Autumn outlook and positioning

Thomas Elofsson, who is responsible for the fixed income management of Catella's Credit Opportunity, Hedgefond, Avkastningsfond and Catella Nordic Corporate Bond Flex funds, agrees with Martin Jonsson, who works with the equity-related management for the hedge fund. Returns this year have been much too weak, but we have identified the reasons so there is hope for improvement.

At the beginning of 2018, both managers said in Catella's podcast that they expected somewhat weaker growth and rising inflation. Since then, leading indicators have fallen slightly but inflation has not intensified. The question is whether we have seen a slowdown. Martin Jonsson thinks so.

"We have seen a slowdown, especially in Europe, China and Japan, but not so much in the US. We have also seen a slide in GDP forecasts and industrial production forecasts. Where this has been least visible is perhaps in company earnings and outlooks," he says, adding that the question going forward is whether, and to what extent, this will be seen in the cyclical companies. Will we see a blip in the curve from the slowdown that has already taken place?

As for inflation, which continues to frustrate the markets by its absence, Thomas Elofsson does not believe this is imminent. And interest rates have not risen during the year but have instead fallen - from levels where the ten-year yield was around 100 basis points they fell back to about half that level.

Thomas Elofsson says the explanation for this lies mainly with the action of central banks. There are expectations of higher interest rates in both Sweden and the rest of Europe, but unlike in the USA, which is some way into a cycle of hikes, there are no such signs on this side of the Atlantic.

"There's not really any inflation in the United States either, but they are abandoning the crisis policies, and that's what we're expecting to happen here in Europe too. But the lack of inflation is making them more cautious and they think they have time to take it easy. If interest rates are to rise then central banks will have to talk a little tougher, and for that to happen they need a bit more inflation to back them up," says Thomas Elofsson.

In the global arena this year there has been great interest focused on what appears to be an escalating trade dispute, mainly between the US and China, but also with other countries involved. So far, the conflict has led to stock exchanges battening down the hatches and risk appetite has diminished somewhat at times. Emerging markets are among those affected by the increased tensions.

Thomas Elofsson calls emerging markets a weak link in the world economy.

"Emerging markets have a lot of debt in dollars and the dollar has strengthened, putting them under pressure. And they depend on world trade in a different way from the United States. Our view is that there is low risk of a global recession, but if things escalate the situation could become similar to the 1998 Asian crisis," he says.

At the beginning of the year, the managers considered that the economy was approaching full capacity utilisation and there might be more investment-driven growth. However, this has not materialised to any significant extent. Normally investments should get going and, at the end of the cycle, most people are in work, machinery is running at full capacity and profits are high.

The same applies to the salary side: when unemployment is low and there are few available workers with the right skills, wages usually rise.

"We have not seen this yet, but there has to be a link between supply and demand," says Thomas Elofsson.

As for commodity prices, base metals have recently fallen somewhat while oil has stubbornly remained at relatively high levels. While lower metal prices may indicate slightly slower growth, such as in China, oil prices are governed by a number of other factors. The oil market is currently quite tight, says Thomas Elofsson, since the market has for a long time been eating away at much of the existing stocks. At the same time, Venezuela has more or less failed as a state, which means a production loss for the world market. An important issue for oil going forward will be the sanctions against Iran, and whether the country will be able to continue to sell its oil.

The performance of Catella's hedge fund has been shaky this year. The managers had positioned themselves for slightly rising interest rates, given that inflation was likely to start to show. In hindsight this position has proven less successful as expectations for key interest rates have shifted forward in time. Thomas Elofsson is self-critical.

"We thought there were good arguments that inflation would start to creep up and that the central banks would begin to act in Europe. This has turned out to be entirely wrong – interest rates have fallen – so this position is now closed. However, this is a position that we fundamentally like because interest rates cannot fall very far but could rise a lot. The asymmetry of outcomes makes it attractive," he says.

Last year's return on the hedge fund, which was a strong 4.7 percent at low risk, has so far not been repeated this year. There are reasons on both the fixed income and equity sides of the portfolio, which roughly consists of half fixed income and half long and short equity positions.

"The return has certainly not been satisfactory. On the equity side we do not work by taking market risk but rather by selecting companies to generate returns and alpha in the portfolio. We have been less successful with this since May," says Martin Jonsson.

"On the fixed income side we have coupons and should have a return, but so far this year we have lost a little money. This is mainly due to the fact that we were completely wrong about interest rates, but it is also because we had a bond with a company that was hit by a lot of suspicion," says Thomas Elofsson.

The company in question is UK-based Lebara, a so-called virtual telecom network operator active in several countries. Its Oslo-listed bond was hit by a collapse of confidence because the company delayed its financial reporting for a long period.

Catella Fonder sold part of its bond holding in Lebara at the beginning of the year, but has retained a portion of its exposure.

"We sold part of the holding at the beginning of the year but in retrospect should have sold a lot more. But we still believe that there is value in the company as it has operations and generates cash flows," says Thomas Elofsson. He adds that in the prevailing economic environment, with a continued low risk of recession, high yield bonds are likely to continue to be a good asset class.

The hedge fund's equity side, in which the managers can choose between long and short positions (owning or short selling stocks), there have also been some less successful company picks this year. The philosophy of the portfolio managers has led to many of the holdings having a common denominator: they are often so-called value shares, which means undervalued shares in companies that are considered to have a stable core and may be in a turnaround phase.

"A handful of exposures have performed poorly. In a couple of cases we have made miscalculations where new information has weakened the case, so we have cut the exposures drastically or even completely. Otherwise we are staying put and believe we may have a good return during the autumn," says Martin Jonsson.

Shares that are commonly classified as value stocks have often been weak this year. Martin Jonsson says this may be due to a weaker growth impetus in the market, which usually means weaker performance for value stocks.

"Even looking at individual exposures the pickings have been slim. But now we think we can make out a change, and at this phase of the economic cycle value should work out better. And we have even seen a turnaround in recent weeks," says Martin Jonsson.

Among the shares that have been troublesome for the managers this year, he mentions Danish jewellery company Pandora, which after a long period of strong growth and share price gains has had a really tough time this year. Martin Jonsson also mentions energy shares, which have generated very good returns for Catella Fonder for a long time, but which have been a weaker exposure recently.

"But in this case we judge that the fundamental situation for the sector still looks good, and that our exposures are very undervalued," he says.

Among other sectors, Martin Jonsson believes that banking has been, and still is, a good investment. Since it was expanded in the spring, the fund's positioning in banking has been favourable. Martin Jonsson says that the attractive thing about banks is that the sector has been very cheap relative to the rest of the market. Also, he believes that the concerns raised about the potential impact of the housing sector on banks were exaggerated.

"Banks have been a little misunderstood, with exaggerated concerns about the development of the housing market with regard to volumes and, especially, margins on mortgages. At some point interest rates will rise, but there can be quite intense pressure on banks' mortgage margins without any impact on income. In a scenario of normalising interest rates, income could even rise on falling mortgage margins," says Martin Jonsson.

As for cyclical companies, the fund manager divides these into engineering and energy. Catella Fonder is cautions about engineering. At this stage of the cycle, upward revisions of earnings forecasts are not expected to be particularly numerous or substantial, plus any positive earnings revisions there might have been are often eaten up by lower multiples.

On the energy side, however, Martin Jonsson's vision is more positive and the fund has also retained some exposures that are still considered to be greatly undervalued.

The health and care industry is also an interesting little sector in which the fund has exposure to companies like Ambea and Humana, as well Capio, which was recently the subject of a bid. Martin Jonsson says that this sector should be regarded as a long-term exposure that is expected to contribute positively for a long time to come.

Apart from specific sectors, he also highlights what he calls the "restructuring theme", companies that may be on the cusp of a positive turnaround. Examples are the fund's positions in Getinge and NCC. The housing market worries are less of a concern to NCC since it spun off its house-building arm into Bonava a couple of years ago. We like the company's new management, and if it comes even close to achieving its profitability targets we believe the share is very cheap.

However, one company that is still entirely dedicated to housing in JM, which the fund has previously shorted. These positions are closed but Martin Jonsson is not opposed to the fund doing more on the short side with JM.

"We remain concerned and do not believe that the market has found equilibrium. There is large supply and plenty of properties remain unsold. These shares have rebounded quite a lot so we do not rule out taking a short position again at some point," he says.

When asked about the fund's other short positions, Martin Jonsson is hesitant to name names but the shorts are mainly in high-priced stocks. Entirely in line with the managers' value philosophy. The selected shorts are companies that the fund managers believe have volume growth that is too weak in relation to the valuations.

These are not primarily highly priced small tech companies, but large companies that have high multiples.

"Major companies in groceries, for example," says Martin Jonsson in conclusion.

CATELLA HEDGEFOND

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