Trade Ideas for 2015

Themes:

  • Macro economic volatility will remain low, limiting trends and macro strategy returns. This is a theme I touched on last year as well.
  • Long term yields in the US look fair, while EU and JP yields are low. (though for good reasons)
  • More QE alone from the ECB is not going to revive growth much. Given the ongoing private sector deleveraging, fiscal stimulus is a necessary requirement to recycle the excess liquidity into spending and GDP growth. The chart below oversimplifies the relationship between European Industrial Production (Blue, LHS) which correlates strongly with GDP growth, and the EU Budget deficit, (Red, Inverted, RHS) but highlights how current budget projections suggest little reason for optimism.

    Having said that, one positive transmission mechanism is that lower periphery yields are likely to be helpful. On that note –

  • Periphery yields vs Germany are likely to continue to tighten for some time longer. I think either we see slightly better nominal growth next year, or the ECB launches QE. Arguably, an ECB QE program should be negative for Bunds, given the implicit sovereign risk sharing. In any case, both scenarios are supportive of that.
  • Globally, risk premiums are perceived to be low, so capital is likely to chase incremental opportunities. This suggests more capital going toward assets junior in the capital structure, as well as assets across borders.
  • However, highly levered (both explicit and implicit) assets are vulnerable as focus shifts toward rising funding costs. Longer duration assets should be OK, as supply is likely to fall in response.
  • The commodity super-cycle will continue to deflate, although oil prices should not have much more downside.
  • Long USD especially vs EUR and JPY, are extremely popular trades. But the risks for the two are very different. One very key point for the EUR is that the monetary union is running the larges current account surplus in history – around 300bn USD worth at current exchange rate. While portfolio and FDI outflows are likely to limit near term appreciation, over the long run, the large surplus is likely to steadily pressure the currency higher vs its trade partners. Additional risks for EUR upside include Chinese FX reserve buildup, though somewhat offset by potential SNB selling. IMO, the outlook for the EUR is much more ambiguous. Pessimism around Europe is very high, but it’s too early to play a rebound. Additional fiscal stimulus will be key.

Trades:

Reload 2 year S&P call options. This is primarily an asymmetric bet that PE will expand further. I’ve already discussed the macro reasons for a higher PE many times, so I won’t repeat them in detail here. 22x trailing PE looks reasonable. Breakeven is a +4.5% rise in the index price. Top down EPS growth is forecast to be ~7.0% YoY, so this could potentially work even if PE doesn’t expand much. The key risk is that the first Fed hike causes a disorderly risk-off move that delays the PE expansion trend. In other words, the sweet spot for this trade is 1Q and probably 2Q. This trade is not as attractive as last year, not only because the index has appreciated but also because 2y yields (and hence forwards) are higher.

Long US High Yield. The cleanest way to play it is just selling protection via the CDX, but an outright long (and thus taking duration risk) should work ok as well. Current market pricing is predominantly driven by worries over the energy sector, which now has limited downside. Spreads are still signficantly above mid year lows despite a benign financial conditions backdrop.

Receive 30y USD vs Pay 30y EUR. This is a bet that the situation Europe stops getting worse. Current pricing reflects quite a dire situation, and the spread is near 15 year highs. 30y EUR inflation swaps are near 1.9%, which means that markets expect the ECB to miss its mandate for the next 30 years. 30y EUR real yields are around -20bps, not far from the lows from the dark days of early 2012, when the world thought the EMU would cease existing. One possibility is that the market is pricing a significant ECB QE program, vis-a-vis the BoJ, which would distort the curve and the information it provides about market expectations. I think the odds of this is low given recent reports and speeches. Any QE program, if it happens, may be limited and likely to have a short maturity target. In addition, the implicit sovereign risk sharing is likely to weigh most heavily on long dated German debt. Carry is marginally positive for this trade, ~7bps a year.

Long Dax vs CAC. The rationale remains the same as last year, though the performance has been unsatisfactory. The fact that relative input costs within the EMU are inflexible suggest that German earnings will continue to outpace French earnings. Germany’s larger export exposure means that a lower EUR should also be supportive. Finally, valuation differentials are quite favorable – Germany equities are priced to yield an additional ~80bps using consensus estimates for next year, which is not far from historical highs.

Long USD vs CAD. This is a rehash of last year’s idea, but the drivers are still in place. Canadian labor costs remain very high vs the US, even as the commodities trade balance moves against Canada. The high private sector debt levels and elevated housing prices also make the Canadian economy more vulnerable than the US. These factors are all likely to make the Bank of Canada keep policy easier than the Fed. All these factors favor this trade.

Long EUR vs AUD. This is two separate trades that are paired up to minimize the correlation to the USD. I am skeptical that the EUR will weaken significantly further. The massive current account surplus and continued fiscal restraint suggest a growing Net International Investment position. People seem to like to compare the Eurozone to Japan. Well, remember what Yen did for decades and decades despite rock bottom interest rates – appreciate! On the other hand, Australia’s Terms of Trade look like a one way train. And if there is anything we can learn from past commodity booms is that the trend tends to persist for years and years. Both regions do a lot of trade with China. However, the composition of trade is quite different – European trade with China is much less resource intensive than Australia. In other words, China’s economic rebalancing away from capex and toward consumption could be supportive.

Other Thoughts:

  • It is true that there is little correlation between interest rates and equity valuations. It is also true that the Fed Model has a poor track record for producing returns. The mistake that most people make is that they stop there. Just as correlation does not imply causation, a lack of correlation does not mean that no relationship exists. (i.e. the correlation between Fed Funds and S&P is also zero) Clearly, and especially over the short run, there are a number of non-interest rate related factors that affect equity valuation. Clearly, there IS a fundamental case for a relationship over the long run. A key point here that most miss is that interest rates are only a proxy for the discount rate for earnings. IMO, the misconceptions around this issue is a great example of how most people simply don’t think deeply enough about the data, despite the quantity available. As I’ve mentioned before, one reason macro is hard is that recursive rather than iterative thinking is required – see the paradox of thrift.
  • I’m also aware that overweights of Japanese and EU equities are very popular. I am skeptical of this because these recommendations ignore the large tail risks embedded in those currencies. Both deflation as well as high inflation significantly depress equity valuations. Given the long duration nature of equity indices, these worries should have a very large impact on the risk premium, at least from the persective of a long term, real money allocator. These concerns do not appear reflected in bank research reports, likely because the client base is skewed toward shorter term market participants. In addition, expectations for earnings growth are already high – the Eurostoxx index, for example, is trading at a 21x multiple trailing PE, and 14x forward PE. Relative performance will strongly depend on whether earnings can beat the already high expectations, (I’m skeptical) and whether the sovereign risk premium can compress further. (likely)
  • There is a fairly widespread belief that volatility will spike once the Fed starts hiking. This is quite possible, but tails should be sold because macroeconomic volatility will (most likely) be low. The option value of dry powder should be more valuable this year.
  • On USDJPY – It seems like everyone and their dog have this trade on. I have been behind on the Japan trade and which suggests that I don’t get it. The fact is, no one understands how QE works – and QE is arguably by far the largest driver here. The BoJ will not be able to keep inflation up over the long run, unless confidence is lost and there is mass flight out of Yen assets. So they will continue printing. The next fiscal risk is the delayed tax hike in 2017, which is some ways away. In addition, the Japanese current account has fallen to the lowest level in at least 30 years, and it is not expected to recover much at all. Due to BoJ printing, bad demographics, and the risk of fiscal unsustainability, market participants do not want unhedged Yen denominated assets. And now they also do not want Yen products and services, at least on a net basis. That may change over time, but it’s hard to see that happening anytime soon. So why is this not one of the trade ideas? The main reason is that for all these ideas, I try to get an idea of the ex-ante sharpe, which is predicated on expected return vs vol. And the fact of the matter is, I don’t know what the expected return is here. If you think the FX rate is predominantly a function of the expected BoJ balance sheet, then perhaps this move is nearly over. The 10/31 annoucement was about a year and a half after the previous one. In another year and a half, the BoJ balance sheet will be close to 90% of GDP – it is hard to imagine that the BoJ can accelerate purchases even further after that and still pay lip service to fiscal sustainability. Yes, the relative balance sheet sizes will continue to widen, but markets are forward looking, and that should be priced in at some point. Recall that USDJPY was essentially unchanged from Feb to Oct even as the BoJ balance sheet continued to grow at a quicker rate. Also, real incomes in Japan have fallen quite sharply since Abenomics started, and political repercussions are already being felt, as Abe’s approval rating has been falling. On the other hand, it is also possible that the market loses confidence in Japan’s fiscal position as the deficit continues to be horrible and nominal growth doesn’t pick up enough to allow fiscal reforms, resulting in a panicked move.
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5 thoughts on “Trade Ideas for 2015

  1. Thanks for sharing; interesting as always.

    I’ve been trying to unpack your implicit equity model for a while, but haven’t really felt like I understand it. Your somewhat cryptic comments today don’t shed a lot of light on this, but fair enough, you’re not here to draw us pictures…

    Allow me however to speak up for Eurostoxx. OK, trailing PE is not a particularly flattering metric, but longer term metrics (CAPE, P/B etc) paint a very different picture. To get an idea of the pessimism embedded in the price, look at the Eurostoxx dividend futures strip. I’ll concede that it’s heavily distorted by structured products hedging, but still, it’s a thing of wonder…

    It may be becoming a popular trade, but it doesn’t feel as if people are overweight (unlike Japan). We can also expect a bit of a fillip to earnings from the weaker EUR. And, after years of cost-cutting, operational leverage should be quite high. So there’s a decent story to be told in the shorter term.

    In the longer term, I’d argue it’s a bit like the Bund – T’s trade: someday, this war’s gonna end. I think the long-term trade for the brave/foolish is a box: Long Ts, short Bund, long Eurostoxx, short US equities. If you’re worried about the politics, you could sub in BTPs for some/all of the Bunds.

    Japan: I’m not touching that hot potato. I think the risk is that foreigners are over-egging this one. There’s an element of teleological thinking: this is a proper move, we need to catch a proper move to make money, ergo we need to be in this. Some call it old-school macro, I call it looking through the wrong end of the telescope.

  2. Thanks a lot for your thoughts. I am sympathetic to all of them, and agree on most. With respect to Eurostoxx, I agree with you that there is a near term impetus for earnings growth. And given stable/falling periphery yields, that it should perform decently next year. What I’m more concerned about is the longer term picture. In the intermediate term, debt levels and debt service costs are still too high, which is blocking monetary policy transmission and is likely to constrain credit and real GDP growth. Over the very long term, the demographics issues are insurmountable, IMO. Per Eurostat, the percentage of Europeans older than 65 as a percentage of the population accelerated this decade, and the velocity will remain constant for the next couple decades. Unless a majority of the equity market profits come from abroad, the profits from the domestic economy have little prospect for nominal growth. For long term real money asset allocators such as endowments or SWFs, I think those are serious concerns. And those concerns all exist with the prospects (however small) of excessively low inflation, sovereign debt deflationary spiral, and a monetary union breakup. For an asset with a duration as long as equities, those small risks are likely to command a sizable risk premium, IMO.

    I hear you about Japan. I think you describe it very well. It’s interesting the amount of conviction people have on this despite the fact that no one understands how QE really works and no one has seen this movie before. (Though maybe it shouldn’t be interesting because people have conviction on lots of things that they actually have no clue on)

    Finally, regarding equity valuation model, Blackrock has one that discounts the S&P free cash flow by the credit market yield to worst. If you haven’t seen it, let me know and I’ll email it to you. It’s not exactly what I use but it captures the largest driver right now.

    Eurostat link:

  3. Demographic effects on the markets is something I’m quite interested in. Some interesting discussion here: http://www.frbsf.org/economic-research/publications/economic-letter/2011/august/boomer-retirement-us-equity-markets/

    Nonetheless, I tend to tune it out over trading horizons (rightly or wrongly), because despite being important, no-one else seems to care, so it’s one of those things it doesn’t pay much to fret about. However, obviously it’s of crucial import over longer horizons as you’re correct to highlight.

    I guess demographics can feed into the European outlook in three ways:
    1) feeds into the European story in an impressionistic way, adding to the picture of Europe as a ‘barren grandmother’, h/t Pope Francis
    2) impact multiples as per the Fed paper
    3) impact earnings

    I guess I think 1) is mostly in the price, but that’s just my feeling.
    With regard to the effect on multiples, I would think this would be quite a bit lower than in the US, where boomers hold much more listed equity, both directly and indirectly.
    As regards the effect on earnings, I confess I haven’t given it much thought, tending to think of the issue more in terms of multiples. As far as earnings go (just shooting from the hip here), I think Eurostoxx is relatively well positioned, with heavy weightings in financial services and defensive stocks – not too many high-flyers to be seen (the few that were there have been winnowed out over the years). This is clearly something I need to think / read about more.

    Thanks for the heads-up on the Blackrock equity model; my Google game is failing me, so if you could send it on (or post a link), that would be much appreciated.

    1. My para 2 came out rather nonsensically: guess I meant to say I tend to fall into the trap of: because demographics aren’t relevant over most trading horizons, I tend to make the error of downplaying them over longer horizons too.

    2. Yes, that FRB-SF paper was interesting, and I’ve spent a fair bit of time thinking about it. My take away is that the fundamental case for the relationship is probably too weak for me to rely on, and the historical fit is something that is more likely to be coincidental. IMO, the reason the fit existed is that the M/O ratio in the paper drives inflation, which as you know at high levels has a negative impact on equity valuations. In addition, the rise in the AUMs of ‘infinite’ duration entities like Endowments, Foundations, SWFs, and super wealthy people in the past few decades is a very large offset to the demographic explanations in the paper and a strong reason to discount them.

      However, that’s not to say that demographics are meaningless, of course. IMO, they are more useful for explaining the Equity Risk Premium rather than the P/E or Earnings yield outright. On that view, my measure of the SX5E ERP is only marginally above where macro factors suggest they should be. A more risk positive environment (possibly as a result of ECB QE?) could certainly push that lower. But given the data, EPS growth is probably going to remain on the weaker side for most of next year. (though maybe that will change if we see QE, who knows) Finally, it’s worth noting that European Equities have historically priced in a higher risk premium than their US counterparts. Explanations for that are many, but given the history, now does not seem to be the time to bet on it being different. So in aggregate, I do expect positive total returns for SX5E, but the probability that they substantively exceed the mid-teens figure that I think is likely for the SPX is rather low, at least IMHO.

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