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Did a Butterfly Just Flap its Wings in Denmark? 

I am not entirely sure, but the decision by a number of plain vanilla investment managers in my home country to increase redemption fees on their high yield funds does raise my eyebrows quite substantially. Last week Sydinvest thus followed Sparinvest in increasing the exit-fees on a number of their high yield bonds, and you don't get a clearer signs of illiquidity. I doesn't, yet, violate my view as expressed in my two previous posts that sector rotation in the latter part of the cycle can still garner significant excess returns, but if this becomes a general tendency, I would run for the hills.

Consider a big diversified HY fund, and the following sequence of events.

1) They try to sell a bond from Energy Turd 1, marked to market at 95, but get it off at 75.

2) The get scared as they begin to sense that liquidity is drying up, and if redemptions continue/accelerate they might not be able to meet cash demands.

3) They impose Hotel California type exit costs in order to share the burden of the illiquidity costs with the investor.

We have heard talk about the Fed, and the regulator, considering exit fees on bond funds, and I am very curious to investigate whether this is actually happening on a larger scale. The Danish example above indicate that it might be, and we should look for this trend, if it is indeed one, to migrate into ETF space as well. If large buy-and-hold investors are still not getting worried, I think we are ok at the margin, but if the likes of Templeton et al. suddenly decided to do a little spring-cleaning in their bond portfolio the liquidity of the market could be stretched to a breaking point. 

During the sell-off in October, the big guns were quick to express their desire to buy the dip, but the hole is just getting smaller. The chart in this post by Dealbook on just how concentrated the holdings of some of these issues are is a huge warning sign for me. This also leads me to adjust my strategy (in preparation) for how to ultimately play this. Shorting the equity and debt of the underlying companies and sectors, energy for example, has been a lucrative punt, but the big one has to be heart of the carousel. When the largest bond funds of the world start slugging it out to reduce their bond portfolio sizes, the equity of the likes of BLK, BEN and ALZ could be real juicy plays on the probability of the non-financial corporate debt binge going systemic. Central banks will come to the rescue, eventually, and the next big rounds of QE in the US will likely include corporate bonds, but we are far from such a point. First comes the panic, and it might not come next year, but when the Fed shakes the tree (and I think it will), apples rottening on the vine will be the first to hit the ground. 

If the notes above represent a working hypothesis for the sources of the next global financial panic, the portfolio remains broadly constructive. It has benefited nicely from the Santa rally, which arrived right on cue, and to boot, the biggest positions has had some real legs in the past week. Unless the world ends in Greece, this year should be very good indeed. Specifically, the position in Eurozone banks is holding up, just, but is trading poorly, and is starting to represent dead money given the uncertainty (and rising bullishness) for the first quarter. Elsewhere, it is all very much steady as she goes except for the performance of CNA which has been atrocious. Overall, in the next few months, I still think the market is about to show the bears just how effective divergent sector leadership can be in forcing a steady grind higher in global equity indices. 


Getting Late, but Still Time for a Drink ...

One of the most widely discussed themes in the plethora of "2015 outlooks" that have passed my desk is where we are in the cycle. In itself, the question yields a number of important limitations on the level of insight [1], but it is a logical narrative to impose on the current market environment. The financial crisis is a distant, but still-potent memory, and the sovereign debt crisis in the Eurozone has been put on hold, but still has the potential to wreck the "timeline" for most investors if it were to rear its ugly head next year. 

Without getting into too much detail, the vast majority of big sell-side research house focus on two overall themes. Firstly, we are currently mid to late in the cycle and a constructive stance on the economy and risk premiums/assets. This view varies from very bullish versions (JPM and DB) to more cautious stories (MS). Secondly, the cyclical divergence which has characterised asset prices and monetary policy this year is in its infancy and will remain a key theme next year. A continuation of the bull market in the dollar, strong global excess liquidity are but some of the obvious themes that can be derived from this view. 

My view in the nutshell is currently close to the consensus perception of global cyclical divergence and mid-to-late cycle dynamics in the OECD, which is slightly uncomfortable but I can't really force myself to deviate too much from it. Risks around such a relatively benign call are well-known; a revival of the Eurozone debt crisis, an accident in China, a panicking Fed crashing the US economy, a severe crisis in one or more of the most vulnerable EMs. But all of these have been covered, debated and perused to almost desperation. As a betting man, I would still put my money on a crisis in non-financial corporate debt markets as the next big crash that pushes the global economy into recession. It will probably be a confluence of EM corporate USD debt and corporates in the U.S./U.K. But the dollar probably has to rise longer and harder as well as the Fed probably needs to start inching up rates before the reality dawns on this sector. I reiterate that the increasing stress in the US high yield energy sector is an important, if also by now widely recognized, threat to watch next year. 

The alternative global panic scenario is really the one that is almost too painful to contemplate. A failure of Abenomics and a loss of faith in one of the major OECD bond markets which pushes up yields faster and more violently than central banks can and will act (or perhas a loss in confidence of central banks themselves). It could happen, but no need to go to work every day expecting to be run over by a bus. We kind of know how this will look too, and any signs of Tapering Tantrum price action in the U.S., the U.K, the Eurozone or Japan would force me to hit the bunker quickly. 

Meanwhile, it is getting late, but keep dancing. You still have time for a drink before the bar closes.


[1] - Asset price and economic cycles vary greatly across countries and markets and may even have seen a structural break since the crisis. I.e. the lenghth of the current cycle is an endongenous variable determined largely by the way you interpret the impact of the financial crisis and its long-run aftermath. Secular stagnation, full recovery etc.