July 2019 - Volatility returns as the trade war saga enters a new stage - Systematic Fund Manager's Comments

The announcement from President Trump to impose a 10% tariff on a further $300bn of Chinese goods and the immediate retaliatory measures from Chinese authorities sent a shock wave through global financial markets. The inability of both nations to make progress in the discussions could well morph into a monetary and financial war. An early sign is the fact that the U.S. has listed China as a currency manipulator. Additionally, the deteriorating economic outlook globally, with manufacturing PMIs across the Euro area, China, Japan and South Korea standing below 50 and the investment trend and corporate earnings showing signs of a loss of impetus, represents for risk assets, a field for erratic moves in the coming months.

By analyzing the long-term behavior of the U.S. interest rates curve and the equity market volatility, there appears to be a relationship between the two (see chart below), advocating for the fact that a volatility regime change is likely to happen in the coming quarters.

US Treasury 2y10y spread advanced 3 years vs VIX Index

Source : Bloomberg, RAM Active Investments, at 31/07/2019

Lower interest rates are no guarantee for the survival of leveraged companies with poor fundamentals

Central banks’ actions are already an implicit acknowledgement that rising debt levels are unsustainable at higher rates and under tighter liquidity conditions. On the other side, there will be a point at which some arbitrage needs to be done between supporting growth at any cost and limiting the consequences of a drastic reversal in risk appetite due to several factors that built up during the decade following the GFC:

• The non-financial corporate debt stock has increased dramatically since 2008. According to BIS figures, in G20 countries, total credit to the non-financial sector (core debt) represents 235.5% of aggregate GDP as at the end of 2018, up from 199.60% in Q3 2008. There is an increasing number of companies facing higher debt levels with deteriorating margin and cash flow situation. Instead of their stock price reflecting company fundamentals, they have been taking the opposite direction as if cheap refinancing is warranted for the coming years!
• One shot equity market supporting factors are having diminishing effects (corporate tax cuts, stock buyback programs, advances in automation reducing the labor costs, etc.).

The following chart indicates a worrying signal that 70% and 80% of issuance in US corporate loans has been performed by companies with leverage (debt/EBITDA) above 5x and 4x respectively:

Increasing leverage in the corporate loan market

Source: S&P LCD, Credit Suisse

Companies with strikingly weak earnings generation ability and deteriorating return on assets would be heavily penalized once stocks are selected based on company specific factors, rather than macro/liquidity reasons alone. We believe the gradual integration of the incoming micro and macro data by the market will correct the extreme market inefficiencies in place today our models are currently detecting and on which they will be able to capitalize in the coming quarters, with a particular focus on:

• Liquidity
• Company fundamentals
• Diversification
• All cap exposure
• Efficient and rapid integration of new information

The establishment of our strong long-term track record has been based amongst others on these points and in our view, they can’t be dissociated from any process driven-investment strategy. Investors should be prepared for this eventuality, as investor perception can shift quicker than everyone expects.