Strategy commentary cont'd:

5-year Constant Maturity Major Bank Senior Bond Spreads

5-year Constant Maturity Major Bank Subordinated Bond Spreads

In the ASX hybrid market, prices declined materially, although performance was more resilient relative to what we saw accompany similarly sized 20-30% equity moves in, for instance, the pandemic shock of March 2020.

Strategy commentary cont'd:

5-year Constant Maturity Major Bank Hybrid Spreads

On a peak-to-trough basis, the Solactive ASX Hybrids Index lost 2.3% in April, which was slightly more than the decline in global investment-grade credit (where the Bloomberg Global Aggregate IG Credit Index (zero duration) had a peak-to-trough loss of 1.5%). The ASX hybrid market outperformed the draw-down in high yield, or sub-investment grade, bonds as proxied by the Bloomberg Global High Yield Index, which fell by 3.0% at its worst. At their wides, 5-year major bank hybrid spreads on the ASX climbed from about 190bps to 265bps, although they have since settled at 215bps.

Solactive ASX Hybrids Index

Strategy commentary cont'd:

Bloomberg Global High Yield Index

Coolabah had a highly contrarian approach to portfolio construction and positioning throughout. Heading into April, we had undertaken a range of aggressively defensive measures, including:

• Taking profits over the prior 12 months
• Deleveraging any levered portfolios
• Moving out of USD and EUR credit back into the relative safe harbour of more highly rated and lower beta or less volatile AUD credit
• Putting in place explicit insurance in the form of credit default swap hedges

Prior 2 April, we had hedged 15% of all our long-only credit risk and 25% of our long-short credit risk in addition to generally derisking over the preceding year. This meant we had tremendous dry powder to use when the volatility erupted.

We had argued for months that Trump was dead serious on his new tariff regime and desire to fully decouple from China. And we asserted that markets were very poorly positioned to deal with this contingency.

We had also warned investors to expect much higher volatility and wider credit spreads, which would nonetheless present buying opportunities. It was important for us to underscore the likelihood of heightened volatility due to the artificially smooth nature of asset prices in recent times, which could lull investors into a false sense of security. It is pretty clear that many were indeed complacent.

On 9-10 April, Coolabah cut all its hedges/shorts and started aggressively buying again. In particular, we bought $1.4 billion of credit on 9-10 April, which we extended to $4 billion of gross buying by the end of the month. We also engaged in $1.4 billion of selling (or $2.6 billion of net buying).

This activity meant that portfolio performance was much more resilient than it has been in prior periods when equities have declined 20-30%. It also meant that portfolios rebounded firmly in the second half of the month, which has continued in May.

Strategy commentary cont'd: Why did we pivot 180 degrees on 9-10 April after having been so bearish about the outlook? As noted above, we argued prior to April that markets were very poorly positioned for Trump’s new tariff regime. He did not disappoint on 2 April and again on (initially) 9 April with his uber-aggressive tariff framework, which was effectively tantamount to declaring a forever-trade-war on every country in the world. We asserted that Trump’s goals were straightforward:

• Actively decouple from China given the US no longer believes that China will ever trade with it on fair terms (ie, without government subsidies and intellectual property theft, particularly in strategically important sectors);
• Decoupling requires credible and permanent trade barriers to convince US manufacturers to return their factories home (ie, the reshoring of supply chains), which also radically reduces US strategic vulnerabilities in the event of kinetic conflict with China;
• Address unfair trade practices by China’s surrogates, such as Vietnam and Mexico, by applying pari passu tariffs on these nations as well and thereby cauterise the loopholes that would otherwise open up by only targeting the Middle Kingdom;
• Address the manifold unfair state subsidies that nations around the world use to steal trade from the US (consider, for example, the huge government support afforded to the Australian film industry, which allows it to compete unfairly with the US); and
• Using the circa US$5.7 trillion in potential revenues that Coolabah estimates could in theory be generated by tariffs to partly pay for the US$8.1 trillion of tax cuts that Trump wants to bequeath.

The savage bond and equity market reaction to Trump’s tariff regime in April evidently convinced him that a more nuanced approach was required. There was also geo-political concern that he would drive key allies and trading partners into the arms of China.

During 9 April Trump engaged in a very sophisticated recalibration after imposing the proposed 2 April package at 12am on that day. Specifically, he offered every country in the world the opportunity to do a trade deal with the US via a three month deferral of their tariffs in lieu of a flat 10% rate that would apply during the negotiating period. At the same time, he boosted his Chinese tariffs to a shocking 145%. What most investors missed is that this actually had the effect of increasing the overall or effective tariff rate that the US was applying across all countries from 32% to 35%, albeit by shifting the incidence or burden of these taxes largely on to China’s shoulders.

It was exactly what financial markets wanted to see—the deal-making Trump in action. And so, the S&P500 embarked on an extraordinary rally and has since recovered a lot of its 22 per cent peak-to-trough draw-down. These were the most volatile market conditions observed since the global financial crisis.

It was, in fact, both Trumps at play: the compromising, mercenary Trump that investors like who is always eager to assuage their apprehensions; combined with a very hard-hitting geo-political and trade hawk who is singularly focussed on decoupling from China and restoring US military and economic hegemony.

For Coolabah, 9 April was a key inflexion point. Trump was demonstrating that he could listen to market signals and thread a much more nuanced needle. We saw this reflexivity in action days later when Trump initially declared that he wanted to sack the Fed chair Jay Powell, which promptly precipitated steep asset price declines, only to quickly walk his rhetoric back within 24 hours when he confirmed that there were, in fact, no plans to dispose of the embattled Fed chair.

Given the moves in credit spreads, a lot of the bad news was now in the price. A reasonable probability of a US recession was being handicapped. Investors expected poor data flowing from both the inflation shock and the disruption to economic activity. While the Fed is nervous about consumer inflation expectations, any recession would quickly compel it to furnish interest rate relief. And Trump was showing that he could be a more nimble actor than the worst of the April price action implied. It was, therefore, time to buy.

We bought in the eye of the storm on 9-10 April when many investors were rushing for the exits. When there was peak fear. Sadly, those fleeing crystallised losses at the worst possible point, highlighting the well-known adage that investors tend to time markets very poorly indeed.

Strategy commentary cont'd: Looking ahead, portfolio yields have improved despite market expectations for four more RBA rate cuts this year. Credit spreads in many of Coolabah’s key sectors are now trading on historically appealing levels (see the two charts below for US financial senior-ranking and subordinated spreads). Senior-ranking bonds issued in USD are especially interesting at present. And there has been a font of new primary market issuance in USD, EUR, and AUD that is coming with much more credible new issue concessions, which Coolabah has been keen to support. Combined, these variables should power future performance.

Bloomberg US Financial Senior Spreads

Strategy commentary cont'd:

Bloomberg US Financial Subordinated Spreads