absolute return : investing in a volatile environment
Volatility is back
The combination of a sluggish recovery in the economy and concerns over the UK’s fiscal position and
credit rating has weighed on UK asset markets over recent weeks. The rally in the equity market has
lost steam, while UK bonds have underperformed their overseas counterparts and the sterling
exchange rate has fallen sharply. Such concerns seem unlikely to dissipate and the recent hung
parliament result of the general election has added to a feeling of instability.
Equity markets over‐priced the recovery and are now correcting (10/15%). Treasuries are low yielding
given flight to quality and are unattractive at these prices in the long run because of associated
inflation and default risks. In our view, commodities remain volatile and Gold is due for a correction,
(surely gold plated ATMs in Abu Dhabi are a sure sign of a bubble). Besides, alternative defensive
holdings, such as cash and gold, are not yielding. Inflation risk in medium/long term with negative
real interest rates
How then to invest for absolute returns?
We believe the fixed Income from real estate offer low volatility, high yielding regular returns against
rated Covenants such as Tesco Plc, UK Government, BT with in‐built inflation protection at a time
when interest rates are low.
STRICTLY PRIVATE & CONFIDENTIAL
Zaggora LLP is a boutique real estate investment partnership focused on acquiring direct commercial property
assets in the UK and Europe on behalf of private investors. The partners of Zaggora have a wealth of
successful experience in acquiring, financing and managing commercial real estate assets and companies in the
UK and European markets with a combined £5bn of deal experience.
The combination of a sluggish recovery in the economy and concerns over the UK’s fiscal position and credit
rating has weighed on UK asset markets over recent weeks. The rally in the equity market has lost steam, while
UK bonds have underperformed their overseas counterparts and the sterling exchange rate has fallen sharply.
Such concerns seem unlikely to dissipate and the recent hung parliament result of the general election has
added to a feeling of instability.
More broadly, the financial markets have begun to re‐price risk after the images of rioters in Greece protesting
against austerity measures brought the realisation of the overwhelming size and scale of public sector deficits
direct to the trading floor courtesy of CNBC.
Key Market View
In our view, we believe that investors should focus on yielding assets with inflation protection within a risk‐
averse strategy that is uncorrelated with the volatility of equity and fixed income markets. Our view of the
world is that;
Equity markets over‐priced the recovery and are now correcting with high volatility
Treasuries are low yielding given flight to quality and are unattractive at these prices in the long run
because of associated inflation and default risks
Commodities remain volatile and are due for a correction
Alternative defensive holdings, such as cash and gold, are not yielding
Key Framework View
This is within a framework view that;
Despite the MPC’s decision to pause quantitative easing, money market interest rates look set to stay
at very low levels for a long time, as the weak recovery delays official rate hikes.
As a result, market swap rates are at an all‐time low and expect 3M Libor to remain between 0.5‐0.7%
until at least Q1 2011. This enables low cost borrowing against real assets that offer inflation
protection and real yield.
While fiscal concerns have pushed bond yields higher, the outlook for economic growth and inflation
suggests that yields will fall again this year. Not least given the flight to quality purchasing.
The lacklustre recovery has already poured some cold water on the rally in UK equities. But there is
still a large risk that the recovery falls further short of markets’ expectations, forcing equities lower.
There is a very real risk of ‘double‐dip’ to the extent the economy falls back into recession. This is not
likely to be compared to the same ‘peak to trough’ declines as 2007‐2008, but may be meaningful
Sterling has been hit hard by fears for the UK’s credit rating. But a major fiscal tightening due to be
announced in the emergency budget should ease some of the pressure on the pound.
STRICTLY PRIVATE & CONFIDENTIAL
The lacklustre economic recovery has already poured some cold water on the UK equity market rally. The bull‐
run that we have seen since March 2008, albeit from distressed levels, has been consistent across the
worldwide exchanges as investors bought the recovery trade and the ‘bargain prices’ of both blue‐ships and
secondary market listings.
However, the market responded nervously to the debt woes of Dubai earlier in the year and saw this is the
first sovereign debt cloud on the horizon. The continued rally in the equity markets came to an abrupt end
with the announcement of civil investigations by the SEC of Goldman Sachs (GS) CDO trades, quickly followed
by news of a potential criminal investigation of GS and other firms. This was followed by the request of Greece
for an IMF bailout and subsequent riots on the streets in protest at austerity measures.
The increasing volatility was represented in a spike in the Vix Index and a ‘flash crash’ of the NYSE on May 6th
when the market fell 10%, before recovering 8%, all in the space of 8 minutes. It is no wonder investors have
taken profits and re‐positioned their portfolio as a result of such volatility. Fundamentally, there is the risk that
the economic recovery story continues to fall short of markets’ expectations, causing equities to fall during
2010, further correcting from here by a further 5‐10%.
In addition, the rate at which investors discount future profits has fallen significantly as a result of actions by
policymakers to boost liquidity in financial markets as well as signs that official interest rates are likely to be
very low for a prolonged period. We know that the rally in the FTSE 100 has coincided with the drop in real
yields on government bonds, consistent with our belief that equity markets would rally as long as interest rates
However, the headwinds represented by the risks of sovereign debt default/re‐structuring or austerity
measures to cut spending both lead to an outcome of instability and lower growth, now being priced by the
market. The rally has also coincided with a sharp rise in confidence in the economic outlook. But the latter
index has recently risen to its highest level in over 11 years. We doubt that such high expectations for the
recovery will be met.
Furthermore, while the prospects for economic growth are bad, the outlook for corporate profits looks worse.
Forward‐looking indicators of corporate earnings, such as the CBI’s balance of manufacturers’ order books, are
still consistent with further falls in corporate earnings over the next year. (See Fixed Income –Corporate
Bonds). In addition, the large amount of spare capacity in the economy, combined with the recent sharp rise
in firms’ unit wage costs, is likely to squeeze firms’ margins severely. We expect macroeconomic profits to fall
by around 6.5% this year and to be flat in 2011.
As a result, the drying up of dividend income could mean that investors switch to other asset classes. Indeed,
they may already have good cause to do so – commercial property yields exceed the earnings yield on equities,
while the gap between index‐linked bonds has also narrowed (see Real Estate)
6000 We suggested in March that the equity market had over‐
5800 bought the recovery and out‐run the corporate earnings
recovery. The gathering clouds on the horizon, first seen in the
Dubai debt wobbles in February had clear implications for
4600 After reviewing the 12 months performance of the FTSE‐100
4400 adjacent, what is the next move? We believe the market will
4200 correct further to the 4,600 in what will be a period of
4000 significant intra‐day volatility.
STRICTLY PRIVATE & CONFIDENTIAL
Fixed Income – Treasuries & Corporate Bonds
While bond yields have edged a little higher since Q4 2009, the prospect of a major fiscal squeeze, sluggish
growth and low inflation and interest rates should provide a more favourable backdrop for bonds later in the
year. The recent rise in yields has reflected three factors.
First, the rapid deterioration of the public finances and a hung parliament at the general election have raised
concerns about the risk of sovereign debt default. The CDS premium on UK government debt – a measure of
the cost of insuring against sovereign default – has risen alongside the rise in bond yields. Worries that the
recent rise in headline consumer price inflation might prove to be rather longer‐lasting than the Monetary
Policy Committee expects have pushed break‐even inflation expectations higher.
The rise in yields has coincided with the easing in pace and (at least temporary) pause in the Bank of England’s
bond purchases under its quantitative easing scheme. The previous narrowing in the spread between gilt
yields and overnight index swaps – which had been attributed to the effect of QE – has recently been reversed.
But we suspect that at least some of these pressures will ease later on in the year. For a start, the cross‐party
consensus on the need to tackle the fiscal position suggests that, even under a hung parliament, further plans
and action to reduce the budget deficit will emerge after the election. This may keep the rating agencies happy
and are due to be announced in the emergency budget.
Second, inflation concerns should also fade in time as the full disinflationary effects of the recession and the
vast amount of spare capacity created become evident.
And finally, while gilt issuance will remain very high over the coming few years, a further extension of the
quantitative easing programme is yet possible. Meanwhile, new liquidity requirements requiring banks to hold
more government debt should also help soak up some of the supply.
Coupled with a fall in international bond yields as the global economic recovery disappoints and inflation
elsewhere remains subdued, we still expect these developments to pull 10 year gilt yields back down to
around 3% by the end of the year. Meanwhile, corporate bond spreads have continued to tighten over the
quarter. But they may struggle to narrow further. Spreads are not much wider than during the 2000s credit
boom. And the relationship between the growth rate of economic activity (as measured by the CIPS surveys)
and corporate bond spreads hints that they may widen a little again.
The commodities market has largely responded to the positive outlook for the recovery in line with the risk
seeking trend of the equities market. The normally inverse correlation between gold and equity prices was
broken some time ago as fears over currency levels have pushed investors into Gold, Silver, Platinum. As the
equity markets have begun their correction, commodities such as crude oil have seen a correction.
240 CBOE Gold Index We strongly believe that the gold market is due
220 for a significant correction. The demand/supply
200 factors behind the $1250 o/z gold price cannot
180 justify this level.
The development of gold plated ATMs, as first
rolled out in Abu Dhabi, surely are clear signs
80 of a bubble?
However, shorts beware, markets can (and do)
stay irrational longer than you can stay solvent.
STRICTLY PRIVATE & CONFIDENTIAL
Despite the Monetary Policy Committee (MPC)’s decision to pause quantitative easing, market interest rates
look set to remain close to their very low levels for the foreseeable future, as the weak recovery prevents
monetary policy from being tightened.
Spreads of 1 and 3 month Libor over overnight index swaps have remained very tight over the last few months.
Meanwhile, the MPC has continued to vote unanimously for Bank Rate to be held at 0.5%. We see little reason
to think that the low interest rate environment will disappear soon. For a start, while the MPC voted to pause
its asset purchase programme in February, the Committee has struck an increasingly dovish tone. The Bank of
England’s quarterly Inflation Report showed that inflation was expected to be below target at the two‐year
policy horizon, even if Bank Rate were held at 0.5%, largely due to the disinflationary impact of the spare
capacity in the economy.
In addition, the Governor has left the door open to further policy stimulus, stating that “it is far too soon to
conclude that no more [asset] purchases will be needed.” A tightening of monetary policy therefore seems a
long way off. In response to these signals, markets have revised down their rate expectations. But they still
expect Bank Rate to rise by 150bps or so over the next two years, in line with expected hikes in the US and
euro‐zone. In contrast, we expect Bank Rate to remain on hold for the foreseeable future. A key effect of such
low libor and real rates is that fixed borrowing costs in the UK swaps market over 1‐30 years are historically
low. Borrowers can fix 5 year loans at 2.5% and 30 year loans at 4%.
Following the collapse of Lehman Brothers and with it the financial markets, we have been analysing the real
estate markets and seeking to understand their direction and true nature as well as talking to investors. Due
to the central role of the asset price bubble in creating the financial crisis, real estate has been avoided by
many investors since 2007, many of which are waiting for prices to fall further before looking at the asset class
The opportunity exists to earn low volatility, fixed income returns of 10‐15% on equity annually (received
quarterly) from acquiring UK commercial real estate assets let to excellent covenants (UK Government, Tesco
leases) for 5‐10 years with 10‐15% annual IRR.
We believe in the current, limited visibility environment this represents an extremely interesting low risk, real
asset investment strategy. As a defensive play, the potential returns profile compares well to other defensive
alternatives such as cash/gold/treasuries. The strategy offers investors low volatility, steady state returns with
in‐built inflation protection at a favourable time to acquire GBP denominated assets relative to USD when GBP
borrowing cost is 2.5% for a 5 year fix and 4.04% for a 30 year fix.
Real assets offering the following investment characteristics;
8‐15% Fixed annual equity return (received quarterly)
10‐15% Annual IRR
Fixed income with annual increases (RPI/CPI/Fixed)
FRI Income (All costs, management, insurance, maintenance, paid by tenants)
Strong residual value driven by quality of asset and location
The UK market structure and framework provides the strongest opportunity because;
Ultra‐Long leases 10‐20 years+ (without tenant break options)
Upward‐only rents, if markets rents fall, tenants continue paying same rent
FRI leases making tenants responsible for all management, maintenance and insurance costs
Active lending market to secure leverage on modest basis (60%‐70% LTV)