Market Thinking - A view from the equity market

• The fallout from the US election so far is a stronger dollar and a steeper yield curve, most other market moves follow from these two. These are relative not absolute moves, rates are still low and the dollar is not uncompetitive, but structured products and trades are having to be unwound.

• This is not the market predicting inflation, it is a reweighting towards real and cyclical assets away from spread trades and also reflects a tightening of monetary conditions thanks to the stronger dollar which affects the whole dollar zone, not just the US.

• Investors are positioned for growth in the US, uncertainty in Europe and confusion but perhaps opportunity in emerging markets (EM). Most are hoping for no more shocks to change those positions between now and year end.

Last week was the start of the US ‘Holiday Season’ with Thanksgiving. Activity is now usually light between now and year end, although there is likely to be some focus on the Federal Reserve (Fed) – who still look likely to raise rates at the meeting on the 13th/14th.

As to markets, it looks and feels like first the traders and then investors have completed their post-election moves and are feeling set through until year end. In the US, we said just before the election that whatever the market did immediately on the result, the best thing for investors (rather than traders) would be to do the opposite – a Hillary win would have been a rally to sell, while a Trump win a sell-off to buy. This was because of pre-positioning and the fact that while both would favour infrastructure spending, Trump would go for a bigger fiscal stimulus with tax reform. As such, the Fed would be more hawkish and thus the dollar would also be strong. It was not, as we stressed, that the market had any particular preference, rather a matter of risk premia around uncertainty. So it has proved, the market zigged and then zagged; the dollar is up and commodities, notably oil and gold are down. More important, since the election there has been a clear shift in favour of equities over bonds – over the last month equities are +4-5% and bonds yields are generally 35-50bp higher. Some are interpreting this as a bet on inflation, but I see it more as a move to normalise real yields. Bond yields were not where they have been because people expect deflation, they were where they are because of quantitative easing and macro-prudential measures creating forced buyers. What we are seeing at this moment is an unwind of some of those ‘bigger fool’ expectations. Leverage is leaving the fixed income markets, partly because of year end, partly because of tighter liquidity (more below), but ultimately because of a growing belief in a regime switch.

Within fixed income we have seen a swing back towards shorter duration assets, hardly surprising given the expectations of higher short rates and the number of traders that were, as we put it earlier this year, buying equities for yield and bonds for capital gain. The iShares long bond ETF, which at one point was up 20% from the start of the year is now basically flat on the year.  Some in the fixed income markets are pointing to measures of inflation expectations, but there is something of a circularity here as the implied inflation derived from the index linked versus the conventional bond markets can often tell you far more about the market mechanics of those markets than any economic forecast. (In a similar manner the derivatives markets for expected dividends often appear to forecast a cut in dividends when in fact they simply reflect balance of buying and selling of the derivatives). Certainly we have seen a sharp spike in the price of industrial commodities such as copper, steel, coal and iron ore, taking prices back up to levels not seen since early 2015, but to sustain there has to be control on the supply side.

Another way of looking at it is the fact that corporate bond yields, which fell steadily over the first half – to a low of 4.2% for BAA corporates – have lost half of their gains, while the S&P500, which had been following the (inverted) corporate bond yield closely, appears to have broken out – presumably on the higher growth expectation.

Chart 1: Corporate bond yields (inverted) and S&P500 – equities pricing growth

Source: Bloomberg

Given that the default risk and dividend risk are not dissimilar, it makes sense that the latest move is about growth expectations offsetting the prospect of a higher discount rate. We shall be monitoring the relative performance of these two asset classes closely. Following on from the commodity rally we have seen a rotation within equities towards infrastructure stocks and those exposed to industrial cyclicals which for factor based investors manifests itself as a focus on value over growth. So called yield proxies have also suffered as many of them effectively traded as spread products over treasuries in the manner of corporate bonds and this can appear as a flight from quality. Our preferred style of income investing favours a combination of yield plus growth – rather than simply the highest yield and these stocks have tended to fare rather better (albeit not matching the rally in deep value and cyclicals.) Going forward we see something of a bar-bell approach being optimal, a mix of yield plus growth with the growth coming from a combination of macro and micro factors, some cyclical, but the balance structural. In this way we benefit from diversification while still having a relatively concentrated portfolio.

Financials of course have also rallied heavily, particularly in the US, on expectations of a steeper yield curve and of having seen ‘peak regulation’. This may turn out to be the case in the US as the US banks sector is now 14.5% up on the month and JP Morgan hit an all-time high, but investors remain rightly concerned about Europe. The Stoxx 600 Banks index, having rallied almost 10% in the wake of the US election, has now given all of that back and is actually down 2.4% since the beginning of November. We said earlier this year that, post-election, attention would soon shift to Europe ahead of the busy and potentially risk filled political calendar and this too looks to be happening. Italian bond yields are currently around 70bp up over the month as markets start to worry about the next referendum, this one on the Italian constitution (Dec 4th) where there are numerous possible pathways to (yet) another referendum, this time on Italy’s membership of the euro. The risk of being paid back in a different currency - an unhedgeable currency risk - was effectively what caused the euro crisis sell off in 2011/12 in Europe and this is moving up on the agenda once again. Banks are seen to be most at risk, insurers who also benefit from a steeper yield curve but are less exposed to cross border lending are still up 5.4% on the month. After Italy next week (and the Austrian Presidential election re-run) we have to look forward to elections in the Netherlands, France and Germany next year. In France, the stage looks set for Mr Fillon against Marine Le Pen as a likely second round to next year’s French elections. Here again from a market perspective, the idea of Marine Le Pen taking France out of the euro is the biggest threat to stability. Thanks to all this uncertainty about the single currency, the euro has weakened – not just against the dollar, but also against the previous weakest currency, sterling. So, just as investors have positioned for a more pro-growth US, so they have positioned to be as flat as possible in Europe ahead of a heavy political calendar.

In EM we have seen a flow driven sell off as much of the positioning put on over the summer reversed on concerns of higher US rates. However,  the idea that higher US rates are bad for EM needs to be put into context – history rhymes rather than repeats and debt levels are different, and offshore debt much less of a problem than in the past. Moreover, EM are sensitive to stronger global growth and if the Trump US is going to have anything like the growth levels he claims then this should actually be positive for emerging markets. The last week or so has seen some support coming in across EM equities, which suggest there might be some value support (the iShares ETF EEM bounced solidly from its long term moving average for example – although not yet for the bonds). These of course benefit less from global growth and are more tied up with currency expectations. Here, the higher yielding bonds – Philippines, Indonesia and Malaysia are also caught up with weaker currency trends at present.

A sense of a swing in the pendulum towards a new regime is reinforced by some of the underlying ‘plumbing’ in markets. We have been highlighting the consistent grind higher of US Libor for some time now and a few months ago, we pointed out that the cost to a Japanese investor to hedge purchases of, say, US treasuries back into yen had become prohibitive. The cost of currency hedging actually exceeded the yield on the bond. In part this reflected the rally in the yen, but mainly it reflected a shortage of offshore dollars – something also picked up by the level of Libor. While in absolute terms this should present little problems, we should not forget that the real issue is with the numerous leveraged spread products that rely on cheap dollar funding for their strategies. If, as appears to be happening, the funding gets more expensive then the strategies need to be unwound. Ultimately the Fed has emergency swap lines in place, but understandably countries are reluctant to use them. The chart shows the yen basis swap – effectively the cost of borrowing, now at multi year lows (highs in terms of borrowing).

Chart 2: Yen basis swap – borrowing dollar in Japan is getting more expensive

Source: Bloomberg

Perhaps the real issue is what this means for the Fed. If there is a dollar squeeze outside of the US, then the fed faces a dilemma: domestic reasons increasingly point to higher rates, but the numerous bubbles in asset markets look vulnerable to higher rates, and not just in the US but in the whole of the dollar zone – which basically includes emerging markets. The stronger dollar is now correlated with tighter liquidity conditions not just for the US but for the whole dollar zone. The Fed baulked before (in my opinion) because they realised that if they tighten and force DXY higher it could cause funding problems in EM. Will they risk it this time?

An interesting paper from the BIS and the LSE recently highlighted how the dollar is now the key driver of/correlation with  bank balance sheets, whereas previously it had been Vix. Recently Vix has come right down again, but there is no sign of financial sector leverage picking up. The LSE believe that the failure of covered interest parity arbitrage (taking advantage of the different costs of borrowing in domestic and offshore currency hedged) is because banks are deleveraging and that watching the dollar rather than the Vix is now the key variable in observing bank risk appetite.

Against all this macro backdrop, we still believe good stock growth stories can prevail and note that in Asia at least you can also get paid quite handsomely in terms of yield to sit out volatility. One obvious area remains the consumer, both in China where the China 2.0 model continues to drive sales and in the US, where higher consumer confidence and the prospect of tax cuts promises to make the US consumer at least “great again”. It is interesting to note that what used to be the big stock event around Thanksgiving, the Black Friday retail sales data has given way to Cyber Monday, as increasingly goods are pre-ordered online and either collected or delivered. This in turn has been overshadowed by the Chinese equivalent, Singles day, when shoppers using the AliBaba platform spent more in the first two hours than Americans spent on both Black Friday and Cyber Monday. Last year the totals were $14.3bn on Singles day versus $5.8bn in the US. This year Singles day hit $17.8bn. That means something like 470m parcels to be delivered. China is one of the few emerging markets that is definitely not part of the dollar zone and is thus subject to an independent monetary policy. This may be seen as a strong positive in the coming months.

Other snippets this week, OPEC meet on Wednesday – most are talking of around a 60% chance of a deal, but in reality things are going to remain very tough for the Middle East producers in particular as there is little prospect of controlling supply, especially with a (more) pro fossil fuel administration in the US, which now produces more hydrocarbons than the Saudis. This budgetary dilemma has implications for markets of course. As noted earlier this year, a lot of the marginal buyers of not only treasuries, but trophy properties and other low liquidity assets in recent years tended to be commodity rich sovereign wealth funds or similar and they have been selling all year. Even this modest bounce is unlikely to produce a resumption of purchases and with the leveraged traders also getting out, there is a risk of overshoot.

China has also apparently sold a lot of its treasuries (http://www.zerohedge.com/news/2016-11-16/saudis-china-dump-treasuries-foreign-central-banks-liquidate-record-375-billion-us-p), but not for the same reason as the Saudis, more to do with the steady focus on its own domestic balance sheet. The Shenzhen Connect is coming next Monday, which is a positive message about the ongoing build out of Chinese financial infrastructure. Meanwhile macro data tells us that not only are Chinese factory gate prices rising but so are Chinese corporate profits. We suspect that 2017 may be the year that international investors decide to get more involved with China, not only because of its independence from the dollar zone, but also its different growth drivers.

Elsewhere the decision by India to address its black economy may yet run into the law of unintended consequences. While the idea of withdrawing the larger denomination notes may work in the medium term, it is causing some problems in the short term. Collapsing the velocity of circulation of money can produce some serious issues in inventory chains, working capital and so on which may yet have knock on effects. Unlike the various referenda and elections, which are known binary events, this one really was unexpected and in a year of shocks and surprises is probably one of the few genuine ‘black swan’ events.

Finally as the Americans celebrate Thanksgiving I find myself repeating an old story, that the story told of the early settlers being saved by the Indians (and hence giving thanks)  is not only a fairy tale, but it is nowhere near as interesting (to students of politics and markets at least) as the true story. In effect, the original settlers of Plymouth Rock were a perfect case study for communism versus free markets. The first two years they were effectively a commune, all produce was collected centrally and centuries before Marx, it was a case of “from each according to his abilities to each according to their needs”. Unfortunately despite the ideal test conditions for a commune – like minded individuals of similar background, ethnicity, religion and ambition, this did not produce enough food. Instead it produced free-riders, hunger and stealing as the less pleasant realities of human nature overtook the utopian ideals. The stakes were high, literally life and death, and it was here that the brighter aspects of human nature took over.  After the failure of the second harvest, the founding fathers changed the system, from communism to capitalism. Individuals were given small parcels of land (property rights) and allowed to keep the fruits of their labour and trade the surplus with others (market economics). Productivity increased massively and the harvest of 1623 was more than they needed to survive. The official day was declared by George Washington in 1789, and the myth about the Indians has become long established, but it was the bounty from this first capitalist harvest that was the first real Thanksgiving.