Monthly Letter April 2015

During the past year both bonds and commodi es have been indica ng (or even pricing in) that the developed world might be heading into de a on. Equi es on the other hand have been pricing in rm earnings growth in a low growth environment. Something has to give. De a on is not good for equi es so if commodi es and bonds are correct equi es should trade lower. Even though equi es have been pricing in earnings growth we would say that they have not been pricing in the very low interest rate environment we are currently experiencing. Just look at the dividend yield vs. corporate bond yield, look at the equity risk premia when you use government bonds as the risk free interest rate (Italian government bonds risk free?). For those of you who are old enough to remember Meatloaf: 2 out of 3 ain’t bad. This is just the opposite though; if bonds and commodi- es are correct then the equity market is in for a rough ride.

Towards the end of April a few things unravelled. Bond yields started to go up, commodi es re- covered. USD started to reverse some of its recent strength and European equity markets started to give back some of the year to date gains. These moves are interes ng for a number of reasons, but for Madrague as equity investors we are mainly concerned with the weakness in the equity markets. Is it ra onal that equity markets go down when we get higher in a on indicators? We would argue not. We believe that we are witnessing a short term phenomena where the markets are reversing some of the very pronounced price movements we’ve experienced in oil, iron ore and government bonds in the past 6 months. Equi es have been strong and the consensus trade has been to buy European equi es. We believe that a lot of the price ac on can be explained by macro hedge funds unwinding trend following posi ons. If indeed the increase in bond yields is a sign of higher economic ac vity, then equi es should bene t. There are signs indica ng that this is the case; e.g. in a on expecta ons in Europe is picking up and employment cost index in the US is also moving higher.

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