markets

Charlie McElligott – Food For Thought

Dropping the overnight cacophony of noise out of UK Brexit rulings, ECB headlines and US poll updates…I want to instead discuss trader mindset over the past week and into next week and thereafter.

 

ELECTION SCENARIO FEEDBACK: I have spent the vast majority of the past week engaging some of our brightest clients in my feedback loop on (completely unsurprisingly) US election scenarios.  Here are a few key bulleted observations:

 

–Overall largest take-away was that this de-risking in stocks has been so orderly and grinding due to the buyside’s lessons from underestimating Brexit possibilities in June, EVEN THOUGH the odds are still in the favor of the perceived “market positive” HRC outcome.  This de-risking is thus a “slow-bleed” and not a panic-grab, as Brexit was much closer to a true “toss up” going into the vote, versus this still likely ’70 / 30’ probability for HRC.  Recall, folks were taking nets HIGHER days into that event-risk.  As you’ll see below, the performance of thematic baskets in my monitor yesterday shows that longs have been taken-down rather precipitously (although somewhat surprisingly that some shorts are currently being added to as highlighted in recent days).  I would add another complication is the timing with “peak earnings” idiosyncratic risk, which has been showing us a number of outsized price reactions, and as such is adding to an overall desire to ‘gross down’ over the longer past week time frame.

 

From a vol perspective, for net exposure at HFs to be cut so low so fast, and for cash to be so high now at MFs heading into the event, it makes some sense to me that there is less “panic grab” for VIX upside simply because folks aren’t all that long / don’t have that much to protect now.  That said, there are certain products and lines where the vol is rich and straddles are pricing in some large moves which I will touch-on later.  And also pretty simply, as VIX is calculated based upon 4th and 5th week SPX options strip…and as this is a ‘one week out’ event, it’s just not being “picked up.”  Thus “VOL OF VOL” (VVIX, convexity) is showing far greater relatively movement than the “underlying” VIX.  As such, “vol of vol” is probably the best sale of all (sell VIX straddles).

 

–Outcome-wise, all were of consensus view that you can now throw-out the ‘risk’ of a Democratic sweep…a scenario that was a very real threat as of last week at this time.  Too much momentum has been lost in the past week.

 

–Ironically (with regards to the swing from one end of spectrum to other), there now is a view that the seeming momentum in the Trump camp could actually create a scenario that was previously “zero delta” which is now a “non-zero” probability of a “Trump Presidency / GOP Congress” regime could produce a “right tail” economic scenario–where the tax plans and deregulation movements could get more economically provocative for both individuals and small businesses.  Again though, this remains low probability.

 

There was a relatively widespread view that in the case of an HRC win (where the probability was perhaps ‘down to’ 60 / 40 yday, although some might say that lack of further surprises and even stabilization per the new earlier-referenced WaPo tracking poll would see that more like a return to 70 / 30 odds in her favor as of today), that there might be a +2% upside from here on a relief-rally, as markets would essentially claw-back what has been lost over this very calm de-risking bleed. 

 

–There was dissent on “where to from there (an HRC win)” as a number of folks are pushing outright “return to bull market” case—with this moving from a ‘rates / monpol’ focused equity backdrop transitioning to an ‘earnings-driven’ one.  My pushback there remains that earnings probably haven’t moved the needle enough to re-rate stocks against the headwind that comes in the form of higher rates and their impact on the ERP.  Equities still feels “stuck” to me, even after a likely ‘relief rally.’

 

–Regarding a Trump win, there was some debate on the next day SPX drawdown (-2% to -3% was the general ‘max’ view, with one outlier -5%), but nearly all agreed that there was a desire to ‘buy it.’  One would come from perceived “Brexit FX benefit,” i.e. that if the Dollar re-rated rapidly lower (essentially a devaluation) that US exporters would see the equivalent benefit (which was what we saw with Brexit and FTSE of course).  The other inputs here are of course the “steroid shot” of both the tax cuts on consumption / demand, the potential for de-regulation, and of course the GDP-kicker that is a massive deficit-spending infrastructure build program.  Other views are too that if bonds were to rally on “risk off” that it makes sense to sell it (especially with the growthy / inflation-inducing policy to come), while others thought that any USD kneejerk lower should also be bot on account of longer-term potential repatriation of overseas corporate cash (part of Trump platform during election), as well as potential for big data looking a year out under the regime.  That said, all were in agreement as to the eventual very bad hangover to follow from this debt binge while cutting tax receipts and not touching entitlements.

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So outside of this feedback exercise….what is always a trade of interest to me is a ‘risk reversal’ or generally asymmetrical ‘skew buying power’ trade with stock index (selling one 10% otm SPY put to finance a buy of almost 19 10% otm calls!!!) into an environment where there is a rush for protection…as evidenced currently by the front-end of the VIX curve inverting, with Nov over Dec now.  Add in the overall portfolio de-risking we have been seeing, high cash / low net exposures, rapidly collapsed sentiment as contrarian ‘bullish’ indicators—in conjunction with ‘positives’ like a pick-up in global growth (Manu PMIs) and earnings trajectory—and it seems like a pretty obvious set-up for a ripper of a rally following the election.
But here is where I struggle with this idea of “fitting” a further rally into Q4: I am increasingly concerned that a relief-rally following an HRC election scenario might be somewhat short-lived due to so much overhang: outstanding FBI investigations in the air and legal noise on ‘contesting the vote’…i.e. this isn’t going away.  I also think that if you look at the ‘windows’ to put on ‘pro-risk’ trades between now and year-end with the US election (and whatever follows), the Dec Fed hike determination, the Italian referendum, now the British Supreme Court “Brexit / Article 50 Appeal” et cetera, you end up with a lot of idiosyncratic event-risk for a fragile buyside psycheThe sequencing and thus the risk / reward isn’t extremely compelling attractive.  When I then add this to anecdotal feedback from many funds I speak with, who are verbalizing a desire to ‘end the year now’ and ‘protect gains’ (predominantly made in Q3 to get back into “up mid-single digits YTD”), I just don’t know how much willingness there is to chase or put on new risk.  That said, surviving and starting a new year ‘fresh’ in Q1 WOULD be a new opportunity to pivot more ‘risk proactive’ again. 

 

One observer at a macro dinner I participated in last night stated that although he understood this view on “Q4 rally reticence,” he also thought that that same Q3 performance claw-back which got many funds back to “up lower to mid-single digits” YTD has now seen a couple percent shaved off of that with the friction “getting out” over the past week.  As such, this person believed that funds sitting near zero then WOULD BE candidates to prep for performance chase into this “seasonality / buyback resumption / election relief / under-positioning / over-bearishness” rally scenario. 

 

It’s all food for thought.

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Third Point 2016 – Letter/Outlook

Third Quarter 2016 Investor Letter Review and Outlook

 

Third Point returned approximately 5% during the Third Quarter, outpacing the S&P 500 index by 1% and the CS Event-Driven index by 2%, with approximately half the net equity exposure. Results were driven by profits in each of our sub strategies – Equities, Sovereign and Corporate Debt, Structured Credit, Risk Arbitrage, and Privates – and also in each geographic area in which we invest globally. We generated alpha in each month of Q3. Despite a difficult year for hedge funds generally and a challenging start to the year for us, we have delivered positive returns for the year to date.

Our results have been driven by a number of idiosyncratic opportunities that we have invested in over the past six months and we see more of the same types of ideas in our pipeline. Trading and portfolio construction have required a strong constitution this year. The “haunted house” market coined by the late JP Morgan legend Jimmy Lee over 18 months ago has continued throughout this year with a constant string of macro “surprises.” A significant share of our time is spent deciphering the chatter to identify the most relevant “key” that will tip market risk and adjusting positioning accordingly. This year, our research led us to transition away from the short China / long Dollar bet in mid-Q1 and go long energy credit and out-of-favor industrial commodities-related equities. Later in the year, we responded to Brexit by covering shorts during the post-vote panic and increasing long exposure.

Today, we are focused on a few key areas: • Understanding the global shift from monetary to fiscal policy: monetary policy’s effectiveness is waning, which will impact bond yields. This influences our overall views of market valuation as well as sector allocation considerations. 2 • Will fiscal expansion become the new world order? While it seems logical and timely, it is challenging considering the very high debt to GDP levels globally. However, fiscal expansion could be an antidote to rising populism around the world which might smooth the way towards stimulatory infrastructure measures at home and abroad. One caveat is that not all countries have the flexibility to pursue such measures. • While China has fallen temporarily off the radar screen, we still see reasons for concern. The stabilization in economic activity has come at the cost of increasing leverage and a potentially overheated housing market. Political change next year may also result in increased volatility.

• We are clearly in the late stages of a business cycle following an eight year (tepid) expansion. While we do not forecast a financial crisis or a recession, a clear path to growth seems elusive. Consumers have been reducing spending and businesses have never regained their pre-2008 capital investment levels. We might soon long for 2% GDP growth. • Earnings have stalled for a few years and while this can be partially explained by falling oil prices, a strong dollar, weak global growth, and flat margins, earnings estimations may be inflated at these levels. This last observation dovetails with both the opportunity and the challenge we face investing today. We have seen a return to a “stock-pickers” market this year. However, that term does not mean what it did fifteen or twenty years ago when we were in our infancy. Then, picking stocks could be done in a virtual bubble and all of our time was spent deep in financial statements.

While our analyst team still spends the vast majority of its workday analyzing fundamentals, getting overall portfolio positioning right is equally essential to generating returns. The macro considerations discussed above must be interpreted correctly and applied successfully. When we add in the use of data sets and “quantamental” techniques that are increasingly important to remain competitive while investing in single-name equities, it is clear that our business is rapidly evolving. 3 We often focus on disruption when generating investment ideas; just as Uber has disrupted the taxi and car rental industries, Amazon has changed retail, and Facebook and Google have altered the print media business, disruptions are also changing investing. While some doors have closed, others are opening. We believe that maintaining our opportunistic and nimble framework has allowed us to transition successfully into this next phase. Our democracy has also been meaningfully disrupted this year.

Social media, primary processes built for the pre-internet era, and illegal foreign cyber-attacks have changed the trajectory of our political system. We try to analyze all of these political and economic events in a dispassionate manner, separating our feelings from what we think the impact will be on the economy, markets, and certain industries. Maintaining such emotional distance has been particularly difficult during the most disappointing and bizarre election in our country’s history. While many important issues affect the next president, from the appointment of a Supreme Court Justice to policies on education, healthcare, immigration, and the environment, we are focused on a few basic questions: What can we expect for economic growth in the coming years and do we face a recession? What is the prospect for monetary policy and where can we see long and short term rates? What impact will rates, productivity changes, and earnings expectations have on multiples? It is too soon to have answers to these questions and we may see surprises on Election Day.

Our short-term base case is for more of the same. This translates into a decent environment for Third Point to find special situations in equity and credit markets and make long-term bets on outstanding companies. Quarterly Results Set forth below are our results through September 30, 2016: Third Point Offshore Fund Ltd. S&P 500 2016 Third Quarter Performance* 5.0% 3.9% 2016 Year-to-Date Performance* 7.2% 7.8% Annualized Return Since Inception** 16.0% 7.4% *Through September 30, 2016. ** Return from inception, December 1996 for TP Offshore Fund Ltd. and S&P 500. 4 Portfolio Positioning Credit Update: Dell and Sprint In addition to Argentine sovereign bonds and energy-focused credit, we have also profited this year from several opportunities to add performing corporate credit exposure. Performing credit is interesting to us from time to time; we typically search for total return opportunities rather than screening only for yield.

We will often look for longer duration bonds in a company we believe has a visible catalyst for an improvement in its credit profile. We are able to create these dislocated positions quickly – before the market catches up – by building on deep fundamental research performed by our sector specialists who work in conjunction with our dedicated credit team. Dell Inc. and Sprint Corp. are two examples that have stood out as top winners this year. During the Second Quarter, Dell announced a large bond issuance to finance the acquisition of EMC Corp. While the Dell issuance is not a situation that would traditionally be popular with event-driven or distressed credit mandates, we believed market dynamics led the deal to price ~200bps wider than where we valued the bonds. Following its own LBO in 2013, Dell significantly improved its business through a variety of operational improvements and cost cutting initiatives. We believed the company would follow a similar playbook with the EMC acquisition and that the pro forma company would be a market leader in several areas including external storage, integrated infrastructure, and server virtualization software.

Dell has stated a goal of achieving investment grade ratings within 18 – 24 months of the acquisition, setting a path to tightening in long duration bonds and to attractive returns for our portfolio. Sprint has been another of our best performing investments this year. We were able to initiate our position at an attractive entry point in Q1 amidst the energy-driven dislocation in the credit markets and after the bonds were downgraded in February over concerns about Sprint’s near-term corporate debt maturities. We believed we were protected on the downside since the company has minimal outstanding senior or secured facilities and could likely issue new bonds higher in the corporate capital structure to refinance the pending 5 maturities. The company is also continuing to improve its business by strengthening the network in key areas, growing the subscriber base, opportunistically incorporating strategic partnerships, and executing an attractive cost of capital cycle.

Private Investments Third Point Ventures (“TPV”) was created in 2000 and currently invests in Technology, Healthcare, and FinTech companies at various stages. TPV receives all of its capital from Third Point’s funds and does not currently take outside dedicated investments. TPV’s aim is to produce superior risk-adjusted returns while adding perspective, ideas, and insights to Third Point’s general research efforts. We have found that being able to invest across the arc of a company’s life, from start-up through each stage of growth to pre-IPO funding rounds, has enhanced investor returns by exposing us to innovative new companies and thinkers. Our role as board members of these companies has introduced us to other Silicon Valley leaders, broadening our network and deepening our knowledge. While our two full-time TPV employees sit in our Menlo Park office, private investments have been sourced throughout the firm across our technology, ABS, distressed, and healthcare teams in New York. We have a significantly higher bar for such investments given their restricted liquidity and have limited overall fund exposure to 10% of NAV.

Of the 41 TPV investments made to date, 14 generated positive returns upon exit and 21 are currently active. Our current portfolio consists of 12 Technology investments, six Healthcare investments, and three FinTech investments. Privates currently represent ~6% of total portfolio exposure and we expect two of our larger investments to IPO in the next 18 months. Two of our portfolio companies, Apigee Corp. and Akarna Therapeutics Ltd., have contributed to returns this year and we have included more information about them below. Apigee TPV initially invested in Apigee in July 2008 when the company was known as Sonoa Systems. The company originally targeted their hardware appliance-based technology at Systems Oriented Architecture (SOA), challenging the industry-leading IBM as enterprises 6 quickly developed to connect application elements over networks. After recognizing in 2010 that there was a transformational opportunity to apply Sonoa’s core technology, Third Point Ventures helped the company rebrand itself as Apigee and pivot to a focus on enterprise digital transformation via a software platform for APIs (Application Programming Interfaces).

Since then, APIs have become the highway for the fast-moving digital economy. Apigee’s industry-leading API platform enables enterprises to meet the demands of customers with scalable and flexible digital technology. API platforms allow businesses to increase innovation while adapting to highly variable customer needs by securely providing shared data and services. The Apigee Edge API Management Platform connects digital experiences in a secure environment. Apigee’s API platform delivers analytics, security, developer portals, monetization, and policy enforcement. Since 2010, over 300 leading global enterprises have selected Apigee to enable their digital business, including more than 30% of the Fortune 100, four of the top five Global 2000 retail companies, and five of the top ten global telecommunications companies. The benefits of interacting digitally drive a large market opportunity. Forrester predicts that U.S. companies alone will spend nearly $3 billion on API management by 2020. Apigee now employs approximately 400 people. Drawing investors with its attractive growth profile, Apigee completed a successful initial public offering (NASDAQ: APIC) in April 2015. On September 8, 2016, Google announced their intention to acquire Apigee for $625 million in cash. Pending approvals, the transaction is expected to close later this year. Over an eight year period, TPV steadily assisted and guided the company as we invested in the Apigee Series B at $25 million valuation and the Series C, D, E, F, G, and H financing rounds before buying into the IPO. We have not sold shares and have remained active on the Board continuously since our first investment. Following the conclusion of the pending transaction, Apigee will have generated an IRR of ~20% and a multiple of invested capital of 2.4x. 7 Akarna Therapeutics TPV was a founding investor in Akarna in Q1 2015. Akarna focuses on the treatment of Nonalcoholic Steatohepatitis (NASH), also known as fatty liver disease. Akarna was attractive for several reasons: