Market Thinking - A view from the equity market

Key points: 

• As markets flatten their bets ahead of the US election it is producing some strong rotation into previously underweight and out of favour sectors. Many of these were cheap for a reason and we should not see their relative strength as a sign that the market necessarily ‘knows’ something.

• It may be too simplistic to say that the correct trade is to do the opposite of the market’s initial reaction, but it is important to recognise that many of the first trades are likely to be an unwinding of pre-election positions and may not be sustained.

• As the dust settles next week we need to look further into the fundamentals of tax reform, policies on trade and regulatory shifts affecting the plumbing of financial markets. Rotations out of sectors with poor fundamentals will likely resume and, I suspect, attention will start to shift to the eurozone into year end.

In some senses we have to question whether or not it is worth writing anything so close to the US presidential election. After all, in three days’ time, everything will be settled. Except of course that it won’t be, for whatever the result, the markets will move on to a different type of thinking about what it means than they have done so far. As such there is no reason not to start a little early.

To date the reactions have been quite binary – Clinton equals continuity and Trump represents change. Markets react to the prospect of change by, understandably, increasing risk premia and thus Trump going up in the polls has tended to create ‘risk off’ profiles amongst traders and vice versa. It is important not to confuse this with an opinion poll on the suitability of either candidate, as we found over Brexit (or at least should have) the markets are ultimately agnostic and reflect the judgement on price versus value. Just as the betting on a favoured home sports team can appear to reflect that there is ‘no chance of them losing’ so the smart money, even from some die hard fans, will shift to the team with ‘no chance of winning’. (In terms of markets backing sports teams, the latest in a list of ‘never going to win’ teams including Leicester City in the UK last year is of course the Chicago Cubs, who have just won the World Series for the first time since 1908, the year that the model T was first made. However, unlike Leicester City, who started at 5000 to 1 preseason and were still at 500 to 1 at Christmas, the odds on the Cubs had been coming in rapidly since about February and they actually went into the finals as heavy favourites. Still a great story though.)

Thus as Donald Trump was rallying in the polls in the wake of the FBI announcement on Hillary Clinton’s emails, so the S&P500 was falling – a straight nine day streak, the longest since 1980. However it is likely that this will be reversed as traders digest the latest reversal of fortunes for Hillary Clinton over the weekend as the FBI say there is no need to investigate further. Here again, no reflection of who the markets ‘want’ to win, just a pricing of uncertainty.

Currencies (and volatility indices) continue to be the main way in which traders are expressing their views on politics. The Mexican peso has become the de-facto bellwether on the US election with short term volatility rising sharply last week – albeit still below the spike in July when the trade ‘started’. Meanwhile sterling jumped to a four week high last week in the wake of a high court ruling that the UK Parliament will get to vote on details of Brexit. As with the peso, the trade has become almost an automatic one on change versus no change, which is what leads me to believe that there is some second order thinking now due.

As discussed last week, when it comes to the US, we know that both candidates intend some way of repatriating the billions sat offshore in Treasury accounts at US corporations, mainly in tech space. On the positive side, this may come back as special dividends that get re-invested or consumed, but the down side may be a squeeze on liquidity in Europe. With hundreds of billions of dollars effectively sat in repo markets in Europe looking to earn an overnight return, the funding costs are obviously very low for anyone wanting to borrow. If we change the supply of liquidity it can have meaningful impacts. As we also noted last week, December 4th will be next up in our list of worries as the Italian Referendum on the constitution could break in any number of ways that allow the Five Star party to gain power and with it the promise of a referendum on the euro. The Italian bond was among the weakest over last week as the spread with Germany blew out further in a repeat of the tensions ahead of the euro crisis in 2012 and the target balances with the European Central Bank (ECB) continue to show cash draining out of Italy and flooding into Germany. This represents real pressure for Italian and other peripheral European countries. At present the US election trade at the sector level appears to be long Banks, short Health and Pharma, which is gathering power from the fact discussed earlier that there are large underweights in Banks generally – especially in Europe.

At least the latest foreign exchange outflows from China have not troubled markets. I have been worried for a few months now that the next ‘panic’ would be a revisit of the concerns over China’s capital outflows that appeared to be behind the huge (incorrect) bear calls on China earlier this year and was wondering if a Foreign Exchange Reserve outflow might be the trigger, especially as it looks like neither candidate in the US is particularly favourably disposed towards China. The fact that the numbers were out the week of the election was never going to help, but suffice to say they appear to have passed uneventfully. To emphasise, while I am not overly sanguine about the capital account in China, nor do I believe it is completely irrelevant. In this instance I have been more concerned about the perception amongst traders, and they seem relaxed at the moment. It may pay to keep an eye on the Australian dollar, since this was one of the ‘trades’ that the macro players were pushing aggressively earlier this year. Back then it was weak and broke down through short term trading supports, driving an ever louder narrative of a weak China being bad for Australia – ironically at a time when the Australian government were making a plausible case to investors that they understood ‘Australia 2.0’ had to adapt to match ‘China 2.0’ (I remember as I was there). Currently the Australian dollar looks reasonably healthy from a technical point of view – as incidentally does the Shanghai Composite.

What else can we look at while we are waiting? Korea continues to play out some interesting dramas with its President, who while refusing to step down in the wake of the influence scandal, has effectively handed over much of her power to the Prime Minister. India has finally managed to pass a nationwide GST, albeit with four different tiers of tax, ranging from 28% to 5% and it is interesting that British Prime Minister Theresa May is there this week talking trade. China also continues to work on its financial service infrastructure, with the Shenzhen Stock Connect expected to be operational by year end. When they were originally envisaged, a lot of investors thought that the main impact would be international investors buying ‘northbound’ into China and obviously the more tech focussed Shenzhen market was expected to attract NASDAQ like flows in contrast to more old economy Shanghai, with a greater proportion of state owned enterprises in the index. To date however, it has been much more of a southbound flow, with a weaker currency and a desire to shift money offshore, as well as for yield and diversification being the primary drivers. Southbound flow is currently around 12% of total HK volume on any given day. Thus in the first instance we would expect to see a bit more flow into some of the Hong Kong listed stocks favoured by southbound investors as well as a pick-up in volatility. Connecting the three exchanges makes the largest exchange system in the world by turnover.

Oil is back towards the bottom of the $42-52 trading band for west Texas, while Gold failed to break out the top of its recent range albeit holding its uptrend. I suspect that come the election result, Gold and Stocks will move in opposite directions. I am also keeping an eye on the High Yield bond ETFs, which have seen some meaningful redemptions in recent days. Prices have pulled back sharply as well – albeit still in a modest uptrend.

One final second order thought ahead of the election is on Global Tax Harmonisation, more specifically the Base Erosion and Profit Sharing Initiative (BEPS) of the OECD. I am indebted to analyst Russell Napier for bringing this apparently esoteric piece of legislation to my attention – although I made the mistake of raising this with a former partner of one of the big international accounting firms and it is clearly a really big topic over there. The reason in a nutshell as to why this might be very important is that it proposes 15 action items, the most significant of which (in my opinion) is the suggestion to cap deductible interest payments to a ratio of EBITDA as discussed by the UK government here. Their proposal (amongst others) is for a ratio somewhere between 10% and 30% of EBITDA. This could obviously have quite profound implications for certain highly leveraged companies, as well as those whose structure embeds a lot of leverage such as REITS or private equity. In effect the distorting effects of the so called tax shield will be heavily diluted.

Bottom line, while everyone focusses on the political headlines, it may well be the shifts in the underlying infrastructure that ultimately catch markets out. Markets reflect the recent history of their participants. If we get a shift in funding costs, tax structures or currency blocs then we can see a big shift in winners versus losers. We need to be wary.