First Off, Marking the 2017 Trades:
Sell puts on 30y Treasuries at ~3.5% yield (roughly 150 on the ultra contracts)
+1.5% on the notional of an Ultra contract a year ago. I assumed shorting new quarterly puts at the close on the day the older puts expired. A year ago the consensus was fairly heavily tilted toward higher rates, so this one worked fairly well in early in the year.
Long US Leveraged Loans outright or HY on duration hedged basis
The S&P Leveraged Loan 100 index returned +3.3%. Default rates were low and the Fed hiked.
-3.0%. This one was looking pretty decent in early May, but turned around rapidly after that as the BoC turned sharply hawkish in mid June, as the unemployment rate began falling sharply. They’ve backed off a bit since, as inflation has remained benign. In retrospect, I didn’t pay enough attention to the surge in employment in 4Q of last year.
Long S&P vs Russell
+7.2%. Probably a surprise to some folks given how well the economy has done as well as the tax bill headlines. IMO, much of that was already in the price a year ago, and the tech sector helped a lot also.
Hit rate: 3 for 4. The results certainly weren’t exciting, but they worked, and delivered on low volatility and low correlation to major asset classes. For a macro mandate, it wasn’t terrible, especially since the industry results were pretty paltry in general. The general backdrop for 2017 was one of low macroeconomic and asset class volatility, which meant very few opportunities in macro space. IMO, the best macro opportunity of the year was in Sept, when the market pricing for the Fed got crazy dovish on the back of the low inflation prints. I discussed this a bit in my last note back in Sept.
2018 Macro Thoughts:
The consensus is for another decent year economically speaking, and it’s hard to find data that suggests otherwise. I’m sure readers have already read many versions of “2018 Outlooks” already, so I’ll try to avoid repeating the more consensus views. The unfortunate byproduct of that kind of forecast is that mispricings will continue to remain scarce, and the long carry / long risk trades will remain in vogue. I don’t see anything that suggests 2018 will be a great year for macro strategies, though in that I hope I’m wrong.
I think the Fed will hike more than is priced in, but the market will only adjust gradually. I don’t think yields will be a problem until we get at least above 2.25%, which means it’s probably a 2019 problem. Given the current trends in train, we may see a bit of volatility in the spring. Core PCE seems likely to pick up at the end of 1Q on a YoY basis. Given consensus expectations though, the risks seem skewed toward them staying pat in March and only hiking after realized inflation picks up, though another noticeable drop in the unemployment rate would likely trigger sequential quarterly hikes. The FOMC voters next year are noticeably more hawkish than the ones this year, though it’s unlikely they’ll rebel against Powell given that it’ll be his first year. There seems to be some sympathy for price level targeting at the Fed currently, which if adopted would give the Fed leeway to keep policy easier. (It’s also possible the Fed rolls it out in lieu of forward guidance in the next recession) If so, we could see a replay of the late 90’s, whereby a lack of financial condition tightening, along with regulatory easing results in a renewed series of financial bubbles. Regardless of what happens, the Fed’s actions in 2019 will lay the groundwork for whether there is a recession early in the next decade.
I’ve been saying for a few years now that for 30y treasuries, 2.75-3% is fair, and the Fed dots seem to agree. Part of the rationale is the decline in inflation uncertainty, which GS has noted, though the decline in policy uncertainty has helped as well. That’s one reason I think US equities are valued fairly here, and if anything a bit on the cheap side. And that’s before taking into account the balance of risks for next year.
European growth is likely to remain robust, but has not translated into good earnings growth. EU core inflation is likely to pick up by more than is expected, but my guess is that the ECB will try to continue to buy more time for the Italians to get their debt situation under control. Fortunately, at current yields and nominal growth rates, Italy is in the clear. The weak earnings growth, however, significantly weakens the value proposition for EU Equities. In general, I see valuations there as fair to rich, despite the sharp underperformance in local currency terms this year.
Unlike the US and Europe, the Chinese economy is likely already slowing. Knock on effects look likely in 1Q, and possibly concentrated in the metals complex. The consensus is that Chinese policy makers have learned from the 2015 growth scare are will be much more careful this time around, which means the slowdown will be mild. That’s certainly pretty reasonable, but the risks are clearly skewed toward a worse outcome, especially given the size, complexity, and leverage levels.
In general, the consensus seems to be pretty bullish EM assets, and from a valuation perspective, it’s hard to disagree. However, it’s worth noting that historically, EM equity outperformance has been driven by a weakening dollar. The BIS, among others, have noted the procyclical effects of stronger EM currencies easing EM financial conditions. So to me, the EM equities bet is strongly related to a bet on a weaker USD. The problem is that I am not convinced that we’re about to embark on a sustained bear market for the USD yet – it doesn’t seem all the pieces are yet in place. On the other hand, EM sovereign debt looks fairly attractive vs DM High yield. EM economic conditions look fairly benign, while delivered DM High Yield defaults are at unsustainably low levels.
Go long a 50/50 basket of S&P 500 and 30yr US Treasuries.
I’ve been writing about the insurance aspects of risk free assets within a portfolio. It’s worth noting that with Bunds, Gilts and especially JGB yields where they are, the amount of insurance they provide in a global risk off is significantly lower relative to previous cycles. (i.e. how much are JGB’s going to go up / pay out in a recession from these levels?) In conjunction with the higher debt loads everywhere, there is a real cap on how high yields can go. Furthermore, GS has noted that the decline in delivered inflation volatility had a major impact on implied volatility on the long end, with likely knock on effects on the term premium as well. 30y yields at 2.90% or so is in my fair value estimate, and as a result provides some portfolio insurance at a reasonable cost.
Short AUD vs USD.
A play on the Chinese slowdown that is in train. Inflation in Australia, like in other DM countries, has remained low, and the RBA is reluctant to hike, especially given the high debt load and the level of the currency. Currently the negative carry is deminimis and looks likely to turn positive later this year (!) given market pricing and consensus forecasts.
Long MIB vs SX5E.
Italian companies seem to have shaken off many of its legacy problems and its relative growth profile has picked up. Looks like the market isn’t buying it just yet, so this looks like a decent entry point.
Because it’s going to change the world, something something. Because you can’t trust governments. Also supply is limited. And it’s totally worth it to pay $25 in fees and wait 15 minutes per transaction for an asset with an annualized volatility of 100%. Finally, and most importantly, because the price is going up. Like a lot!! What are you going to do, not buy it?!? FOMO dude!! This guy gets it: “valuation is immaterial.”
In case it’s not obvious, the last one’s a joke. Some of the stuff is just so out there you have to laugh a bit. I wish there were more substantive ideas, but between the market landscape and other responsibilities taking up my time, I couldn’t find more ideas compelling enough to hold for multiple quarters. As always, constructive criticism is welcomed!