Brevan Howard Global June Letter: The external sector presents the greatest threat to the US economyVW Staff
Brevan Howard Global Limited commentary for the month ended June 30, 2016.
Q2 2016 Portfolio Update
The information in this section has been provided to BHG by BHCM.
The BHG USD shares appreciated by 1.32% (net of fees and expenses) in the second quarter.
The bulk of the profits were generated in credit and interest rate trading. In credit, the Fund benefitted from recovery in a number of corporate high yield and distressed positions, in particular within the energy space. Additional gains arose from other credit exposures including structured finance legacy positions (i.e. bonds issued prior to 2008). In interest rate trading, tactical and relative value trades as well as strategic long exposures in USD, EUR and GBP were the main contributors.
Additional small gains arose in FX trading. Gains from FX volatility trading and short exposures to EUR and GBP against USD were partly offset by long exposures to commodity related currencies including AUD and MXN during the early part of the quarter.
Tactical trading in equity indices, and to a lesser extent commodities, were detractors over the quarter.
Systematic trading had a negative quarter despite a strong recovery during June. The bulk of the gains arose from long exposure to global bond markets. The gains were more than offset by losses in other asset classes. In FX, a short exposure to USD against a basket of currencies including AUD and EUR at the beginning of the quarter generated losses. Additional losses arose in equity indices and commodities.
The Investment Committee (“IC”) increased the Fund’s allocation to the DIP to approximately 50% during the quarter. The DIP has been the main positive contributor during the second quarter and for the first half of the year. Allocations to BHA and BHMF were reduced over the period.
Portfolio Update for Brevan Howard Global
The information in this section has been provided to BHG by BHCM.
Monthly, quarterly and annual contribution (%) to the performance of BHG USD Shares (net of fees and expenses) by asset class*
Monthly, quarterly and annual contribution (%) to the performance of BHG USD Shares (net of fees and expenses) by strategy group*
Quarterly and Annual Contribution (%) by Underlying Allocation as at 30 June 2016
BHG Underlying Investment Exposures as at 30 June 2016 (allocations subject to change):
Allocation Changes as a % of NAV as at 30 June 2016 (allocations subject to change):
Exposures by Asset Class as at 30 June 2016 (exposures subject to change):
Exposure Changes as at 30 June 2016 (subject to change):
Monthly Performance Review for BHG
The information in this section has been provided to BHG by BHCM.
BHG Monthly Commentary
The NAV per share of BHG’s USD shares appreciated by 1.71% and the NAV per share of BHG’s GBP shares appreciated by 1.46% in June 2016.
Monthly Performance of BHMS Underlying Allocations*
Brevan Howard Master Fund Limited (“BHMF”)
The NAV per share of BHMF Class Z USD shares appreciated by 1.12% in June. Gains in interest rate trading were predominantly generated from long directional positioning in European and US rates as well as long positions in Japanese and UK interest rate volatility. European swap spread and peripheral bond trading also contributed modest gains. Gains in FX trading came from directional trading of a broad range of currency pairs including GBP, EUR and BRL, and from associated moves in implied volatility. Equity trading losses came from tactical positions in Japan and in Europe.
Brevan Howard Asia Master Fund Limited (“BHA”)
The NAV per share of BHA Ordinary USD shares depreciated by 0.04% in June. Losses in interest rate trading came mostly from long volatility positions in US rates partially offset by gains from curve trading in Korean rates. FX trading generated losses from a long USD theme against JPY and several other Asian currencies. Equity gains came predominately from the decline in US equity volatility via long positioning in put options on the VIX.
BH-DG Systematic Trading Master Fund Limited (“BHDGST”)
The NAV per share of BHDGST Class Z USD shares appreciated by 5.51% in June. June saw positive returns in all sectors excluding energies and equities. Bonds were the top performing sector and contributed substantially to overall returns, resulting in increased risk in this sector. In STIR markets, the model reverted net short positions in Canadian Banker Acceptance and Eurodollar futures into longs. In indices, the model took a more bearish stance overall. In currencies, the model’s position in GBP flipped between long and short several times as Sterling saw increased volatility leading into and post the UK’s Brexit referendum. Exposure in energy markets was largely reduced in June. The model reduced short positions in LME base metals and flipped a short position in aluminium to long. In precious metals, longs in gold and silver futures were substantially increased as prices broke out on safe-haven buying.
Direct Investment Portfolio (“DIP”)
The Direct Investment Portfolio (“DIP”) appreciated by 1.82% in June. The DIP generated the bulk of the profits in credit, FX and interest rate trading. In credit, most gains arose from long exposure to residential mortgage backed securities originated by Countrywide following the settlement of a court case in favour of the bondholders. In interest rates, long exposures in EUR, USD & GBP were the main positive contributors. Additional gains were generated in FX where the DIP benefitted from higher volatility and a modest short exposure to GBP against the USD. Some of the profits in DIP were offset by tactical trading in equity indices. Commodity trading was flat for the month without any significant exposures.
Manager’s Market Review and Outlook
The information in this section has been provided to BHG by BHCM.
Economic activity picked up in June. Hiring rebounded smartly after having stalled in May, allaying concerns that the labor market was sliding unexpectedly into recession. Taking the longer view, employment gains have slowed from a rapid pace. In the first quarter, employment expanded nearly 200,000 per month and, in the second quarter, the monthly pace was approximately 150,000. Economists’ estimates of the long-term sustainable increase in employment range from 75,000 to 125,000 per month, so the current gains still represent moderate progress in absorbing slack. At the same time, the unemployment rate rose to 4.9%, but part of the increase was accounted for by a rise in job seekers. Wages appear to be increasing moderately, which is impressive compared with lacklustre productivity growth but disappointing compared with prior business cycle expansions.
Real consumption spending increased by approximately 4% annualised in the second quarter. In particular, retail sales accelerated, led by brisk online sales, but motor vehicle purchases cooled. Business investment continues to languish. Indicators suggest that spending on equipment, structures, and intellectual property like software and research and development are all weak. For example, orders for nondefense capital goods excluding aircraft contracted in the first two months of the second quarter and are running below the level of shipments, a negative indicator of future demand. Various business surveys and anecdotes point to similarly cautious business sentiment toward capex.
Inflation trends have been little changed. Core Personal Consumption Expenditures (“PCE”) inflation is running at 1.6% with overall inflation somewhat slower. If the exchange value of the US Dollar and energy prices stabilise, inflation should firm in the second half of the year. In the meanwhile, one of the most remarkable features of the inflation landscape is that the Federal Reserve (the “Fed”) has consistently missed its 2% inflation target during the expansion. Perhaps as a result, inflation expectations appear less well anchored. Market-based measures of inflation compensation are near record lows and surveys of consumers suggest inflation expectations are trending down, although the latest monthly readings have bounced.
The external sector presents the greatest threat to the US economy currently. Although Brexit passed with little spillover to the US, the political roadmap for both the UK and the European Union remains highly uncertain. Such uncertainty may ultimately have no significant impact on the US economy. However, risk management suggests the best course of action is to wait and see before deciding one way or another. It’s still early days, but the Fed appears to be following this script. With still-solid fundamentals, the removal of policy accommodation appears warranted. However, with unthreatening wage and price inflation and unsettled international conditions, the Fed can afford to be cautious and patient in deciding the timing of the next rate increase.
The UK voted to leave the European Union in the referendum on 23 June, with 51.9% of voters choosing to leave, versus 48.1% who wanted to remain. Prime Minister David Cameron, who campaigned for the UK to remain in the EU, subsequently announced his resignation and has been replaced by Theresa May as Prime Minister. Cameron has left it to his successor to enact Article 50 of the Lisbon Treaty, which would commence the legal process of the UK leaving the EU. Until then, there is no legal requirement for the UK to leave the EU. Moreover, only once Article 50 has been enacted will EU officials begin discussing both the terms in which the UK can leave the EU, as well as negotiations regarding the UK’s access to the single market.
Economic data, prior to the Brexit vote, was already soft in part due to the uncertainty created by the referendum. Manufacturing output had experienced a slow-steady downward decline over the year to March, falling -2% y/y. In April, however, manufacturing output rebounded by 2.3% m/m. The outlook for the manufacturing sector is mixed as the recent fall in the currency should support growth in exports, but at the same time, the uncertainty caused by the Brexit vote will deter investment. The construction sector has struggled in recent quarters, barely growing over the past year. Furthermore, the construction PMI fell 5.2pts to 46 in June, reaching the lowest level since 2009, suggesting a fall in activity is to be expected. Retailing has remained relatively robust. Indicators on the services sector suggest that the rhythm of activity will moderate markedly. The housing market appears to have softened in recent months – although prices remain relatively robust, surveys on activity have softened considerably, likely a result of both the tax changes made in April as well as referendum uncertainty. The unemployment rate hit a new low in April, reaching 5%, however, the recent increase in jobless claims suggests that the unemployment rate may begin to rise again. In May, headline inflation recorded 0.3% y/y, with core inflation at 1.2% y/y, both well below the Bank of England’s (“BoE”) inflation target of 2%.
So far, there is little economic data available that reflects the state of the economy post the Brexit vote. However, due to such monumental economic and political uncertainty, the UK economy is expected to slow markedly. Reduced demand via a shock to confidence may be in part offset by the sharp fall in the exchange rate. However, in turn, the lower exchange rate will put upward pressure on the price of imported goods, lifting inflation. The BoE Governor, Mark Carney announced interest rates will remain on hold at the historic low of 0.5% for the foreseeable future following the July Monetary Policy Committee meeting (“MPC”). Looking ahead, the medium to long-term outlook of the UK economy will fundamentally depend on the decisions made regarding the UK’s relationship with Europe and its access to the single-market. However, for now, growth is likely to be subdued on account of significant political and thus economic uncertainty.
Incoming data in the euro area have been consistent with a deceleration in growth in the second quarter after a good performance in Q1, mostly driven by domestic demand and favourable one-off factors. Industrial production (“IP”), construction, retail sales and car registrations are all slowing following the overshooting in the first quarter of the year. In May, IP was subdued, especially in Germany, falling substantially by 1.3%, also reflecting further contraction in construction activity. The June Purchasing Managers’ Index (“PMI”) surveys have indicated a further moderation in growth at the beginning of the summer driven by retail, construction and business services, while activity in manufacturing improved. Meanwhile, the labour market continued its gradual downward adjustment, with the unemployment rate falling at an average pace of 1% per year to 10.1% in May for the EMU as a whole, the lowest level since August 2011. Looking at prices, inflation remains stubbornly stuck at low levels – the euro area Harmonised Index of Consumer Prices (“HICP”) inflation rate remained close to zero in June (0.1% y/y, up from -0.1% y/y in May), with core inflation at a mere 0.9% y/y.
In response to the UK’s unexpected decision to leave the EU, European Central Bank (“ECB”) officials stated that uncertainty could partly reverse the recent economic recovery, while they needed to “wait a little bit to see if we need to respond.” The ECB allotted its first TLTRO-II operation at the end of the month. While the bank’s gross take-up stood at EUR39bn, it included rolled liquidity from previous TLTROs, meaning the net take up is estimated to be much smaller at around EUR30bn, at the low end of expectations. At the same time, corporate bonds purchases under the ECB Quantitative Easing programme started on 8 June as planned, with cumulative assets purchased totalling EUR6.8bn as of 1 July. The ECB has already bought more than a trillion Euros’ worth of assets under its Expanded Asset Purchases Programme which started at the end of 2014, while inflation continues to be far from its target of “below but close to 2%”. The volatility created by the UK referendum induced renewed concerns about the state of banks in Italy, where the government is trying to find an acceptable deal with the EU in order to manage the large amount of non-performing loans without imposing a too large burden on creditors in light of the European state-aid regulations. On the legal side, the German Constitutional Court cleared the ECB’s Outright Monetary Transactions (“OMT”) programme in its final ruling, stating that the programme was legal provided certain conditions are met. More locally, the re-run of the elections in Spain saw Prime Minister Mariano Rajoy's Popular Party coming in at first place again, gaining 137 of the parliament's 350 seats, compared with 123 in the December 2015 elections. However, the elections still left him without a majority and the same difficulty he faced trying to form a coalition government after December. The Socialist Party came in second place with 85 seats (compared with 90 in December). Anti-establishment left-wing Unidos Podemos obtained 71 seats, the same result as in December.
Activity data in China in May/June showed mixed signs. In June, the official Purchasing Managers Index (“PMI”) came out in line with expectations but the Caixin PMI fell from its prior figure to 48.6, with a fall in both orders and in their ratio to inventories. IP growth rebounded from 6.0% to 6.2% y/y, exceeding consensus forecasts. On the demand side, while retail sales accelerated, Fixed Asset Investment (“FAI”) growth continued to slow on the back of further moderation in private investments. Trade data indicated a monthly drop, on a seasonally adjusted basis, across both imports and exports. Overall in Q2, GDP growth improved relative to Q1, rising from 1.2% q/q to 1.8% q/q, above the market consensus, although it remained stable in y/y terms at 6.7%. The People’s Bank of China (“PBoC”) has maintained a neutral monetary policy stance so as to support a recovery: the 7-day repo rate has been maintained at about 2.4% for the past month, while credit data, after showing some payback in April and May following a strong expansion in Q1, surged again in June. Still, Total Social Financing growth remained strong at 16.5% y/y in May. Investments in infrastructure and investment by State Owned Enterprises (“SOEs”), both a gauge of policy-driven growth, rebounded further in May. FX reserves in June increased by US$13.5bn, exceeding market expectations.
Economic activity in Japan appears to be drifting at the modest pace seen recently. IP continues to decline and it fell sharply in May, however, IP is a volatile series and the decline mainly puts the index back on its trend. Survey data were mixed but qualitatively unchanged. The Tankan index of actual results for all industries dipped 3 points in the second quarter but remained positive, while the forecast for the third quarter inched up. The Shoko-Chukin survey of small and medium enterprises moved up, though only to the relatively subdued levels seen in 2015. The Economy Watchers survey declined from an already weak level.
Inflation measures continue to disappoint relative to where they need to be in order to reach the Bank of Japan’s (“BoJ”) 2% goal. Western core prices (the CPI excluding food and energy) for Japan as a whole were flat in May on a seasonally adjusted basis and have only edged up 0.1% over the last six months. Unless they accelerate, the 12-month change at 0.7% will decline once the solid increases seen in the summer of 2015 drop out of the calculation. The Tokyo western core rate ticked up in June, but it too is up only 0.1% over the last six months. Forward-looking indicators look worse. The yen appreciated sharply against the dollar throughout June; the 14.5% appreciation over the first half of 2016 erased almost all of the depreciation seen over the second half of 2014 that had contributed significantly to the earlier acceleration in consumer prices. Meanwhile, consumer inflation expectations fell in June to their lowest level since January 2013.
Despite the ongoing deterioration in the inflation outlook, the BoJ left policy accommodation unchanged at its mid-June meeting. There is some thought that the BoJ was waiting to see the fallout from the Brexit vote. If true, however, it sends a bad signal that the BoJ thinks its ability to increase monetary accommodation is limited. That would contradict Governor Kuroda’s denials that there is such a “quantitative limit”.
Upper House elections were mixed in their implications for fiscal and structural reforms. Prime Minister Abe’s Liberal Democratic Party (“LDP”) and coalition partners added upper house seats, which should make it easier for Abe to argue that he has a mandate and to mechanically pass legislation. The LDP itself, however, just fell short of winning a majority, which would have strengthened its hand within the coalition. Including a number of like-minded smaller parties that won’t be part of the coalition government, forces that favour amending Japan’s constitution now have the needed two-thirds “super majority” to initiate a constitutional referendum. Some analysts worry that the government’s focus will shift exclusively to amending the constitution, but that’s clearly not the case presently. It appears that there is popular support for some changes, but not nearly enough support for overturning the so-called pacifist Article 9. Abe may merely tailor his efforts towards what is potentially feasible now rather than spend all his political capital.
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