06.10.17

Snapshots can’t help but feel sorry for Theresa May after her disastrous conference speech and the continued infighting in her party. But then politics is a bloody and cruel sport.

The original 1990 series of House of Cards was set around a Conservative Party leadership challenge and is said to have drawn inspiration from Macbeth and Richard III.  For TV buffs it is a must see.

My turn on the policy joy-stick

The pendulum is swinging from central bankers and monetary policy to government and fiscal policy.  Monetary policy has been used in enormous size since the 2008 financial crisis but it is a blunt tool that works on a macro level.  It prevented a depression and stabilised the economy, but it created distortions in the distribution of wealth that have been compounded by changing demographics.  Fiscal policy works at the micro level by targeting specific regions, sectors and demographics and can address these distortions.  Theresa May’s price caps on utility prices and the subsequent sell off in utility share prices is a case in point.  We expect politicians to continue to pursue looser fiscal policies.

As this shift occurs, we expect the distortions in credit assets to normalise.  Liquid markets have been compressed by monetary policy and we believe trade with a liquidity discount.  Structured credit and non-public securities trade with a healthy illiquidity premium.

The next crisis

The cover on the Economist magazine is titled “The Bull Market In Everything”.  Asset price concerns are high because we are late into this business cycle and monetary policy is turning.  No one knows how this will end but JPMorgan published an excellent thought-provoking piece.  They called the next crisis the GLC (Great Liquidity Crisis) where outflows from central bank unwinding could trigger outflows in passive strategies that are on “autopilot”.  Reduced buying capacity from banks and active managers due to regulatory and structural market changes would trigger this liquidity crisis.

The way to mitigate credit portfolios from this is simple.  Don’t make stupid late cycle lending decisions, match up your assets and liabilities as much as possible and create a capital cushion where you have gaps. Easier said than done we know, but as Floyd Mayweather Jr says about his Rocky beating 50 and 0 record it is all “Hard Work and Dedication”.

Margin of safety and defaults

The other way to mitigate the risk in a portfolio is to buy with a margin of safety.  When it comes to pools of defaultable assets the approach we take is simple.  Defaults are currently running at unusually low levels because of monetary policy.  Defaults mean revert to cycle averages.  To mean revert to average that means some very high peak defaults.  We stress test our margin of safety to those.

By Asif Godall
Co-Chief Investment Officer