Market Thinking - A view from the equity market

• Markets are nervous and drifting down, waiting for something to happen. Meanwhile Libor continues to move up and sterling continues to move down – the former reflecting technical changes in money markets and the latter one of the few ‘big trades’ out there.

• With three weeks until the US election, attention is shifting towards Fed tightening by year end. Some are trying a replay of the ‘taper tantrum’ playbook from 2013, but in emerging markets at least we see sufficient differences at play to argue against anything more than profit taking.

• An outlying risk is that year end factors and a weaker RMB may trigger some pressure on Chinese currency reserves and a revisit of the Q1 China panic. The fact that the data is out on November 7th won’t help either.

Markets are in something of a holding pattern, waiting for the Federal Reserve (Fed), the US election,  greater clarity on Brexit and for Christmas. The noise traders remain mainly focused on sterling, which at a 31 year low against the dollar is struggling to find any medium term technical indicators to support it. As such it is trying to establish some short term trading ranges with the recent closing low of $1.2123 an obvious support/target. Meanwhile, gilts were among the weakest of a generally weak set of sovereign debt moves. Having broken above their short and medium term trend lines in September, US Treasury yields backed up through 1.78 per cent  last week (the long term moving average) in a pattern that looks very similar to the November/December period in 2012. At that time rates moved from 1.8 per cent (pretty much where they are now, up to 2.1 per cent as the market anticipated tightening by the Fed. Then an aggressive rally at the start of Q2 2013 brought rates all the way back to 1.6 per cent before the ‘taper tantrum’ kicked in and US bonds sold off to hit 3 per cent by September 2013.

There are undoubtedly some fears of a repeat of the ‘taper tantrum’ of 2013 as expectations build of a US rate rise in December. The S&P500 has been soft, it remains above its long term trend but broke down through short and medium term moving averages last week which probably led to some moves to cut positions. As risk is taken off the table, perhaps not surprisingly the VIX index ran up quite sharply  over the last week touching 17.55 before pulling back to sit at around 16. Against this, some of the big losers in 2013 – in Asia we think most readily of Indonesia – have been remarkably stable, reminding us that history offers no exact templates. As Mark Twain always says, history doesn’t repeat, but it does rhyme.

It has been said that there are essentially three types of trading and investment. The first is some sort of spread or carry trade between two assets and is usually accompanied by significant leverage. The second is some form of momentum trade, buying what is going up or selling what is going down, again often accompanied by significant leverage. The third is some form of valuation or mean reversion trade. I am not sure if this was first ‘discovered’ by our friends at Gavekal, but I certainly took notice when they said it many years back. I might add in a fourth: compound interest in terms of dividends or coupons. In some senses this is a form of spread trade between holding cash and cash flow from securities, but generally it does not incorporate much leverage, if any.

The reason for bringing up the three trades is that at the moment they are all struggling for direction – one of the undoubted problems facing many of the famous traders that are leaving the industry. First and most important is that the leverage traders need certainty about the cost of and the access to that leverage which of course is why so much time and effort goes into Fed watching. In my view not because we really care about the high frequency macro data or even the impact of Fed funds on the US economy, but because we care about the impact that the data will have on policy and by extension the price and availability of the raw material of trading – leverage.

Unconventional monetary policy has certainly distorted this framework and while many continue to focus on ‘what happened last time’ with Fed funds and the taper, it is probably more instructive to look at a different (better?) proxy for the cost of leverage, Libor rates. As previously discussed, one thing that is certainly different from ‘last time’ is the position of US Libor, as shown in Chart 1.

Chart 1: US 3 month Libor continues to push on upwards

Source: Bloomberg

We can clearly see that Libor jumped following the Fed rate rise last December, but while the Fed has not moved this year, Libor has tightened by almost 30 basis points (bps) already. As previously discussed, much of this has been connected with the new regulations on US money market funds that came into place last week. Briefly, capital rules have made it unattractive for many money market funds to buy commercial paper, pushing corporates into the interbank market instead for short term liquidity funding. Part of the importance of Libor for the real economy of course is that a lot of real world lending rates are pegged to it, so in effect the market has already been doing the Fed’s job for it. In markets it means that trades are taken off the table, unwinding some of the spread trades and ending some of the momentum trades – gold might be just such an example.

When momentum trades stop and indeed reverse, there is a tendency to jump to a stronger one. Here is where technical analysis comes in, particularly in what I refer to as noise (essentially momentum) markets. Since the beginning of the year, gold and the yen were in uptrends, while oil had been in a down trend. Oil bottomed in mid-February before reversing its momentum through until July. Currently it is unclear whether the uptrend will hold so money is being taken off the table. Meanwhile gold looks to have topped in early August, the yen looks to have peaked at 100 in late September. Again, there is no clear trend to trade. However, the one that looks the strongest has been the downtrend in sterling. What is unusual, however, is that unlike the other currencies and indeed commodities, there are very few leads from the technical indicators for sterling. As such the markets are trying to establish some. Chart 2 shows some very short term movements around the Fibonacci retracement.

Chart 2: Sterling traders trying to find some technical road map

Source: Bloomberg

This is not to say that traders are only using this sort of chart (or indeed using it at all) but there is a process of ‘feeling in the dark’ here, with the spike low of 1.21 an obvious focus. To repeat last week’s comments, the flash crash and the longer term Brexit related fundamentals are two separate issues, the latter may be driving direction, but the former almost certainly reflected some internal market dynamics including low liquidity, stop losses and the aforementioned lack of technical support levels. What should also not be overlooked is the other side of this trade, a general strength of the dollar, and this has particular implications for Asia and emerging markets.

Those implications are more fundamental in my view – most particularly the impact on the cash flows and balance sheets of companies from overseas (dollar) debt. My investment type four. However, in the short term I believe that there are a lot of traders trying to trade emerging markets on the basis of ‘what happened last time’ – a form of mean reversion analysis. In my view this can often be incorrect and throw up investment opportunities. As noted earlier, Indonesia has been relatively stable as concerns over rates have grown, which is encouraging given previous performance and highlights Mark Twain’s point about rhyming.

Thailand of course was the original Asia crisis contender back in 1997, not least because of the foreign debt position, but has evolved significantly since ‘last time’ and is running on a different cycle. The market has seen some profit taking in recent weeks after a very strong run, and risk premia have now risen following the death of the King. In addition, the fact that the period of official mourning will last a year does mean that economic activity, not just tourism, but domestic consumption will likely be more subdued than previously thought. Elsewhere in the region Singapore continues to struggle with an oversupply of property and a hangover from the 1MDB scandal and further concerns over the banking sector in the wake of some bond defaults in companies sold to private investors. None of this is much to do with US rates, or indeed the dollar. One other factor may also be at work here, which may be helping the relative stability of Indonesia is that a tax amnesty in Indonesia announced this summer is looking to be far more successful than previous attempts. The government estimates it will raise $76 billion, although the private sector estimates are probably half that. However this compares to previous efforts that raised hundreds of millions rather than billions. This is obviously important for Indonesia and its budget, as well as potentially for banks around the region, including in Singapore. Monies ‘forgiven’ under the amnesty have to be reinvested for a minimum of three years in government approved investments in Indonesia. This is perhaps best seen as more positive at the margin for Indonesia than it is negative for Singapore, but it does highlight the need for ‘old’ industries in Asia to adapt to structural change.

Meanwhile, in the Philippines, after a strong run in the first half, the equity market has seen a 10 per cent correction (bouncing right on the long term moving average) not so much on fears about US monetary policy but more as markets digest the recent shift in tactics by President Duterte, who, in my opinion continues to gather headlines as he plays the two regional powers, China and the US off against one another. With the US distracted by the election it seems that China’s soft power approach associated with One Belt One Road (OBOR) may be paying off in winning over allies in the South China Sea. Duterte has announced there will be no joint patrols with the US. Elsewhere  comments that Australia will not be patrolling the area have been taken as further evidence of China ‘winning’, albeit probably much to do with a perceived ambivalence from the Obama administration on the issue. Clearly though it is too early to claim any meaningful decline in tensions.

One other big issue for the Philippines is foreign worker remissions, particularly from the Middle East and clearly they are suffering from the low oil price. According to the Philippines Overseas Employment Administration, the Philippines had 1.4 million workers deployed overseas in 2014, of which over 30 per cent or 400,000 were in Saudi Arabia, an area that is now struggling with low oil prices and many are now losing their jobs. They are also struggling with maritime employment. Philippine workers are estimated to provide around a quarter of the 1.5 million seafarers worldwide according to Bloomberg – and here too the slowdown in shipping is causing problems.

There might be some short term relief for the Middle East from a bounce in oil prices. Last week we noted how the oil price seemed to have broken out of its recent relatively tight $40-$50 trading range – although as previously discussed, the extent to which this reflected enthusiasm over an Organization of the Petroleum Exporting Countries (OPEC) reduction in supply, history tells us to be wary. Certainly the trend followers look to have stepped away earlier this summer and had in some senses been replaced by mean reversion traders who have rushed to cover on an apparent breakout. However, something else caught my eye this week, to do with the other aspect of supply, the stock rather than the flow. An article here, suggests that China’s strategic reserves are probably nearer 440 million barrels rather than the official number of around 234 million which helps explain Chinese buying that has helped support the oil price from the lows this year. A company called Orbital Insight, who use satellite images, came up with  an estimate for a combination of strategic and commercial stockpiles at 600 million barrels with a suggestion that capacity is nearer 900 million.

If true this has a number of implications. First, that oil demand from China may not correlate so directly to gross domestic product as some believe. The energy intensity of Chinese growth is certainly dropping and if more of the demand was for strategic reserves than previously thought then not only will demand going forward not necessarily be as strong as many are assuming, but it could reverse sharply, merely on a pause in inventory building. This also got me thinking about the world’s biggest reserve of oil, the Strategic Petroleum Reserve of the United States (SPR). As of September, this stood at 695 million barrels, not far off its total capacity of 727 million barrels. The origin of the SPR was energy security in the wake of the Arab/Israel war in the 1970s and more recent post 9/11 events gave greater impetus to build the reserves which are effectively held in vast salt caverns under the desert in Texas. However, with the development of shale oil and the approach of US energy independence, the need for such a large SPR diminishes. Originally intended to supply 90 days of oil, US oil imports have dropped from 10 or 11 million barrels per day (bpd) in the early 2000s to around 7 million bpd by 2015. Latest data has it back over 8 million bpd. Under the old ‘rules’ that would suggest the current level is about right, but a recent Department of Energy (DoE) report suggests a more reasonable level should be 60 days and that suggests a sale of about 100 million barrels. Indeed, last year Congress authorised the DoE to sell $2 billion of oil from the SPR between 2017 and 2020. If we remember back to 2011, the US sold oil from the SPR in what was seen as a price stabilisation trade and obviously could do so again.

The Korean market of course continues to dance to the tune of Samsung. When I saw the Galaxy 7 warnings on aircraft inflight entertainment screens during September, I took it as one of those real world indicators that a company was in trouble. Often we agonise over small pieces of news flow affecting a brand, but every now and then there is a big one, and this looked like one of those. Even then I had not expected that they would release a ‘new’ version that also caught fire and then withdraw the phone completely. Thus after a strong start to October on the back of activist intervention, the share price then plunged 10 per cent. The obvious beneficiary of course has been Apple, which between August 2015 and August 2016 had underperformed Samsung by around 40 per cent on a common currency basis (having outperformed by around 120 per cent over the 12 months prior to that. But this isn’t just about stocks, it also has some interesting index impacts. Apple is currently the largest stock in the S&P500 index with a weight of around 3.4 per cent, while Samsung is third in the emerging markets and Asia ex Japan benchmarks at around 4 per cent weight, and it is over 20 per cent of the Korean index.

Finally on China. While it is still down year to date, the Shanghai Composite has rallied 15 per cent from its January post Davos lows (where everyone was forecasting the end of the economy, 40 per cent currency depreciation etc.) and after trading ‘aggressively sideways’ for the last six months, has finally broken above its long term moving averages. This is encouraging, but there is one thing that still makes me a little cautious. We characterised Q1 as a panic about China, Q2/3 a panic about Europe and Q4 a panic about the US election. There is some valid concern that we might be rotating around to another panic about China. Not that I necessarily agree that one is valid, rather that the same factors – principally a stronger dollar/renminbi rate and the potential for a fall in foreign currency reserves could trigger a re-run of last year. On the positive side, momentum is just starting to turn positive so there are few momentum players involved and it looks like leverage in terms of margin debt is about 25 per cent down on the end of last year, so the market is arguably more robust than then. Nevertheless I would still watch out for reserves data (next release 7th November and the trigger last year) as the quota for $50,000 per person to take out of the country gets reset at the end of the year and we may see some year end effects come into play. Certainly the recent weakness of the RMB is making Chinese investors think again about geographic diversification. To repeat, we do not see this as a bad thing, but many in the market do and in that sense the market is ‘right’. One to watch.

To conclude, the trading funds are struggling with assessing the cost and availability of their raw material; liquidity for leverage. Regulations, changing market structures and uncertainty over monetary policy have brought a disconnect to traditional models of assessing funding. This has driven investors towards spread products that embed large amounts of leverage that is not counted as ‘risk’ – not least because many of them invest in low volatility products that are defined as low risk (but may not be in reality). Meanwhile trading funds have moved toward momentum trades, many of which are technically driven and have a tendency to become crowded causing the very volatility that drives investors towards the spread trades. Mean reversion traders and investors meanwhile need to bear in mind that trading bands can break and that long term valuation metrics often assume an underlying constancy of buyer behaviour that doesn’t exist.

Currently the number of clear directional trend trades is falling; spreads have narrowed everywhere making the trade more about the leverage than the spread. As such, news flow, be it high frequency economic data, flow of funds, reserves data or geo-politics can all trigger quick reactions from leveraged traders, causing trend reversals, breakouts, distressed selling or forced buying. This is contributing to the market’s current wait and see mode. These may affect underlying (type four) cash flow fundamentals, but more often than not they do not and that is where I believe opportunity will appear for investors. We just need to be patient.