Does geopolitical instability spell opportunity in European credit?

Does geopolitical instability spell opportunity in European credit?


“The market is still underestimating the possibility” of further fragmentation in the European political order, says Andrew Jackson of credit specialists Cairn Capital. But this volatility spells opportunity, he argues.

CHRIS HIBBERT: We’re here this afternoon with Andrew Jackson CIO of Cairn Capital. Thank you for joining us. So do you, Andrew, expect long-term political consolidation in Europe or further fragmentation after Brexit?

ANDREW JACKSON: One of the things I said the day before the referendum in the UK is that I thought the market was underestimating the possibility that we might vote to leave and I think the market is still underestimating the possibility that fragmentation will occur.

That said, it’s not my base case. I think the base case is still we carry on with this European construct. We just had a debate before the cameras were rolling about whether we’ll actually see Brexit. I don’t know what we’ll see but I think we will see further social unrest. I think we’re seeing that across the whole of Europe: it’s not just the peripheral states that are experiencing that.

But I think the possibility of more fractures is real.

CHRIS HIBBERT: Where you do you see the geopolitical fault lines really appearing? Italy just came up as something that really is going to be contentious in the next few months but are there any particular other hotspots that you think are going to flare up?

ANDREW JACKSON: We have elections all around Europe this year and next year. I think Spain is already shown itself to be a little fragmented. I’m surprised there hasn’t been more social unrest in Spain given the level of youth unemployment that we see there.

I think that France is a hotbed and it’s not just the headline-grabbing terrorism that we’re seeing in France. I think that France is not as united as it has been in the past. Not as united as those who love France as I do would like it to be. I think the Front Nationale – they’re a very dangerous group. I think that number of votes they will get next time is meaningful and we can’t dismiss that.

I mean it would be lovely for centrist people like myself – liberals in the broader sense of the word – to get rid of people like that but we have to acknowledge the fact that they are speaking for a large populace in Europe – that’s going to be Italy, Portugal, Spain, Greece…most likely the countries where they’re looking at what’s happening in Germany and thinking why isn’t that happening here?

Just look at the GDP per capita differential between Italy and Germany over the last five years and that will tell you why there’s more social unrest in Italy than there is in Germany.

Where should prudent investors be looking to weather political turbulence in Europe?

ANDREW JACKSON: I’m a credit guy, so If you ask the equity guy the sun’s always shining and for credit guys it’s always it’s about to rain. So I’m bound to sound bearish and you ask me questions to make me sound bearish, in the classic journalistic way. I have no problem with that. I’m happy to signal the things that I’m worried about.

But I think that it’s not just Europe, I think emerging markets and the US and Europe all have problems that they’re facing. But I do think there are a number of investments that are absolutely rock-solid despite what happens.

The way I think about my investment philosophy is that I look at all the different paths that we may take going forward. I don’t dismiss paths even though they might be relatively low probability events. I’m not designing a base case and saying that is what’s going to happen. I’m not naive enough to think that I can predict the future. But I am looking at all the potential outcomes and I’m saying that in the vast majority of potential outcomes the kind of things that we’re investing in will do fine. And actually there are a lot of really interesting trades and actually if we think about it…the ability to find trades in Europe…I think it’s actually easier than it has been for quite some time.

Bizarrely, as a result of what the ECB’s done. The ECB has driven fixed-income markets into negative yield territory but they’ve also created this big gap between the liquid and the less liquid: the simple and the complex. The space that we inhabit tends to be the more complex stuff, the less liquid stuff, the stuff that you have to really do your homework on and be comfortable that you can hold over a long period of time and in that space the opportunities are still there: maybe even more rich than they have been in the past.

And the volatility that we’ve seen over the last year, first as a result of what happened in terms of China and oil in November and December and then January and February of this year, then the volatility post-Brexit…they throw up more opportunities not less. Volatility is good for us in that it does give us opportunities to pick up some of these assets.

What strategies will be successful in a volatile European market?

ANDREW JACKSON: The best trade that you could have done over the last couple of years is just be as long as you possibly could with as much leverage as you possibly can on the stuff that’s most vanilla and boring because the European Central Bank has been buying all that stuff and they’ve driven yields into negative territory. The data coming out of corporate bond purchases that they’ve done suggests that almost a fifth of the bonds that they bought were negative yield and that’s…for me that’s a strange paradigm. They’re buying negative yielding assets but telling us everything is okay. You don’t buy negative-yielding assets because everything is okay in my opinion.

But that’s been the trade: buy investment-grade corporate bonds, buy the Bund…I don’t think that’s the trade going forward over the medium to long- term. I think the trade is to buy things that are more complex that have a richer yield and I think there are plenty of things out there for savvy investors…that’s maybe too strong a word for somebody like me, but for somebody who can who can tolerate mark-to-market volatility and looks over a medium to long term.

CHRIS HIBBERT: To what extent are you taking over territory that’s been rescinded by the banks?

ANDREW JACKSON: That’s a tough question to answer. I think banks have definitely changed what they do and will continue to change what they do as a result of changes to capital ratios and other things. I think there has been some disintermediation of banks post the financial crisis: I think that was something that regulators wanted. How much of what we do is stepping on a territory that they used to do? That’s a tough one tough one to call I think.

CHRIS HIBBERT: Do you think European politics will continue to affect the banking sector and by extension perhaps what you’re doing as well?

ANDREW JACKSON: Yeah I think it will. We’re sitting here the day after Mario Draghi had his press conference and he didn’t want to be asked about Italian banks but everyone wanted to talk about Italian banks, again. So yeah, I think European politics has a very big effect on banks.

I think that we will see European banks continue to go through this period where…the longer-term trend is improving capital ratios but the short-term trend scan be meaningful increases in nervousness around nonperforming loans in particular in Italy but capital ratios more generally. So I think European politics has a large part to play and how we deal with European economies…and European economies as Mario Draghi rightly pointed out yesterday, are powered by European banks.

That isn’t the case all over the world but the European economy is a banked economy and requires banks. It’s not nice for politicians to have to be nice to bankers. It’s really tough, but I think that banks are the method by which liquidity gets out to markets and by which entrepreneurs borrow and create jobs and create wealth.

So as much as politicians don’t like being nice to bankers and don’t like to be tarnished as accommodative to bankers…I think in Europe as Mario Draghi signalled yesterday we’ll have to do things that keep banks solvent and liquid and able to do what we need them to do which is to lend to corporates.

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