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Credit Markets To Adjust to Changes In Global Monetary Policy: A conversation with Louis Gargour, Chief Investment Officer, LNG Capital

19 March 2015
Giada Vercelli

Interview with Louis Gargour, Chief Investment Officer, LNG Capital

Following the FOMC committee change of guidance, Euromoney Conferences have spoken with Louis Gargour, Chief Investment Officer at LNG Capital, a London based Credit Fund, to hear the market’s expectations on global monetary policy and adjusted strategies. In this interview with Euromoney’s Giada Vercelli, Gargour explains how he is building  positions in longer dated investment-grade issuers, specifically those where renewed economic activity is driving demand for those sectors.

Euromoney Conferences: Yellen has mentioned as conditions to begin tightening: i. improvement in the labor market and ii. evidence that inflation will move back to its 2 percent objective over the medium term. While job growth seems on the right path, wage growth is not keeping the pace. Inflation is low, also due to low energy prices, suggesting slack has yet to be picked up. When do you expect to see some action? April, June, September?

Louis Gargour: Our view is that the latest data out of the US has indicated slower than expected growth in housing and other principal data. Our view on the Fed is that they need to signal that they are prepared to raise rates and as a result we think the first rate hike will happen between June and September however we do not think that they will follow the initial rate hike with any further rate hikes until inflation clearly meets their 2% target and stays there.

We believe the Fed has moved away from a policy which looks exclusively at the labor market, and has begun to focus on headline inflation price inflation and is becoming much more sensitive to wage deflation. The Fed's policy in our view going forward will seek to closely monitor inflation, growth, and will have less of a focus on unemployment, and job growth.

The rationale behind explaining what they're looking at is that the current market conditions need to improve vis-à-vis inflation and growth for them to follow on with the firstrate hike with a series of further rate hikes. That being said we believe that they will be obliged by the market to demonstrate that they are willing to begin the rate hike cycle or "lift-off" by an initial hike of 25basis points regardless of what inflation is and this rate hike is likely to beat the latest September and more likely in June.

Euromoney Conferences: When the Fed started to tighten monetary policy in 1938, bonds sold off and the stock market crashed, prompting the Fed’s U-turn. to reverse course. Could it be 1937 again if the Fed rises too fast? What is your take?

Louis Gargour: I believe the comments in the press this week with the CIO of Bridgeport specifically pointing out that this was a risk to the market has identified and emphasized for the Fed the sensitivity of the market to the situation you have alluded to in your question i.e. one of an initial rate hike which then needs to be reversed due to a drop in growth.  Our observation is that the severity of the economic downturn both in the US and globally is significantly less than that observed in the 1920s\30s. We therefore believe a forced reversal of rate hike policy is unlikely especially with the gentle and textbook increase ingrowth, and decrease in unemployment that we have observed over the past three years in the US. Further analysis leads us to be concerned about the effect of an interest rate hike on emerging market growth, unemployment, and inflation. We believe the dollar’s appreciation is the only counterbalancing factor to economic slowdown in emerging markets. And that without an increase in dollar the looming increase in borrowing cost for emerging markets could bode very badly for global growth

Euromoney Conferences: If this is not the case, what will the new normal be after the QE tapering in the US? What has the taper tantrum of 2013 taught us?

Louis Gargour: The new normal in the US will be careful observation and monitoring of price but more importantly wage inflation. We believe that the Fed is much less concerned with higher levels of inflation than they are with sub optimal US growth. Remember politicians get re-elected in times of economic growth and inflation, politicians are replaced in times of unemployment, economic shrinkage, and recession. Therefore the new normal is small incremental rate hikes if necessary with a first symbolic rate hike to demonstrate that the Fed is in control, easing cycle is over, and that we are in a new paradigm where money may become tighter. The objective of the Fed is the ease the markets off easy money not to startle them into a correction and then have to reverse its policy.

Euromoney Conferences: Weak growth in Europe, China and Japan has prompted central banks to ease policy. What are the consequences of monetary policy divergence?

Louis Gargour: It's all about currencies. We have seen a rush to the bottom of relative interest rates throughout Europe and Asia in order that the individual countries currency can remain competitive in order to maintain export markets. The Fed's comments tend to indicate that they are concerned about the rapid appreciation of the US dollar vis-à-vis world currencies and are concerned about the velocity of change vis-à-vis the euro. Clearly the ECB has indicated that its desire is to create a more competitive export environment for Europe through monetary policy as well as through a weakening euro. We believe that interest-rate and monetary policy are being used to keep currencies competitive against other currencies with the exception of the US dollar in order to maintain an equilibrium in export competitiveness.

Euromoney Conferences: Years of central bank liberality have pushed money  through the global financial system, yet trading liquidity has diminished, as it is getting harder and more expensive to transact in size. Have global asset allocations been distorted by monetary policy and regulations? How?

Louis Gargour: Certainly the role of banks has diminished greatly, data out of the New York Federal Reserve indicates that  only 10% of the capital is available for proprietary trading today than was available in 2007. The obvious principle effect has been the elimination of banks as the buyers of last resort, and has also seen the banks not providing a smoothing of price action as a result of building up positions in certain securities based on price opportunities

Asset allocations may not have been distorted however the nature of the holders of investment-grade and government securities has changed significantly with a larger proportion of bonds being held by insurance companies and pension funds with longer maturity requirements due to the liability profiles. The proportion held by these longer maturity seeking buy-and-hold institutions is estimated to have increased by 50% of the overall market size. These investors typically do not trade out of positions, do not turn over the portfolios, and therefore trading volumes even in large liquid issues has dropped enormously. There are securities or pockets of securities where liquidity remains, but generally speaking these are not held by real money accounts but held by leveraged and proprietary trading accounts. As a result these liquid securities typically exhibit higher levels of volatility.

The largest distortion we believe currently exists is the increase in issuance by European governments of long dated government bonds in order to meet the insatiable demand by the ECB for long dated government securities. There has therefore been a distortion created by the demand by the ECB for government paper, which has resulted in an increase in issuance by European governments to meet the man, i.e. a distortion that was recently identified and flagged in Italy and Spain with larger than expected 30 year government bond issuance creating price volatility and undigested government bond issuance.

Euromoney Conferences: Yields on conventional long-term government bonds are extremely low. Is the ECB’s QE working only to move into riskier assets?

Louis Gargour: We believe that there is now a large amount of attention being focused on sub investment-grade opportunities. Specifically ratings between B and BBB offer value, as the risk free curves have both flattened and parallel shifted. The discrepancy between credit and investment-grade is now at historical wide, and we believe this disparity will be arbitraged as intelligent market participants seeking yield look to sub investment-grade as an alternative to a massive extension of maturity in order to generate higher returns.

Furthermore we believe low cost funding will begin to benefit high-yield companies as they will be able to raise longer-term funding at lower costs enabling them to work into their capital structures, have dedicated capital for business expansion, reduce the cost of borrowing once the credit quality has increase in leverage has reduced, and increase the number of national champions that began a smaller and medium-sized companies. We believe that the principal objective of both the Fed and ECB in their bond buyback\QE programs is to migrate investors into riskier assets, and to encourage banks to lend, specifically to smaller clients. Takeaway banks’ ability to make money risk-free and have positive rates on cash and you encourage migration into higher-yielding assets, equities, and small and medium-size businesses.

Euromoney Conferences: Looking at your strategy, please give us an overview on LNG and how are you adjusting your strategy.

Louis Gargour: We have adapted to the current market environment in two ways. We have identified strong sub investment-grade corporate issuers where we believe investors will be able to comfortably migrate and own names with stable business models, increasing revenues, and reasonable financial margins. We have also begun to build positions in longer dated investment-grade issuers, specifically those where renewed economic activity is driving demand for those sectors, such as auto parts, construction, leisure and travel.

We have hedged out all currency exposure as we believe currency volatility and depreciation in the euro will continue is our standard policy to hedge out currency exposure.

The strategy is paid off handsomely and we are happy to report that we are having a very good 2015 placing us in the top quartile of credit managers.



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