Before we get to the ideas, a quick note on my predictions and ideas from the past year. Overall, it’s been a decent year for my calls. Part of that is due to the major swings in asset prices over the course of the year. Here were my key calls and subsequent market price action: (I used SPX as the proxy for risk assets and 5y Treasury yields as a proxy for risk free rates)
On 10/22/2015, I wrote ‘It’s time to be Neutral or Short Risk.’ (assets) That proceeded a 13% drop over the subsequent 3.5 months:
On 1/21/2016, I wrote ‘It’s time to start building exposure to risk assets.’ That was a bit before the ultimate low (which I acknowledged was likely at the time), but was subsequently followed by a double digit gain over the subsequent 3 months:
On 6/23/2016 I wrote ‘Here comes the Squeeze,’ where I noted that equities were likely to rally regardless of the Brexit referendum outcome.
On 8/22/2016, I wrote ‘It’s time to short the front end,’ where I argued that it was time to bet on higher rates:
To sum up, most of the intra-year calls have worked out, though it seems I was a bit early on all of them.
My 2016 ideas all showed nice profits at mid year, but have retraced much of their gains over the past month.
· Short CHF vs JPY worked pretty well. Regular readers will recall that I proposed taking profits when the cross was at 106 mid-year.
1. 12/11/15 level for 12m fwd: 123.84
2. Current Spot: 112.22
3. PL = +8.4%
· Short AUD vs USD. This trade hit a 5% profit within a month of initiation, but gave it all back. The PBoC easing starting in late 2015 was the main factor that knock the trade into a loss.
1. 12/11/15 level for 12m fwd: 0.7073
2. Current Spot: 0.7460
3. PL = -3%
· US 5s30s Flattener. This trade was up +35bps by the end of Aug, when I’d suggested potentially booking profits. Since I proposed going short duration, the trade has gone back to flat.
1. 12/11/15 level for 1yfwd 5s30s in swaps: 0.742
2. Current Spot: 0.726
3. PL = +1.5 bps.
Thoughts about the Current Macro Environment: (This will provide some context for the 2017 trade ideas)
The global economic & inflation rebound has some more room to go. The current economic momentum and some leading indicators suggests another quarter or two. The deflation / recession mindset that was in place for much of last year is now a good base against which the economic cycle can extend. EM balance sheets are now fairly healthy, (though potentially at risk if the USD strengthens a lot more) and FX levels undemanding.
Global cyclical indicators are now close to the peak levels seen from late 2013 – late 2014. (below chart is from GS)
With G8 unemployment now near multi-decade lows, it is questionable how much the acceleration can continue.
The biggest long term risk remains rapidly tightening monetary policy. By my estimates, US policy rates above 3% would be enough to trigger a recession. We’re obviously still a ways from that, but by the end of 2017, we could be almost halfway there. In contrast with the low odds of recession near term, I think the odds of a US recession during 2019-2021 period is quite high. How quickly policy actually tightens, however, will be dependent on the evolution of fiscal policy and inflation. That’s one reason I’m hesitant about making any longer term bets on the belly of the curve.
I don’t think there’s that much upside left for equities, at least on a risk adjusted basis. On my models, they are already trading rich, but that may well be justified due to the corporate tax cuts that Trump has talked about. GS noted that a reduction in effective corporate taxes by ~10% could increase EPS by ~15% or so. That certainly justifies some sort of premium, but further gains on that front will require some legislative details. DM yields and equity valuations are roughly in balance here, so a further rise in yields will be a significant headwind for equities, though rising earnings will provide some offset.
Nevertheless, it is key to recognize that there is more uncertainty now about the appropriate risk free discount rate than at any time since the end of 2013. This key input that goes into essentially every asset valuation model presents a key source of uncertainty that lowers the conviction on any calls one can make. Note that this uncertainty is also being reflected in vol space, as rates and FX vol are both quite high compared to the past 5 years.
2017 trade ideas:
Sell puts on 30y Treasuries at ~3.5% yield (roughly 150 on the ultra contracts)
There is a limited amount of upside for 30y yields from here. The global savings glut and wealth inequality is not going away. No president is going to move us out of the new normal. As global momentum slows at some point next year, those views will be talked about again. In addition, implied vol for US rates is on the high side. Currently, 3m puts are ~1’20 bid, or ~88bps of notional. On an annualized basis, that is roughly 3.5%. I think you are supposed to get long 30y treasuries at that yield, if not sooner, and get longer if the opportunity arises. As I mentioned, I am strongly convinced that policy rates in excess of 3% is likely to trigger a recession, so 3.5% is a good level to lean against.
In addition, per JPM, various positioning metrics suggests that Treasury shorts are now fairly crowded.
On the other hand, it seems unlikely that we will see the highs for yields until at least the end of the year or even inauguration. There is simply too much uncertainty and current yields are not quite high enough to justify the risks. In addition, with economic and inflation momentum on the rise, risks are still biased to the upside. As a result, selling puts provides a reasonable alternative, IMO.
Long US Leveraged Loans outright or HY on duration hedged basis
Though clearing levels for risk free rates are in question, credit spread levels are easier to call. Credit spreads are ~3.6% for loans, and ~3.7% for HY CDX. Given that near term economic risks are low, neither are unreasonably tight given expected defaults and is likely to provide a decent source of vol-adjusted carry. The higher total yield is not a problem – interest coverage ratios remains healthy. (per GS – see chart)
This is a fairly consensus call. Having said that, it is important to be mindful of where we are in the business cycle, and that credit spreads are only somewhat attractive. In other words, it’s not the time to load up on illiquid bonds!
After the 1998-2007 oil boom, Canada is suffering from a mild form of dutch disease, IMO. Despite the 25% depreciation in the real effective exchange rate since 2007, the current account deficit remains quite poor at -3.5% of GDP. Over the past 40 years, the only other two periods of such sustained current account deficits saw large depreciations that continued until the deficit was corrected. I think that’s a pretty good template this time around also.
In addition, the trade has the added bonus of being positive carry, and negatively correlated to risk assets.
The biggest pushback on this is that oil is likely to rally, which has historically meant CAD strength. In this respect, it is important to recall that the US is now a major oil exporter – in fact, the net US petroleum trade balance is almost flat, levels not seen since 2002.
Long S&P vs Russell
Higher real rates are negative for small caps relative to large caps. The current levels are already extrapolating a jump in growth:
There’s certainly a bit more room for small caps to outperform, but they seem more likely to mean revert – either due to growth mean reverting or a tightening Fed.
On a final note of clarification, these are not necessarily trades that anyone should hold blindly for the year. But I do think that they provide some interesting risk/reward tradeoffs over a longer time frame that at least will provide some food for thought for readers. As always, thoughts and disagreements are welcome. Good luck and best wishes for a profitable and educational 2017!