Beset by bearishness

Mark Tinker, Head of Framlington Equities Asia, comments on US and Asian Markets:

  • Thin volumes, deleveraging, and policy shocks are making for a rocky end to a year in which it is reasonable to say ‘nothing worked’. Technicals are dominating a lot, but fundamentals should  reassert.
  • Good news: Trade War 1 (TW1) is about resetting multilateral agreements back as bi-lateral agreements better suited to the US. This is almost over.
  • Bad news: Trade War 2 (TW2) is unfortunately only just starting, and is about the US trying to resist the rise of China. This is the background for 2019.
  • Deleveraging will also be a continuing theme for 2019, as China deconstructs its shadow banking system, the end of QE, and a rising cost of cash eliminate the profitability of a lot of market trading strategies.
  • This background will place a premium on quality of balance sheets, certainty of cash flows, and stability of institutions.

Hopefully we are not in the midst of another downdraft of the size of 2008 or even 1998, but we are looking like starting 2019 in a similar position to 1999 and 2009, beset by bearishness and with all the negatives highlighted and the positives ignored – almost a mirror image of this time a year ago. This of course is par for the course for Mr Market as legendary value investor  Benjamin Graham refers to the imaginary investor who is driven on any given day by panic, euphoria and apathy and approaches investing according to his mood, while Warren Buffet in his 1987 investment letter famously summarised it – Mr Market is there to serve you, not to guide you.

We noted a few weeks back that the thin markets into year-end  would mean higher volatility and were hopeful that there might be a squeeze higher. Initially there was, on the announcement of a form of trade deal, but that was hit by a wave of negativity, notably from US institutions, and this was compounded at the end of last week by concerns over the arrest of the CEO of China telecoms group Huawei in Canada – evidentially at the same time as Presidents Trump and Xi were agreeing on some form of deal.  Interesting that this wasn’t announced for several days, which may perhaps explain why some people were less enthusiastic about the ‘good news’. 

Sadly, this action reinforces our belief that there are in fact two different trade stories. One is quite straightforward and based around a belief by President Trump that ‘everyone else’ is benefitting from globalisation except (his) America. This is the trade war of tariffs on steel and aluminium, of leaving the TPP, and threatening to pull out of NATFTA. It is the war of telling so called US allies like Germany, Japan, and South Korea that their auto companies are not playing by the rules.  This war focusses on China only in so far as it has the one of the biggest bi-lateral deficits (although not if you adjust for services ‘imports’ such as tourism and education). This war is going to be relatively easy to resolve as China has already acknowledged that it is ready to import more Oil and Gas and agricultural foodstuffs from the US. It has also acknowledged that opening up its financial services and autos industry to foreign competition is a good thing. It has almost certainly watched how other  countries that followed the Mercantilist approach ended up with domestic monopolies, relatively inefficient financial systems and a lack of consumer choice in autos (think Japan, Korea, and even Germany). This is the war that involves Treasury Secretary Steve Mnuchin and Economic Advisor Larry Kudlow. It is the war that Trump needs to declare as ‘job done’ before it starts to shift from a win to a loss, because the reality is a 25% increase on the next round of imports from China is going to be much more painful for the US than it is for China. This is because the next round of products are things that, generally speaking, only China makes. If you raise the tariff, the US consumer ends up paying. This then is Trade War 1 (TW1). And it is almost over.

The bigger problem however is Trade War 2 (TW2), and this one  has only just begun. This is the war that involves Trade Representative Robert Lighthizer, Economic Advisor Peter Navarro (author of Death by China), and National Security advisor John Bolton. This war is focussed as part of a new economic cold war almost exclusively on China and this one is going to be a lot tougher for everyone. At its heart (and following the Navarro doctrine) it is about preventing China from attaining ascendancy in the fourth industrial revolution, the world of robots, AI, advanced aerospace, and autonomous cars. Meanwhile, the National Security aspect (already used to justify export restrictions) is tied up with a belief that the US military dominance is a function of its technological superiority. This is certainly a major factor in the Huawei charges – although whether it is because Huawei may open a back door for Chinese surveillance or that they refuse to open a back door for US surveillance isn’t exactly clear. This is the talk about IP and patents and what threatens to unpick complex global supply chains and what is driving a “Red Team v Blue Team mentality in US foreign policy. For global investors, used to worrying about the minutiae of Fed monetary policy and the so called Kremlinology of its members, the ever changing cast list in the White House and the shifts between Hawks and Doves in almost every aspect of policy both foreign and domestic is of deep concern.

It is also going to focus the attention of the rest of the world on de-dollarization. If, as we see with Huawei, the US is going to continue to weaponise the US Dollar payments system, then it  is effectively presenting a choice; either allow the US to set global foreign policy for all of you, or build your own system. Already Germany has suggested that an alternative to the SWIFT payments system is built and we know China has moved to demand oil exporting countries accept payments in RMB– albeit exchangeable into gold. Some talk of a new gold standard, but perhaps a system built around the Special Drawing Rights (SDR), including but not controlled by the US Dollar? Perhaps greater use of the blockchain for international exchange?  A few months back I attended a lunch talk by tech guru and futurist George Gilder whose recent  book, The Scandal of Money discussed the fact that the biggest industry in the world by value (here’s a Christmas quiz question for you) is the “$5.1trn per day currency trading carnival”, which as he pointed out doesn’t even yield stable currencies.  Some see this as a plea for cryptocurrencies, which indeed it may partly be, but it also raises a fundamental question about how appropriate the structure of dollar financial markets actually are. A major disruption to the biggest industry in the world?

Having said all that, this current market behaviour looks very technical in nature. We noted a few weeks back that the US equity market had broken through its long term moving averages (the last major market to do do) and it has effectively given up all the gains it made in Q2 and Q3 and is currently hovering around end March levels. There was some dramatic talk about a ‘Death Cross’ as well (though not yet on the moving averages I use) and there is no doubt that there is some technical selling. Asian equities meanwhile, which had appeared to be bottoming have fallen back, albeit continuing to recover relative to the US since bottoming in early October.

In my view and leaving aside the short term noise this could just be a simple mean reversion of the bond equity allocation. Consider Chart 1, which shows the ratio of TLT US, the ETF that tracks the US long bond, against the S&P500, normalised to January. By early October, the equity market had outperformed the bond market by 17%.

Chart 1: A simple Bond Equity Allocation?

Bloomberg AXA IM December 2018

What is very interesting to note is that this ratio peaked the day before the S&P 500 broke its medium term moving average, which in this system would suggest that asset allocators switch equity to bonds.

What is also interesting to observe since then, is not only has the S&P500 given back two thirds of that gain, so  is now only 5% ahead, but that lower volatility equities, as proxied by the Invesco ETF SPLV, which tracks the S&P low volatility index, what might perhaps thought to be bond proxies, have fared much better this quarter. Indeed it is only in the last week that they have given anything back against bonds.

Partly this will be due to the ongoing unwind of FANG stocks. As we discussed previously,  FANG stocks outperformed bond proxies by 30% in the first half of the year before giving it all back in the second half, but I also suspect that the selling of the wider index is part of a forced hedging process. This has a feel of LTCM to me, an inability to get out of illiquid positions being ‘resolved’ by selling the only thing they can, the US futures. It has been noticeable that almost regardless of overnight behaviour there has been selling of US futures in the equity markets at the opening of the Asia session. Someone is hurting, we just don’t know who – or how much. Yet.

There was a lot of talk last week about the US yield curve flattening and how this was an indicator of a forthcoming recession. Rather like the ‘Death Cross’, the yield curve gives a lot of false signals – while every recession in recent memory has been preceded by an inverted yield curve, not every inverted yield curve produces a recession. Something economists would refer to as ‘necessary, but not sufficient’. Normally an inverted yield curve measures the spread of 2 year to 10 year bond yields and on that measure it is currently basically flat, at around 12basis points. The biggest inversion in recent history was in 1978-81 when Paul Volker deliberately and aggressively tightened monetary policy to kill inflation, and it is really this period which anchors people’s perceptions about the predictive power of the yield curve.  In fact the last time the yield curve on this 2-10 year measure went even slightly negative was in 2006/7, before that 2000 and before that 1989. The fact that around those times the stock market also fell has perpetuated this idea of its predictive power. However, what is much more important in my view is that around those times, the short end of the yield curve, basically the spread between 3 month money and 2 year bond yields, or 5 year bond yields went very negative, while the spread between cash and corporate bond yields went out to 500bp or more. Currently neither of those things is happening. It is important to remember that QE and associated macro prudential measures have distorted most of the messages from the yield curve, specifically as many financial institutions are being forced to buy long dated bonds as part of their regulatory capital for year end. This is pushing down bond yields while squeezing liquidity at the short end raising LIBOR rates to 10 year highs.  This remains one of the key risks to market internal dynamics in my view. The fact that a decade of Quantitative Easing has produced a lot of products that rely on spread, carry and leverage has left financial markets vulnerable to an unwind of these strategies.. As mentioned above, some of the price behaviour at the moment has echoes of LTCM back in 1998, when an unexpected event (Russian bond default) caused what seemed to be a very low risk spread trade – short Treasuries, long Danish mortgage bonds to blow up. There was nothing wrong with the Danish Bonds, indeed they had a nice spread over Treasuries and had extremely low volatility. The problem was when a flight to quality pushed treasuries higher, LTCM (and their many clones) were forced to cover and effectively deleverage. When they did so, they discovered that the low volatility in the mortgage bonds actually represented a one way trade – everyone had been a buyer. Now there were only offers and no bids, so the price collapsed and they were forced to liquidate other strategies. And thus as the book title puts it we had a ‘When Genius Failed’ situation. Then, as in 2008 and now in 2018, forced deleveraging has the ability to move markets a long way from fundamentals.

As I mentioned in the last note, and again on CNBC this week, all the winning trades in the first half of the year appear to have unwound, while few of the losing ones have recovered. Indeed,  2018 looks set to go down as “a year in which nothing worked”, much like 2014, in fact. Much of this in my opinion is down to deleveraging – both in economies and in markets - something that was very much a theme of 2018. It began with the deleveraging by the noise traders back in February, when the bubble burst in the short  volatility carry trades that were funding their long positions in equities, commodities and ‘all things China’, leading them to flee the equity markets, taking their leverage and their bullishness with them. By mid-year, the dollar was rallying and asset allocators decided to unwind the short dollar-long Emerging Markets trade that had been so profitable in 2017, but were now giving back a lot of the profits. Because (greater) China is over 40% of the Emerging Market index, rotation back into Developed Markets (DM) by necessity meant selling a lot of China or its proxies. Asian markets gapped down, creating further downward pressure from speculators, who in need of a narrative drove the whole Trade War story as justification for the market mood swing. At the same time, the Chinese authorities were trying to deleverage the Chinese financial system, pushing business away from the shadow banking system towards the legitimate one. Such deleveraging remains necessary, but was put on hold mid-year to ensure that the slowdown around the trade dispute was not compounded by deleveraging to knock China off its growth trajectory. We would expect this policy to resume, once the trade war (TW1) is resolved.

Meanwhile, as noted above and in previous notes, the rise in the cost of cash – the key raw material for financial products – is threatening a lot of financial business models and exposing real world companies that have stretched their balance sheets under QE. The selloff in oil, the unwind of the S&P outperformance of not only Asia markets, but also of bonds, the collapse of the FANG stocks relative to low volatility stocks, the cutting of GE’s credit rating and its dividend; all, in my view, are a direct result of higher cash costs and a need to deleverage. The higher costs and/or returns on cash mean we should favour equities with strong growth and sound balance sheets.

Chart 2 picks up on some of these three year trends and shows how they are unwinding in the second half of 2018. A long FANG versus S&P trade, for example, which had delivered fantastic returns since 2016 – c.80% relative at one point, has underperformed by 13%, while as noted earlier the S&P versus the low volatility equivalent is off 10%, and against the long bond it is down 5%. Only the US versus Hang Seng is still up, at 13% having been up 23%. Indeed, since the beginning of the quarter, all of these trades are down between 5% and 12%. Oil incidentally is off 23% over that period.

Chart 2: Winning trades unwind – no doubt painfully

Bloomberg AXA IM December 2018

However, it is worth noting that, on a two year view, crude is basically flat and the US market is only modestly ahead of the Hang Seng and in line with a low volatility index of  bond proxy stocks. US equities are still ahead of bonds however  and the FANG stocks still a long way ahead of the rest of the market (note this is a basket of US high tech stocks, not just the big four).

Finally, a quick comment on Europe and the UK Withdrawal Agreement. I had delayed this note, hoping to be able to comment on the meaningful vote on UK Prime Minister Teresa May’s proposed deal with the EU. However, in yet another political shock this vote is now no longer taking place this week. The problem is, right now this is a decision tree with too many binary outcomes along the way.  So we have to wait a little longer.  Meanwhile, with relatively little attention compared to the EU and France, the unusual left wing /right wing coalition in Italy remains in my view, a meaningful risk to the Euro further into next year.

To conclude. A year of deleveraging has unwound many  of the winning trades of the last three years over the last six months. Thin markets and a whiff of leveraged distress suggest that markets have probably moved away from fundamentals, but also imply a need for some stability and signs of bottoming out before investing more.  While not repeating the stress of 2008 or even 1998 (LTCM), we do feel like 2019 will start in a similar way to 1999 and 2009; the narrative is terrible, risks are everywhere and all are gloomy. Yet both years ran well from the end of Q1. In terms of trade concerns, TW1 is almost over, which should provide some economic respite, but TW2 has only just begun which should keep risk premia elevated. As such returns will default to cash flow rather than multiple expansion at the market level, although both can occur at the stock level. Cash itself is now a meaningful asset class, and both a challenge to hedge funds in terms of hurdle rates to beat and the economics of underlying leveraged or spread strategies. As QE unwinds yet further, a back to basics approach focused on sound balance sheets, strong cash flow and active management looks sensible – attributes in which Asia has much to offer.



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