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)
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: