Views From the Floor

In this weekly publication, read about playing Brexit via the British pound and how E&P, midstream provide ample investment opportunities.

Playing Brexit via the British Pound

We believe the way to play Brexit is via the British pound. We do understand that the range of outcomes for the GBP is uncertain. Figure 1 shows the range of outcomes Bank of America Merrill Lynch believes the GBP could take: as high as 1.5 against the USD in the event of no Brexit and as low as 1.1 in the event of a no-deal Brexit.

Within Man Group itself, there are differing opinions on what route Brexit will take. Some of us believe that there will be a no-deal Brexit as UK Prime Minister Theresa May cannot afford to budge from the deal agreed upon at Chequers.

On the other hand, of course, there is the possibility that, in typical EU style, some deal is cobbled together. If you’re in that camp, then straddles may be the way to play. At the time of writing (August 30), the breakeven move for 6-month GBPUSD straddle (with strike at 1.30) is around 5%1. Within that timeframe, it could be likely that we move 90% of the way, either to deal or no deal. On BAML’s estimates, that’s either up 8% or down 15%.

Figure 1. Range of Outcomes for GBPUSD

Source: Bank of America Merrill Lynch; as of 31.08.2018.

E&P, Midstream to Provide Ample Investment Opportunities

Despite a backdrop of strong commodity prices and OPEC supply cuts, the energy sector has seen muted merger and acquisition (M&A) activity. We believe the energy sector is ripe to catch up with the overall robust M&A environment.

We observe contrasting market reactions in two energy subsectors: Exploration and Production (E&P) and Midstream. Three recent E&P transactions resulted in the acquirers’ shares prices declining on the day of announcement, followed by relative underperformance versus the SPDR S&P Oil & Gas Explore & Production ETF (XOP)2. High prices paid and limited near-term growth acceleration/accretion were reasons cited by market participants for the underperformance.

In contrast, recent midstream transactions have resulted in acquirers’ shares prices appreciating on the day of announcement followed by a general outperformance versus the midstream ETF, represented by the JPMorgan Alerian MLP Index ETN (AMJ)3. Corporate simplification, distribution cuts, and improved financial leverage profiles were reasons cited by market participants for the outperformance.

We believe these subsectors will continue to provide ample investment opportunities. E&P management teams may learn from the negative market reactions and could be more disciplined about purchase prices, while midstream players may continue to pursue corporate simplification that have been well-received by the market.

Options an inexpensive way to get exposure to banks

The beginning of August was rather choppy, with headlines focused on Turkey, trade wars and emerging-market (EM) currencies. Considering the magnitude of declines in EM currencies and risks facing EM economies, the risk of contagion does not appear to be priced into the options market, despite the European banking index having fallen (see Figure 2). We believe Brazilian elections may further exacerbate concerns for banks with exposure to Latin America. The relatively low price of options may offer an inexpensive way to hedge or to get long via calls in a sector that has underperformed dramatically.

Additionally, US stocks have proved to be relatively resilient. As markets rallied, US investors began to move from buying puts (to protect downside) to buying calls (to participate in the upside). Put/call ratios fell to the lowest levels since June (see Figure 3 below), but have not yet approached the levels of the global equity market chase in January. With hedge funds in the US underperforming equity markets, the risk of floundering further – should equities continue to rally – may be leading to the renewed interest in call buying.

Figure 2. Implied Volatility for European Banking Index

Source: Bloomberg, as of 31.08.2018.

Figure 3. Put/Call Ratios Fall

Source: Bloomberg, 30.08.2018.

Signs of a US Recession?

A recent dip in 10-year Treasury yields, while 2-year rates are driven higher by the Federal Open Market Committee (‘FOMC’), has led to the flattest US yield curve since July 2007. An inverted yield curve is seen by some as the harbinger of a recession; given the limited number of observations, we would tend to side with those FOMC participants who, in the minutes of the August meeting, “emphasized that inferring economic causality from statistical correlations was not appropriate.”

In that sense, some view President Donald Trump’s recent comments on the Federal Reserve rate increases as following a path well-trodden by former occupants of the Oval Office, most notably Richard Nixon: preparing the ground for blame-shifting if the economy slows down in the run up to the 2020 elections.

Figure 4. US Yield Curve Slope (10yr-2yr spread) versus GDP recessions

Source: Bloomberg; Federal Reserve Bank of St. Louis; Man AHL, as of 31.08.2018.

With contribution from: Jonathan Nye (Man AHL, Principal Quant), Peter van Dooijewert (Man Solutions, Head of Institutional Hedging), Himanshu Sheth (Man GLG, Portfolio Manager), Ben Funnell (Man GLG, Portfolio Manager) and Henry Neville (Man GLG, Analyst).

1. As per Bloomberg and Man GLG calculations.
2. Man GLG calculations.
3. Man GLG calculations.