Current Thoughts

It’s been a while since my last note, so I thought I’d make an update. Broadly speaking, not a great deal has changed over the past couple months.

On Rates:

In my last note, I suggested the possibility of a move higher in yields. Clearly that has been wrong so far. Yields have not moved higher, although it has not made new lows, at least not yet. My view remains the same, but the timetable is delayed. The current backdrop suggested a somewhat subdued Q2 for the US economy, with a pickup in 2H. Current market pricing continues to present a very low risk premium for the possibility of Fed hikes. By 4Q, with the labor market at full employment and headline CPI & core PCE just a bit below 2%, I think it will be difficult for the Fed to avoid hiking this year, barring a major shock. Once the Fed hikes once, it will be hard for the market to avoid discounting further hikes, which means the current market pricing of just 2 hikes through the end of 2017 will look quite low. This could be a catalyst for a move higher.

One reason for the current low level of interest rates appears to be market fear of persistent disinflation. Fwd starting inflation swaps look interesting. 1y1y is at just 1.6%, with core CPI @ 2.1% last. In fact, the lowest core CPI print since mid 2011 was 1.6%. Real yields are also low, with 2y real swap yields currently at -75bps, near the levels in May 2015. So it’s quite clear that inflation & term premiums are both very depressed, contributing to the low level of rates currently. IMO, this is the main reason yields were not able to break lower this year – current pricing is difficult to justify barring a shock.

On Equities:

Positioning and sentiment are both quite negative, which suggest limited downside here. For example, the most recent BAML survey showed the lowest allocation to equities since Feb, and before that mid-2012. The average cash balance is also back to 2012 levels. The rolling 5 week outflow from equity funds was the highest since August 2011. AAII sentiment is also quite bearish.

Of course, limited downside doesn’t mean imminent upside in this environment. With earnings growth still weak, a continuation of the range bound environment seems the most likely, at least until later in the year. After that, earnings growth should start to pickup a bit, but this will be offset by risks from Fed tightening and politics. With the skew currently quite elevated, selling puts seems to be a superior expression of a long bias here.

The market seems to be focusing on the CNY again. The chart below plots USDCNH (inverted, white) vs SPX.

You can see why the market may be concerned, but it’s worth recalling that the backdrop now vs January or last August is very different. Both expectations and positioning were much more bullish then, even though credit markets were tightening and growth & inflation expectations were falling. A sharp correction in equities here on the back of the CNY move is likely a good fade, IMO.

On FX:

CNY is getting back on people’s radars, as I noted earlier. In addition, it’s worth noting that that CFETS RMB index has now fallen 6% since it was published 6 months ago, meaning that the PBoC is managing a 12% annualized FX depreciation, even as the 12 month rolling trade balance is hitting new highs. This is not a sustainable trend.

IMO, it is not a coincidence that Brexit and Trump have been gaining in popularity the same year. In the two DM countries with the worst trade balances. I think that this is at least partly driven by workers who have been displaced by trade. Yes, much of those workers’ jobs have been displaced by technology rather than trade, but the fact is that they are sick of politicians not even trying to do anything about it. These voices became apparent with the Tea Party wave at the turn of the decade and are unlikely to fade away until they are addressed. To me, Anti-Trade & protectionist policies are likely only a matter of time, regardless of who winds up getting elected. This is likely positive for USD, GBP, at least in the longer run, and obviously quite bad for equities in Germany & Japan.

Finally, a quick update from a recent visit to China. Faith in policy makers continue, despite equity market turbulence last year. In general, optimism remains high, in contrast to opinions of Westerners.

Are we at the start of a major move higher in yields?

First, a Post Mortem on Jan 21st note:

I put out a note then that I thought it was the beginning of the bottom for risk assets. In retrospect a month and a half later, that seems to have been the right call. While not all risk assets bottomed then, many commodity and EM related assets did (BRL, ZAR) with developed market assets bottoming a bit lower and a bit later on Feb 11th. In general, buying risk assets at or below Jan 21st levels has been the right move. To me, this means that my understanding of the market narrative hasn’t been too off.

OK – on to the main idea.

Obviously, risk free yields have fallen dramatically since the end of 2013. There were a number of reasons for it, but in aggregate, I think there is a good chance that the move lower has been played out for the next few quarters, especially in the US. For simplicity, below are a number of drivers for the move lower the past few years, and reasons to believe those drivers are turning or abating:

· Easing by central banks elsewhere has been a major driver for moves in US yields, especially the long end. Well, after today, it seems like the ECB is done, at least for a couple quarters. And effectively, so is the BoJ, since they appear to be out of ammo. (how much more will 30y JGBs fall and will it matter?)

· The strength of the dollar has been exerting a significant and continuing drag on US growth since 2014, with the speed of the strengthening in 2014 front loading the effects. While the drag is likely to continue for several quarters longer, there are several mitigating points. First, the negative effects were previously underestimated. That seems to have been corrected. Secondly, even if the dollar strengthens further, but bulk of the move is already behind us. As the chart below of the trade weighted dollar shows, the dollar has already appreciated 38% from its lows, on par with the 40% strengthening in the late 90’s / early 2000’s. And even if the dollar were to repeat the early 80’s performance, (hard to see given the limitations of NIRP) we are already more than halfway.

· In conjunction with that, the US data has been stabilizing vs expectations, which suggests we may start getting some positive surprises. Citi has an aggregate economic surprise index for the G10, which has turned higher from very low levels that was last seen in 2013 that foreshadowed the ‘Taper Tantrum.’

This is also corroborated by the data flow. The Manufacturing ISM has bounced off of the 48 area and broken above the 6 month average, in a manner that is reminiscent of what happened during prior dollar bull markets in the mid 80’s and late 90’s:

· Oil prices has been driving both realized and market-implied inflation lower since 2014, and it has bottomed. (Even if we make a new low, it won’t be significantly lower than the prints we’ve seen) Realized inflation has turned up already. The last headline CPI print was +1.4% from 0% in Sept. (though given oil prices YTD, we may need to wait until 3Q to see higher prints) Inflation markets have begun to turn higher. (outside Japan anyway) 2y & 5y US breakevens are at the highest levels since last summer, though longer dated measures remain depressed. (though those are likely more affected by foreign developments)

· Credit market strains have improved significantly

· Technicals globally point to the potential for higher yields in the intermediate term:
US 10y treasury yields failed to sustain new lows and have turned higher: (chartists would call it a double bottom)

Same story for 30yr German yields:

And perhaps most interesting of all, 30y JGB’s seem to be putting in the type of price action that preceded the 2013 Taper Tantrum:

For what it’s worth, I think most of the mispricing in the US curve is in the belly. 30y levels looks only somewhat low, but given how far we’ve overshot to the downside, the likelihood of an overshoot to the topside seems more likely than not.

Thoughts on other asset classes:

For the dollar, I think it depends on the cross, as it’s arguably it’s harder to make generalization. USDJPY seems to already pricing in a rise in US yields. Against other DM currencies, higher yields are likely to be a positive for the dollar.

For equities, the picture is probably even more mixed. Earnings trends are only just beginning to stabilize, and are unlikely to grow much more than low to mid single digits by year end, with risks skewed to the downside owing to well known factors like the dollar and rising labor costs. Against that, a decrease in the credit risk premium should allow for a bit of compression in the equity risk premium as well. The upside from that source is probably capped, however, given where we are in the business cycle. Against that, volatility is unlikely to fall much, which makes the ex-ante risk/reward proposition not especially attractive.

Credit is probably the most attractively priced of the major asset classes, though the attractiveness comes primarily relative to low risk free rates. On an outright yield to worst basis, my view is that they are only somewhat cheap given the business cycle risks.

For EM, a resumption of Fed hikes and a stronger dollar probably means that investors will remain skittish, especially since for many EM’s, the structural & institutional imbalances that lead them to where they are remains unfixed.

On a separate topic, one of the many interesting trends we’ve seen over the past few years is the combination of more money in passive strategies, but also active managers underperforming more. At first glance this appears to be counterintuitive, since one would think that less active management would imply more opportunities to add alpha. A potential explanation is that the market has gotten more efficient, and in general the opportunity to generate alpha has fallen. The below post would seem to support that hypothesis. In general, and unsurprisingly, most easy and/or simple quantitative strategies are no longer working:

The Markets are sending Central Banks a Message

What’s Going On

EU Banks were over levered going into the EU crisis. The ECB has forced them to delever and build up capital, even as they faced rising loan defaults and market headwinds. While most of the loan defaults are behind them, the banks’ plans to get to regulatory-mandated levels of capital makes assumptions of large increases in retained earnings.

Over the past year, a combination of QE and negative rates has flattened the yield curve substantially. The flattening has in turn resulted in substantial lower interest rate margins for the banks. In turn, this means lower expected earnings for the banks.

For the least profitable and weakest banks, this combination of low capital and lower future earnings has resulted in solvency concerns.

Since Deustche is a large bank, this very quickly turned into systemic concerns.

Systemic solvency concerns, as anyone who worked through the last recession knows, is everything.

Likely Effects in the Future

Weak Bank equity valuations will likely exert a drag on economic growth over time.

Generally speaking, banks need to increase or at least keep stable their net loan books.

Nominal GDP = Money Supply * Velocity

By keeping its loan book stable, banks can at least keep the Money Supply variable stable. That is one reason why historically it has been unusual to see NGDP grow with an extended period of contracting money supply.

When bank equity valuations are cheap, banks are incentivized to delever and buy back equity and / or debt, rather than make loans.

Here are some charts that show this. This shows the US bank index Price to book in white vs Commercial and Industrial Loans outstanding in Orange. Note how dips in value below 1.0 has historically preceded declines in C&I Loans outstanding.

This one is for Europe. Non-Financial Corporate Loans outstanding is in Orange.

The message from bank shareholders seems to be clear: stop the easing.

There is a big difference between liquidity concerns, solvency concerns, and profitability concerns. The order of importance is respective.

· At this point, liquidity concerns for senior unsecured debt is fairly minimal given ECB policy.

· Solvency concerns a bit higher, but is mitigated by lots of factors: a trigger on CoCo bonds would be supportive for solvency, and Germany and other EU countries in general are much better placed to inject capital. Yields are negative for them, after all!

· Profitability concerns are pretty big. The chart below shows the index price on top vs trailing 12m Earnings Per Share on the bottom. Despite the easy monetary conditions and the decrease in oil prices, EU banks have not really been able to sustain positive earnings over a 5 quarter period until recently:

Bank Solvency Concerns can take on a life of its own.

This shouldn’t be news to old market hands. The credit worthiness of a bank is to a large extent an article of faith by its creditors. Especially for large, opaque concerns like Deutsche, no one really knows the full extent of the risks. That is why solvency concerns can very quickly lead to a drying up of funding by creditors and an eventual liquidity crisis, which is what kills banks.

Having said that, given sufficient liquidity and time, these effects can stabilize. For banks that have sufficiently long and stable liquidity, they can buy back debt and/or equity. Even if RoE is zero, buying back debt below par and equity below book is accretive to earnings and valuation. But again, this is something that will take some time and/or action from policy makers.

I think credit spreads have also been getting impacted prior to this episode, but not in the way one’d think.

I’ve noted in the past that the Yield to Worst for investment grade credit has been broadly stable. However, there has been a sharp decline in treasury yields. The net effect is the credit spreads have widened by quite a bit. As the chart below illustrates, 30y credit spreads has hit levels not seen since mid 2009, even as the credit Yield to Worst has been stable:

Delving into the decline in treasury yields further, the decline has been mostly driven by the inflation compensation component. (in White below, with real yield in orange) Since the June highs in the nominal yield, the vast majority of the decline has been driven by the breakeven leg:

The interesting thing is that breakevens seem to have dropped even beyond levels implied by oil forwards: (not that 30y breakevens should be tracking oil price that closely anyway, but I digress)

A major additional factor is the policy rates overseas. The Fed has a measure of term premium for the 10y that has dropped sharply since the crisis. This term premium is strongly inversely correlated to the yield differential between US treasuries and global bonds elsewhere. The chart below illustrates: term premium is in white, and the US 10y yield differential between a basket of German, Japanese, and UK 10y yields is in orange and inverted.

Anyway, the point is that it seems like monetary policy overseas has also been a contributory factor to the pricing of treasury yields, which impacts US credit spreads, which in turns has implications across the capital stack, and a key driver of equity performance this year.

Credit spreads are so far having a limited impact on the economy, due to past bank deleveraging and regulatory prudence. This is supported by the recently released results from the Fed’s Senior Loan officer survey, which showed that despite the sharp widening in corporate credit spreads, only a small percentage of banks tightened credit to corporate borrowers on net, roughly unchanged from 3Q. Obviously, we shouldn’t expect this divergence to persist forever, but it does suggest that the new regulatory policies has been successful in insulating banks from market volatility somewhat.

Further Out

The goal of QE is to decrease yield, lift risk assets and weaken the currency.

Since 3m OIS swaps have declined below -10bps and 0bps in Europe and Japan respectively, exactly the opposite has happened. In Europe, since 3m OIS swaps (orange) declined below 10bpsin early April, the EUR (white) is higher vs the dollar, bank shares (purple) has gotten annihilated, and even the average of 30y EUR sovereign bond yields, (yellow) the asset the ECB is buying directly, is higher in yield.

The story is the same in Japan. Since the BoJ cut, the Yen (white) is 6 figures stronger vs the dollar, the Topix bank index (yellow) is 20% lower, and even 30y JGB yields (green) are higher post cut!

My hope is that the ECB and BoJ have started to recognize these issues, and are beginning to consider ways to mitigate them. At the very least, the pace of deterioration in bank shares the past few weeks will have gotten their attention. A bit of stability in oil prices should also help inflation stabilize and reduce the desire for further easing.

A pullback by these central banks from further easing will help both bank prices as well as treasury yields rise. This in turn is likely to be supportive (or less unsupportive) for lending, while the higher Treasury yields allow the EUR and JPY to weaken. Paradoxically, a shift away from dovishness by those central banks is likely to be risk positive. Because as many of us have intuitively understood, negative rates are not stimulative on net.

It’s time to start building exposure to risk assets

Back in late October, I published a note entitled “It’s Time to be Neutral or Short Risk”

I now think that current market levels and conditions warrant getting long. My reasoning is as follows:

Oil prices have been a major driver for other assets, primarily via second round effects. So let’s start there.

First, speculative positions in Oil are now very low, back to 2009 levels:

Second, the ~26 level on oil is a very long term support resistance level that stretches back several decades:

Third, $20 or so is the current cash cost of producing shale oil, which means that even if prices get there, they are unlikely to be at that level for long. As such, this means downside is capped.

Finally, Oil has had a seasonal tendency to bottom around now:

In addition, investment grade credit, which lead the way lower, has been broadly stable on an outright yield basis, though spreads have widened as risk free yields have fallen.

In high yield space, the spread (Barclay’s HY OAS below) has hit levels not far from the very worst levels of 2011:

The fundamentals for the economy also remain decent, though not robust. Earnings ex-energy are still growing. Employment is still growing, though likely to slow a bit in the months ahead. Retail sales still strong. Credit conditions easy. Even in China, the policy easing we’ve seen over the past 4 months will start to bear fruit soon – allowing for at least some stabilization in the data. The Philly Fed has bounced, which suggests that ISM manufacturing could do the same:

It is also worth noting that while the negative effects of lower oil prices are front loaded, the positive effects play out over a longer period of time. Per FTA, current oil expenditures as a percentage of world GDP has dropped at a pace not seen since the mid 1980’s:

Back then, world GDP in USD terms subsequently rose strongly over the next 5 years:

Here is a related chart from Deustche Bank:

Fear, as proxied by cash levels from the BAML survey, are already as high as highs from 2011 / 2012:

And the price action has been bad enough to have triggered technical selling on the breach below the ~1880 area. But note that a break below, followed by a rally above the close would bring a lot of chart driven short covering. The break has probably been bad enough to flush out most of the remaining ‘weak hands.’

Supporting that hypothesis is the fact that futures volume yesterday was about ~4mm contracts, a level that has historically coincided with near term lows:

The bottom will take some time to form. Volatility will need to fall to bring buyers back in. But I do believe that we are at the beginning of the end rather than the end of the beginning.

In interest rates space, investor expectations are now very gloomy indeed. Citi distributed a survey yesterday to its rates clients, and reported that 3/4th of respondents expect a terminal Fed Funds rate at or below 1% this cycle. (!) A stabilization (and possible bounce) in oil and associate risk assets, in conjunction with improving data, will allow inflation breakevens to reprice substantially. In the inflation swap market, 5y5y forward inflation is through the 2008 lows: (caveats apply given the market, but the point applies regardless. 30 TIPS breakevens are ate 1.5%)

Questions for 2016

Despite the fact that major asset classes have had a returns near zero this year, there are a number of interesting disconnects. Here are a few that I’m watching, and some of my conjectures. I think many of these are likely to be resolved next year, but there is a clear risk that some of them continue for longer. As usual, readers are welcome to comment.

Will the disconnect between corporate credit spreads and the broader economy continue?

This is something I’ve highlighted before. In fact, I think the biggest general surprise for market participants globally in 2015 was the massive widening in credit spreads in the fact of fairly benign economic conditions. The chart below illustrates – the ISM composite index, a proxy for growth, is in blue and inverted on the LHS, and long dated BBB credit spreads is in red. The current disconnect is about as wide as levels prevailing in early 2000, and a major reason some bears are calling for a recession next year. (To be clear, I do not expect one)

There are a number of reasons for the disconnect, IMO, so I do not expect the gap to fully close. The strengthening of bank balance sheets has allowed consumer credit conditions to substantially disconnect corporate credit conditions. Supply / Demand mismatches in corporate credit space, especially at the long end, is likely another reason.

As the chart above shows, credit spreads are currently at levels we’ve only seen historically ahead of recessions. Having said that, I do not think it is likely that spreads will be able to tighten substantially from here, even in a best case scenario. With the economy at full employment and the Fed hiking, recession risks will be on the minds of credit investors until we actually get one.

Will the disconnect between credit prices and equity prices be resolved?

Even though credit spreads have widened dramatically this year, equity prices were broadly unaffected. Part of this is due to different weightings in the respective indices, part of it is due to the fact that the broader economy has done OK, as noted earlier. But the fact is that these two markets are currently pricing in fairly different outcomes in the year or two ahead. Credit markets are discounting a recession, while equity valuations are quite full and nowhere close to that. Historically, these disconnects have resolved themselves via either a robust increase in earnings or a recession. Neither seems especially likely at the moment. Another possibility is that the disconnect resolves itself through time. A full blown equity bubble seem unlikely at this stage – IMO, we would’ve seen one developing by now if that was in the cards. The fact is that the tightening in corporate credit conditions has already been felt across the corporate landscape in varying degrees. Valuations of start ups and high end real estate, for example, have already been impacted this year.

Currency moves seem to have a smaller impact on domestic conditions in many countries. Will this mean higher currency volatility in the future, especially with monetary policy in many countries at ZIRP?

This is a topic that has been getting increasing attention:

This is also something that we’ve seen in the data. In general, the weakening of the EUR and the JPY have had only modest effects on domestic conditions.

This is the case for the EU, according to Coeure, who noted that “For the euro area, ECB staff research recently found that an increase in the share of the euro as an invoicing currency can lower exchange rate pass-through considerably.”

On the other hand, Fischer noted in a November speech (h/t CP) that the effect of an appreciation of the dollar is both substantial and gradual, with more than half the effect occurring after a year:

A weaker immediate but longer lasting effect on growth from changes in FX seems a reasonable result of a longer and more global supply chain. If that’s true, how will central banks react in the future – especially the central banks of small, open countries? Will they try to do more, knowing that the immediate effects are more limited? Does that mean greater currency volatility than in times past? How will they do it, with policy rates already at zero and balance sheets enlarged?

Japan’s current account balance has been improving substantially, even as the BoJ maintains easy policy. How will the Yen react? In general, will currencies be more responsive going forward to current account balances in a world where monetary policy faces larger constraints?

The Japanese Current Account balance has improved very significantly since year, and much faster than consensus expectations. The chart below illustrates the consensus forecast for the Japanese current account this year. It has been revised up by 2% of GDP!

Part of the improvement has been oil, part the currency, but other factors apply as well. For example, a Japanese court has authorized 2 nuclear reactors to restart, which means 4 of Japan’s 43 reactors will be back online soon, and the central government is behind the effort.

To put the improvement into context, the last time Japanese current account was at 3% of GDP was in 2011 and USDJPY was below 80. In addition, the surplus is expected to persist for the foreseeable future.

I’ve already noted that being long Yen (vs CHF) seems attractive, and this is just one reason. As usual, how things play out in Japan will provide valuable lessons for other countries in the future.

Will the Phillips Curve reassert itself?

The Fed thinks so – but the market seems more skeptical. As a reminder, the Phillips curve is a historical inverse relationship between Unemployment and inflation.

This is a pretty big deal, because central bank orthodoxy makes many of the same assumptions. The widely cited Laubach-Williams ‘Natural Rate of Interest’ embeds an output gap estimates that is informed by an estimated Phillips curve, for example. Recent central bank commentary suggests that the strong consensus remains affirmative. The last time short term unemployment rates coincided with such weak inflation figures was in the late 90’s:

As we now know, the recovery in core PCE figures then allowed the Fed to accelerate its hiking cycle.

Year End Trade Ideas

For new readers:

Around this time every year, I try to think about the global backdrop and pull out some longer term themes.

I’ll start with generalized thoughts on the macro landscape, followed by the trade ideas.

A recap of last year’s ideas will conclude.

In many developed countries, the labor gap to ‘full employment’ is closed or nearly closed. Here’s a chart from Goldman illustrating that:

The US is obviously the biggest contributor to that, but even in Japan, the unemployment rate is now roughly 50bps below the OECD’s estimate of NAIRU, which matches the lowest differential in at least half a century. The biggest exception, of course, is Europe, but even there, it’s not clear how much more easing they will do next year. Core inflation has clearly picked up, and headline inflation is almost certainly going to rebound sharply in the months ahead as base effects drop out.

Now normally, this phenomenon tends to occur in conjunction with both tighter monetary policy as well as higher nominal GDP growth, which offsets the economic effects of higher policy rates. The higher nominal growth in this cycle is not occurring, at least not yet. This represents a higher than normal risk that risk-free yields are raised too quickly, causing undesirable results. Fortunately, central bankers seem broadly aware of this.

The proximity to full employment means that uncertainty around monetary policy is likely to remain elevated. This also means that volatility for financial assets will also be higher than recent experience, while trends are also likely to be weak. In aggregate, this probably means an even tougher year from macro themes and macro profitability. This is something that is reflected by the large number of closures of macro funds this year. It’s also reflected anecdotally by Goldman’s macro strategy team recommendations. Goldman’s usually excellent list of top trades for next year was in many ways a rehash of last year’s ideas, and most were correlated or driven by just one theme – higher nominal US yields.

In this environment, macro participants should focus even more on preserving capital. Given the low liquidity of markets, domination of trading by algos, the next recession is likely to provide many major pricing mispricings. David Tepper noted that there are times to make money and times to not lose money. I fully agree that this is the latter type of period. Having said that, we are probably 2 or more years from a recession, so patience will be needed.

I’ll add a few observations on asset class valuations in general before moving on to the ideas:

In US risk free rates, there is a wide divergence between the Fed’s dots and market. This is something that we’ve lived with for a long time, and which the market ignored because lift off kept getting delayed. With lift off now looking quite likely to occur in December, this is a dichotomy that will be resolved, probably next year, as the Fed gets going. The dots represent a pace that is about twice as fast as the market is pricing in. Historically, but market is usually right, but the substantial size of the divergence suggests the risks are skewed.

The ECB is likely to ease further, but I don’t think it will be dramatic. I also think that further easing, even if substantial, will have limited long term effects on asset prices.

European corporate earnings have been surprising to the downside consistently for 4 years now. Granted, there was a EU sovereign debt crisis at the start of that period, but there has also been multiple global QE programs, a massive decline in sovereign yields, a massive cheapening of the currency, a large rise in risk assets, some mutualization of sovereign credit risks, along with decent growth and a massive drop in oil prices. Yet earnings still haven’t improved.

Of course, just because they haven’t improved so far doesn’t mean that they won’t improve in the future. But the fact that earnings weren’t able to go up with that backdrop certainly makes me skeptical that they could go up as those effects fade. IMO, a comparison between EU equities now against their Japanese peers in the mid 1990’s is instructive. The history lesson there seems to be that corporate earnings have a hard time rising until the banks are done deleveraging & writing off bad loans. On that metric, European earnings may remain stagnant for another year or more.

In general, low ex-ante returns seem to be priced into most asset prices here. The NY Fed recently noted that dealers’ current low holdings of debt securities may be a result of the very low levels of expected returns, defined as the sum of credit spreads and the 10y ACM term premium:

In aggregate, this should not be especially surprising. With the expansion now quite old historically, large mispricings should be expected. On the other hand, this also means the margin of safety is quite thin.

For US equities, many of the tailwinds from years past have turned into headwinds, with risks skewed negatively:

  • Dollar: from weak to strong. (which will affect corporate profits much more than the domestic economy)
  • Rates: Going higher. Fed policy is a dominating effect globally, as the Taper Tantrum showed
  • Margins: from low to near all time highs with labor cost pressures building.
  • Credit spreads: from tight to wide, with limited room for compression given where we are in the cycle.
  • Equity Valuations: cheap to fair. Appreciation in equities from a low discount rate is broadly over. That was what allowed equities to do so well despite growth continually disappointing expectations in the past. Another sign of this is that the buyback theme no longer working for equities – the buyback index has been underperforming consistently since 1Q. The last time we’ve seen underperformance of this magnitude was in 2H 2007.
  • Volatility: Going higher. Greater monetary policy uncertainty + divergence, higher cost of leverage (swap spreads, FX basis swaps are at historic levels) all means higher vol.

Historically, most of these headwinds were offset by the simple fact that nominal GDP also increases. This allows revenue and often earnings to grow along with the tighter financial conditions. In this cycle, nominal growth has disappointed to the downside vs expectations almost every year since the beginning. This suggests that the risks to the headwinds above are even more skewed than usual. That doesn’t mean that investors should be completely out of equities, but it does suggest that a larger margin of safety should be sought.

Trade Ideas for 2016:

US 5s30s Flattener

The US is basically at full employment. This is evident in not just the unemployment and job openings data, but also in wages. It is not a coincidence that many different measures of wage inflation have been rising over the past few months. My view is that wages have been held in check by the weak headline inflation, and that as base effects begin dropping out, wages are likely to tick notably higher. The dichotomy between market pricing and the Fed dots remain very wide, and I think the risk is pretty asymmetric here, given that the market is pricing in just over 2 hikes per year over the next couple years. With the Fed looking very likely to lift off soon, a large chunk of the move up in yields in the belly is likely to happen in 1H 2016. At the same time, the long end of the curve looks fairly priced, and provides carry and protection in the event of a demand shock. Historically, Fed action has been a catalyst for flattening trends – see the price action in 2004 and 2013. (the commencement of tapering) Carry is roughly -3bps per month – i.e. it needs to flatten that much per month to break even. The monthly chart suggests that the curve has failed to breach resistance at both the 150 level as well as the 20 month moving average, and is now set to continue its trend lower.

Also helping this trade is the fact that 5y inflation breakevens seem quite mispriced. The chart below shows the US core CPI in white vs 5y TIPS inflation breakeven rates. The current gap, in excess of 50bps, is quite sizable and has historically been good entry points to enter into higher breakeven trades.

Short CHF vs JPY

This one is essentially a combination of two plays – long EURCHF and short EURJPY.

EURCHF: Swiss data has been trending weaker since 2012. EU data was weakening even further, so the room for the SNB to act was somewhat limited. However, over the past year, EU data has been picking up quite nicely, even as the Swiss data has been weakening. (Swiss unemployment at the highest level since 2010, consumer confidence at levels not seen since 2012 and at 2002/2003 levels) The argument for further SNB easing – in excess of ECB easing – is now building.

JPY: As I alluded to earlier, Japan is beyond full employment. Core inflation is trending higher, and the size of additional BoJ easing on a scale that would impact fundamentals is very large. With 10y JGBs yielding just 31bps, additional easing in JGB space will require extending purchases well beyond the 10y sector. The problem is that at the longer end, it is not at all clear that it is advisable to push yields significantly lower. The BoJ wrote a staff paper back in May whereby they try to estimate the Japanese 10y natural rate. The take away is that current 10y real rates are already in excess of 100bps below the estimated natural rate:

Of course, this does not preclude additional easing necessarily. After all, Kuroda began easing even while the gap between the two was small. But for central bankers who spend a lot of time thinking about whether interest rates are simulative or constrictive, the current state of the Japanese economy seems at odds with the state of policy. And even if there is further easing – the impact on the Yen is not obvious. With the real trade weighted currency at the weakest level in decades, Japanese trade partners all facing substantial slowdowns, and domestic corporate surveys that show significant caution against further currency cheapening, it is unlikely that further easing will have similar impacts to those already observed.

Other Considerations: The cross is extremely rich on both a nominal and real basis. In addition, the rally from the 80 figure in 2012 to the monthly closing high of 132 is the largest sustained nominal appreciation in half a century, on par with the move in the late 70’s. Currency crosses are mean reverting, and historically, when rallies of this magnitude reverse, the price action has been sharp. The 20 month moving average has been a key pivot point for the cross historically, along with the 120 area. A clean break of that area would suggest that a rapid fall to the 100/105 level is quite possible.

Short AUD vs USD

This trade has been a macro favorite for a few years now. It’s not very common for trades to remain popular for this long, but in this case, there is a good reason for it. The Australian economy is closely tied to the commodities cycle, which has very long half lives. In fact, I think the best analog for this cycle was the mid 1980’s period. That was the last time we got the end of an oil super cycle, courtesy of both the baby boomer demographics effect along with OPEC embargos. Since this trade has been reasonably well covered by others already, I’ll just limit my commentary to a few points:

  • I think an eventual move to the mid 60’s or lower is the highly likely by late next year
  • The recent bounce in AUD data is mostly driven by the consumer rather than industrial part of the economy, but is likely to provide some support for the cross in the near term. The recent monetary easing in China may also provide some support. Also, the price is also a bit stretched vs moving averages. And there is a seasonal bias for stability and a rally through mid April, with a large chunk of that coming in March – possibly related to the Chinese new year. Finally, speculators are pretty short. This all suggests that we could see some near term stability or a bounce to the 0.74 or even 0.76 area. As a result this is probably a trade to scale into over the next few months.

Marking Last Year’s Trades

My ideas last year turned out very badly indeed. The largest driver, in hind sight, was probably due to the fact that I thought oil prices would be higher by now. The weak prices lead to multiple negative second round effects. Lower revenue growth, weaker margins, wider credit spreads, among others. After a very successful list the year prior, this year is a timely reminder that this is not an easy business!

Recap 10-22-15: It’s Time to be Neutral or Short Risk

Let’s go over the current backdrop, which, as it stands, is really not a whole lot different from that a couple months ago. The most important aspects of the macro environment as it relates to asset prices since the beginning of the year has been the move in oil prices. That move has had two key effects. First, it has lowered inflation to zero. And second, it has caused a massive improvement in the current account deficit. Both of these have hard major impacts on the pricing of risk assets.

First, the drop in inflation means that in many sectors, pricing power has disappeared. As a result, revenue growth for corporations has declined and earnings growth even more so due to operating leverage. Obviously this is a very broad generalization across sectors but I think this is broadly accurate. Even outside materials & industrial names, earnings growth expectations have been falling for many months now, and that trend doesn’t look like it’s turning quite yet.

Second, the impact of the adjustment to the current account has also been substantial. The main reason is the ownership structure of USD assets. Essentially, as Michael Pettis likes to say, the current account deficit is the obverse of the capital account surplus. In other words, exporters to the US have been major buyers USD financial assets, especially in credit as well as treasuries. In effect, what happened in the prior cycle is that Americans have been saving or spending less on net – the saving has been done by foreigners, but in USD assets. This is a key distinction because Americans save mostly via putting cash into bank deposits, whereas foreigners save mostly via buying USD assets like corporate bonds.

Given the banking legislation introduced in the past few years, banks are now not able to change their lending standards much. What this means is that despite the increase in bank deposits, credit growth via banks (especially via the mortgage channel, and ex-student loans) has been weak. In other words, credit availability from foreigners have declined (due to the drop in the US capital account surplus) but banks were not able to offset that deleveraging. The net result is that credit costs have jumped quite sharply this year. (Note that this channel did not affect treasuries because treasuries have a zero risk weighting on bank balance sheets. In other words, banks were able to respond to foreign selling in treasuries. )

The result of both of these factors has been a sharp worsening of corporate financing conditions. Not only has revenue growth been falling, which is a negative for credit sustainability, but credit costs have moved higher as well, which means refinancing debt is no longer accretive to the bottom line. This has been especially bad for the riskiest credit sectors. HY ETF prices remain near the lows from back in 2011/2012. From a cross asset perspective, these factors apply to equities as well, though somewhat less so due to the fact that the maturity profile for large cap equities is much longer.

On top of that, real risk-free yields globally are now essentially pinned at zero. What this basically means is that there is simply very limited room for central banks to counter-cyclically ease financial conditions further. In fact, in places like Europe and Japan, the only way to push real yields much lower is by raising the market-implied inflation compensation rate. In an environment of falling / weak commodities prices, that is very difficult to do. As we’ve seen with Japan – there is a sharply diminishing return on policy action on that channel, which makes sense because it is hard to make investors pay prices that lock in negative returns.

The implication of these forces are, as you can probably surmise by now, fairly negative for risk asset prices. To be clear, it’s not recession-like bad, but they are certainly negative in that both the upside as well as downside scenarios are worse. There is less upside because earnings growth and credit costs are higher. And there is more downside because future central bank policy easing is likely to be less effective.

Now, I’m not saying these conditions are going to persist forever. Inflation is likely to pick up in 1Q as base effects drop out – but this is assuming oil prices don’t fall much from here. And assuming economic growth continues (still my base case, to be clear) a Fed lift off is likely to push real rates a bit higher, thereby providing some more cushion. If things go well, many of these factors should be alleviated at least somewhat by the end of 1Q next year. But that is still a long ways off in financial market time. To me, the key driver of these risk vectors remains oil prices. A further decline here is likely to exacerbate those channels and pressure risk assets further. And at current prices, the margin of safety by my calculations is very close zero.

A couple charts illustrate how far equity prices have ramped up relative to other growth assets the past few weeks:

S&P vs a High yield ETF: (Note that it closed flat today!)

S&P vs 1y1y WTI oil forwards: