As always, comments & feedback are welcome.
- Yields remain low, but what is different now is that expected macro volatility is also low, after major shocks over the past few years. As a result, we are likely to enter the part of the cycle where leverage starts to build and credit quality begins to deteriorate. This is a trend that really only just started this year and has a fair bit of room to run. As people begin to get more comfortable using leverage, the riskiest assets usually perform the best. Low macro and asset vol means consensus trades are more likely to work because the probability of a sharp change in the consensus is lower. Given these conditions, risk asset prices should not be just ‘fair’ – they should be ‘rich.’
- Both ILBE as well as realized inflation is very low, which is likely to contain any aggressive CB tightening, which appears to be a major investor concern at the moment.
- The lack of macro volatility as well as fairly stable central bank policies mean that opportunities for good macro bets is also likely to diminish.
- The low potential growth in DM is not due to ‘damage’ but due to falling labor force growth. It is here to stay, which suggests that asset prices will price in lower returns over the long run, which is another way of saying that asset prices can drift higher even if the expected income stream stays stable.
Long S&P via LT (>= 2y) calls
- Vol is very low, and so is time decay.
- Risk premium is likely to compress (meaning PE is likely to rise) during this part of the cycle
Long DAX vs CAC
- France just hasn’t done enough to normalize its productivity-adjusted labor costs vs Germany.
- CAC is quite a bit more expensive than the DAX on forward earnings metrics relative to history.
Short TSX60 vs S&P 500, currency unhedged
- Problems facing Canada include an overly strong exchange rate (still just 10% from all time highs vs USD) and falling energy exports to the US courtesy of fracking.
Long EU 5y vs US 5y
- This one is SO popular it’s almost embarrassing to include it here. But the economics behind it is pretty solid, although the list of possible catalyst is murky and the carry is unpleasant. Unemployment in the US has been declining for 4 years, where as EU unemployment may have just peaked and is unlikely to decline quickly anytime soon. As a result, it is really just a question of when the Fed will tighten first.
- Potential catalysts include a series of strong US payroll prints or some kind of growth accident in Europe that leads the ECB to take further measures.
Long 2y Italy (or Spain)
- These are still ~100bps over Germany and France. The ECB probably won’t be in a position to tighten until that spread compresses significantly further. In fact, they have implied as much when noting the fragmentation of EUR money markets. Furthermore, rolldown is ~20bps a quarter.
- The risk of yet another shock so soon after the last one is less likely. Historical vol looks high but with somewhat better data, that is likely to decline. For comparison purposes, 5y EUR financial CDS is trading at ~100bps also. Politics remain a risk, but with a current account in surplus, this is less likely to affect shorter term Italian yields. Another good sign is that the correlation between short term yields and economic data has flipped– i.e. weaker data is now correlated with lower yields.
- A recent comment by ECB members Praet and Coeure suggested that there could be a risk weighting for sovereign debt on bank balance sheets. If so, that would have the dual impact of forcing some sales of periphery debt by periphery banks as well as reducing their Tier 1 capital. Given that the Eurozone is just starting to exit a recession, such a change seems unwarranted and is more likely to be phased in over time – especially since the ECB is still operating under an ‘easing bias.’ (NB: Draghi reportedly said last night that the ECB will NOT unilaterally assign risk weights for banks’ holdings of government debt: "This is not the task for us or for now. This is the global task that will be discussed by the Basel Committee (on banking supervision) at the proper time".) But it is certainly a risk given the ECB’s history of giving EUR risk takers the shaft.