Market Thinking - A view from the equity market

• While everyone focuses on the headline, the detail is what matters - and its consequences. For example, both US candidates suggest repatriating tech cash balances, but this may put pressure on European liquidity, while funding infrastructure spend could put pressure on bond yields.

• Meanwhile those wishing for a successful constitutional reform in Italy need to be aware that it could actually trigger a referendum on the euro. Growing nerves here likely explain the widening of the spread between German and Italian bonds as investors try to hedge ‘currency’ risk.

• In Asia, while the focus has been on North Korea, South Korea has erupted in a corruption scandal and the pivot to Asia has seen a rotation as previous allies of America gravitate to China and vice versa as they play off the two components of Chimerica against one another.

While we have the Federal Reserve (Fed) talking this week and the usual non-farm payrolls on Friday, it’s the FBI announcement last Friday that has obviously dominated market thinking for the last few days. As previously discussed, the markets had, rightly or wrongly, concluded that they preferred the stability of a President Clinton as opposed to the uncertainty of a President Trump. This is not so much a view on policies, since very little has actually been said about policies, rather a verdict on change versus more of the same. Most investors have been reduced to spectator mode, waiting to see what happens. Halloween, Divali, bonfire night and an October surprise for Hilary Clinton. So many metaphors. Only a week to go, thank goodness.

In terms of policies there is of course the second level of complexity which is the make-up of the House and the Senate, the ability to enact policy by either candidate could be limited by opposition elsewhere – as it is designed to be. The separation of powers is a deliberate construct to prevent a too powerful president, as such it will be the balance of powers not solely the Presidency that determines policy. As speaker of the House, Paul Ryan is probably the most important player here and either candidate will likely need to broker a deal with him, which given his own ambitions to run in 2020 could add yet more complexity. There are some policies which both candidates have espoused however, notably on infrastructure spending and the repatriation of offshore cash surpluses – mainly of tech companies. For infrastructure, we doubt it would be the ‘shovel ready’ projects of 2008/9 which were in many cases questionable in their value add. More likely it would be wider in scope, not just the traditional bridges and roads, although these are needed, but also in areas like the smart grid and even cyber security. Moreover, it seems likely that both candidates would encourage public private partnerships (PPP) as a structure, which would offer opportunities for yield hungry capital. Some of this capital could of course come from the huge corporate cash surpluses  currently held offshore, with both candidates discussing some form of tax reduction or amnesty to encourage  repatriation. According to Moody’s, over 70% of all US non financials US cash holdings of $1.7trn are held offshore. This may come direct or via higher (special) dividends to shareholders, who in turn recycle the cash into infrastructure projects.

The flip side of this however is the fact that the surplus cash is currently parked (largely) in euro cash and a large scale repatriation would likely put pressure on short term rates in Europe and in particular on strategies that use overnight repo markets. Remember that it was a small tightening in funding rates for companies like Long-Term Capital Management (LTCM) back in 1998 that triggered a widespread market sell-off. Meanwhile, 3 month Libor, the day to day cost of money for corporates, continues to grind steadily higher. On the other hand, if the infrastructure projects are funded through hypothecated funding – although Hilary Clinton has promised no more borrowing to fund her spending, special Build America Bonds, or something similar might be a way around this – then that would put pressure on existing  bond yields. Put simply, the existing market structures reflect an excess of cash looking for a home. Change that dynamic and you change the nature of markets.

Meanwhile in Europe, the Italian Referendum on constitutional reform in early December threatens further instability. The Italian Prime Minister Matteo Renzi has threatened to resign if the vote on the reform of the constitution does not go his way, which has been worrying markets. The fact that he is now seen as unlikely to follow this through is seen as some comfort if he doesn’t win, but arguably the real risk is that he wins rather than that he loses. On current polls and trends, a reform of the upper house (which is what is being proposed) could deliver power to the M5S party, who have promised a Referendum on Italy’s membership of the euro. This would threaten a re-run of the 2011/12 euro crisis since the problem would be the same as back then; how do you hedge an unhedgable currency risk? Owners of Italian bonds (and the perception would be of other peripheral countries as well) would risk being paid back in a depreciating currency.  Not surprisingly money then flows out of the periphery back to the core countries, placing strain on the balance sheets of peripheral country banks. Strain that is offset by offsetting transfers via the ECB. We can monitor this via the fact that the ECB publishes data on theses flows, known as TARGET balances, standing for Trans-European Automated Real-time Gross Settlement Express Transfer system. Chart 1 illustrates the trends in Italian and German transfers.

 

Chart 1: European TARGET balances, Italy and Germany

Source: ECB Bloomberg November 2016

We can see that while the positive flows on Germany are not quite as high, the negative balances in Italy are now greater than they were at the peak of the euro crisis in 2012.

Either or both of these factors, tighter liquidity thanks to repatriated cash balances or renewed concern about the stability of the euro could cause problems for European banks. These have rallied over the last month, presumably on the back of rising bond yields (see below) but would need to be watched carefully.

Perhaps reflecting this the yield on Italian 10 year bonds has risen more rapidly than that for German bonds in the last few weeks, as shown in Chart 2. While German yields are still a little over 20% lower than this time last year, Italian bond yields are now higher.

 

Chart 2: Euro bonds – Germany vs Italy

Source: Bloomberg November 2016

In effect the spread between the two has widened noticeably in the last month. As we pointed out a few weeks back – most trades are either spreads (with leverage), mean reversion or momentum. The Italy Germany spread appears to be the new hedge/spread trade on the block.

In terms of momentum and mean reversion, German bund yields, while still at very low levels have broken back above a zero yield over the last month and from a technical perspective have broken through their long term moving average. Even Japan, which started the trend of getting paid to borrow money is now almost at zero, the Japanese 10 year benchmark bond is now at ‘only’ negative 5 bps. It too is very close to breaking its long term trend.

Generally speaking, when an asset class is both negative on a twelve month view and breaks its long term moving averages, it makes sense to move to hedge some of the possible downside risk – as momentum has gone and the probability of mean reversion is rising. Italian bonds already fulfil both criteria and while neither Germany nor Japan are negative in absolute terms, they are close to breaking trends. As noted last week, the US 10 year yield has already broken up through its long term trend.  For commodities, oil (West Texas) at $47 is up slightly in absolute terms (2%) on the year, with a long term trend at $42, so looks ‘ok’ for now – although as we noted a few weeks back, it’s range bound rather than trending, while gold is still positive and holding above its trend line. The S&P 500 index is in a similar position – showing weakening short term momentum but still above its long term (small) uptrend, as are stocks that pay good dividends (and thus appeal to the search for yield).

Here in Asia, there is an emerging recognition of the value – and the need – to balance between the two poles of “Chimarica”. Last week we discussed how President Duterte of the Philippines, a country traditionally close to America was now courting China, while Vietnam, traditionally closer to China was now getting closer to America. This week we see Malaysia moving closer to China, while Australia and Indonesia have announced that they are considering joining patrols in the South China Sea. This of course is all part of the US pivot to Asia which in some circles (in both the US and China) is seen as a mechanism for limiting China and for many analysts has echoes of the ‘Great Game’ played between the major European powers at the end of the 19th century.  It also has pragmatic elements – as  part of the dispute over the South China sea, the Philippines has been cut off from China sourced infrastructure funding for the last four years. The US has been a source of foreign direct investment (FDI), but that has mainly been in manufacturing, the Philippines need infrastructure and China is offering that. Equally, the US is offering countries like Australia, Japan and Vietnam, access to sophisticated weapons systems to ‘defend them against the threat from an emerging China’.

Of course, Asia has not been without its own political scandals, 1MDB Malaysia being the latest until this weekend when South Korea saw the emergence of another corruption scandal (Korea has not exactly been immune from these over the years) and President Park Geun-hye looks to be in some serious trouble as one of her close confidants has been caught running a huge slush fund and had skipped the country. She has now been brought back. The details are quite surreal at times and as this blog (courtesy of my Hong Kong colleague Will Chuang who really does read Korean blogs at the weekends) explains it goes much deeper than that, which explains why Korea is so shocked.

To conclude, the real risks are the ones you don’t at first see. As we look through the short term noise, it is worth thinking through some of the potential unintended consequences from policy actions that might at first seem universally positive. For example, the fact that a repatriation of US tech company cash could trigger a liquidity squeeze in Europe or that Matteo Renzi winning the referendum could usher in M5S and a referendum on Italy leaving the euro are not only logical when you think about it, but have a higher probability than is likely priced into markets. Similarly, while politicians talk of infrastructure spend, we should not forget that the current low interest rates to a large extent reflect an imbalance between demand for yield and supply. Introducing capital market financing to fund the (necessary) hundreds of billions of dollars of infrastructure will ‘solve’ that problem, which is good for investors like pension funds and insurance companies, but not necessarily good for the current level of bond yields. In Asia, a renewed pivot to Asia could drive previous US friends towards China and vice versa, the opposite of what was expected or intended. It’s never simple.