Wednesday 11 March 2020 by Jonathan Sheridan Trade opportunities

Q&A with Jonathan Sheridan

Jonathan Sheridan, FIIG’s Chief Investment Strategist, joins us for a broad discussion on what he currently sees in the market and how to approach investments in times of uncertainty.

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Can you give us your thoughts on the events of the last couple of weeks and why financial markets are behaving the way they are?

It feels a bit like, after the strong gains in 2019, financial markets were waiting for the straw to break the camel’s back. Bond markets had already priced in slower and lower growth which could be seen in the data but equity markets ignored it and kept pushing higher on expanded multiples and confidence the central banks would have their back. Unfortunately, monetary easing can’t stop the spread of a virus and therefore alter behaviour.

What are the similarities and differences compared to the GFC?

The atmosphere feels the same to me as in late 2007/early 2008 when there was general disbelief that anything bad was possible, and we should all carry on regardless. All the talk has been about “buying the dip”, as if this is a temporary thing that will be resolved in a couple of weeks. I very much doubt that will be the case and, in my mind, the reaction to the possibilities of the virus will be felt much worse (on a global scale – of course the local human impact to those suffering is large) than is currently priced. So far, only a few companies – the obvious (airline, cruise ship operators) and the brave (large, market leaders like Apple) have come out voluntarily to talk about the damage to their business.

I think this is a unique situation – both a supply and a demand shock at the same time and we don’t know how to deal with it all at once.

Based on the GFC analogy, how long do you think the current market dislocation will continue?

I think we will continue to see high volatility for a few weeks yet, until the news flow moves on to something else and we get used to it. That sounds harsh but it is the reality in today’s soundbite world with instant access to information. The virus will also play itself out and hopefully settle down to a ‘regular’ flu. As companies report the impacts, we will see individual issues arise, and they may well snowball into the whole market having a problem. With debt levels and equity valuations where they are, we could tip over the edge if someone big has a large problem.

Are you seeing a lot of desperate sellers at the moment from large institutional investors?

Not right now. The market seems to be pretty orderly at this stage. On the really bad equity days, we have seen liquidity dry up a bit but it’s been back the next day. Individual bonds such as Virgin are struggling a bit but that is to be expected – they are on the frontline of the virus impact. I think it will take unexpected downgrades or a default to shock the market into desperation.

I see pricing on your website but actual trades are executed at sometimes greatly different levels. Can you explain what’s happening here?

Sure. As we charge custody fees based on the value of the portfolio, if we published those valuations ourselves, there would be a conflict of interest as we would be setting the values we charged fees on. To remove that conflict, we have our valuations provided by an independent market pricing provider, and these prices are also the ones published on our website. The published prices are therefore a collection of where they see the bonds in the market, and are also a mid-market price. In the over the counter (OTC) market, there is a spread on either side of this price to actually trade – sellers are lower and buyers are higher – so a traded price is unlikely to be the same as the mid- price. Sometimes, the published price is also away from where we are seeing and trading it in the market – for example in less liquid bonds or those that aren’t traded widely in the external market. Always check with your Relationship Manager for executable prices.

Is it time to sell everything before things get really bad?

Absolutely not. In risk off environments like these, it is important to remember that bonds have a maturity date, when the issuer is obliged to pay you the principal. This allows you to look through market volatility. Of course, at the higher end of the risk spectrum, the risk you are taking for the higher yield is that you might not get paid back, but I don’t think we are anywhere near that point yet. For investment grade bonds in particular. I don’t think we’ll ever get to that point – I would be highly confident of getting all your capital back.

You are buying Government securities in your $1m portfolio but, with interest rates falling further, the income will be really low. What’s the rationale for this trading strategy?

The rationale in these positions is twofold, as I explain in our Portfolio Construction seminars. Firstly, I have had the belief for some time that the global economy has been and will continue to slow, which naturally follows that rates will be lower. Lower rates on long duration government bonds will result in capital gains due to price increases, in addition to the coupon income. Secondly, should a dislocation happen, such as we are seeing now, as government bonds, they will always be liquid, and so I will use them as a source of liquidity to take advantage of serious mispricing which tends to come around in periods of economic stress, when I will be actively looking for undervalued opportunities.

Given the drop in the equity market has been greater than for bonds, isn’t the upside greater with equities, if you assume a recovery?

Clearly the upside is greater in equities, but so is the downside. To recover from a 50% fall in value, you need to get a 100% gain. Having the safety of a known maturity date in the future when your capital will be repaid to you (assuming the issuer is solvent) means you can look through the price volatility at any particular time, whereas in equities you do not have this luxury – they are only ever worth what the market will pay you for them at the particular time you want to sell them. The assumption that equities always go up in the long term has held true over the last 100 years, but for significant periods in between, it has not been the case. For example, the S&P500 in real terms (after inflation) was flat from 1965 to 1983 – that’s 18 years without a return on your equity capital.

What are the key metrics you are currently looking at for any issuers in which you have exposure to?

In these markets, we focus on liquidity, i.e. cash on the balance sheet, and stability of cash generation from operations to give us confidence that we will be repaid. That’s no different to any other time but when refinancing will be tougher due to market conditions, you always have to go back to fundamentals. From a technical perspective, I have for a while been looking at extending maturities beyond 2022 and making sure we are the first in line in terms of the company’s debt maturity timeline, just in case a dislocation such as this happened, so that the bonds we are invested in which may have refinance issues have a clear runway in the short term.

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