Time To Hedge Your Delta

by: Tautvydas Marciulaitis
Summary

When everything is expensive, long-short strategies become interesting - especially when you want to ride big trends.

In fixed income universe, long Portugal 5 year / short Germany 10 year spread looks good and gives positive coupon carry of ~100 bp.

EU/US equities ratio trade is at 10 year lows - however EU offers 150 bp dividend premium.

Three weeks ago J. Yellen baldly said that asset valuations are "rich". However this message did not discourage bullish investors and since then equity indices all over the world reached new highs.

At times like this it is rational to think about systemic long shorts. Put simply, you should short the largest systemic risks you can find, while having a long position that would serve as a partial hedge if systemic risk does not materialize.

It is the same old long-short strategy. However instead of trying to extract value from differences at micro level, one needs go for longer term macro factors. By doing this, one prepares portfolio to win big if key macro trends shift and/or systemic risks materialize. On the other hand, portfolio is hedged from large losses if current trends prevail.

European bond systemic long-short (long 5 yr PT, short 10 yr DE)

Despite having a single currency and being in the same economic union, countries in Euro zone have different credit ratings and default risks. This leads to differences in sovereign bond yields. As risks and yields change over time, long-short trade opportunities emerge.

Now it seems to be a good time to long peripheral EU govies (Portugal is my favorite) and short EU core (Germany seems to be the best choice).

By doing so, one enters a trade which offers good return when European Central Bank (ECB) starts to tighten monetary policy. Tightening usually comes with economic growth, what implies inflation and puts pressure on bond prices. As Portugal yields are rather high already, they should not increase by that much. However, Germany yields are at all time lows.

Thus it may be expected that price of German debt will fall by much more than Portuguese, when ECB normalizes monetary policy. That is the core idea behind this systemic long-short. Trade becomes even better, if one buys shorter term Portugal bonds and sells longer term Germany debt.

Let's go through this step by step.

At the time of writing, spread between 10 year bunds (Germany bonds) and 10 year Portugal govies stands at ~250-260 BP:

It wasn't like this always. Before the Global Financial Crisis and European Debt Crisis, yields on different European government bonds were equal. Back in 2008 yields on German, Portuguese and Greek debt were the same. While spread between yields started to widen only in 2010:

Of course, now it is obvious that Portugal carries different risk than Germany. Due to what yields on their bonds should not be equal. Thus one should not expect PT/DE spread to approach zero.

Nevertheless, 0.5 yield on 10 year bunds when YoY inflation is ~1.5 and U.S. is yielding 150-200 BP more is rather preposterous. Especially when ECB already started taper tantrum.

Few weeks ago, when M. Draghi made some hawkish comments, not only bunds, but whole govie market went crashing. So when ECB actually becomes hawkish, not only speaks about being such, bund yields will rise more sharply.

Thus systematically, following the central banks and overall macro trends, it is rational to have a short position on German bonds. It is obvious that they cannot stay at current levels forever.

However, as every obvious idea, shorting bunds has its own pitfalls. If inflation remains low, there is no growth for couple (or more) years in Europe or there is some large systemic shock, yields on bunds might go back below zero. Thus you need to hedge this short position.

And to do this one might use Portugal govies. Due to few simple reasons:

  1. They still yield something - thus getting stuck with such trade offers at least 2.5 percent per year in coupon payments, if you buy and sell debt with the same 10 year maturity (3 pct from long Portugal minus 0.5 from short Germany);
  2. Yields on Portugal government bonds stand where they were in 2008-2010, while prices of most others EU government debts are at all time highs;
  3. PT is in Euro zone and European Union and despite having some structural macro problems, it is in much better shape than it was 5-6 years ago, also with a positive outlook.

Thus going long Portugal and short Germany looks good. Especially, when one can go long 5 year Portugal (consult the whole PT curve for the best option) and short 10 year Germany, still making money from coupons, however decreasing interest rate sensitivity from long position, what will increase net capital gains when ECB actually starts being hawkish.

Europe/U.S. ratio trade

If you are not into bonds that much or have less capital, try going long European equities and short U.S. There are number of reasons for that. Ranging from technical to deeper macro.

Please read a short and excellent piece about this trade from the Macro Tourist. He explains the key idea, but here I will elaborate a bit more.

Looking at a bigger picture, we see an obvious trend:

Chart Fundamental Chart data by YCharts

Since 2008, S&P 500 almost constantly outperformed EuroStoxx 50. In fact, if one forgets this ratio for a second and looks at percentage returns, an enormous performance gap between Europe and the U.S. might be observed:

Chart SPY data by YCharts

It could have been more or less explainable during 2010-2012 (European Debt Crisis), however after that may be explained only by quantitative easing from FED and absence of it from ECB.

As FED started to stop the QE almost three years ago, while ECB is still pouring money into the markets (and will continue to do so for the foreseeable future of at least 6-18 months), gap created due to differences in monetary policy should start to tighten.

In addition, SPX is more expensive than EuroStoxx when compared in typical valuation metrics. For example, at the time of writing, as according to Bloomberg calculations (mind you, different sources calculate PE in different ways), S&P 500 PE is at 21.5. While EuroStoxx 50 is almost 10 percent cheaper - with PE of 19.5.

Thus even if earnings of S&P 500 stocks grow by 10 percent, while EuroStoxx 50 companies show no growth at all, EuroStoxx 50 remains cheaper (ceteris paribus). However expectations of 10 percent earnings growth for S&P 500 companies might be a bit too optimistic.

If one looks at data provided by Bloomberg, EuroStoxx 50 appears to be superior to S&P 500, at least in the short-mid term:

ESTXX vs SPX projected growth, courtesy of Bloomberg

Source: Bloomberg

In addition, as according to Walter White, valuations are in the 97th-100th percentile versus history for the median S&P stock:

Source: heisenbergreport.com

Looking at all this data it is hard not to agree with J. Yellen. Valuations of U.S. equities are actually rich.

When considering equity ratio trades, it is important to remember that one usually needs to pay for the short position. In this case, by shorting SPY, one will have to pay ~2 percent in yearly dividend payments. However EuroStoxx 50 pays out almost 3.5 percent per year.

Thus such trade would carry 1.5 percent dividend return, which could serve as downside protection whilst EuroStoxx 50 / S&P 500 ratio keeps going down for whatever reasons.

Now lets quickly look at macro factors.

In addition to reasons explained by Macro Tourist, most of large financial institutions offer their clients to go long Europe (eg. from GS), as it has good growth potential. And their clients actually listen.

The key macro reasons cited by these large institutions follow the same reasoning - EU has more growth potential as it was subdued because of political and economic reasons; as unemployment falls, wage growth will recover leading to increase in inflation and consumption; growth will contribute to positive expectations and overall sentiment.

And they are right about that. The upside surprise potential from Europe is much larger than from the U.S. The U.S. went through macro recovery while EU was trying to solve its solvency issues. And as those issues are in the past, macro should once again become the key focus for most investors, what will have a positive effect on EU financial markets.

Thus macro, monetary and technical reasons align on this - Europe is a good bet. However, as it is rather risky to simply buy at current levels, better go for a ratio trade, which may neutralize delta and still offer decent returns.

Key takeaways

I deliberately tried not to name too many products or ETFs in this article. Both trades may be executed via futures, ETFs or direct purchases of bonds/equity portfolios. It is up to you to decide how to trade this out.

Whatever you choose, please remember these key points:

  1. Shorter bonds are usually less sensitive when interest rates are going up - thus if you want to do European bond spread trade, long shorter term peripherals and short longer term core govies. By doing that you decrease the yearly coupon payment but get more desirable exposure to interest rate sensitivity;
  2. Equity ratio trades work well when you get dividend payouts. These payouts offer additional liquidity and financial cushion, whilst trade idea does not play out. Collecting payouts over the long term, especially if compared to using strategies where you pay them, may increase your performance dramatically.

Follow these two and you should be good. Just remember that both of these ideas are longer term systemic trades. It might take time for them to play out, nevertheless if Western Civilization does not collapse overall, they will almost definitely play out someday. The only question is how long one will have to wait for that.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.