Readers, please feel free to share your thoughts. Opposing viewpoints are particularly appreciated.
- Pessimism for 1Q growth due to high fiscal multiplier on austerity measures, optimism for 2H 2013 as a result of low inventories, better bank lending as a result of completing Basel 3 requirements, continued strength in US housing, and falling commodities inflation. Peak fiscal drag globally is also likely to hit next year, and asset prices are likely to look ahead of that. Unfortunately, this view is also very consensus, which points to the risk of the opposite happening.
- Low economic volatility in 2H2013. The reason is that we’ve had so many shocks and tremors over the past few years that most short term imbalances have already been shaken out. So in aggregate, there is likely to be less economic volatility next year, which probably means that the range for financial asset returns will also be narrow. Near zero interest rates means there will be little funding pressure, which favors carry. As a result, default rates can remain low. Carry will likely be an important source of return, as the lack of economic volatility suggests that market timing based returns may be weak. Note that implicitly, this means global macro strategies / ideas are likely to continue to exhibit lower returns.
- Bifurcated growth globally. Though short term imbalances have mostly been resolved, longer term imbalances continue to remain substantial, and need to be resolved. And the likely lower level of macro volatility may be favorable for these types of bets.
- The global High Grade Credit shortage is worsening. Treasury & MBS supply is falling. So risk for High Grade yields is rangebound to lower. Consensus expectations for DM government bonds also look too low. There is a growing shortage of high grade credit, and demand is very sticky due to institutional constraints on real money managers. Despite articles to the contrary, demand is likely to increase, as this chart from JPM shows:
- Consensus expectations for equity returns globally look almost universally too optimistic. With peak margins and low nominal GDP growth, a double digit return on equities requires a 1x increase in the PE multiple. This does not appear to be likely given the DM demographic shift toward retirees, who favor debt. The chart above points to a continued decrease in P/E, although share buybacks will probably mitigate that somewhat. As a result, junior credit appears to be a more attractive way to express pro-cyclical views.
- Japanese voters want deflation. It has been said that inflation is a political decision. So in Japan, many market participants believe that the political will to force the BoJ to print will result in inflation. However, this view does not take into account the fact that the majority of Japanese voters are elderly who are living off of savings and/or fixed pensions, which means they don’t want inflation! Inflation may be a political decision, but Japanese voters have already decided that one – they want deflation – a condition they’ve been fine with for over a decade now.
Long EU High Yield
- With funding costs not far above the rate of inflation, many high yield companies can continue operating for an extended period of time. That means there is a much higher probability that they can avoid default.
- With the EU in a late stage recession, this is the best part of the business cycle for this asset class.
- Low macro volatility is also favorable for this asset class
- US HY should also do well, albeit returns will be lower
Long Dax vs Eurostoxx 50
- The German Economy has 2 advantages vs the rest of the EMU: cheaper labor costs per unit of out put, and cheaper funding costs. Both are in the process of reverting, but due to institutional rigidity, the timeline for that is measured in years, if not decades. These structural advantages are likely to be a key differentiator and are not priced in. The Dax is actually trading at the cheapest levels vs the Eurostoxx in many years.
- The main arguments against this trade is that the Eurostoxx earnings are coming off of depressed levels, but are likely to bounce as a result of ECB easing and a better fiscal backdrop. That is probably true, but to a large extent, also priced in. Fiscal consolidation in a low growth environment almost always takes longer than expected to play out, and European banks continue to delever. Trends in relative export performance, or relative deposit growth across EMU countries all continue to widen. The variant perception here is that this is NOT a typical post recession recovery, which most EMU equity managers appear to expect. It is much more of a Japan-like recovery, as long term imbalances have much more room to improve.
Long US Tech Sector vs S&P 500. (Nasdaq 100 is a rough proxy)
- Tech sector remains a relatively high growth area in a low growth world. The massive institutional overweight in Tech was unwound over the past 3 months, but the fundamental story still sound. As a result of the unwind, the Tech sector is trading at the cheapest level vs the index in recent memory.
- Recent Tech earnings likely curtailed by fiscal cliff uncertainties. A rebound in capex following the end of the cliff will likely lead to a bounce regardless of if there is a recession or not.
Short AS51 (Australia) vs S&P 500, currency unhedged
- The Australian currency is very overvalued – something the RBA governor has explained well. This means competitiveness is low, and growth is likely to slow.
- Commodity super cycle over, but mining investment is 8% of Australia GDP vs 2% in 2005. Risk is another super stimulus in China, but it appears the leadership there understands the need for rebalancing. Even if growth in China is maintained in the high single digits, mining capex in Australia will decline, which will necessitate rebalancing and lower growth & earnings.
Short Nikkei vs S&P, currency hedged
- This idea may be the most anti-consensus trade here, so I will elaborate a bit further. The consensus expectation seems to be that Shinzo Abe, who has already failed once as Prime Minister, (Resigning after 1 year) will be able to bring both growth AND inflation to Japan, despite multi decade trends to the contrary. Despite many years of QE that has failed to increase growth, Abe is campaigning on the idea that more QE by the BoJ will increase growth and inflation. Even if this is achieved, an increase in nominal bond yields would be a massive hit to the Japanese financial sector, which is laden with JGBs. An increase of 10y bond yields from 70bps to even 1.5% would drive 10y JGB prices from 101 to 94. With the election in a couple weeks, much of the optimism may be near local extremes.
- More QE will NOT result in more profits. QE impact on stock prices is limited, as we have seen with Japan over the past decade, and in the US since QE infinity was announced in Sept. Remember that Japan has tried a massive QE program before. From late 1999 to early 2002, the BoJ balance sheet doubled, (+70Trn Yen) which increased M1 growth to a peak rate of 33% by early 2002. During this time, the Nikkei declined 36% even as the yen weakened 28% vs the USD.
- A weaker currency would certainly help earnings, but < 1/3rd of Nikkei revenue comes from overseas. So even IF the BoJ is successful at creating inflation & weakening the currency, it’s not clear if that will be sufficient to allow the Nikkei to outperform. Also Yen shorts at the highest level since July 2007.
- The consensus view seems unanimous in loving the Nikkei and hating the Yen. That’s usually a good sign to go the other way. Here is the chart of the S&P vs the Nikkei over the past 4 years. Maybe this long term trend is over, but it still looks like a correction to me:
Long US Homebuilders vs S&P 500
- The tailwind for homebuilders in certain sections of this country is substantial. While we will not come close to seeing the boom levels of 2005/2006, the market is still discounting very modest growth in that sector. The price ratio, despite increasing 50% from just over a year ago, remains at levels last seen in mid 2007 and before that early 2002. It will take a 150% rally from here for the ratio to get to the 2005 highs.
- I wasn’t smart enough to think of a way to really mitigate the beta component of this trade. The SPX beta is ~1.5 right now, but has ranged from 1 to 2.5. And using the S&P to beta hedge actually hasn’t been very useful for improving risk adjusted returns because this is a cyclical product. A simple 1:1 ratio should serve to mitigate the volatility, but an outright long position also looks reasonable.
Receive US 5y inflation 1y forward
- Market is pricing in inflation of 1.35% over the next 12m, but an average rate of 2.5% over the next 6 years. If you do a 1y5y forward by receiving 6y inflation and paying 1y inflation, you can receive 5y inflation starting in 1y at an implied rate of 2.71%, which incidentally is also the highest print for the 5y inflation swap over the past 4 years, and also a high level even during the 2007-2008 period.
- With continued high unemployment and a declining energy trade balance, US inflation is highly likely to remain subdued over the next few years. Since the recession ended in June 2009, realized inflation has been just 2.1% annually.
Short BAZ3 vs Long EDZ5
- No hikes are priced in, even though the BoC expects hikes by 3Q next year Carney became more hawkish in the last BoC statement, noting in particular the housing bubble. Though he is moving on, the rest of the staff will likely continue his policies
- Long EDU5 will mitigate risk on/off, and carries positively in case no hikes or cuts happen.
- Canadian Inflation pressures likely to become evident by 2Q.
- This is mainly an expression of AUD bearishness. The cross is very, very rich by most valuation metrics.
- Mining capex in Australia is in the process of peaking. The trade balance has been negative for almost a year, and is worsening. The only reason the cross hasn’t traded lower already is because of inflows into Australian government bonds. But some more cuts by the RBA could change that.
- CAD is used as the long leg because of its procyclical correlation and also because BoC is the only CB that hasn’t eased this year.