As the week comes to an end, many investors appear to be on the fence. The indifference of recent months has disappeared. But despite geopolitical factors, pullbacks in multiple stock markets and — in the U.S. in particular — concerns about historically high valuations, equity investor sentiment is far from reaching a point of panic; yet the structure of the bond market suggests traders are not positioned for a significant sell-off either. In a report issued today, Société Générale macro strategist Kit Juckes in London echoed this neutral sentiment. After checking off the litany of concerns facing global investors, he concludes: “All of that represents a reason not to overplay the current sell-off. But ‘buying the dip’ after a modest widening in spreads at the end of a monumental rally seems a bit too much like rushing out to pick up the last few pennies as a steamroller approaches.”
Bank of Japan rate decision: With recent data causing concerns that Abenomics-spurred growth is sputtering out, the Bank of Japan left stimulus measures unchanged in an announcement today. The BOJ cited concerns over weakening trade and production data in recent months and pledged to continue to expand the monetary base aggressively to revive inflation. Haruhiko Kuroda, governor of the central bank, commented in a press conference that recent setbacks in external demand are not yet a cause for significant concern and that the domestic impact of recent tax increases is dissipating.
China trade data: China Customs reported a record trade surplus for July, with exports advancing 14.5 percent higher than the same month last year and a marginal decline in import levels. U.S. and European-bound shipments were the primary driver for this expansion, which suggests recovery in primary Western economies will reduce concerns in Beijing about the possible need for additional stimulus measures. As has been the case for trade data reported in recent quarters, multiple analysts commented on probable distortions in trade data caused by hidden capital flows.
Earnings announcements on deck: U.S. large cap equities reporting second-quarter 2014 earnings today include Brookfield Asset Management, E.W. Scripps Co. and Sotheby’s. In Germany, Allianz announced quarterly results that beat consensus forecasts as the insurer’s net profits rose 11 percent in the second quarter.
U.S. Treasury markets remain calm. In a note issued yesterday, interest rate analysts at Barclays noted that the underperformance of risk assets in recent weeks has been very similar to market dynamics earlier this year, but more subdued. “Over the past month, broad equity markets have sold off, spread products have underperformed, and the U.S. dollar has strengthened to a similar extent as it did in January.” They continued, “However, ten-year yields have declined 10 to 15 basis points, compared with almost 40 basis points in January.” The bank continues to urge caution against outright duration trades.
Portfolio Perspective: The Risk in Risk Arbitrage — Thomas Kirchner, Quaker Funds
Investors used to get excited about Merger Mondays. Since this week, however, they fear Deal Crash Wednesdays. To put it mildly, three transactions getting into trouble in one day is unusual: $20 billion getting wiped off the value of merger-related stocks occurs once per decade.
To put this into context, just a few months ago, deal makers and arbitrageurs were happy when a deal worth more than $10 billion was announced. The largest investable merger in 2013 had a deal value of $37 billion. This year before summer is even over, there have been eight mergers larger than that. With the exit of investment banks from proprietary arbitrage, the capital constraint of today’s arbitrageurs is noticeable in the comparatively wide deal spreads that accompany many of the larger mergers. While it is hard to generate more than 5 percent annualized returns on sub-$10-billion mergers, the larger deals can have annualized arbitrage spreads north of 15 or even 20 percent.
This week’s Deal Crash Wednesday reminded investors that risk is not just an abstract number. Allocating capital to the right types of corporate events is just as important as classic arbitrage analysis. Given arbitrageurs’ capital constraints and idiosyncratic deal risk, merger spreads on large M&A transactions should remain at wide levels, and many observers will continue to scratch their heads.
Thomas Kirchner has been the portfolio manager for Quaker Event Arbitrage Fund at Malvern, Pennsylvania–based Quaker Funds since its 2003 inception.
