Market Thinking - A view from the equity market

• The US election produced an initial risk off move, then a rapid reversal and a rush to a more growth biased portfolio, out of bonds and into US equities. Much remains uncertain however and we need to be wary of the volatility having caused distress to certain strategies.

• There are multiple angles to discuss but clearly the new administration in the US look to be mounting a classic fiscal stimulus which suggests a normalisation of monetary policy as well. This is good for US equities and the dollar, bad for a lot of other asset classes.

• Asia and emerging markets have so far focussed heavily on trade threats, but it is likely that a stronger US economy and a stronger dollar will be a positive in the medium term.

There has been so much already written about the US election, it feels difficult to add very much and we certainly try and avoid pontificating on politics, not least because things become emotional and that is exactly the character trait that behavioural finance tries to push out of investment thinking. Last week I suggested that regardless of the winner, the correct trade to put on would be the opposite of the markets’ initial reaction since that would be a position unwind (either way) rather than investment funds moving. And so it proved. In the case of Mr Trump, as the results came in, the bellwether indicator, the Mexican peso, reversed an early rally to drop almost 15% over the next few hours, not because the market really believed that a Trump victory would be terrible for the Mexican economy, but because the traders knew that all the other traders would be trading on the same news flow. Currencies were a straight momentum trade, and to paraphrase Keynes’ famous line “When my facts change, I change my mind, what Sir, do you do?” as Florida came in, the new facts flipped the trade around aggressively and the sharp selloff in the peso told the story of the day as well as any election count map.

Chart 1: The Mexican peso told the story of the day

Source: Bloomberg

Across other assets however it was slightly different. As a Trump victory became more likely and the peso sold off, the asset markets reacted by increasing risk premia and so called risk assets sold off and Treasuries rallied – the low on the US 10 year benchmark bond yield was two and a half hours after the selloff in the Mexican peso began. Similarly S&P futures opened down 800 points, oil sold off, gold rallied and the dollar weakened. Within hours however, all of those asset markets had reversed those initial positions as the risk premia subsided and the trading books were closed out. Now, the numerous notes written and conference calls broadcast are mainly trying to second guess the policy details and turn them into earnings narratives for investors. There are multiple angles to play here and we will continue to digest the policy implications over the coming weeks and months. My favourite quote was that after the black swan event that was Brexit, what Donald Trump described as Brexit plus, plus, plus, should be termed ‘An Orange Swan’ event.

At the asset allocation level the technicals tell their own story – the S&P reversed its nine day losing streak on Monday and has since bounced sharply off its long term moving average (MA). Meanwhile US 10 year bond yields broke convincingly higher - having already breached their long term MA at the end of October. Other bond yields have followed suit, Germany is up through its long term MA and Italy more so. Indeed, Italian bonds continue to be some of the worst performers.  Only Japan of the major bond markets has a yield below zero (and below its long term MA) but with the Bank of Japan actively targeting a rate of zero at the ten year that is perhaps hardly surprising. Gold holds its uptrend – while (Nate) silver is obviously a short. Oil continues to trade in a band (above a sideways moving long term MA) but momentum is weak. Interestingly, while sterling now appears to be in something of a two way trade now, having established a range as we discussed a few weeks back, the euro has broken down through the technically and psychologically important 1.08 level against the dollar.

We do not yet know exactly what a President Trump will do. We do know that there is a Transition Team and that they have a website, the subtly named greatagain.gov but it seems likely that for a combination of reasons he will be neither as ‘good’  as his supporters hope, nor as ‘bad’ as his detractors fear. One issue of course is that we have to distinguish between campaign rhetoric and government action. I like the quote from tech investor Peter Thiel (an early supporter of Trump) “mainstream media never took Trump seriously, but they did take him literally. Many of Trump’s supporters took him seriously, but they did not take him literally.” We shall see, but certainly his acceptance speech (probably the first speech outside of the debates that many Hillary supporters had actually seen) seemed far more measured and pragmatic and that helped reverse the immediate jump in risk premium. One of the more unexpected sources of insight I discovered over the latter stages of the election campaign was the blog of Dilbert cartoon creator Scott Adams. This was not so much because he predicted a Trump win (he did) but because of the framework he used to discuss the candidate, that of Trump as one of the great ‘persuaders’ of our times. He also said that for Trump the election would play out like a classic three act movie where the ‘hero’ changes his life, overcomes obstacles and ultimately wins through in the end. More important, he now believes that Trump will now turn to healing.

One thing we do know about Mr Trump is that he intends to cut/reform taxes and spend money on infrastructure; the fact that he said so in his acceptance speech is almost as important as the fact that the former at least is part of the Republican programme. As noted last week, actual policy will depend on the balance in the other chambers and the fact that all three are Republican does increase the chance of more being achieved, although we should not lose sight of the fact that the President has a far from traditional Republican agenda. High on the agenda for many Republicans is the reversal of Obamacare, although here too President-elect Trump is rowing back in on the campaign rhetoric, talking of reform rather than wholesale demolition. When it comes to fiscal policy, there will doubtless be debate about the Republican approach to fiscal stability, but I very much get the sense that what Donald Trump will say, and what he believes his supporters voted for, is that he has a mandate for a change in the balance of fiscal and monetary policy. In effect he will say to Congress and the Federal Reserve (Fed), that it’s time for fiscal instead of monetary stimulus. This is putting pressure on spread and carry trades across the board and has caused some unpleasantness at the long end of the yield curve. Earlier this year, I discussed the increasingly ‘Alice in Wonderland’ world of investing where investors were being encouraged to buy equities for yield and bonds for capital gain and obviously the longer the duration of the bond, the better the capital gain. Thus TLT US, the i-Shares ETF of the US long bond has returned a total of 26% over the last three years – around 8.2% a year, only slightly less than the S&P 500 on 8.8% annualised and of course for those that measure their risk through volatility at much lower ‘risk’. This led to inflows as more investors increased their duration risk and in the first six months of 2016, when the S&P was up around 5%, the long bond ETF was up almost 20%. However, that started to unwind mid-year and after last week, as Chart 2 shows, it has effectively given almost all of that back.

Chart 2: Long bonds get hit – is this the long awaited bond / equity switch?

Source: Bloomberg

A technical analyst looking at the chart might conclude that TLT has retraced 50% of its rally from the start of 2014 until the high in early July, or focus on  the break of the long term (and other) moving averages. Either way it doesn’t look healthy. The real problem however is that while it is unlikely that the 15% drop from the peak will break a portfolio, the issue is that bonds are not supposed to go down that much. The real risk is that because the text books say bonds are ‘safe’, many buyers will have geared up multiple times, so that 15% drop could potentially wipe out half your capital. We need to watch out carefully for any distressed selling of long duration trades.

The other issues we discussed last week were more technical, as the $1trn or more of US corporate cash which could possibly be repatriated under some sort of tax amnesty comes back to the US, it is likely that it will not be allowed to simply go into management pockets or share buybacks as happened last time in 2004 when over $300bn came back. In any event it will rebalance the supply/demand situation for overnight money, particularly in Europe. Leveraged funds playing carry or spread trades (usually in fixed income) will find the costs of capital rising and the availability falling. As I pointed out last week, the Long Term Capital Management (LTCM) collapse in 1998 was not caused by a failure of any of their particular strategies, so much as it was down to their funding model of being short Treasuries. Meanwhile, our favourite chart of US Libor continues to grind higher.

Chart 3: US Libor. Monetary conditions continue to tighten

Source: Bloomberg

Any fund relying on access to lots of overnight and cheap liquidity may find their business model compromised. Here again we need to watch carefully for signs of distress between now and year end. All this is worrying bond markets generally and some are inferring that the Fed will therefore not move rates in December, pointing to their reluctance to destabilise financial markets as a key policy driver. Most however think that the rebalance will mean the long awaited normalisation of US monetary policy can begin, and this is certainly what appears to be the opinion of the currency markets, where the dollar index is approaching 100 again, just shy of the March high of 100.3. In my view we may look back at this election as being the tipping point for the bond/equity switch.

A steeper yield curve and a sense that we may have seen ‘peak regulation’ of the financial sector gave banks and financials strong momentum last week, helped in this case by some closing out of structural underweight positions. Tactically this certainly makes sense, although strategically the European banks look more challenged due to a combination of issues around, the euro, bad debts in peripheral countries, a continued deleveraging of European household debt and the squeeze on liquidity outlined above. Insurers however look better positioned and it is no surprise to see that Japanese insurers were some of the best performers last week. The flipside of this rotation was a selloff in bond proxies, by which we mean higher yielding stocks with limited growth prospects – utilities, REITs and others. In some sense this was little more than profit taking and a rotation and tactical switch to a more growth biased portfolio, but with rates rising and curves steepening, the dash for yield will likely ease. While we are keen on higher yielding stocks in Asia, we do like them to have underlying dividend growth as well.

This dollar strength in turn is being viewed as ‘bad’ for emerging markets, which coupled with concerns over trade wars and more generalised profit taking has helped drive an outflow from emerging markets generally over the last week. Both emerging markets and high yield bonds, both seen as vulnerable to higher borrowing costs in the US, have sold off in the last few days and are now approaching long term support levels. In some senses this makes a lot of sense; a lot of emerging market debt tends to be offshore dollar denominated where of course both a stronger dollar and higher rates can spell a lot of trouble for a borrower. However, as ever, the devil is in the detail. Looking back at ‘what happened last time’ assumes constancy in balance sheet size and structure – something that in real life is rarely so. After all, the emerging markets themselves learned the lesson from real life that the computer picks up from its historical correlations. Dollar debt is not absent, but it is no longer as widespread as it was. Equally, the proposals as far as we can tell look likely to have a stimulating effect on the US economy which tends to be positive for trade and we are not alone in suspecting that much of the rhetoric on trade will turn out to be more noise than reality.

Elsewhere in the region we note that the Hong Kong Shenzhen Connect may come as soon as this week – I attended a lunch with Hong Kong Exchange last week and they hinted heavily that it was coming very soon. This is not a shock to the system - it has been well trailed, but should be seen as part of the ongoing financial infrastructure build in China. The combined Hong Kong, Shanghai and Shenzhen exchange will then be the largest in the world by volume. The majority of the participants however remain Chinese households, which according to Exchange Head Charles Li is exactly why the government feels a need to constantly step in when things look too volatile. The question remains therefore as to what extent the Chinese volatility is imported alongside the Chinese customers. Meanwhile, talking of the power of Chinese households, the impact of Ali Baba’s Singles Day promotion got rather overlooked in the wake of the US election, but suffice to say that it once again broke previous  records, hitting $17.7bn, compared with $14.3bn last year.

To conclude. The ‘Orange Swan event’ last week has triggered a lot of volatility and a lot of repositioning across asset classes. The transition website gives us some clues as to what the new administration will prioritise, but it looks like tax reform and fiscal stimulus through infrastructure spend will be high on the agenda. This would likely set in train a process of normalising US monetary policy which would likely lead to a stronger dollar. After the initial jump in risk premia, markets now appear to be pricing this new world – good for equities, especially cyclicals, bad for bonds. Good for financials as yield curves steepen and (perhaps) regulation is seen to have peaked and less good for bond proxies. Asia and emerging markets have been hit by fears over trade wars and a historical negative correlation with higher US rates. However, on this one I would disagree with the conventional wisdom as the stringer US economy would be good for emerging markets while the debt issues – and I suspect trade rhetoric- are almost certainly overplayed. In the meantime we need to be wary of forced buying or distressed selling as some of the more leveraged structures come under pressure – hopefully not as dramatically as LTCM back in the late 1990s – but such shocks have a habit of blowing up someone’s carefully crafted ‘no brainer’ strategy.

Finally, it looks like Douglas Adam’s famous Babel Fish is coming to reality soon. Waverly Labs claims that its Pilot smart earpieces “translate between users speaking different languages”. This may come in useful for any US citizens following through on their pledge to leave the country.