Divvy thoughts

If yesterday was a reminder that there is risk in "risk parity", it probably didn't come before time.  From the shellacking in bonds to a dip in prompt crude below $40 to yet another evisceration of European banks, it was a tough day if you owned much of anything other than precious metals.

For European banks, it really does seem to be the case that the only good kind of news is no news at all.  While the stress tests were ostensibly calming on the surface, the follow-up newsflow  (a dire profit warning from Commerzbank, Deutsche and CS getting booted from the Stoxx Europe 50 [which is not the same as the Euro Stoxx 50, mind you]) has been less than rosy.  The good news is that the SX7E has yet to hit its recent lows....yet.


While Macro Man pointed out a market divergence yesterday, there's another, lesser-known one that he'd like to touch on briefly today.  Long time readers will be aware of Macro Man's occasional fascination with Eurostoxx dividend swaps, which exist in futures form and allow one to make bets on the dividend payout of the underlying index years into the future.

While they settle into the actual payout, and are thus immune to the ebb and flow of supply and demand as they approach maturity, longer tenors tend to represent the liquidity environment more than they do the market's underlying belief in the stream of dividend payouts.   This is primarily a function of the large structured product business in Europe, which leaves dealers long a stream of dividend payouts.   While they can hedge this by selling a strip of dividend swaps, the only natural buyers are plucky speculators.  As a result, the strip a) tends to trade at a discount to consensus dividend payout forecasts, and b) has a higher beta to the underlying index the further out you go.

What's notable is that further dated divvy swaps have tended to track the SX7E banking index very closely.   This makes sense on two levels: 1) the banks themselves are in many ways mere measures of market liquidity and risk appetite these days, and so are impacted by the same drivers as longer dated dividend swaps, and  2) more prosaically, even after the dividend cuts of the last few years banks still comprise 20% of the expected dividend payouts in the index.  Obviously, the more that bank stocks reflect a crisis footing, the more likely it is that the market will fear dividend cuts in the future.

As such, Macro Man was intrigued to see that the the overlay chart of the SX7E and the 5th dividend swap contract (representing 5 calendar years out, currently 2020) has displayed some divergence as noted above.  Simply put, DED5 has remained somewhat more resilient than you'd expect given the decline in SX7E.

Now, it's entirely possible that this is because no one's bothered to sell any yet, and in any event it is unrealistic to expect too close a fit, as you can observe elsewhere on the chart.  We can make a few observations, however:

1) The DEDZ0 (ie 2020) contract is currently priced at 92.6.  This is well below the current year payout (119 forecast, and it's largely baked in the cake) and all of the annual of payouts since the crisis (which have ranged from 109.8 to 124.3).

2) It is also well below the consensus forecast for payouts in 2020, though that's less interesting; the consensus has generally been way too optimistic on European dividend growth in the seven years that Macro Man has been involved with these.

3) The strip is pricing an annualized decline of 5% between now and 2020, and 6.5% between the end of next year and 2020.  These implied declines are low but not at critically depressed levels.


4) While owning the DEDZ0-DEDZ7 spread will very likely make money on a hold to maturity basis, the best time to put these trades on is after a dump, not during an an environment of slightly surprising resilience.

5) For the brave at heart, selling some puts on DEDZ0 will almost certainly work on a hold to maturity basis.   The 85 put settled at 19.42 yesterday; given Macro Man's experience in that arena, they'll probably bid you 17...and settle it at 20.   (But no need for the regulators to look into dodgy settles on futures exchanges now, is there?)  Of course, you won't make any money for the next 6-12 months, so that's one for the PA rather than the professional account.

6) From Macro Man's perch, the dividend swaps are clearly a better trade than long European banks.   No, there's not the potential upside, but frankly there isn't as much downside, either.  At the very least there are some solid businesses underpinning the divvys, whereas the banks are sitting on a wing and a prayer.  Of course, "a better trade than long EZ banks" is damning with the faintest of praise; for Macro Man to get enticed into trading these again, he'd either need to see signs of clear underlying improvement in the EZ economy/profit dynamic (yeah, right) or a proper "just get me outta here" panic sell-off.  In the meantime, he intends to wait...and see if the carnage in the banking sector extends further.
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Anonymous
admin
August 3, 2016 at 11:48 AM ×

Isn't this a function of the banks weight in SX5E, which i would guess has been falling? (Haven't checked)

Another reason to prefer the div trade, your underlying automatically (if slowly) rebalances to companies which aren't at zero.

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Thud and Blunder
admin
August 3, 2016 at 12:58 PM ×

Indeed; index reconstitution is your friend over time. Also, once you've cut your dividend to zero (looking at you, DB), there's limited downside from there (one would hope...).

So the SX7E / divi correlation is interesting and perhaps well-founded, but inherently unstable, and I would expect it to begin to decouple in a bank stress scenario as we're experiencing at the moment.

Micro observation: Z0 is expensive vs Z9 and Z1. If I was punting long, I'd pick one of those two, depending on my predilections.

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12yo HFM
admin
August 3, 2016 at 3:18 PM ×

Today's strategy: Equities down a couple of days... gotta be time to buy more right? #easy_money

PS What're these "really big systemic risk off events" that LB was talking about yesterday? Is that like when ES is down 10 handles? lolz

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johno
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August 3, 2016 at 4:36 PM ×

South African municipal elections today. No clue who wins and little clue how market will interpret. A successful outcome for pro-business DA may be seen positively, but ANC losses that spur populist fiscal stimulus ahead of the 2018 elections would have negative implications for the credit rating. That said, when I look down a list of EM currencies ordered by FX-implied rates, ZAR stands out as the high-yielder with a central bank that actually welcomes more appreciation.

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Nico G
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August 3, 2016 at 9:27 PM ×

http://failedevolution.blogspot.gr/2016/08/varoufakis-alert-financialized-capital.html

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Anonymous
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August 3, 2016 at 11:56 PM ×

The fail will be epic...
Bloomberg Headline of article in wkly Leveraged Capital newsletter: "Tidal Wave of Insurance Cash Pointed Toward Junk Bonds"

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checkmate
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August 4, 2016 at 12:23 AM ×

"varoufakis"
It's a perspective. One of many ,but not particularly insightful or more valid simply because it comes from him. Let's face it we all struggle to escape the bounds of our own bias when it comes to trying to explain and validate these type of issues.V is certainly no different in that respect.

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