In this week's conversation, we will reflexionate around the latest bout of volatility and what we think it entails in terms of risk/reward ideas.
"The larger the body, the more rapid their descent", as one can vouch from observing the death of the $55 billion tax inversion AbbVie -Shire deal in the Merger Arbitrage world. Obviously, what appears interesting to us is the change in the rules announced by the U.S. Treasury Department to make tax inversion deal more difficult in conjunction with the European Commission being on the offensive about Irish and Luxemburg Tax deals involving the likes of Apple and Fiat.
It makes even more likely that these companies tax advantages may vanish at some point in the near future, making it possible for a "Maelström" to occur, generating in the process a powerful "downdraft" on the stock price in the process.
The effect of the cancellation of the AbbVie-Shire deal on Shire's stock price - graph source Bloomberg:
Biotech stocks, one of the biggest winners of the five-year bull market in a context of increasing tax risk appears to us considerably vulnerable from the rapacious appetite of over-indebted governments we think. "Lower Liquidity" is already causing "Higher Volatility".
We think that the "too much liquidity" popular trades of biotech, internet, gaming and small cap are up for more pain in the future. Technology and Health Care Companies in the S&P 500 index are both heavy users of adjusted earnings measures in their financial statements: Of 69 technology companies in the index, 56 use non-GAAP earnings, of 56 Health Care companies, 45 use them. (source "Earnings, but Without the Bad Stuff", Gretchen Morgenson, November 9 2013 - New-York Times). The vast majority of public biotech companies in the U.S. (87%) do not pay taxes because they lose money as they pursue breakthrough therapies and cures as well as using non-GAAP metrics to boast are more "positive" accounting picture. Young high tech companies often end up paying less than 10% of income in taxes whereas old railroads and utilities often pay more than 25% and cannot easily "jump" countries using M&A for tax inversion purposes.
The impact of the tax inversion related M&A 2014 frenzy on the Biotechnology and Drugs Industry - source CSIMarket:
From a credit perspective, spreads in Merger Arbitrage situation widened on the back of risk adjustments spillover from the ABBV-Shire situation as portrayed in a note from the 16th of October from the UBS Special Situation team:
"Merger arbitrage spreads continued to widen:
o Spreads are widening as a result of market volatility and now also as a result of risk adjustments arising from new developments in ABBV- Shire
o The median annualized spread for definitive deals late in the day on October 15 was 11.0%, as compared with 9.6% on October 14, 8.0% on October 10 and an average level of 6.5% during the eight week period preceding the market stress period (restricting the sample to spreads between 0 and 30% annualized)
o If we restrict the sample to spreads between 0% and 50% annualized, the median annualized spread late in the day on October 15 was 11.7%, as compared with 9.9% on October 14, 8.8% on October 10 and an average level of 6.8% during the eight week period preceding the market stress period
o If we look at spreads on a non-annualized basis, the average level on October 15 was about 150 basis points wider than the average level in the preceding weeks (widening from ~2.9% to 4.4%)
o This 450-500 basis point widening in annualized spreads and ~150 basis point widening in non-annualized spreads relative to pre-stress levels are comparable to maximum spread widening in prior market stress episodes" - source UBS
In continuation to our recent conversation highlighting the relative protection offered by Investment Credit, the market changes since the 8th of October as displayed in Bank of America Merrill Lynch's note from the 17th of October entitled "Macro policy: no room for error" clearly indicates the relative protection offered by the asset class:
No surprise as well that when it comes to "capital inflows" and our "Maelström", flows have indeed been driven towards safer asset as indicated by Bank of America Merrill Lynch's recent Flow Show note entitled "Crash Flows & Feedback" from the 16th of October:
"Equity stabilization ($2bn of redemptions) after big risk-off flows past 2 weeks
Big caveat: huge inflows to small cap (14% of IWM float) & energy (10% of XLE float) probable “ETF-creation” for new shorts
Note Aug’11 equity plunge coincided with much larger $42bn redemptions European capitulation: biggest outflows from EU equities ever ($5.7bn – Chart 1)
Risk out of favor: HY, floating-rate debt and EM equities extend outflow streak"
43 straight weeks of inflows to IG bond funds ($5.6bn)
Big $3.9bn inflows to govt/tsy funds (largest in 10 weeks) (Chart 2)
7 straight weeks of outflows from HY bond funds ($2.0bn)
14 straight weeks of outflows from floating-rate debt ($1.0bn)
6 straight weeks of outflows from TIPS" - source Bank of America Merrill Lynch
Go with the flow and don't fight the "Maelström"....
Of course, as we pointed out in our conversation "Wall of Voodoo" on the 23rd of September, CCCs in credit have indeed been the canaries in the risky asset coal mine. When it comes to the "credit whirlpool" created by the meeting of opposing forces (aka our "Maelström"), we could not agree more with Bank of America Merrill Lynch's comments from their 17th of October note entitled "Zero rates vs Zero growth":
"The bond market’s great tug-of-war
Yet asset markets are really reflecting a tug-of-war between the conflicting forces of “zero rates” and “zero growth” in Europe. Nowhere can this be seen more clearly than in credit where high-grade and high-yield markets have totally decoupled. The chronic shortage of yield is – and will stay – the dominant force for high-grade tightening, we believe. But we think the growth downturn in Europe needs to be addressed (by central banks or policy makers) for high-yield to rally decisively." - source Bank of America Merrill Lynch.
Hence our comment in last week's conversation "Actus Tragicus" in relation to the appeal of Investment Grade credit in a deleveraging/Japanification world:
"While it is true that the "interest rate buffer" in case of a surge in rates is nearly exhausted in the current low yield environment, but the environment for investment grade credit is still favorable"
We also added:
"While the "Actus Tragicus" continues to play out in the deterioration in Europe of economic fundamentals putting additional stain on stretched equities valuation. In the credit space, at least in investment grade, thanks to the "Japanification" process, it continues to be "goldilocks" we think."
From a risk positioning perspective, we agree with our cross-asset friend and fellow "Macronomics" blogger "Sormiou" in the sense that given the relative recent moves, getting exposure to US High Yield via selling the CDX CDS index HY 5 year versus Short S&P 500 via long puts 3 to 6 months seems relatively enticing - graph source Bloomberg SPX vs CDX HY:
In terms of additional risk positioning, a thematic trade idea based on Japan's latest pension allocation reforms and put forward by JP Morgan on the 21st of October in their note entitled "Thematic Trade Ideas on GPIF Reform Update" is interesting we think:
"Government Pension Investment Fund (GPIF) reportedly to boost domestic stock allocation to 25%. According to the Nikkei newspaper, GPIF is considering increasing its allocation target for domestic equities to about 25% as well as raising the allocation of foreign stocks and bonds. We concede there is a large amount of uncertainty about the composition of GPIF reform, but the much stronger potential allocation ratio for domestic equities versus our pervious expectation of 20% leads us to think that results of the GPIF reform could surprise positively and add to the gains of Japanese equities.
Implementation could occur before announcement of the new investment strategy. The Nikkei article also suggested GPIF will update its portfolio allocation targets later this month, although the timing of implementation is unclear. Nonetheless, advisors to GPIF are well aware of the adverse market impact of publishing target weightings beforehand. In fact, recent interviews with Professor Ito, the government’s top adviser on GPIF reform, suggest that the implementation could happen even before the announcement.
The allocation increase could spur buying of c.¥10 trillion of domestic stocks. We analyze the flow implication under the scenario suggested by the Nikkei newspaper. Due to the uncertainties on asset returns and fund redemption schedule, our analysis is solely based on the expected change in the allocation ratios and investment results at the end of June 2014. Our calculation suggests additional purchases of domestic stocks will be ¥9.8 trillion if the domestic stock allocation is boosted to 25%. After examining flows data, we believe positioning in Japan is light, and any surprise could easily lead the price action to change very quickly.
Bullish index options strategies: In view of renewed attention towards GPIF reform and an eventful Japan in the next few months, we recommend that investors add upside exposure in Japanese equities for the remainder of the year. In addition to outright calls and call spreads, investors may want to consider structures that take advantage of the current elevated skew, such as risk reversals (buying calls and selling puts, and possibly with knock-in barriers embedded in the puts). JPX-Nikkei 400 is our preferred underlying index among major Japanese benchmarks due to its lower volatility and direct linkage to the corporate governance reform theme." - source JP Morgan