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The Age of Fragility

Sohn Conference, June 2018

Page 1

Alberto Gallo, CFA

Portfolio Manager, Algebris Macro Credit Fund and Algebris Tail Risk Fund

Head of Macro Strategies


Page

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L-2163 Luxembourg


Page 3

The Age of Fragility

“Once fragile financial structures exist the incoherent behaviour characteristic of a

financial crisis can develop. Incoherent behaviour occurs when the reaction to a

disturbance amplifies rather than dampens the initial disturbance.”

Hyman P. Minsky, A Theory of Systemic Fragility, New York University, 1976

“The crisis takes a much longer time coming than you think, and then it happens

much faster than you would have thought. […] It took forever and then it took a night.”

Rudi Dornbusch


Page 4

QE and ZIRP/NIRP at the Base of the Carry Trade Pyramid

$2tn Short Vol Strategies

$8tn High-Dividend/Growth Equity

$11tn IG/HY Credit$2tn EM Hard Currency Credit

$12tn Sovereign Debt at <1% Yield*

$21tn Central Bank Balance SheetsZIRP/QE

Source: Algebris (UK) Limited, Bloomberg. *Data sourced from GS

Fragility


Page

Binary Markets

Fragility

5

Source: Algebris (UK) Limited, Bloomberg

0%

5%

10%

15%

20%

25%

30%

35%

40%

5-10 10-15 15-20 20-25 25-30 30-35 35-40 40-45 45-50 50-55 55-60 >60

Pre QE Post QE

Longer periods of

low volatility…

… but also a fatter tail of very high volatility


Page

Fed Tightening Cycles End in a Burst

Fragility

6

Source: Bank of America Merrill Lynch Global Investment Strategy, Bloomberg

'29Wall St crash

'37Fed

"policy mistake"

'70Penn

CentralBK

'74 Franklin Natl

BK

'82LatAm debt

'87Stock market crash '90

S&Lcrisis

'94Tequilacrisis

'00Tech

bubble

'97Asia/

Russia/LTCM

'07Subprime

crisis

0

2

4

6

8

10

12

14

16

18

20

'15 '21 '27 '33 '39 '45 '51 '57 '63 '69 '75 '81 '87 '93 '99 '05 '11 '17

US Fed Funds target rate, %

?


Page 7

Where Are the Cracks?

“Politicians are resourceful people. …

A smart politician can see that if somehow the consumption of middle-class householders

keeps rising, if they can afford a new car every few years and the occasional exotic

holiday, and best of all, a new house, they might pay less attention to their stagnant

monthly paychecks.

And one way to expand consumption, even while incomes stagnate, is to enhance access

to credit.”

Raghuram Rajan, Governor of the Reserve Bank of India, August 2010


Page

Fragility

Source: Algebris (UK) Limited. With reference and inspiration from Antifragile: Things that Gain from Disorder, N. N. Taleb (2013)

8

Nature, Policy and Markets

Fragile Robust Anti-Fragile

Medicine Anaesthesia Vaccine Mithridatism

Pension System Defined Benefits Defined Contributions Social Shock Absorbers

Technology Centralised Hard Drive Underground Storage Cloud Storage

Mythology Damocles Ulysses Hydra

Nature Dinosaurs Land Turtle Ant Colony/Bacteria

Objects Tea Set Anvil Spring

Financial Markets

Passive Investing/Herding

Financial

Engineering/Complexity

Active Management Tail Risk Strategies

Monetary Policy Forward Guidance Rule-Based Approach Macro-prudential Policy

Capital Structure Debt Equity AT1

Sovereign Debt Hard Currency External Debt Domestic Currency Debt Growth-Linked Debt

Economic Agents Politicians RegulatorsLong-Term/Contrarian

Investors

Government

StructureEurozone Singapore Switzerland


Page 9

Public and Private Debt Overhangs Are Still Standing

Overhangs

Source: Algebris (UK) Limited, Bank for International Settlements (BIS)

Total Non-Financial Debt by Segment of the Economy, % GDP

0%

100%

200%

300%

400%

500%

Luxe

mb

ou

rg

Ho

ng

Ko

ng

Ja

pa

n

Ire

land

Be

lgiu

m

Po

rtu

ga

l

Gre

ece

Fra

nce

Ca

na

da

Sin

ga

po

re

Ne

the

rla

nd

s

No

rway

Sw

ede

n

Sw

itze

rlan

d

Sp

ain

Ch

ina

UK

Un

ite

d S

tate

s

Eu

ro a

rea

Ita

ly

De

nm

ark

Fin

land

G2

0

Au

str

alia

Ko

rea

Au

str

ia

Ne

w Z

ea

land

Ma

laysia

Isra

el

Ge

rma

ny

Ch

ile

Hu

ng

ary

Tha

iland

Bra

zil

Po

land

So

uth

Afr

ica

India

Cze

ch R

epu

blic

Turk

ey

Ru

ssia

Sa

ud

i A

rabia

Me

xic

o

Arg

en

tin

a

Indo

ne

sia

Government Households Non financial corporations


Page 10

Fragile Debt Dynamics: Is Italy’s Debt Sustainable?

Overhangs

Source: Algebris (UK) Limited, IMF, Bloomberg.*Assuming an average annual primary surplus of 1.47% of GDP (long-run average for Italy since 1988); assuming 10% of total debt will be refinance every year.

Italy Debt to GDP Ratio in 5 Years in Different Growth and Yield ScenariosRed Cells = Debt to GDP Ratio > 130%

Average Annual Nominal GDP growth

Yie

ld C

ha

ng

e

-5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5%

-1.0% 187% 177% 168% 159% 151% 143% 136% 129% 122% 116% 110%

-0.5% 188% 178% 169% 160% 152% 144% 137% 130% 123% 117% 111%

0.0% 189% 179% 170% 161% 153% 145% 138% 131% 124% 118% 112%

0.5% 191% 181% 171% 162% 154% 146% 138% 131% 125% 119% 113%

1.0% 192% 182% 172% 163% 155% 147% 139% 132% 126% 119% 114%

1.5% 193% 183% 173% 164% 156% 148% 140% 133% 127% 120% 114%

2.0% 195% 184% 175% 166% 157% 149% 141% 134% 127% 121% 115%

2.5% 196% 185% 176% 167% 158% 150% 142% 135% 128% 122% 116%

3.0% 197% 187% 177% 168% 159% 151% 143% 136% 129% 123% 117%

3.5% 198% 188% 178% 169% 160% 152% 144% 137% 130% 124% 117%

4.0% 200% 189% 179% 170% 161% 153% 145% 138% 131% 124% 118%


Page 11

Fragile Politics

Geographical Income and Political Polarisation

Source: FT

2018 Italian Elections: Leading Party by Region

Source: University of Oxford

2016 Brexit Referendum: Remain vs Leave


Page 12

Source: Algebris (UK) Limited

UK/Brexit US/Trump

1. Dream

2. Enemy

3. Policies

Results

Economic

Political

Foreign

Domestic

Militarism

Nationalism

Protectionism

Large deficits

Resource misallocation

Rising public debt

Financial Repression

(Inflation, Taxes & War)

£350mn a week Revive manufacturing

Take back control MAGA

Europe Mexico, China, NK

Immigration

Spain/Gibraltar/Russia

Wall, Buy American

Tariffs Border Adjustment Tax

Immigration

Defence spending

Tax haven

Political RisksInvesting in Times of Populism

Italy/5S & NL

Jobs

Contract with Italians

EU/ECB

UBI

Flat tax

Immigration

Police spending


Page 13

Trades

“… I have doubts that on the other hand, one can go back to the simple life of

monetary policy as it used to be, with very small central bank balance sheets and just

policy targeting the overnight money market rate..”

Vítor Constâncio, Vice-President of the ECB, 26 April 2018


Page 14

1. Buy DXY

1. We are moving out from a goldilocks synchronous global expansion to an

environment of divergence where the US is outperforming

2. The Fed is likely to overlook a slowdown in foreign economies

3. It is harder for other central banks (ECB, BoE, BoJ, Riksbank) to normalise

their policies due to slowing growth momentum, unresolved structural

imbalances and financial fragility across banks and property markets

4. Trade wars/tariffs may further increase the growth differential between the

US and the Rest of the World

5. Protest politics and policies (Italy, Spain, UK) may also hinder central bank

normalisation

6. Fiscal stimulus could help, but no spending in Germany yet


Page

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

2004 2006 2008 2010 2012 2014 2016 2018 2020

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

2004 2006 2008 2010 2012 2014 2016 2018 2020

Eurozone Core HICP March 2014 projections

March 2015 projections March 2016 projections

March 2017 projections Latest ECB projections(March 2018)

15

Source: Algebris (UK) Limited, ECB, Bloomberg. *Linear interpolation between ECB year-end projections.

Eurozone Inflation Undershooting ECB Target


Page

-3%

-2%

-1%

0%

1%

2%

0.8

1.0

1.2

1.4

1.6

1.8

Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16 Jan-18

EURUSD CURNCY (LHS) EUR-US 5yr rate differential (RHS)*

16

Euro Still High vs Interest Rates Differentials

Source: Algebris (UK) Limited. Bloomberg.

* 5-year swap rates


Page

1. The US economy is showing late-cycle signs: full employment and stimulus

are supporting corporate top-lines and margins

2. Credit fundamentals are deteriorating: US HY interest coverage is falling

and spread per unit of leverage is at multi-year lows

3. The Fed is likely to continue on its hiking path: highly levered companies

with weak margins are vulnerable to higher rates or a turn in the cycle

4. Why own a double-B junk bond at 5% when you can buy a Treasury at 3%?

5. HY firms used to be good businesses with bad balance sheets. Now they

are zombie businesses with bad balance sheets (e.g. Blockbuster vs Netflix)

6. Short MLALHYCS Index: 40 equal-weighted stocks with the highest

leverage, lowest interest cover and/or lowest margins

7. Average rating BB, Net Debt/EBITDA at 4.1x, Interest Coverage at 3.1x and

EBITDA Margin at 16.5%

17

2. Sell Junk Stocks: MLALHYCS Index


Page 18

US High Yield Bond Spreads Are Near Record Tights


0

200

400

600

800

1000

1200

1400

1600

1800

2000

1996 2000 2004 2008 2012 2016

BB B CCC or below


Page 19

Performance vs SPX

Source: Algebris (UK) Limited. Bloomberg. US HY based on ICE BofAML US High Yield Index.

* 1:1 basis price returns - excludes dividends & shorting cost.

Normalised

PerformanceUS HY Yield

5.0%

5.5%

6.0%

6.5%

7.0%

90

95

100

105

110

115

120

125

May 2017 Aug 2017 Nov 2017 Feb 2018 May 2018

Hundre

ds

US HY YTW (RHS)

MLALHYCS Performance*

SPX Performance


Page


Page 21

Appendix


Page 22

Historical Performance vs High Yield Spreads

y = -0.2852x + 0.0393R² = 0.431

-8

-6

-4

-2

0

2

4

6

-15 -10 -5 0 5 10 15 20 25

CD

X H

Y 5

Y S

pre

ad

MLALHYCS Index



Page 23

2. Short High Yield Rated Stocks


Sector Breakdown, % Total Net Leverage Breakdown, % Total

Consumer Discretion

ary22%

Industrials20%

Materials15%

Consumer Staples

12%

Health Care10%

Utilities8%

Telecom Services

5%

Energy5%

IT3%

Net Debt/EBITDA

0%

5%

10%

15%

20%

25%

30%

1-2x 2-3x 3-4x 4-5x 5-6x >6x


Page 24

High Yield Rated Stock Basket Composition (1/2)

Valuation Leverage Operating Performance

Company Industry (GICS)SP Credit

Rating

EV / nxt yr.

est. EBITDA (x)

Est. P/E

ratio nxt yr. (x)ND / Adj. EBITDA (x)

(EBITDA Capex)

/ Interest Expense (x)

EBITDA margin

(3yr hist. avg., %)

EBITDA growth

(5yr CAGR)

WYNN RESORTS LTD Consumer Serv. BB- 12.3 20.0 4.1 3.1 23.4 2.8

ONEOK INC Energy BBB 14.1 24.1 4.2 2.5 17.0 6.7

ALLETE INC Utilities BBB+ 12.0 21.1 3.6 3.0 28.4 10.0

HALYARD HEALTH Health Care Equip. BB- 20.9 34.5 2.4 -0.8 -8.2 NA

CARPENTER TECH Materials BBB- 8.6 16.0 1.9 5.5 10.6 -6.1

AMC ENTERTAINMEN Media B+ 7.1 45.3 4.7 1.7 14.5 11.2

SELECT MEDICAL Health Care Equip. B1 9.2 14.0 6.3 3.1 10.7 5.2

HD SUPPLY HOLDIN Capital Goods NA 9.9 12.6 2.0 4.1 14.0 6.4

KLX INC Capital Goods B+ 10.9 14.4 3.2 3.5 0.0 NA

LA QUINTA HOLDIN Consumer Serv. BB- 12.9 41.0 5.4 2.9 26.3 -2.1

NISOURCE INC Utilities BBB+ 10.3 18.1 6.1 -0.6 30.0 -1.6

INTERNATIONAL GA Consumer Serv. BB+ 7.3 16.1 4.0 1.3 21.5 NA

TELEPHONE & DATA Telecom Serv. BB 4.7 34.0 1.6 3.3 19.3 -5.8

ASHLAND GLOBAL H Materials BB 10.0 19.2 3.6 1.6 11.4 -9.6

SERVICEMASTER GL Consumer Serv. BB- 13.2 19.7 3.4 3.7 20.8 NA

CLEAN HARBORS Commercial & Prof. Serv. BB+ 8.7 39.7 3.2 4.2 13.7 2.7

AMERICAN ELECTRI Utilities A- 9.7 16.3 4.3 -0.1 30.1 4.5

COVANTA HOLDING Commercial & Prof. Serv. BB- 9.9 158.0 6.7 1.5 18.3 -7.7

BALL CORP Materials BB+ 10.2 14.4 3.8 4.7 11.7 7.4


Note: Next year consensus forecasts, financials, sourced from Bloomberg.


Page 25

High Yield Rated Stock Basket Composition (2/2)


Note: Next year consensus forecasts, financials, sourced from Bloomberg.

Valuation Leverage Operating Performance

Company Industry (GICS)SP Credit

Rating

EV / nxt yr.

est. EBITDA (x)

Est. P/E

ratio nxt yr. (x)ND / Adj. EBITDA (x)

(EBITDA Capex)

/ Interest Expense (x)

EBITDA margin

(3yr hist. avg., %)

EBITDA growth

(5yr CAGR)

AECOM Capital Goods BB 8.9 10.9 NA 3.3 4.1 38.3

ZIMMER BIOMET HO Health Care Equip. BBB 11.4 14.5 3.5 4.2 22.6 5.8

JOHNSON CONTROLS Capital Goods BBB+ 9.0 11.9 2.6 7.8 11.7 29.4

ARMSTRONG WORLD Capital Goods BB 9.7 13.7 1.8 6.9 30.9 0.2

SERVICE CORP INT Consumer Serv. BB+ 10.8 18.6 3.7 3.6 25.9 6.8

T-MOBILE US INC Telecommunication Serv. BB+ 6.2 14.0 2.8 5.3 25.1 49.3

ENBRIDGE INC Energy BBB+ 11.9 17.1 6.2 0.9 12.0 10.8

DARLING INGREDIE Food, Beverage & Tobacco BB+ 9.5 18.5 3.7 1.9 12.4 6.7

NUANCE COMMUNICA Software & Serv. BB- 8.9 11.0 4.8 1.7 16.2 -1.8

SUMMIT MATERIA-A Materials NA 8.9 15.2 4.2 3.4 19.6 36.4

GROUP 1 AUTOMOTI Retailing BB+ 11.6 7.8 6.7 1.5 3.4 8.9

BOYD GAMING CORP Consumer Serv. B+ 8.0 21.5 4.9 3.0 22.1 NA

VALVOLINE INC Materials BB+ 9.9 13.7 2.2 9.4 23.4 22.6

OWENS-ILLINOIS Materials BB 6.0 6.3 4.1 3.2 16.0 -2.0

MONDELEZ INTER-A Food, Beverage & Tobacco BBB 12.9 14.7 3.7 9.2 20.9 -2.8

ALLSCRIPTS HEALT Health Care Equip. NR 9.4 14.4 4.4 2.3 14.4 9.8

EW SCRIPPS-A Media BB- 10.7 26.9 5.4 1.8 7.7 -15.1

RITE AID CORP Food & Staples Retailing B 7.2 27.8 4.5 1.6 2.9 -13.6

SPECTRUM BRANDS Household/Personal Prod. NA 13.1 15.5 6.4 3.5 15.2 13.3

COTY INC-CL A Household/Personal Prod. BB 11.5 16.7 6.0 -0.1 9.0 26.3

MACQUARIE INFRAS Transportation BBB- 9.3 16.6 5.7 2.6 29.1 43.5

Basket Avg. 10.2 22.7 4.2 3.1 16.5 8.5

Basket Median 9.9 16.5 4.1 3.0 16.1 6.4


Page 26

Bibliography

- Gallo, A., Pan, T., Aney, A., Ameli, A., Morenes, P., Cotroneo, T., The Silver Bullet | Have Central Banks Missed the

Exit Train?, 1 May 2018

- Gallo A., Beware the fragility of the global economy, World Economic Forum, 23 March 2018

- Gallo, A., Pan, T., Aney, A., Ameli, A., Morenes, P., Cotroneo, T., The Silver Bullet | A Fragile System: The Return of

Volatility, 27 February 2018

- Gallo, A., Pan, T., Aney, A., Ameli, A., Morenes, P., Cotroneo, T., The Silver Bullet | 2018: Irrational Complacency, 12

December 2017

- Gallo, A., Pan, T., Aney, A., Ameli, A., Morenes, P., Cotroneo, T., The Silver Bullet | The Central Bank Bubble: How

Will It Burst?, 31 October 2017

- Gallo, A., Cotroneo, T., Pan, T., Aney, A., Morenes, P., The Silver Bullet | Interplanetary Bubbles, 21 September 2017

- Gallo A., Our global financial system is broken. Here’s a plan for fixing it, World Economic Forum, 6 July 2016

https://www.algebris.com/the-silver-bullet-have-central-banks-missed-the-exit-train/

https://www.weforum.org/agenda/2018/03/hurricanes-while-the-sun-shines-how-to-survive-the-age-of-financial-fragility

https://www.algebris.com/the-silver-bullet-a-fragile-system-the-return-of-volatility/

https://www.algebris.com/2018-irrational-complacency/

https://www.algebris.com/the-central-bank-bubble-how-will-it-burst/

https://www.algebris.com/silver-bullet-interplanetary-bubbles/

https://www.weforum.org/agenda/2016/07/our-global-financial-system-is-broken-here-s-a-plan-for-fixing-it/


Page

Algebris* is a global investment manager with a historical focus

on the financial sector across the capital structure

Founded in 2006, Algebris has gradually expanded its expertise

and entered the global credit and Italian securities (equity and

credit) spaces to capture a broader set of value opportunities

24 Investment Professionals

150+ Years of Combined Experience

Diverse Strategies

Long Only and Hedged

* Algebris hereinafter refers to Algebris (UK) Limited

EUR 12.3bn

Regulated daily dealing funds and AIFs

AUM

A Global Asset Manager

11 Years

Successful Track Record in FinancialsBoston

Regulated by the SEC

LondonRegulated by the FCA

Milan

SingaporeRegulated by the MAS

6 Offices

Enabling 24h Coverage and Local Footprint

Introduction to Algebris

AUM data as of 30.04.2018 and across eleven funds and a number of white label funds.

Source: Algebris

Luxembourg

Tokyo

27

Documents

The Age of Fragility - Home - SOHN · S&L crisis '94 Tequila crisis '00 Tech bubble '97 Asia/ Russia/LTCM '07 Subprime crisis 0 2 4 6 8 10 12 14 16 18 20 '15 '21 '27 '33 '39 '45 '51