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: http://libertystreeteconomics.newyorkfed.org/2015/12/dealer-positioning-and-expected-returns.html
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!