As an associate director at Pacific Alternative Asset Management Co., Sam Diedrich is understandably concerned by developments in the European Union. After all, the Irvine, Calif.-based firm runs funds of hedge funds with roughly $8 billion in assets under management, assets that will feel the fallout of the troubles.
Diedrich believes investors are currently preparing for three potential resolutions to the current sovereign debt crisis and he took time recently to analyze these potential outcomes—and the ways in which investors are positioning for them—for FINalternatives Senior Reporter Mary Campbell.
You see three possible outcomes to the European crisis currently motivating investors. The first is “mutualization of debt.” Can you tell me something more about that?
This is where the European Union would band together and form stronger fiscal ties that would allow them to issue debt backed by all EU members. This is generally seen as the most market-friendly, positive outcome and would support the peripheral debt because it would allow that debt to be supported by a broader economic base and importantly, Germany. Germany is really the only one in a position to provide assistance to the peripheral economies—it’s really all about Germany.
In this case, German taxpayers would be on the hook for Eurobonds that could be issued by Spain with revenues which could be used for Spanish spending and Spanish infrastructure. The Germans are, unsurprisingly, reluctant to pursue this option. But German Chancellor Angela Merkel has stated that she’s open to it, as has the European Central Bank president. All the peripheral countries are obviously in favor of it, as well, but Germany, essentially, wants stronger fiscal ties in place before they’re ready to implement it. In other words, they want to make sure that the peripheral countries have responsible fiscal spending and that there are avenues to dictate their fiscal policy within some broader EU scope.
Aren’t these the sort of strong fiscal ties that critics of the Eurozone have been calling for from its inception?
Yes, absolutely. And that’s part of the problem with having the common currency bloc without a fiscal union, because, previously, having separate currencies, the peripheral countries could de-value their currencies until their economies became competitive again, until their productivity levels offered value relative to German productivity. With a common currency, that’s no longer the case; they can’t easily alter their price levels.
It's the most market-friendly outcome but it’s also seen as probably years away, because there’s a lot of work to be done. They could do a temporary program, a version of this, if they had to; that’s probably the most likely, but to have this all figured out, it’s years away.
How are hedge funds and other market participants positioning for this outcome?
Those with a more positive outlook have sought to buy what they see as distressed European assets that offer value. This could be select European equities, it could be highly distressed sovereign bonds in Europe; it could also mean buying assets that European banks are trying to get rid of. That’s where hedge funds who are pursuing this outcome have really focused.
The second possibility is monetization of debt. What would that look like and how are hedge funds positioning themselves for it?
Some would argue that this has already begun to take place to some extent. Simply put, you would have a large-scale currency printing in order to reduce a real debt load. The ECB has engaged in this Securities Market Program in which they purchase Spanish debt and keep it at a certain yield. If they could expand that program quite a bit and allow Spain and other peripheral countries to issue new debt, they would then buy that debt and effectively cap the interest payments at whatever rate they want.
This would have the advantage of keeping debt servicing costs in poorer countries low. Also, large-scale money printing would likely lead to inflation, which could spur nominal gross domestic product growth—although it may not spur real GDP growth. But even spurring nominal GDP growth could cut your real debt-to-GDP. Another positive could be that a weakening of the euro could help some of these peripheral countries as a tailwind for their exports.
For the monetization of debt, the most popular positioning among market participants, I think, is to be short the euro currency. Hedge funds and other market participants have been, basically, short the euro since the crisis began but it hasn’t so far really been that profitable.
How market-friendly is this option?
It’s very hard to tell. I would say it’s not market friendly because there’s a high risk that people could lose confidence in the euro. Inflation, once that started, could be very difficult to contain. It’s basically trying to restructure the debt through inflation rather than through outright restructuring, so debtholders would still be in for some pain. is not a very market friendly outcome, but it’s better than the third possible outcome, which is possible breakup. That’s one thing about this crisis: The scale of it is so immense and basically the outcome is unknowable.
The third possibility is the most drastic—breakup of the eurozone. What might that look like?
You could have one or two countries leave just the euro bloc but still be part of the political union in some form. You could have a more dramatic breakup where multiple countries leave the euro bloc and issue their own currency. Really, this is almost a train-wreck scenario where the moving parts end up wherever. It’s hard to really gauge that.
Existing EU laws and EU treaties don’t really address practical issues like, what will happen to contracts denominated in euros? And what will it mean for cross-border trade and currency controls? There would have to be new laws and new treaties to address some of the pragmatic details.
There would be real losses in this scenario too. Under Target2 [Trans-European Automated Real-time Gross Settlement Express Transfer System] accounts, Germany currently has over €600 billion owed to it by peripheral countries. With a breakup of the euro, it’s hard to see how that would be repaid. And for peripheral European countries, it would likely mean large-scale capital flight, large-scale bank runs, capital controls, hyper-inflation, and you would likely see highly correlated sovereign default events which would also inflict pain on global financial institutions and anyone holding that sovereign debt. I think it has the potential to be very painful. In the long run, though, it could lead to the eventual recovery in peripheral countries as they will have reduced their debt loads and regained competitiveness due to a devalued currency.
Positioning for this, among market participants, varies quite a bit. Some have bought short-dated German T-bills or German bonds as a way to buy the new potential Deutsche mark. Another really common trade that’s been going on for a quite a long time, since the European crisis began, is to short European sovereign debt through CDS or just outright. A lot of other people, I think, have just brought down risk and tried to mute their exposures and focused on return generation in more idiosyncratic exposures that are somewhat isolated from Europe in some way.
Can you give me an example of such an idiosyncratic exposure?
It could be a corporate event for some company in the U.S. or emerging markets. One area that I’ve been particularly focused on lately has been non-agency U.S. mortgages. They still offer quite a high cash-flow—you can get yields of 7% to 12%, depending on which type of collateral you’re buying. You have something where the fundamentals could be actually in a positive turnaround right now. The indicators are showing some positive momentum. But those yields are modeled based on further declines in housing and further pain in terms of unemployment in the U.S., so there’s a margin of safety already built into that.
There is a risk from Europe to holding those assets, which is that you could have European banks sell a large amount of that paper if they were forced to liquidate, but with the longer-term refinancing operations in place, in does provide a little more stability to their ability to hold onto the paper. These are really, probably, among some of the best assets that they hold; they’re not going to want to sell these unless they absolutely have to, and even if they did, it would provide the opportunity to pick up some more really valuable paper.
Given how unpredictable things are, how do investors approach it—do they choose a likely scenario and prepare accordingly or try to prepare for any and all likely outcomes?
It’s definitely a challenging environment, and a different type of uncertainty, too. In normal markets, uncertainty tends to be driven by noisy changes in macro data. Uncertainty in the data leads to uncertainty across asset class pricing. Here we have a policy-driven environment where the fundamentals are generally very poor—in peripheral Europe I would say they’re pretty awful. And even globally, the fundamentals are starting to weaken and be worrisome.
So you have very choppy markets with periodic sudden, strong swings in one direction or the other. And these swings often completely diverge from the fundamentals. Some investors position for outcome—the short euro position is very popular. And sometimes they’ll try and position for a couple of different outcomes. I think being cognizant that there could be these changes in volatility and large swings in markets means that hedge funds are generally keeping their net exposures low, keeping gross exposure on the medium-to-lower side as well, and then focusing on these more idiosyncratic areas for return generation.
In terms of politics, how significant is the recent election of a Socialist government in France?
Markets were definitely focused on France and I think François Hollande was definitely seen as a non-market-friendly result; however, I don’t know if the impact will really be as dramatic as some people were fearing. He has the same realities and choices, and though he may lean a little bit towards one side or the other, I don’t think it really changes any of the large outcomes with regard to France.