The first full work week in September in the U.S. kicks off with a series of divergent factors in the background. This weekend for the first time, a poll of Scottish voters showed separatists pulling ahead with a majority in the run-up to Scotland’s September 18 referendum on whether or not to secede, causing selling pressure for the U.K. pound. Chinese trade data released today told very different stories for external and internal demand in the nation that has been an engine for global growth for over a decade, sparking concerns for trading partners that growth in the world’s most important market for raw materials and industrial supplies remains fragile. In equity markets, a growing chorus of strategists argue that despite historically high valuations, the present bull market can extend into next year as the U.S. economy strengthens and accommodative policies remain in place across the developed world. Contrarians are also making their case, with the upcoming massive Alibaba IPO making a compelling argument that markets have reached a peak. Perhaps the most sinister divergence weighing on market sentiment as the week kicks off is the report of continued fighting in eastern Ukraine despite the announced cease-fire deal between Kiev and Moscow.
German exports soar. Seasonally adjusted trade data for July showed exports rising 4.7 percent over June. Import levels contracted by 1.8 percent for the month, pushing the total adjusted trade surplus to €22.2 billion ($28.7 billion). Taken in aggregate with positive surprises for industrial production and new-order indicators released last week, this new point of data bolsters the case that the European Union’s largest economy is regaining momentum.
China announces a record surplus. Chinese exports rose sharply in August according to a release today from the country’s General Customs Administration release this morning, with shipments to Europe and the U.S. as primary drivers. Total exports registered a 9.4 percent year-over-year expansion, down from 14.5 percent last month while imports contracted by 2.4 percent from the same month in 2013, compared to a 1.6 percent drop in July, leaving a record trade surplus of $49.8 billion. The slack pace of goods arriving from abroad is another possible signal that the nation’s economy is cooling in some segments, notably some heavy industries, even as improving conditions in the U.S. and elsewhere sustain healthy external demand.
Is Abenomics stalling out? Revised second-quarter 2014 gross domestic product data released in Japan this morning registered a marginally steeper contraction of an annualized 7.1 percent, a larger slump than anticipated by most forecasters and the largest drop off in activity in five years. The new release saw personal consumption levels adjusted downward for the period as the April sales tax weighed on household spending. A major political challenge facing Prime Minister Shinzo Abe’s administration will be pressing ahead with a controversial further tax increase scheduled for next year as the nation grapples to pay down massive debt levels. While administration officials have commented in recent weeks that a further increase in taxes will be paired with fresh stimulus programs, without a rebound in overall activity in the coming quarters the plan may be viewed as untenable.
U.S. household debt expected to grow. The U.S. Federal Reserve is scheduled to release U.S. July consumer credit data today at 3 pm Eastern. Consensus forecasts see an increase to $17.4 billion from a prior $17.3 billion. There was a significant expansion in June in nonrevolving debt, driven largely by automotive financing and student loans, extending a trend driven by improving economic fundamentals. With retail sales and consumer sentiment data for August scheduled for release later this week, the health of the U.S. consumer will remain in the spotlight for market narratives.
Portfolio Perspective: Capital Structure Arbitrage as a Credit Portfolio Hedge — Craig Kelleher and Brian Connolly, Millstreet Capital Management
Capital structure arbitrage is a cost-effective way to express a negative view on a credit versus an outright cash short, because a capital structure arbitrage trade allows weakening fundamentals to play out as opposed to timing the market. By going outright short on a 10 percent coupon bond, a manager could be right on the fundamentals and see the bond trade down ten points over the course of a year. But the fund would have made no money for investors due to the cost of carry. This makes timing a critical aspect of an outright short. Instead, through capital structure arbitrage, a manager is able to express a negative view on a credit by going long more senior debt and short more subordinated debt within the same capital structure while minimizing the carry cost of the trade.
Our capital structure arbitrage trades are always intradebt; that is within the same capital structure and always debt versus debt, which differs materially from pair trades, basis trades, or debt versus equity because we want the correlations to be as high as possible. We also analyze covenants to understand potential restrictions from both a long and short perspective and match durations as best we can in order to limit our downside in the event of an early tender or call.
With capital structure arbitrage, the overall cost of each trade is much lower than for cash shorts given the netting effect of the coupon differential. Thus timing on the capital structure arbitrage trades becomes much less of a factor, and we believe we can make money two different ways — when these companies falter on their own due to high leverage and weak fundamentals or if the market trades off and spread differentials return to more long-term averages.
Capital structure arbitrage trades provide us with a meaningful portfolio hedge on our portfolio.
Craig Kelleher is co-founder and chief investment officer and Brian Connolly is co-founder and portfolio manager of Millstreet Capital Management, a Boston–based investment adviser.
