Fund Manager
Frank Mersch
The developments in global markets in the month of July followed smartly in the footsteps of June’s fears of US Sub-Prime mortgage defaults and marquis hedge fund implosions. Indeed it would appear that conditions are getting worse in this area of the credit market as more major mortgage lenders declare insolvency, name-brand investment managers liquidate their funds claiming losses up to half of their capital, and banks across the globe admit that they will be taking charges to their earnings thanks to the revaluation of Sub-Prime mortgage CDOs. The response in the bond market has been a sharp rally in Treasury yields (25-30 basis points), with traders now pricing in at least one Federal Reserve interest rate cut over the next few months. Not surprisingly, spreads on high yield corporate debt have widened sharply with yields rising close to 2% in the past two months. Although from a 10 year perspective this move only takes high yield debt back towards more “normal” levels, it greatly reduces the ability of private equity players to transact profitably in the leveraged buy-out market thanks to the higher borrowing costs. Although a collapse in the M&A market seems unlikely, we would expect the pace of activity to slow rather sharply, with a renewed focus on strategic rather than financial acquirers. Interestingly, despite the increasing presence of fear in the equity markets (the VIX “fear” index hit multi-year highs) stocks were only off modestly, with the TSX down 0.27% and the S&P 500 down 3.20%.
Despite the largely US-specific credit concerns, the global growth story appears to be still intact. In fact, Chinese GDP growth in the second quarter increased at the fastest pace in twelve years, coming in at 11.9% while inflation ticked up to a two year high at 4.4%. As we have said in the past, the Chinese growth story has visibility through at least this year (the national Congress year) and next (Beijing Olympics) and this has been reflected in the stable (yet still historically high) prices for commodities. In particular, the price of oil has been hitting record highs and is closing in on $80, while metals such as copper, lead and molybdenum are at or near record highs also. We feel that producers with exposure to these metals will continue to be the object of takeovers in the months to come. At the other end of the metal spectrum, nickel fell another 16% this month (after falling 20% in June) in the face of Chinese substitution, while aluminum and zinc are similarly lower on a year-to-date basis.
STRATEGY
For the month, the fund was up 1.8% thanks to limited exposure to the financial sector and a still large allocation in cash (25% plus). Fundamentally, equity markets are not expensive as they trade around 14-15X forward earnings, while interest rates are still near historical lows, and earnings growth is solid although less spectacular than in years past. At this point we are taking the opportunity to slowly add to positions trimmed earlier in the year. We continue to look for opportunities outside the commodities area such as the tech sectors and special situations.
We expect continued volatility as markets sort out the impact of widening credit spreads. At this juncture, the risk is primarily isolated to the U.S. but we are concerned that it may impact the U.S. consumer confidence and thus ripple overseas.
Frank Mersch
Portfolio Manager
Front Street Capital
Front Street Canadian Hedge
Date Published
Fund Manager
The developments in global markets in the month of July followed smartly in the footsteps of June’s fears of US Sub-Prime mortgage defaults and marquis hedge fund implosions. Indeed it would appear that conditions are getting worse in this area of the credit market as more major mortgage lenders declare insolvency, name-brand investment managers liquidate their funds claiming losses up to half of their capital, and banks across the globe admit that they will be taking charges to their earnings thanks to the revaluation of Sub-Prime mortgage CDOs. The response in the bond market has been a sharp rally in Treasury yields (25-30 basis points), with traders now pricing in at least one Federal Reserve interest rate cut over the next few months. Not surprisingly, spreads on high yield corporate debt have widened sharply with yields rising close to 2% in the past two months. Although from a 10 year perspective this move only takes high yield debt back towards more “normal” levels, it greatly reduces the ability of private equity players to transact profitably in the leveraged buy-out market thanks to the higher borrowing costs. Although a collapse in the M&A market seems unlikely, we would expect the pace of activity to slow rather sharply, with a renewed focus on strategic rather than financial acquirers. Interestingly, despite the increasing presence of fear in the equity markets (the VIX “fear” index hit multi-year highs) stocks were only off modestly, with the TSX down 0.27% and the S&P 500 down 3.20%.
Despite the largely US-specific credit concerns, the global growth story appears to be still intact. In fact, Chinese GDP growth in the second quarter increased at the fastest pace in twelve years, coming in at 11.9% while inflation ticked up to a two year high at 4.4%. As we have said in the past, the Chinese growth story has visibility through at least this year (the national Congress year) and next (Beijing Olympics) and this has been reflected in the stable (yet still historically high) prices for commodities. In particular, the price of oil has been hitting record highs and is closing in on $80, while metals such as copper, lead and molybdenum are at or near record highs also. We feel that producers with exposure to these metals will continue to be the object of takeovers in the months to come. At the other end of the metal spectrum, nickel fell another 16% this month (after falling 20% in June) in the face of Chinese substitution, while aluminum and zinc are similarly lower on a year-to-date basis.
STRATEGY
For the month, the fund was up 1.8% thanks to limited exposure to the financial sector and a still large allocation in cash (25% plus). Fundamentally, equity markets are not expensive as they trade around 14-15X forward earnings, while interest rates are still near historical lows, and earnings growth is solid although less spectacular than in years past. At this point we are taking the opportunity to slowly add to positions trimmed earlier in the year. We continue to look for opportunities outside the commodities area such as the tech sectors and special situations.
We expect continued volatility as markets sort out the impact of widening credit spreads. At this juncture, the risk is primarily isolated to the U.S. but we are concerned that it may impact the U.S. consumer confidence and thus ripple overseas.
Frank Mersch
Portfolio Manager
Front Street Capital