Stocks Are On Track for Solid 2019 Returns

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Screen Shot 2019-12-11 at 4
Photo: Pxfuel CC0. Stocks Are On Track for Solid 2019 Returns

The U.S. stock market started November with a sharp two-day rally sparked by a strong October jobs report that calmed recession fears. This set the stage for stocks to move higher for the month and to continue the 2019 series of record closing highs.
 
During the month, there were temporary sell offs from negative trade war related news but these were followed by positive headlines that moved stocks higher. On balance, improving trade negotiations, Brexit clarity, a resilient U.S. consumer and an accommodative Fed kept stocks on track for solid 2019 returns.
 
The M&A event catalyst for the three day pre-Thanksgiving spike in stock prices was ‘merger Monday’ when a flurry of large deals were announced including: Charles Schwab’s $26 billion transaction for TD Ameritrade, LVMH with a $16.2 billion deal for Tiffany, and drug maker Novartis in a $9.7 billion takeover of The Medicines Co. The global M&A volume wave that started in 2014, as measured in U.S dollars, continues to roll along with $2.73 trillion in 26,321 announced pending and completed transactions through November 30, 2019 versus $3.07 trillion in 30,225 deals in 2018 according to Bloomberg data.
 
Relatively unknown hotel operator Unzio Holdings (3258.T) was targeted with a rare domestic hostile bid from Tokyo travel agent H.I.S. Co (9603.T) in July.    This catalyst has surfaced intense interest from prominent global private equity firms, banks, and hedge funds, all attracted  to Unzio’s Japanese and other real estate properties selling at a discount, while also testing Prime Minister Abe’s efforts to boost shareholder returns for foreign buyers with revamped corporate governance and disclosure. The unprecedented cross-border hostile and friendly bidding war for Unizo heated up on November 24 when it said it had received six more buyout offers in addition to the deal proposed by Blackstone Group. More M&A activity to come…

Column by Gabelli Funds, written by Michael Gabelli

__________________________________

To access our proprietary value investment methodology, and dedicated merger arbitrage portfolio we offer the following UCITS Funds in each discipline:

GAMCO MERGER ARBITRAGE

GAMCO Merger Arbitrage UCITS Fund, launched in October 2011, is an open-end fund incorporated in Luxembourg and compliant with UCITS regulation. The team, dedicated strategy, and record dates back to 1985. The objective of the GAMCO Merger Arbitrage Fund is to achieve long-term capital growth by investing primarily in announced equity merger and acquisition transactions while maintaining a diversified portfolio. The Fund utilizes a highly specialized investment approach designed principally to profit from the successful completion of proposed mergers, takeovers, tender offers, leveraged buyouts and other types of corporate reorganizations. Analyzes and continuously monitors each pending transaction for potential risk, including: regulatory, terms, financing, and shareholder approval.

Merger investments are a highly liquid, non-market correlated, proven and consistent alternative to traditional fixed income and equity securities. Merger returns are dependent on deal spreads. Deal spreads are a function of time, deal risk premium, and interest rates. Returns are thus correlated to interest rate changes over the medium term and not the broader equity market. The prospect of rising rates would imply higher returns on mergers as spreads widen to compensate arbitrageurs. As bond markets decline (interest rates rise), merger returns should improve as capital allocation decisions adjust to the changes in the costs of capital.

Broad Market volatility can lead to widening of spreads in merger positions, coupled with our well-researched merger portfolios, offer the potential for enhanced IRRs through dynamic position sizing. Daily price volatility fluctuations coupled with less proprietary capital (the Volcker rule) in the U.S. have contributed to improving merger spreads and thus, overall returns. Thus our fund is well positioned as a cash substitute or fixed income alternative.

Our objectives are to compound and preserve wealth over time, while remaining non-correlated to the broad global markets. We created our first dedicated merger fund 32 years ago. Since then, our merger performance has grown client assets at an annualized rate of  approximately 10.7% gross and 7.6% net since 1985. Today, we manage assets on behalf of institutional and high net worth clients globally in a variety of fund structures and mandates.

Class I USD – LU0687944552
Class I EUR – LU0687944396
Class A USD – LU0687943745
Class A EUR – LU0687943661
Class R USD – LU1453360825
Class R EUR – LU1453361476

GAMCO ALL CAP VALUE

The GAMCO All Cap Value UCITS Fund launched in May, 2015 utilizes Gabelli’s its proprietary PMV with a Catalyst™ investment methodology, which has been in place since 1977. The Fund seeks absolute returns through event driven value investing. Our methodology centers around fundamental, research-driven, value based investing with a focus on asset values, cash flows and identifiable catalysts to maximize returns independent of market direction. The fund draws on the experience of its global portfolio team and 35+ value research analysts.

GAMCO is an active, bottom-up, value investor, and seeks to achieve real capital appreciation (relative to inflation) over the long term regardless of market cycles. Our value-oriented stock selection process is based on the fundamental investment principles first articulated in 1934 by Graham and Dodd, the founders of modern security analysis, and further augmented by Mario Gabelli in 1977 with his introduction of the concepts of Private Market Value (PMV) with a Catalyst™ into equity analysis. PMV with a Catalyst™ is our unique research methodology that focuses on individual stock selection by identifying firms selling below intrinsic value with a reasonable probability of realizing their PMV’s which we define as the price a strategic or financial acquirer would be willing to pay for the entire enterprise.  The fundamental valuation factors utilized to evaluate securities prior to inclusion/exclusion into the portfolio, our research driven approach views fundamental analysis as a three pronged approach:  free cash flow (earnings before, interest, taxes, depreciation and amortization, or EBITDA, minus the capital expenditures necessary to grow/maintain the business); earnings per share trends; and private market value (PMV), which encompasses on and off balance sheet assets and liabilities. Our team arrives at a PMV valuation by a rigorous assessment of fundamentals from publicly available information and judgement gained from meeting management, covering all size companies globally and our comprehensive, accumulated knowledge of a variety of sectors. We then identify businesses for the portfolio possessing the proper margin of safety and research variables from our deep research universe.

Class I USD – LU1216601648
Class I EUR – LU1216601564
Class A USD – LU1216600913
Class A EUR – LU1216600673
Class R USD – LU1453359900
Class R EUR – LU1453360155

Disclaimer:
The information and any opinions have been obtained from or are based on sources believed to be reliable but accuracy cannot be guaranteed. No responsibility can be accepted for any consequential loss arising from the use of this information. The information is expressed at its date and is issued only to and directed only at those individuals who are permitted to receive such information in accordance with the applicable statutes. In some countries the distribution of this publication may be restricted. It is your responsibility to find out what those restrictions are and observe them.

Some of the statements in this presentation may contain or be based on forward looking statements, forecasts, estimates, projections, targets, or prognosis (“forward looking statements”), which reflect the manager’s current view of future events, economic developments and financial performance. Such forward looking statements are typically indicated by the use of words which express an estimate, expectation, belief, target or forecast. Such forward looking statements are based on an assessment of historical economic data, on the experience and current plans of the investment manager and/or certain advisors of the manager, and on the indicated sources. These forward looking statements contain no representation or warranty of whatever kind that such future events will occur or that they will occur as described herein, or that such results will be achieved by the fund or the investments of the fund, as the occurrence of these events and the results of the fund are subject to various risks and uncertainties. The actual portfolio, and thus results, of the fund may differ substantially from those assumed in the forward looking statements. The manager and its affiliates will not undertake to update or review the forward looking statements contained in this presentation, whether as result of new information or any future event or otherwise.

 

CERPIs Dominate Over CKDs in the Amount Placed in the Last Two Years

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Screen Shot 2019-12-02 at 7
Pixabay CC0 Public DomainFoto: MarcusWoeckel. MarcusWoeckel

In 2018, 20 CKDs and 18 CERPIS were issued, totaling 7,584 million dollars in committed resources. In 2019 (as of November 25), only 4 CKDs and 6 CERPIs, totaling 1,818 million dollars, have been issued, which shows a significant drop in amount and number compared to the previous year.

The average committed amount of the last 5 years (2014-2018) has been 3,697 million dollars per year, which means that in 2018 it rose slightly more than double the average and in 2019 it takes half.

Much of the explanation for the 2018 boom is because it was the year on the eve of the presidential elections held in July 2018 and that in January 2018, CERPIs were allowed to invest 90% of the resources globally leaving only 10% locally. The fall in issues of CKDs and CERPIs in 2019 is explained by the change in the government where institutional investors are being more cautious in new investments in private equity.

CKDs vs CERPIs

Of the resources committed between 2018 and 2019, the General Partners (GP) have called only 27% on average and the rest, they will receive it in the coming years.

The value of the resources committed through CKDs and CERPIs is 24,767 million dollars of which 19,176 million dollars are CKDs and 5,590 million dollars are CERPIs which means that, with only two years of having authorized global investments for CERPIs, they already represent 23% of investments in private equity that reflects AFOREs remarkable interest in diversifying globally.

The number of CKDs, between 2008-2014 it did not exceed 10, while since 2015 the issuers fluctuated between 15 (lowest number) to 38 (highest last year).

Currently, CKDs and CERPIs represent 6.0% of the resources managed by AFOREs at market value and if the committed resources that will be delivered to the GPs are considered, the percentage almost doubles to reach 11.3 %. The maximum limit that the AFORE have for investing in this asset class is 18% on average according to the limits that each SIEFORE has, which leaves room for investments in private equity to continue growing.

With the numbers observed in 2019, we must recognize that CERPIs are being an option that competes with CKDs.

Column by Arturo Hanono

Trade Finance: New Opportunities in an Old Industry

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Chuttersnap trade Unsplash
CC-BY-SA-2.0, FlickrChuttersnap. Chuttersnap

Trade finance is one of the oldest forms of credit. Historical researchers have found some clay tablets from Babylon dating back to approximately 3000 B.C., showing samples of the first letters of credit. Trade finance flourished for several millennia driven by Italian lenders who financed the expeditions to the East in search of spices and other goods. After the fall of the Roman Empire, the industry mostly disappeared, until the fifteenth century. Around that time, the Trade Finance industry reemerged, led by European banks and financial institutions. However, it was only recently that it became accessible to private and institutional investors.

Currently, the term ‘trade’ has received some negative press. Since Donald Trump became U. S. President, we have seen many trade frictions, specifically between the United States and China. Nevertheless, global trade is still of enormous proportions. The value of global trade measured through export volumes exceeded US $19 trillion in 2018, reaching a new all-time high. Annual compound growth in the last 3 years stood at 6% and trade volumes are expected to continue this growth trend. This implies a massive financing opportunity. According to the World Trade Organization (WTO), only a small part of international trade is paid in cash in advance, since importers generally prefer to pay on receipt of merchandise in order to check for damages upon arrival, and exporters wish to receive payment on dispatch.

To bridge the gap between exporters and importers, a credit or payment guarantee is required. Trade finance provides this credit, guaranteed payment, and the necessary insurance to facilitate the transaction and establish the terms to satisfy both the exporter and the importer. Unfortunately, there are no comprehensive official statistics showing the exact composition and size of the global trade finance market, but the Bank for International Settlements (BIS) found that, in its broadest definition, the market is very large, well above US $12 trillion annually, and about 1/3 of this sector finances the trade in raw materials.

More importantly, after the Great Financial Crisis, traditional lenders such as banks have begun to withdraw from trade finance activity, driven by increased regulation and compliance costs, which has caused a shortage of financing. Small and medium-sized enterprises (SMEs), especially those that are located in emerging markets, suffer the most, because they face great obstacles to access financing under affordable conditions. According to the WTO, this is especially worrying, as SMEs contribute to more than 60% of total employment in developing countries and 80% in developed ones.

Currently, there is a need for unsatisfied trade finance worth trillions of dollars, particularly in emerging markets. Meanwhile, many investors have been desperate to find attractive returns in a world where traditional fixed-income instruments, such as corporate and sovereign bonds, offer very low returns, in some cases even negative returns for investors. In fact, the market value of bonds that offer negative returns is around 12 trillion dollars.

Therefore, it’s only logical that trade finance funds have emerged in recent years, allowing investors to benefit from the industry’s attractive dynamics, and alleviating, at least partially, the financial scarcity faced by importers and exporters.

Likewise, the risk / return profile of the trade finance sector has improved significantly. New practices and conventions have evolved to reduce risk for investors. For example, trade financers take the assets described in the contract as collateral and hire local agents to inspect and check the products in detail. Similarly, contracts have been standardized, typically using the law of developed jurisdictions, thus avoiding the risk of corruption in local courts. In addition, well reputed specialists in international warehouses ensure the existence and security of guarantees. Finally, multinational insurance companies cover the risk of accidents, weather, terrorism and fraud during shipping.

As a result, the risk to investors has been significantly reduced. In fact, in the past 20 years, default rates have been approximately 0.1% per year. And, given the high recovery rates in case of default, the annual expected loss rates are around 0.01%, which is much lower than the corporate bond risk. Meanwhile, expected returns are very attractive compared to corporate bonds. Most of the foreign trade funds have annual yields of between 5% and 8% in dollars, which is attractive, given the low risk profile, low volatility, and the fact that many trade finance funds offer investors monthly or quarterly liquidity. In addition, trade finance funds provide an excellent source of diversification for portfolios, given their low correlation with traditional asset classes and their low sensitivity to the economic cycle.

 

Tribune by Pascal Rohner, CIO at Katch Investment Group  

 

A Strong Economy, Low Unemployment and an Accommodating Federal Reserve Have Led to Ripe Conditions for Accelerating M&A Activity

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Screen Shot 2019-11-06 at 9
MaxPixel CC0. Una economía fuerte, con un desempleo muy bajo y una Fed acomodaticia aceleran la actividad de fusiones y adquisiciones

While we are bottom-up stock pickers (and not stock market prognosticators or macro traders), we do note that despite the strong rally in the market so far this year, we continue to find many opportunities of stocks trading at significant discounts to our estimate of Private Market Value. Many of these are so-called “value” stocks including consumer staples, media and industrial companies.
 
The economy continues to be strong, with very low unemployment and now an accommodating Federal Reserve. This has led to ripe conditions for accelerating M&A activity, which, along with financial engineering, can cause undervalued stocks to close the valuation gap with over business values as Buffet and others typically describe.
 
Stocks have rallied into November first setting record highs as a solid October jobs report, improving China trade talks, easy central bank monetary policies, and the December UK election date agreement all fueled the advance.
 
After the FOMC statement release on October 30, Chairman Powell gave his assessment of the effect of recent rate reductions on the current state of the economy: “You are seeing strong durable goods sales. You are seeing housing now contributing to growth for the first time in a while. And you are seeing retail sales”…”More broadly, monetary policy is also supporting household spending and home buying by keeping the labor market strong, keeping workers incomes rising, and keeping consumer confidence at high levels.” Translation – rate pause. This all has benefits for the economy and value investing.
 
That said, it has seemed before that we are on the precipice of a trade deal with China, only to learn we are no closer and/or more tariffs are coming. So we wait and watch macroeconomic and political events closely, and seek a portfolio of companies that can withstand whatever economic conditions are before us. Furthermore, as we enter 2020 the market will surely be looking ahead to the November US Presidential election, with the market and specific sectors reacting accordingly which could help fuel further momentum for value stocks.
 
As always, we seek to buy high quality businesses trading at a discount to Private Market Value with Catalysts present to surface value.

Column by Gabelli Funds, written by Michael Gabelli

__________________________________

To access our proprietary value investment methodology, and dedicated merger arbitrage portfolio we offer the following UCITS Funds in each discipline:

GAMCO MERGER ARBITRAGE

GAMCO Merger Arbitrage UCITS Fund, launched in October 2011, is an open-end fund incorporated in Luxembourg and compliant with UCITS regulation. The team, dedicated strategy, and record dates back to 1985. The objective of the GAMCO Merger Arbitrage Fund is to achieve long-term capital growth by investing primarily in announced equity merger and acquisition transactions while maintaining a diversified portfolio. The Fund utilizes a highly specialized investment approach designed principally to profit from the successful completion of proposed mergers, takeovers, tender offers, leveraged buyouts and other types of corporate reorganizations. Analyzes and continuously monitors each pending transaction for potential risk, including: regulatory, terms, financing, and shareholder approval.

Merger investments are a highly liquid, non-market correlated, proven and consistent alternative to traditional fixed income and equity securities. Merger returns are dependent on deal spreads. Deal spreads are a function of time, deal risk premium, and interest rates. Returns are thus correlated to interest rate changes over the medium term and not the broader equity market. The prospect of rising rates would imply higher returns on mergers as spreads widen to compensate arbitrageurs. As bond markets decline (interest rates rise), merger returns should improve as capital allocation decisions adjust to the changes in the costs of capital.

Broad Market volatility can lead to widening of spreads in merger positions, coupled with our well-researched merger portfolios, offer the potential for enhanced IRRs through dynamic position sizing. Daily price volatility fluctuations coupled with less proprietary capital (the Volcker rule) in the U.S. have contributed to improving merger spreads and thus, overall returns. Thus our fund is well positioned as a cash substitute or fixed income alternative.

Our objectives are to compound and preserve wealth over time, while remaining non-correlated to the broad global markets. We created our first dedicated merger fund 32 years ago. Since then, our merger performance has grown client assets at an annualized rate of  approximately 10.7% gross and 7.6% net since 1985. Today, we manage assets on behalf of institutional and high net worth clients globally in a variety of fund structures and mandates.

Class I USD – LU0687944552
Class I EUR – LU0687944396
Class A USD – LU0687943745
Class A EUR – LU0687943661
Class R USD – LU1453360825
Class R EUR – LU1453361476

GAMCO ALL CAP VALUE

The GAMCO All Cap Value UCITS Fund launched in May, 2015 utilizes Gabelli’s its proprietary PMV with a Catalyst™ investment methodology, which has been in place since 1977. The Fund seeks absolute returns through event driven value investing. Our methodology centers around fundamental, research-driven, value based investing with a focus on asset values, cash flows and identifiable catalysts to maximize returns independent of market direction. The fund draws on the experience of its global portfolio team and 35+ value research analysts.

GAMCO is an active, bottom-up, value investor, and seeks to achieve real capital appreciation (relative to inflation) over the long term regardless of market cycles. Our value-oriented stock selection process is based on the fundamental investment principles first articulated in 1934 by Graham and Dodd, the founders of modern security analysis, and further augmented by Mario Gabelli in 1977 with his introduction of the concepts of Private Market Value (PMV) with a Catalyst™ into equity analysis. PMV with a Catalyst™ is our unique research methodology that focuses on individual stock selection by identifying firms selling below intrinsic value with a reasonable probability of realizing their PMV’s which we define as the price a strategic or financial acquirer would be willing to pay for the entire enterprise.  The fundamental valuation factors utilized to evaluate securities prior to inclusion/exclusion into the portfolio, our research driven approach views fundamental analysis as a three pronged approach:  free cash flow (earnings before, interest, taxes, depreciation and amortization, or EBITDA, minus the capital expenditures necessary to grow/maintain the business); earnings per share trends; and private market value (PMV), which encompasses on and off balance sheet assets and liabilities. Our team arrives at a PMV valuation by a rigorous assessment of fundamentals from publicly available information and judgement gained from meeting management, covering all size companies globally and our comprehensive, accumulated knowledge of a variety of sectors. We then identify businesses for the portfolio possessing the proper margin of safety and research variables from our deep research universe.

Class I USD – LU1216601648
Class I EUR – LU1216601564
Class A USD – LU1216600913
Class A EUR – LU1216600673
Class R USD – LU1453359900
Class R EUR – LU1453360155

Disclaimer:
The information and any opinions have been obtained from or are based on sources believed to be reliable but accuracy cannot be guaranteed. No responsibility can be accepted for any consequential loss arising from the use of this information. The information is expressed at its date and is issued only to and directed only at those individuals who are permitted to receive such information in accordance with the applicable statutes. In some countries the distribution of this publication may be restricted. It is your responsibility to find out what those restrictions are and observe them.

Some of the statements in this presentation may contain or be based on forward looking statements, forecasts, estimates, projections, targets, or prognosis (“forward looking statements”), which reflect the manager’s current view of future events, economic developments and financial performance. Such forward looking statements are typically indicated by the use of words which express an estimate, expectation, belief, target or forecast. Such forward looking statements are based on an assessment of historical economic data, on the experience and current plans of the investment manager and/or certain advisors of the manager, and on the indicated sources. These forward looking statements contain no representation or warranty of whatever kind that such future events will occur or that they will occur as described herein, or that such results will be achieved by the fund or the investments of the fund, as the occurrence of these events and the results of the fund are subject to various risks and uncertainties. The actual portfolio, and thus results, of the fund may differ substantially from those assumed in the forward looking statements. The manager and its affiliates will not undertake to update or review the forward looking statements contained in this presentation, whether as result of new information or any future event or otherwise.

 

Private Investments Risk (Part 2): “Asset Aggregator or Value Creator?“

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Screen Shot 2019-10-30 at 1
CC-BY-SA-2.0, FlickrFoto: Sheila Sund . Private Investments Risk (Part 2): “Asset Aggregator or Value Creator?“

Which would you choose to add to your portfolio of private investments – an asset aggregator’s latest fund or a value creator’s fund?  It is an important question that deserves deep thought.  And it matters because too often, investors make the wrong choices, thereby increasing their risk profiles and undermining their odds for achieving decent returns when things do not go according to plan.

As private investments become an increasingly important part of any diversified asset allocation, representing anywhere between 10% and 40% for high net worth families as well as institutions, private investment managers respond in one of two ways.  Certain managers choose to collect as many commitments as possible, focusing their energies on expanding the size of their AUMs and also expanding the variety of fund strategies they offer.  Other managers continue to focus substantially all of their energies on value creation and to stick to what they are good at.  Despite claiming they can achieve both objectives, very few managers do so.

Why is it so difficult to successfully focus on both aggregating maximum available AUMs for your strategies, while prolifically expanding the number of strategies offered, and continuing to successfully focus on true value creation within each strategy without sacrificing performance and without increasing risk profiles?  The answer is – incentives.  Incentives drive behavior and these objectives have competing paths to riches.  

Before managers raised mega funds, their overwhelming priority and incentive was to generate a meaningful profit so that they could earn their 15-20% carry (their share of the profit).  If they succeeded at creating value (which means not competing for the same deals and overpaying, not using excessive leverage or piling on other forms of risk, applying disciplined growth plans, and selling to a strategic acquirer after ~5 years of value creation efforts), they raised another fund (maybe of same size or slightly larger), and with consistent focus over time created meaningful personal wealth for their investors and themselves.  

As the asset class became more popular and moneys flowed to it, managers who adopted the asset-aggregator-above-all-else-approach did so because the 1.5-2% annual management fees on a much larger pool of assets was an easier and quicker path to riches. 1.5% per annum of a $10 billion fund generates $1.5 billion in management fees over 10-12 years (that’s much more than is needed to pay for basic salaries and office space).  And as more money flowed to these asset aggregators who built their brands initially using true value creation approaches, their businesses became more competitive and they felt more pressure to quickly put their capital to work, allowing them then to raise more AUM.  Driven by these incentives, underwriting standards dropped as a result.  Their pitches shifted from ‘we target a 20% IRR’, to ‘we now target a 15% IRR’, to ‘you should thank us for delivering a 10-12% IRR’ (while not drawing attention to the fact that many of their risk profiles increased in the process).

When you review your recent investment choices, take a look at your managers’ incentives and how well they are personally aligned with your objective.  Don’t be afraid to drill down deeper to get your answers.  Have their business models changed? If so, how?  Is the risk profile greater?  If so, why?  Are they personally committing a meaningful amount of their net worth to the same fund or is their firm subsidizing their commitment? How does their underwriting model compare to previous funds?  How has their competitive landscape changed?  How has their focus changed? It is possible to do better and to find alignment. It just takes more effort.

Column by Alex Gregory

Factoring in Brazil: An Attractive Investment Opportunity

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agustin Diaz Rio de Janeiro Unsplash
CC-BY-SA-2.0, FlickrAgustín Diaz. Agustín Díaz

Brazil is a country full of contrasts. The biggest Latin American country is not only known for its sunny beaches, vast Amazon jungle, samba and passion for football, but also for poverty and social inequality, mostly seen in places like the country’s famous favelas.

The Brazilian economy has long benefited from the world’s, and particularly China’s, strong appetite for Brazil’s abundant natural resources, such as soya, oil and iron ore. The commodity boom led to strong economic growth. From 2000 to 2012, brazil was one of the fastest-growing major economies in the world with an average annual GDP growth of over 5%. However, the economy started to slow down in 2013 and entered a recession in late 2014 that lasted until 2016, driven by an economic slowdown in China that caused a sharp decline in commodity prices. The Brazilian economy shrank by more than 7% in two years, which made it the longest and deepest recession in its history.

The recovery process after the recession has been desperately slow, held back by political uncertainties, corruption scandals and external shocks (crisis in Argentina, global trade war). However, the current president, Jair Bolsonaro, has started to push through an ambitious reform agenda that should improve structural growth in Brazil. More importantly, there is still a lot of overcapacity and slack in the economy, which has helped to keep inflation under control. The central bank’s policy rate has come down from 14.25% in 2016 to 5.5%, and additional cuts are likely. Structurally lower rates and economic reforms should improve Brazil’s competitiveness and stimulate economic growth.

Investors can get access to Brazil via its stock market, the Bovespa. But investing in Brazilian stocks has proven to be a very volatile ride with massive ups and downs, and typically concentrated exposures to some large stocks with political influences, such as Petrobras, Itaú Unibanco, Bradesco, AmBev and Vale. 

But there is a much more conservative way to invest in Brazil via receivables-backed funds called Fundo de Investimento em Direitos Creditórios (FIDCs). FIDCs are mutual investment funds that apply the majority of their financial resources in receivables. They offer relatively high yields and huge diversification benefits. Brazil is a fantastic example for the deficiency of the traditional banking sector with a concentration of almost 80% amongst the top four banks. These banks tend to focus on mortgages and long-term loans for larger corporates. Small- and medium-sized enterprises (SMEs) are often struggling to get access to traditional sources of funding. Also, bank spreads in Brazil are much larger than in any other major country. While interest rates have come down, banks are still widely lending at rates above 30%.

Alternative financing options, such as accounts receivable factoring, may provide the working capital SMEs need. Accounts receivable factoring is financing that comes from a business selling its accounts receivable to a factoring company. Given the lack of lending provided by traditional banks, the Brazilian authorities implemented an investor friendly regulation for the factoring industry. In Brazil, FIDC are fully regulated and monitored by the Brazilian Securities Commission (CVM). The concept was first introduced in 2001 but since then, the transparency and accountability has been improved significantly. Today, FIDCs must comply with a number of rules that guarantee strong governance and independent controls through regulated fund administrators, independent auditors, registered managers, custodians, etc., which gives investors a very high level of transparency and accountability. Brazil is probably the country with the highest standards in terms of the regulation of the factoring industry, a real factory paradise, and definitely a positive aspect to be added to the list of contrasts. The strong regulatory framework that protects the interest of investors paved the way for sizable capital inflows, that helped to meet the strong demand from SMEs. Currently, there are around 800 different FIDCs with a total asset size of around B$ 120 billion (around USD 30 bn).

Investors have many advantages if they invest in FIDCs compared to corporate bonds or equities, for example. First, receivables portfolios usually contain receivables from a diverse group of debtors, which means that there is much less concentration compared to traditional corporate bond or equities portfolios. Second, investors mainly face the credit risk of the buyer (obligor), which tends to be a bigger, more established company, typically multinationals, that have a much lower credit risk. What is more, the credit risk of the obligors can be insured against default at relatively low costs. Third, FIDCs can also get guarantees from the suppliers, such as real estate and personal guarantees of key executives. This gives a strong incentive for suppliers to buy back the receivables in the rare case that the buyer does not pay the invoice to the factor. Therefore, expected default rates are below 2% and expected loss rates (after renegotiation and recovery) are below 1% in the Brazilian factoring industry. Interestingly, loss rates remained below 1% even during the deep recession of 2015/2016, which has been an excellent stress test of the resilience of the Brazilian factoring industry. And last but not least, the expected performance for international investors is highly attractive. Even if we deduct hedging costs (that have come down a lot thanks to the lower rates in Brazil) and any other costs related to the origination, management and administration, net returns for USD investors should be in the 8-10% range.

Opinion by Pascal Rohner, CIO at Katch Investment Group

Liquidity Crisis in the US Repo Market

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Crisis de liquidez en el mercado estadounidense de repos
Pixabay CC0 Public Domain. Crisis de liquidez en el mercado estadounidense de repos

September 2019 saw a ‘liquidity crisis’ in the US repo market, a market principally operated by private banks. This liquidity stress led to a spike in funding costs. As a response, the Federal Reserve intervened through cash injections to restore an operational normality to this market. 

The last time this event occurred was in 2008 at the height of the financial crisis. Back then, two main causes for this malfunction had been identified: a mistrust between commercial banks in their interbank lending operations and a growing discomfort on the collateral proposed for repo transactions (especially collateral backed by real estate loan portfolios. The US property market was in turmoil in 2008). 

The September 2019 funding stress was a surprise to many. Present-day economic conditions are a far cry from the subprime meltdown eleven years before. In addition, Fed policy had been recently adjusted with the end of ‘Quantitative Tightening’ program in August. Yet despite this preemptive monetary action, the liquidity made available as a result seems to have been grossly inadequate.

New York Fed’s ex-President Bill Dudley provided his account of the current repo situation. He pointed to the corporate tax payment season and recent treasury auctions as having dried up market liquidity. These explanations have left many perplexed. Why could such liquidity flows not have been anticipated by the Fed?  What other reason would eventually lie behind the present funding crisis in the repo market?   

To delve deeper into this phenomenon, certain analysts have put forward structural arguments, based on recent world Central Bank policy, as well as other cyclical events. The first structural issue concerns the collateral used in the repo market. Traditionally, this kind of financial transaction uses US government bonds as collateral because they are considered to be the best quality instrument available. Since 2008, Central Bank interventions have progressively soaked up government debt making them more difficult to come by.

As a result, more and more corporate bonds are being put up as collateral in repo transactions instead. However, corporate debt is considered to be of lower quality by dealers in this market place. Following recent economic data showing a downturn in world activity, corporate bonds are being increasingly perceived as carrying a higher risk than in previous months. This has led to a rise in their risk premium and by extension the funding cost for those who use them as collateral. 

The second structural issue involves around bank reserves. American Banks have been encouraged through regulation and the remuneration of their deposits to park their excess liquidity as reserves with the Fed rather than make it available as funding for the repo market.

In sum, the US repo market has been exposed to decreasing collateral quality and uncertain funding flows for its large banking liquidity providers. To top it all, additional cyclical factors have come into play. 

International demand has been increasing for US dollar cash and fixed income assets, over the last few months. Geopolitical uncertainty in Hong Kong and the Middle East, rising bond prices on the back of lower US interest rates, plus international investment capital desperately seeking yield, have combined to disrupt the traditional bond and liquidity flows associated with the repo market. All these structural and cyclical elements seem to have come to a head in September 2019. 

In a recent interview, Jeffrey Gundlach from DoubleLine described how the repo market has been under pressure since the end of 2018. He believes this situation could last for a while longer and he views the recent Fed liquidity injections to be on the road to fresh asset purchases by the American central bank.

Michael Howell of Crossborder Capital brings a different perspective to this liquidity crisis. For him, monetary accommodation in Europe, China and Japan must be viewed in the context of a currency war against the US dollar. He anticipates the Trump administration and the Fed will not be able to allow the current liquidity stress to last for any period of time. He believes the Fed will have to react at some point by opening up more aggressively the liquidity channels, notably for the US repo market.   

Column by Steven Groslin, executive board member and portfolio manager at ASG Capital

Equities in September Closed on a High Note, but Long-Term Rates are Still Low…

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Photo: PxHere CC0. Equities in September Closed on a High Note, but Long-Term Rates are Still Low...

In a notable display of resiliency, U.S. stocks closed September near all-time highs against a very uncertain investment backdrop and finished the month and the third quarter with a gain and with a double-digit return for the nine months. Stock prices gyrated as they interfaced with diverse news headlines and world events. A partial list of topics includes the China/U.S. trade war, Brexit, Saudi oil field drone attack, central bank easing, yield curve inversion, negative interest rates, U.S. recession concerns, and relatively slow growth in China and Europe.

Top trade negotiators for the U.S. and China are set to square off on October 10-11 in Washington, as both sides seem more willing to resolve some issues. The U.S. economy, though starting to show some trade war related stress in the industrial sector, is still expected to grow about two percent in the third quarter. Employment, housing and a record $113.5 trillion household net worth are key.

During the post FOMC Statement Press Conference Q&A on September 18, Chairman Powell asked a timely rhetorical question: “But why are long-term rates low?  There can be a signal about expectations about growth there for sure, but there can also just be low term premiums. For example, it can just be that there’s this large quantity of negative yielding and very low yielding sovereign debt around the world, and inevitably that’s exerting downward pressure on U.S. sovereign rates without really necessarily having an independent signal.”

Corporate earnings, as measured by the S&P 500, are currently projected to rise 4.1 percent in Q4 2019 and be up 11.2 percent in 2020 based on IBES data. Though global M&A activity declined in the third quarter due to trade war fears, a September 30 NIKKEI Asian Review headline – Japan eyes tax breaks to steer idle cash into M&A deals – Companies hoarding profits miss out on innovation, ruling party tax chief says – sets up new deals for merger arbitrage.

GAMCO continues to research new investment opportunities in the North American equipment rental market for infrastructure replacement and new structures for highways, bridges, buildings, energy and water. Public drinking water systems are projected to need about a trillion dollars in upgrades and new systems over the next 25 years.

Column by Gabelli Funds, written by Michael Gabelli

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The information and any opinions have been obtained from or are based on sources believed to be reliable but accuracy cannot be guaranteed. No responsibility can be accepted for any consequential loss arising from the use of this information. The information is expressed at its date and is issued only to and directed only at those individuals who are permitted to receive such information in accordance with the applicable statutes. In some countries the distribution of this publication may be restricted. It is your responsibility to find out what those restrictions are and observe them.

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Budget 2020: Risks Of Failing Macroeconomic Forecasts

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Presupuesto 2020: Los riesgos de fallar en los pronósticos macroeconómicos
Foto: Banxico. Presupuesto 2020: Los riesgos de fallar en los pronósticos macroeconómicos

On September 8th, Mexican IRS (SHCP by its Spanish initials) delivered the 2020 Budget to Congress. As expected, most of the fiscal discipline lines remained unchanged: 1) Fiscal surplus of 0.7% (although below 1.3% presented in the pre-criteria); 2) Lower expected growth for this year (0.9% vs. 1.6% of the pre-criteria); 3) Financial requirements of the public sector (RFSP) deficit without much change (2.6% of GDP by 2020); 4) Indebtedness (Historical balances of the RFSPs) at 45.6% of GDP by 2020 (0.5% above those published in the pre-criteria).

A precise estimation of these macroeconomic criteria is of vital importance since income and expenditure relay entirely on them. To err when estimating them could mean falling short to carry out the spending program that the government wants to execute.

An example of the above was announced in recent months, which was endorsed in the text of the 2020 Budget: the use of the Budget Income Stabilization Fund (FEIP, by its Spanish initials) for an amount of $ 129.6 billion (43.8% of the resources available in the fund) to alleviate the lower income received during 2019. This means that the government errs in making its calculations of macroeconomic variables and revenues in the 2019 budget will fall short. However, there is no problem, that is the intention of the FEIP: to be a “cushion” that allows to stabilize the budgetary income if the calculations fail.

However, the FEIP has a limit, and to err constantly might carry out the extinction of the fund, leaving public finances to the sway of global and local shocks. In this sense, after the “bite” that the government will give to the FEIP this year, the stabilization fund will be reduced by 2020 and will have a balance of $ 166.4 billion. Is this enough to face the risks of a sharp fall in income the following year? The answer is not so obvious.

The General Criteria for Economic Policy (CGPE, by its Spanish initials) presents a sensitivity exercise of income and expenditures to the different macroeconomic variables (Graph 1). Let’s see how sensitive the numbers are to “realistic shocks” in the macro variables.

FT1

GDP growth

The relationship is quite direct. Greater economic growth means greater activity and, therefore, greater tax collection. In fact, for every 0.5% change in economic growth, revenues would move in the same direction $ 17,247.1 million.

I see a problem here. The SHCP is forecasting 2% growth of the economy by 2020, but I think that is a bit optimistic. In the latest Banxico survey, the forecast for 2020 is only 1.39%, and historically, growth forecasts have tended to fall as time goes by, which is not far-fetched to assume for the future if trade war problems continue. Therefore, for the purposes of this analysis, I will assume that next year’s growth turns out to be 1%. This would imply a reduction in estimated revenues of $ 34,494.2 million.

Oil price

If the price of a barrel increases by US$ 1, the oil-related revenue will increase by $ 13,775.80 million pesos. However, if we fall into an economic slowdown due to a slowdown in the US, prices will tend to fall. In fact, the government is assuming this could happen as they lowered the estimated price of a barrel from US $ 55 in the pre-criteria to US $ 49 in the 2020 Budget.

However, the downside risk should not be that worrisome because of the oil hedges that the government have bought this year. Now, if the exercise price of these hedges is at US $ 49 (same as the Budget), then the risk is minimal. If the strike price is lower, then there is a risk in which money could be lost if the price of the barrel falls.

For the purposes of this exercise, we will assume that the government has perfect coverage, and the estimated price of the barrel is what they will receive, that is, US $ 49. Therefore, this macroeconomic variable does not affect us for the calculation of sensitivities.

Exchange rate

The exchange rate plays a double role in income / expenditure sensitivities. On the one hand, a depreciation (appreciation) of the exchange rate would increase (decrease) oil revenues; on the other hand, the same depreciation (appreciation) would increase (decrease) expenditures in the form of financial cost due to the interest that must be paid in foreign currency. What effect is stronger?

The effect related to oil revenues is greater, in fact, the size of the effect of the financial cost represents only 10% of the total effect of the change in oil revenues. Given this, that the exchange rate depreciates is positive for the 2020 Budget.

However, the estimated average exchange rate in CGPE is $ 19.9 per USD, slightly above that estimated by the market ($ 19.8 per USD). However, an appreciation greater than that estimated by the market is not difficult to imagine given the restrictive course the Fed has begun to follow. Remember that when the Fed cuts rates, emerging markets benefit. On the other hand, if the commercial war between the US and China continues, Mexico would benefit in terms of exports to the US, strengthening its currency.

In this sense, thinking of an average exchange rate of $ 19.5 per usd is not that difficult, so if we had an appreciation of $ 0.40 per usd in the peso, we would stop receiving $ 13,675.6 million.

Oil production

I believe that this is one of the most critical parts of the assumptions made by the SHCP. The Budget assumes an increase in oil production of 224 mbd, which implies a growth of 13%. Given the current conditions of Pemex, it is difficult to think of an increase of that size.

The government argues that the rounds made during the last government will begin to bear fruit, however, it is likely that this will only stabilize the drop in production we have experienced month by month.

For the sake of the exercise, and being more pessimistic than in the other points, I will assume that production stabilizes, that is, it does not grow in 2020. This would imply a loss of 224 MBD, that is, a decrease of $ 73,012.35 million in the income of 2020.

Interest rate

The interest rate directly hits the expenditures, especially, the part of the local debt that is referenced at a variable rate: the higher the rate, the higher the interest-derived expenditure.

The budget assumes that the average nominal rate in the year will be 7.4%. In this area I believe that the government has been quite conservative. The consensus expects that Banxico rate to be 7.5% at the end of 2019, with the possibility of continuing to lower its rate. In fact, the consensus assumes that by the end of 2020 Banxico will have the reference rate at 7%.

Given the above, thinking about a lower rate makes sense. For this exercise I will assume that the average rate of the year will be 7.10%, so the expenses will be reduced by $ 5,843.37 million.
Oil hedge

It should be remembered that the FEIP also serves to contract the oil coverages mentioned in the second point. These coverages have had an average cost of $ 16,000 million in the last 5 years, so we will assume that by 2020 this average cost remains.

Conclusion

FT2

We see that “small changes” in macroeconomic variables could bring a cost of $ 131,338.78 million in the 2020 Budget, which is no small matter. On the other hand, the balance of the FEIP will be 166,400 million, so, although it could help to alleviate the negative effects of a bad estimate in the Budget, it would leave the Public Treasury in a very precarious position to be able to take countercyclical measures in case the income decreases further.

The government is approaching a crossroads. Extraordinary measures to alleviate income shortfalls are limited and we are running out of them. In my opinion, the next logical step should be the implementation of a comprehensive tax reform that is not popular but is very necessary.

Column by Franklin Templeton México , written by Luis Gonzalí, CFA

Negative Interest Rates Increase the Attractiveness of Private Debt

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Jeremy Bishop Water Palm trees Unsplash
Pixabay CC0 Public DomainJeremy Bishop. Jeremy Bishop

Years ago, it would have been unthinkable to contemplate that Interest rates, which are the cost of money, could ever be negative. What this means is that the lender, or investor, will have to pay in order to lend his money, in short, he is assured of a loss, which doesn’t make any sense at all; yet the problem is that this is now a fact in developed economies.

Almost 1/3 of the global bond market (US $16 trillion) offers returns below 0%. Both short- and long-term bonds issued by the governments of Germany, Denmark, Finland and Switzerland offer negative rates. These governments are rewarded for issuing debt, as they will have to return to bond buyers less money than they collected. Even more surprising, the third largest bank in Denmark called Jyske Bank has begun to grant 10-year mortgage loans with annual rates of -0.5%, the bank must now pay consumers, and to put the cherry on the cake, approximately 3 % of global bonds offer interest rates greater than 5%, something never seen before.

How did we reach this point? It all started when, in 2012, Denmark’s central bank reduced its reference interest rate to 0.20%. Later, the European Central Bank and the Central Bank of Japan reduced their rate to –0.10% in 2014 and 2016, respectively. Today, “the negative interest rate policy” (NIRP) is another tool in the arsenal of unconventional monetary policies of central banks to face deflationary pressures, unwanted appreciation of currencies, and disappointing rates of economic growth. It’s no coincidence that central banks covering about ¼ of the world’s GDP have negative benchmark rates.

The only one not currently treading this unchartered territory is the United States. However, interest rates in the world’s largest economy have fallen dramatically and are not indifferent to the global environment. The 10-year treasury note currently offers a yield of 1.7%, accumulating falls of about 100 basis points during the year, in August alone the fall amounted to 40 basis points.

At the moment, the inflection point is still out of sight, the fixed income market is becoming increasingly riskier and less attractive, and if you want to obtain good returns on traditional investments you must be prepared to assume a fair amount of risk. So where can investors find attractive returns? Private debt is an interesting option.

This asset class shines in an economic environment of high uncertainty, high levels of volatility, and low, and even negative returns, because it provides benefits such as low volatility with deviations below 2%, solid collaterals, excessively low default rates, stable returns, and low correlation with traditional markets.

The Katch Global Lending Opportunities (GLO) fund offers these and other benefits, such as short duration, as the term of the loans is normally between three and nine months, being little sensitive to the movement of interest rates and with a lower credit risk, with more predictable economic environment, financial stability and credit profile of the borrower. On the other hand, all the fund’s loans have solid guarantees and the amount borrowed does not exceed 70% of the value of the asset that backs it.

Loan terms, such as those mentioned above, largely help to explain the low default rates. For example, in the commercial financing strategy, the default rate in the last 15 years, including the Great Financial Crisis of 2008, has been 0.1% vs. 3.5% of that in high yield bonds. Additionally, the recovery rate is high, close to 75%.

Diversification is another great feature of the Katch GLO fund, with exposure to different strategies (factoring, bridge loans, commercial financing, amongst others) with no correlation between them and different geographies, such as Brazil, the largest economy in Latin America, which, although it contracted by 6% in 2015, during the strongest recession in at least 50 years, the default rates in factoring remained below 1%.

In conclusion, in an environment of low, and even negative, interest rates, private loan funds such as the Katch GLO fund, are quite attractive, thanks to their characteristics such as a very low correlation with traditional financial markets because they operate in completely different niches, the strong guarantees that substantially reduce credit risk and allow for very high recovery rates in cases of default, as well as to high and very stable returns with very little volatility, are a great option to complement investment portfolios.

Katch Invest

 

Tribune of Pascal Rohner, CIO at Katch Investment Group, and Diego Agudelo, research analyst.