was amplified by, variously, the US-China trade war, which should be resolved this quarter; Brexit, which will be sorted out one way or another; North Korea, which is now on the sidelines; Italy and Turkey, which have faded as concerns; and manifold other Trump-related uncertainties. While Trump was manna from heaven for markets in the first year of his tenure, he turned into Dr Strangelove in 2018, perhaps propelled by the hubris of the market’s ebullience during his opening stanza.
Crazy bond returns
After the bond market tried to ignore the early bouts of equity weakness, it has, for the time being, reverted to its historically anomalous, post-global financial crisis reflex of an inverse (or negative) correlation with shares, which gripped strikingly in December, driving the crazy bond returns in that month. Equities and bonds have been positively correlated most of the last 150 years, including during the 1980s and 1990s, and tend to have a positive (negative) correlation in inflationary (deflationary) shocks.
There is, however, an inherent contradiction in the market’s logic: equities have been petrified about US 10-year government bond yields rising above 3 per cent. So when they start getting hammered every time the discount rate duly breaches this level, bond prices have rallied hard, slashing the discount rate back down again to historically very low levels.
It is a psychological game of pass-the-parcel: either we (and the early equities’ reaction function) are going to be right and the global inflation cycle is building, which will force long rates higher; or government bond junkies know more than we do and a global recession is looming.
I would submit that the empirical case for our inflationary thesis has never been more persuasive, albeit that it will inevitably take time to fully play out. Yes, global manufacturing indices have rolled over, but this seems to be largely a function of pull-forward demand driven by the trade war and the desire to stockpile cheap inventories before tariffs bite, with the flip-side being temporarily weak data until the dispute is settled.
The prospect of a deceleration in economic growth in 2019 and an increasingly dovish Fed is only likely to elongate the post-GFC expansion in the US. Some folks worry about US GDP growth falling back to its trend rate around 2 per cent, but this is exactly what should happen when the Fed lifts its cash rate eight times to a level that is within its “neutral” range.
Our bottom line is that the 2018 volatility was not being driven by fundamentals per se, but rather by uncertainty and noise. And that is likely a buying opportunity for financial credit, which is one of the few cheap asset classes vis-a-vis pre-GFC marks, especially accounting for the striking deleveraging of bank balance sheets and the new-normal of streamlined, utility-like businesses characterised by extreme risk-aversion that is negative for equities and positive for creditors.
The price action in January has certainly vindicated this view, and should lay the foundation for a period of normalisation in spreads and superior returns. We have observed a very strong bid for bank senior bonds, sharp spread compression in subordinated debt and outstanding capital gains across the hybrid market, echoing global moves as investors desperately scramble to buy the credit they dumped in late 2018.
The author is a portfolio manager with Coolabah Capital Investments, which invests in fixed-income securities including those discussed by this column.