BRIDGEWATER SHORTING EUROPE : A pinch of salt or a well-anchored disbelief?

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1 MARCH BRIDGEWATER SHORTING EUROPE : A pinch of salt or a well-anchored disbelief? AUTHOR INES MAO INES.MAO@EDHEC.COM It has been a hot topic in the media lately. Bridgewater, an American investment management fund, has shorted European stocks for $22 billions last February. The discomfort arousing from that bet is that it is discordant with the happy talks regarding EU equities outlook. Despite the recent turmoil on the US equity market, 2017 s solid economic backdrop and increasing profitability should drive equity returns to new highs in 2018 even as we see earnings momentum weakening. The following article will allow us to do an overview of the European equity markets, its potential potholes, and to demonstrate that the bet of Bridgewater is nothing but rational over the very long-run, and certainly not worth all the worries. THE BEAST AND THE BET First of all, what is Bridgewater? Or rather, who is Bridgewater? Bridgewater Associates is America s largest hedge fund with $160b AUM. Its founder, Ray Dahlio, is one of these figureheads of the investment world. Having created Bridgewater Associates in 1975 in his New York apartment, Dahlio is now leading the most profitable individual hedge fund of history Pure Alpha, with $63billion in AUM and $45b in returns between its inception and the end of 2015, also sharing his principles of success in a book or taking part to Davos summit talks alongside Christine Lagarde. So really, when Ray Dahlio shorts for $22b, it is worth to be noticed. In just one week, Bridgewater more than quadrupled how much it s betting against European Union companies. The biggest short positions in value are concerning the DAX - including Siemens, Deutsche Telekom, Deutsche Bank, or Daimler, the MIB (Italy) and the IBEX (Spain) where the fund targeted the utilities-, financial-, or even fashion industry. Other countries at stake are France (Total, BNP, Societe Generale), or Netherlands (ING Groep). Since the Feb. 8 regulatory filings, Total has fallen about 1 percent as markets slumped. Airbus, BNP Paribas, ING Groep and Banco Santander have sunk roughly 2 percent. The bet here is that share prices are going to continuously drop, resulting in a downward trend in the long-run. What could be the underlying assumptions? An interest rate capacity constraint? The uncertainty of Italian elections? The inflation outlook? The problem that arouses to my mind is that the bet is going to succeed only if there s a slowdown in the economy or if euro stocks are a less attractive opportunity compared to US equities. However, none of these hypothesis is likely to happen in the short-run. So why shorting EU and not an other region in a time of happy talks?

2 MARCH DAHLIO VS THE REST OF THE INVESTMENT WORLD equity market is doing fine and almost everyone agrees on it has been a remarkably profitable environment for equities with a global recovery, interest rates remaining well-anchored and many of the uncertainties related to political events gradually fading away. Despite the slower pace of growth anticipated, the global expansion is to be continued in What is at stake in Dahlio s short bet is the extent to which the economy will be able to navigate in the significant potholes of Quick scan of risk factors and why I think they should be tempered: WHO TRIGGERS POSSIBLE CONSEQUENCES WHY IT SHOULD BE MITIGATED Aggressive hike is negative Aggressive rate climbing could affect consumer spending and economic pace Equities can remain in a bull market if the tightening reflects higher growth, nominal or real. ECB tampering its QE policy Be cautious with the VIX An aggressive hike in rates could also lead to a high-volatility period on the equity market, as shown in early February on the US equity market, as investors forecast a rise in interest rates. One thing important to notice is the relatively important role of ECB compared to the FED. Europe may be two years behind the FED in terms of normalizing rates, but the role of the central bank is much bigger in Europe relative to the market size than it is in the U.S. Tapering is not strengthening: has a more stable outlook than the US U. S. and monetary policy and rates look set to diverge. ECB s has signaled it will not raise rates until well after it has ended its net asset purchases: the rise in rates is expected to be moderate. On the other hand, the Fed is likely to put some distance as it has officially announced its balance sheet shrinking and delivered its projected three 0.25% rate increases in Poor performance of EU firms compared to US: MiFID II and IFRS 9 will force banks in Europe to Too tight regulations provision for souring loans much sooner than at present and transparency obligations are putting additional pressure on financial industry US tax-cut effects are only on the short-run: there s a limitation to the increasing of the US economy because there s a production limit On the other hand, US government is fostering its firms profit by cutting taxes and deregulating financial markets 2017: the roots of a political and economic pothole Political risks rooting in 2017: Catalonia and Greece leaving the EU, Ukraine conflict climbing, Brexit negotiations fail, markets fear the Five- Star movement in Italy Chinese risk of economic downturn: less demand for European goods and services This is probably the most negative scenario for the, with a disinflationary setback. However, the probability of it occurring is low according to analysts investment outlooks. If China faces a roll-over of its economy, the is certainly not the only region that will have to face an impact on its economy; relatively, it is not a reason to prefer an other equities market over the

3 MARCH Five-star movement: Italy 5SM and weak financial industry The gamble is almost won for the anti-establishment, Eurosceptic, anti-immigration and pro-green party. The uncertainty arouses from the decisions the new Italian government could take regarding the public debt, its involvement in EU, and its economic policy EU third largest economy but weak financial industry: Dahlio is targeting Italy s financial sector, which is indeed still fragile and could be impacted by ECB s reduced-bonds repurchase Italy s current economic performance is stronger than it had been in many years, so there s a high probability 5SM decides in the end not to rock the boat and just stick to the recovery without impacting it as much as expected. Italy has recently decided a new law limiting the impact of anti-establishment parties like 5SM and ECB is only to tapper on the QE not stop it Potential indigestion of Spanish banking sector: The decline and fall last year of Spain s sixth biggest bank, Banco Popular, serves as a reminder that Spain s Spain Catalonia status quo banking system is far from fixed, despite the tens of billions of euros thrown at it. Dahlio shorting Spanish banks may be a viable bet. N/A Catalonia: There is still no government in Catalonia and negotiations stand still; Catalonia s problem becomes Europe s problem Germany Coalition problematic Stock markets sensitivity: DAX tumbled after coalition talks pass deadline without a deal in February Risk of a lack of cohesion at the top of Europeleading country Uncertainty related to the German coalition is fading away, and even if a Merkel-led minority government results, an element of certainty would be reinstated. Crosscurrency effects Dollar is in a 3-year low There s a high probability that dollar will strengthen relative to euro in the medium-term, thus squeezing Euro firms profit. The more at risk are companies heavily relying on oversea profits, such as Total. The earnings in dollar will be much less in euros, and dividends for oversea shareholders will be eroded. A stronger dollar will push forward profits of US firms relatively to Euro firms. However, a stronger dollar will benefit European exports to the US and may inflate earnings of internationally diversified European firms. I believe that overall outcome of the cross-currency effects are pretty uncertain today. At first sight, each risk factor taken individually doesn t look substantial enough to support the bet of R.Dahlio because we can always find a reason why it should be mitigated. I acknowledge the fact that upcoming elections or uncertainty related to Spain for example are worrying for the European Union policy s cohesion but I believe that they are not worth shorting $22 billions on European stock markets. To my mind, the problem is not about highlighting what could possibly go right or wrong in the, or if Ray Dahlio is mistaken, but rather to reframe the problem in terms of matter and timeline.

4 MARCH LET S BE VERY LONG-RUNNISH AND VERY CAUTIOUS By taking short positions on European stocks, Ray Dahlio acknowledges two things: First, we need to look beyond annual investment outlooks. For such a gamble to succeed, the fund certainly has a very long-term vision, and we need to mitigate every risk factor that individually occurs on the short-run, such as low performance of EU firms compared to US firms, or German and Italian elections. Two long-term macro factors look strong enough to support the short bet of Bridgewater: o The uncertainty about the hike in ECB interest rates and the extent to which European stock markets will react in the long-run: the risk being that inflationary pressure erodes euro profits o The appreciation of the dollar relative to the euro may lead to a downturn in firms profit over the long-run: a lot of Europe s largest companies are now so internationally diversified that many don t even earn the majority of the profits in Europe. Among companies shorted by Bridgewater, Airbus for example only makes a third of its sales in Europe. Recently, BlackRock upgraded its outlook for US companies due to their earnings growth while shifting to neutral on Europe. Second, the fund acts as a forewarning concerning local politics and local rates. One has to agree on the fact that these factors are way more significant now than they have been in Europe in the past. We may consider political risk individually in each European countries to be relatively benign for the at the current time but in some respects, the accumulation of short-term risk factors could represent a high risk in the long-run for the whole. Something important to mention is that Bridgewater may reap the benefits of its strategy in the long-run because it reflects the well-anchored disbelief in the European Union. I notably refer myself to political potholes the EU will have to navigate in 2018 and beyond. Additionally, I would like to highlight the fact that new information on hedge funds position is to be taken with caution. Why? Regulatory fillings oblige funds to disclose publicly what they invest in, but we don t know that much about what they have on the other side. I think Bridgewater might be long on Euro stocks or some type of derivatives, and that they re shorting to reduce their long position. Finally, I would add that once a stock market goes well or even very well such as the US equity market in 2017 there s a high chance it slumps in the medium- or long-run. It doesn t necessarily means that the market is going bearish, but just that the market is readjusting to fundamental values. As one knows, financial markets are cyclical and patterns of high equities performance are always followed by patterns of lower performance.

5 MARCH The only question arousing is: when is the transition to the new pattern? No one knows. After having crunched every annual investment outlooks I could, I can fairly affirm that the European equities market is likely to go well in 2018, or at least until summer 2019 when rates could possibly be upgraded. There s no need to torment over Bridgewater s bet: I believe it is a pinch of salt in the investment world in the short-run. However, they may reap the benefits of their strategy in the longrun. I personally acknowledge the fact that Bridgewater is stock picking rather than passive investing and thus helps arousing debates over investment outlooks beyond I strongly believe that an active investment approach is best suited to unearth opportunities in attractive areas of the European stock market. This is very important as volatility has raised again since February 2018, something that would expose vulnerabilities in the market, including mispriced assets. Sources: 2018 investment outlook of: - Blackrock - Goldman Sachs - Citi - Credit Suisse - UBS - BNP Paribas - Lazard - Bloomberg SeekingAlpha.com MarketWatch.com DISCLAIMER About the article This Article has been compiled by the author mentioned above and published by her via the EDHEC Student Finance Club ( Club or ESFC ) platform. The club confirms hat the author is an active member at the time this article is published, but emphasizes the fact that opinions and views given by the author in this article are his/her own views. ESFC takes no responsibility for the completeness or correctness of information provided. No investment advice is given with the text above and the reader hould not take any financial position based on the information published in this article. The Club recommends extensive research by the reader before investing in any inancial asset. General The article may be based on the information extracted from various sources including but not limited to various companies and statistical agencies websites, online portals, third-party research, annual reports etc. No representation or warranty of any kind is or may be made with respect to the accuracy or completeness of, and no representation or warranty should be inferred from, any projections or futuristic statement contained herein or any underlying assumptions. This article may include descriptions, statements, estimates and projections/futuristic statements with respect to current and anticipated performance of the underlying. Such statements, estimates and projections reflect various assumptions and best estimates made by the participants concerning anticipated results, which assumptions and estimates may or may not prove to be accurate or correct. There are no assurances whatsoever that any statements, estimates or projections contained in this article, ncluding without limitation any financial or business projections, accurately present in all material respects the underlying s financial and/or business position as of the espective dates specified and the results of its operations for any respective periods indicated. No copyright or trademark infringement is intended in any form. Copyright EDHEC Student Finance Club