CME - VGI Partners - CME: Current Conditions Highly Favourable
Summary
- US-listed derivatives and futures exchange operator CME Group is our largest investment position.
- The key driver of trading activity for CME is in its interest rate derivatives products.
- We expect the growth in the size of the US Treasury market to remain a powerful underpinning of CME’s interest rate derivatives business.
- We believe current conditions are highly favourable for CME’s interest rate derivatives business.
The following segment was excerpted from this fund letter .
CME Group ( CME )
CME is a business likely familiar to you, being one we have owned in our global strategy since 2008 and which was our largest VG1 position at the end of 2022.
CME operates futures and derivatives exchanges, including the Chicago Mercantile Exchange, the New York Mercantile Exchange, the Chicago Board of Trade, and the Dow Jones Index Services. On top of this, CME also owns other key assets related to foreign exchange trading & infrastructure and a strategic shareholding in Standard & Poor’s (S&P) Index business.
The key driver of trading activity for CME is in its interest rate derivatives products, where it has an effective monopoly in the exchange trading of interest rate derivatives in the United States, with benchmark products across the entirety of the interest rate curve. Demand for interest rate derivatives is driven by volatility in interest rate markets, whose effect is compounded by the number of bonds held by those looking to manage interest rate risk and, by extension, market liquidity.
The below chart of average daily volumes of interest rate derivatives and US Federal debt held by the public illustrates the extremely strong relationship the size of the US Treasury market and volumes growth, although there are deviations around this primarily around Fed intervention (for example, at the start of the pandemic, volumes were suppressed by an enormous amount of Quantitative Easing (QE) and effectively zero interest rates which reduced the demand for hedging products).
Size of the US Federal Debt Held by the Public vs Average Daily Volume of CME Interest Rate Contracts
Source: CME Group, Congressional Budget Office.
We expect the growth in the size of the US Treasury market, particularly in relation to privately held US treasuries as the Fed undergoes a balance sheet unwind, to remain a powerful underpinning of CME’s interest rate derivatives business.
As such, we are high conviction that the reversal of QE and the normalisation of bond market conditions will provide a significant tailwind for CME’s trading activity in the near term, while its net interest margin should benefit from greater investment income on margin collateral. Other derivatives complexes, including equity and energy, are likely to also benefit from a normalisation of market conditions and we note that incremental futures contracts generate an extremely high drop-through rate to cash earnings due to CME’s strong operating leverage as a primarily digital platform.
As a result, we believe current conditions are highly favourable for CME’s interest rate derivatives business, other derivatives complexes and net interest margin and we see substantial upside risk to consensus earnings and free cashflow estimates. At writing, CME is trading at a CY23 PE of 20x, free cashflow yield of 6% and dividend yield of 5%.
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VGI Partners - CME: Current Conditions Highly Favourable