TAKING IT TO THE BANK
Canadian fund managers see opportunity in lenders under Trump’s pro-business policies, rising rates
The global regime change in favour of a rising interest rate environment, coupled with the success of populist leaders around the world such as Donald Trump, is creating a lot of dispersion in financial markets.
But it’s not just occurring across asset classes — it’s also happening within sectors and on an industry versus industry basis.
That type of environment is very good for traders, and is driving the makeup of strategies in the Inflection Strategic Opportunities Fund, Vancouver-based Inflection Management Inc.’s fund of hedge funds.
It has 12 underlying portfolio managers, although that number changes frequently, as Inflection makes adjustments to macroeconomic events.
Rising rates are partly behind what is likely the firm’s highest conviction idea at the moment: community and regional banks.
Ari Shiff, Inflection’s president and chief strategist, noted that the Dodd-Frank Act changed everything when it came to regulations for banks. But the financial reform legislation was particularly onerous for smaller banks, of which there are thousands in the U.S.
He also highlighted a demographic trend, where the average age of CEOs at small banks is somewhere in the 60s, forcing them to make some important decisions about the future.
“It was basically a roll-up situation, where they were going to be acquired by bigger banks because of these two factors,” Shiff said.
While higher interest rates will provide an earnings lift to these banks and their share prices, the election of Trump was the “serendipitous factor” that came into play, since he promised to roll back Dodd-Frank.
“That both made these banks more attractive, but also gave the bigger banks a higher stock value in order to make the purchases,” Shiff said. “So what started out as a good idea became a great idea.”
Inflection’s vice-president of investments, Jamison McAuley, highlighted the boost domestic-sensitive smaller banks will receive from U.S. tax reform.
He also pointed out that Trump’s plans for pro-cyclical fiscal stimulus come when the U.S. economy is basically at full employment, and rates are still low.
“Not only does it have the potential to be inflationary, but also very stimulative to the domestic economy,” McAuley said.
He noted that when consumers have more money, they can borrow more, banks can lend more, and the economy grows based off of credit growth.
“It’s a very strong tailwind for regional banking on top of the secular consolidation trend, and the extra sweetener of deregulation,” McAuley said.
A more recent addition to the portfolio was a manager focused on the U.S. high yield market.
For much of the past year, high yield traded like equities, because a large proportion of this segment of the bond market is in energy.
Now that high yield has recovered, some areas are going to start to trade like bonds again, while others will continue to move with stocks.
McAuley noted that with the U.S. economy improving, that’s a positive for credit risk. At the same time, rising rates are generally a negative factor for bonds.
“When you having interest rates going up and these bonds coming down, but the creditworthiness of borrowers improving, the cross winds are hard to figure out,” he said.
Inflection has chosen a highyield manager that takes a marketmaking approach and fills the gaps banks have backed away from.
The manager captures shortterm mis-pricing due to imbalances in supply and demand, but also takes a catalyst-driven approach to buying undervalued bonds.
McAuley also pointed out that the high-yield market has only been around since 1980, when interest rates were basically at alltime highs.
“It’s never seen a secular rising interest rate environment, so how it is going to behave in that environment is going to be hard to predict,” he said. “You’re going to want to be nimble and take a deep dive to know what you actually own.”
Another area of focus for Inflection is volatility, where it has invested with two managers that provide similar sorts of protection, but do it in very different ways.
One of them trades futures, and has generated double-digit returns since the late 1990s. But what’s important about this manager, is it produces the best returns when they are needed most.
McAuley noted that when markets looked like they were falling apart in January and February of 2016, this strategy was up roughly 15 per cent. Around the time of Brexit, it rose approximately seven per cent.
“Getting paid to own insurance is key to the portfolio as a whole, because hedging can become very expensive,” Shiff said.
The other manager trades the VIX exclusively, capitalizing on “naive” inefficiencies created by the massive growth of passive ETFs and the formulas they follow.
“Typically what people do with tail hedging is they buy an S&P put, or another hedge, at the same price every month,” he said. “That creates massive inefficiencies that can generate yield or returns.”
This manager buys anywhere from zero to 100 per cent, based off of perceived risk in the market. It uses a machine-learning model that makes forward predictions using a variety of factors.
“Like tremors before an earthquake, or a forest fire indicator, financial markets are sort of the same,” McAuley said.
“They exhibit signs leading up to bad events.”
It’s a very strong tailwind for regional banking on top of the secular consolidation trend, and the extra sweetener of deregulation.