The Contrarian Quartet (Part I)

“If all the economists were laid end to end, they’d never reach a conclusion.” – George Bernard Shaw

“Twenty years from now you will be more disappointed by the things that you didn’t do than by the ones you did do.” – Mark Twain

 “Studies have shown that most rational people, including people that fit that profile, that their decision making breaks down in an environment of negative reinforcement. The ultimate example of which would be interrogation, where your ability to withhold information is broken down by various physical or mental techniques.” – Jim Chanos

 

  

Is there any population cohort exposed to a more rigid daily routine than school going children and teenagers?

The constant ringing of bells, schedule of classes, lunchtime, homework, each a daily fixture throughout the academic year. It is no wonder then that most people tend to be conformists – the rigidness of school stamps out individualism in favour of conformity.

The irony of it all is that we celebrate the individuals who have managed to resist the rigidness and maintain their non-conformist streaks. Our heroes are Steve Jobs not Jeffrey Immelt, Muhammad Ali not Floyd Mayweather, The Beatles not Coldplay.

Capital markets too have on occasion handsomely rewarded the contrarians, like Dr Michael Bury during the Global Financial Crisis, Paul Tudor Jones in 1987, and Jesse Livermore in 1929. Markets do not, however, look kindly upon the reflexive contrarian – the investor that cannot help but go against the trend. Markets can be conformists for extended periods of time and hence why momentum following strategies can be so rewarding.

We like to consider ourselves independent investors – investors that scour the market for signals that may provide us with opportunities to generate outsized returns. Our aim is neither to be contrarian nor momentum driven. Today, however, we see four areas of the market where the risk-to-return profile in being contrarian is far more attractive than in following the herd. We outline two out of the four areas of opportunity below and will outline the remaining contrarian opportunities in a follow-up next week.

Turkey

“Bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria.” – Sir John Templeton

  

In Turkey today we see many reminisces of what occurred in Brazil in 2015, with the caveat that with Turkey embroiled in a geopolitical storm as compared to the internal political strife in Brazil in 2015 makes Turkey potentially far more volatile.

Consider Brazil at the height of its crisis in 2015:

  • The premium on Brazil’s three-year credit default swaps surged by 189 per cent over a period of four and half months
  • The Brazilian real declined by 43 per cent versus the US dollar in a period of four and half months
  • Using the twenty-five year average, Brazil’s real effective exchange rate was one standard deviation below its average

Brazil Real Effective Exchange Rate (25 Years)Brazil REER 25Y

Source: Bank for International Settlements

  • Using the five year average, Brazil’s real effective exchange rate was two standard deviations below its average. As the political turmoil subsided and the real effective exchange rate reverted towards the mean, the Brazilian equity market rallied and foreign investors enjoyed the leveraged effect of a rising equity market coupled with the strengthening real

Brazil Real Effective Exchange Rate (5 Years) vs. MSCI Brazil IndexBrazil REER 5YSources: Bank for International Settlements, Bloomberg

  • Brazil’s rating was downgraded from Baa2 to Baa3 by Moody’s and from BBB-minus to BB-plus by Standard & Poor’s

Now consider Turkey in 2018:

  • The premium on Turkey’s three-year credit default swaps has increased by 152 per cent in less than three months
  • The Turkish Lira has declined by 26 per cent versus the US dollar in a period of less than three months
  • Using the twenty-five year average, Turkey’s real effective exchange rate is almost one standard deviation below its average

Turkey Real Effective Exchange Rate (25 Years)Turkey REER 25Y

Source: Bank for International Settlements

  • Using the five year average, Turkey’s real effective exchange rate is two standard deviations below its average

 

Brazil Real Effective Exchange Rate (5 Years) Turkey REER 5Y Sources: Bank for International Settlements, Bloomberg

 

  • Turkey’s rating has been downgraded from Ba1 to Ba2 by Moody’s and from BB to BB-minus by Standard & Poor’s

The bad news is that Turkey runs a current account deficit of around US dollar 40 billion a year and has external debt stock of approximately US dollar 450 billion. The net amount of outstanding external debt is around US dollars 290 billion, representing 34 per cent of its GDP.

The good news is that the vast majority of Turkey’s foreign currency denominated debt is held by local banks. We do not expect Turkey to default on the debt it owes to foreign investors. This view is founded on the assumption that while President Recep Tayyip Erdoğan can afford to antagonise the US and Europe on the political front given Turkey’s geopolitical significance, he cannot afford to antagonise foreign investors as Turkey relies on international capital markets to fund its economy.

We think the time is coming to scale into Turkish assets. The sequence of scaling in being the Turkish lira first, foreign currency bonds second, local currency bonds next and the equity market last.


Swiss Franc

“You can’t do the same things others do and expect to outperform.” – The Most Important Thing by Howard Marks

Hedge funds and speculators are holding the biggest net short Swiss franc position in more than ten years at a time when the Swiss franc is close to being undervalued relative to the US dollar – a first since the start of the new millennium.

CFTC CME Swiss Franc Net Non-Commercial PositionCHF CFTC

Source: Bloomberg

Over the last decade, Switzerland has run an average current account surplus of 9.3 per cent of GDP. The Swiss franc should not be undervalued. If anything, given that Switzerland has consistently run current account surpluses and enjoys the so called global safe haven status, the Swiss franc should be overvalued.  We all know the reason why the currency is not overvalued: the non-stop printing and selling of its currency by the Swiss National Bank.

At the end of last year, the State Secretariat for Economic Affairs revised its economic growth forecasts for Switzerland upwards, forecasting GDP to grow by 2.3 per cent in 2018 after growth of 1 per cent in 2017. The revision was driven by industrial orders rising by a fifth in the fourth quarter last year and a booming tourism industry that is benefiting from the artificial suppression of the Swiss franc.

In the face of such strong economic growth we doubt that the Swiss National Bank can sustain the suppression of its currency. We suspect the Swiss National Bank, not for the first time, is going to cause a lot of pain to those unwisely betting against its currency.

We will gradually look to get long the Swiss franc once we see the broader short interest against the US dollar unwinding – we expect such an opportunity to be presented imminently.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein  

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