Shrinking liquidity means higher volatilityMarket thinking 03 December 2018
Mark Tinker, Head of Framlington Equities Asia, comments on US and Asian Markets:
- With ‘book closing’ into the Thanksgiving weekend, markets are now in a lower liquidity phase, with redemptions and deleveraging in commodities driving market noise.
- Equities outside of the US look to be basing, investors are looking for signals that forced sellers are fully out. Fund flows and valuations look supportive for both Asian Equity and Credit. Cash flow is a good competitor for cash.
- Against such a background, hints of positive news, such as an end to Fed tightening and or some agreements on trade, could produce a classic Santa Claus rally.
We have discussed in recent weeks how Thanksgiving in the US tends to mark the end of the financial year for many active US fund managers, resulting in deleveraging and book squaring and that certainly seems to have been the case this year. Liquidity is shrinking across most markets, which is leading to higher volatility. Indeed, the Vix index of implied volatility, after an aggressive spike in early October, seems to have moved into a band centred around 20, double its level at the end of last year and is making a series of higher highs and higher lows at the moment, suggesting that the ‘low volatility’ strategies that have dominated the QE era may be unwinding as the Fed runs down its balance sheet.
Meanwhile, everyone’s favourite pre-Christmas drinks party story from 2017, Bitcoin, is down around 88% from the date they launched the Bitcoin future on December 17th 2017, thus allowing both leverage and short selling into the eco system. As we discussed at the time, the real importance of Bitcoin was what it said about the underlying operating system, the Blockchain, rather like the Chinese stock market in 2015 (or for that matter 2017) told us more about hype and leverage than the importance of the underlying Chinese economy.
Looking perhaps for straws in the wind, we notice some Equity markets in Asia are attempting to bottom out – although obviously they remain vulnerable to low levels of year end liquidity. MSCI Asia Pacific index for example, while still below long term (investors’) moving average has nevertheless broken (and held) above its short term moving average, while the Shanghai Composite is close to its medium term (asset allocator) level, as is the MSCI China index. Our old friend the FXI US ETF, which a lot of US investors use as a proxy for China, has also broken back above its short and medium term moving averages. The Hang Seng is at an eight week high and above both short and medium term moving averages, while the Nikkei, which along with the S&P500 was one of the last markets to break down through the long term moving average, is looking a lot better technically than its US cousin. At times like these, investors look to the technical to give possible insights into the forced selling that drives prices beyond fundamentals. If this is abating, then some tentative buying can take place and if there are more positive macro events such as more dovish comments from the Fed, or more constructive talks on US China trade, there could easily be a Santa Claus rally.
Another way of trying to assess what longer term saver and investors are doing is to look at ETF and mutual fund flow, albeit acknowledging that traders also use ETFs for positioning/hedging. Thus, if we look at the latest ETF/mutual funds flow data from the team at Jefferies, we see a continuation of the trend to switch from US Corporate Bonds (YTD HY –US$62bn) into Government Bonds (+ US$32bn) and Money markets ($64bn in the last 5 weeks) and ongoing liquidations of inflation protected bonds and EM bonds. Interestingly that flow into EM equities has been positive, mainly driven by Asia. In fact, on the Jefferies data, Asia Pac equity inflows in terms of ETFs have been on a 17 week streak amounting to inflows of US$46.4bn, bringing a total of US$115.5bn year to date. It looks like the sharp depreciation of a number of EM Asia currencies against the US dollar mid-year actually brought forth some value players, picking up local equities. Recent moves have focussed more on Asia EM, which we expect will become more of a sub asset class going forward. We suspect however that this may reflect some macro traders playing the weaker oil price via long positions in EM energy importers like Indonesia, Thailand, and South Korea, while selling exporters such as Brazil and Norway.
Over the last 12 months equity inflows have actually held up well overall, the real brunt of ‘risk off’ (as defined by investors rather than traders) being from Corporate Bonds, notably high yield, and particularly commodities, both areas I would suggest vulnerable to the declining attraction of spread trades and leverage.
While Asia has seen inflows, Europe has seen outflows, particularly at the country level, although interestingly two weeks ahead of the UK vote on the EU withdrawal agreement outflows from the UK appear to have stopped. The Brexit negotiations have hung like a cloud over UK assets all year and remain so politicised as to make the UK almost un-investable at the moment for many people, leaving the ‘market opinion’ to be reflected in the movements in Sterling, currently off 11% against the US dollar since April. However, as we have said on previously the vote of the Foreign Exchange markets are rarely considered an opinion of economic outcomes, rather a reflection of certainty (or the lack of it). Technically we do have a hard deadline on the UK withdrawal of March 2019, when at least markets would know what we are dealing with, although even here the clear intention of many parliamentarians is to somehow change these rules. So we wait.
While much of the English speaking press is focussing on the EU in the context of Brexit, the picture headlines at least have been captured by the Gilets Jaunes (high-visibility jacket) protests in France, with rioting and fires lit in central Paris, ostensibly around hikes in fuel prices, but in reality capturing some of the same ‘insider/outsider’ dynamics being expressed across much of the west. It is interesting to explain to a US visitor for example that the reason that everyone in France has a Gillet Jaune is that it is a legal requirement to have one in your car, along with your licence, proof of insurance and your ownership document. Oh and you need to carry your own breathalyser kit! Failure to comply can lead to large on the spot fines. At the same time, a US visitor is staggered to realise that petrol and diesel prices in France (and much of Europe) are almost three times that in the US due to taxes. Of course this so called tax wedge makes the response to oil prices much more muted so that the cost/benefit to consumers is much lower. If we look at the chart of average gasoline prices in the US, below, we can see that there is a clear boost coming to disposable income from the unwind of speculative long position(black line) feeding through to lower US crude prices (gold line) and ultimately to lower prices at the pump (green line).
Chart 1: Falling pump prices a boost for US consumers
Source Bloomberg, AXA IM November 2018
They are also a boost to Emerging markets of course, although here too, the existence of either a tax or a subsidy wedge is important in determining the size of the transmission effect. As such while it makes for a more comfortable backdrop, we would be wary of chasing lower oil prices as too much of a theme in a lot of emerging markets, where for many the real problem remains the corporate debt market. Chart 2, illustrates how EMB, the ETF that tracks the emerging market debt index continues to hit new lows, heavily influenced by the strength of the dollar, but also the structural problems in many of the current account defcit countries (the ETF is 85% invested in sovereign debt and does not hold any thing in China as far as I can tell).
Chart 2: Emerging Market Sovereign Debt struggling as an asset class
Source Bloomberg, AXA IM November 2018
Meanwhile in the other area suffering outflows, Iron Ore took a pounding this week, probably based on the ‘last man standing’ idea as other commodities have struggled and the move was likely triggered by talk of slowdowns and falling inventory in Chinese steel mills. However, it was interesting to notice that on spite of this, the Australian Dollar has been rallying. This is something that we pointed out a few weeks back; while the economic rationale for the AUD following the swings in views on China is that Australian exports so much coal and Iron Ore to that country, the currency doesn’t actually follow the movements in these so called fundamentals. Instead it tends to track FXI, the China market ETF, which as noted earlier has broken up technically through resistance at the short and medium term moving averages.
Such movements do however throw up some interesting opportunities around fundamentals at the stock level. For example, the big Australian miners, who continue to throw off vast amounts of cash even at Iron Ore prices considerably below here, are offering very high and extremely well covered dividend yields to investors (Rio is almost 8% for example). They are not alone; indeed my colleague Simon Weston who works on our Asian Dividend strategies identified a list of over 50 Asian companies with well covered dividends in excess of 7%, almost half of which has a year 2 forecast dividend greater than their year 2 projected PE.
On the other side of the table are Asian High Yield Bonds. Here, my colleague Jim Veneau has been out banging the drum this week to highlight the fact that, thanks to the spread widening and sell off that has hit all High Yield bond markets this year as discussed earlier when looking at the flow data, Asian high yield is offering some extremely attractive potential returns, certainly relative to the bigger US market. In the first instance the spread over the US high yield market is meaningful at almost 300bps, while as an asset class Asia has significantly lower exposure to lower grade single B issuers at 38% of the benchmark versus 55% for the US. This is important as single B have exponentially higher default rates than BB or higher. Of course such valuations reflect a heightened level of concern about corporate debt, not least because approximately half the JP Morgan Asian High Yield Index (JACI) is in China, but Jim believes, and I agree, that this can be mitigated by effective credit research. Moreover, whereas our Equity Income Strategies are looking for growing dividends (not just high yields we hope won’t get cut) a high yield bond strategy assumes that there are defaults and that they are partially mitigated by recoveries. Jim and his team calculate that even if you double the historical default rate and halve the recovery rate, you can still generate compelling credit loss adjusted returns from an active Asian high yield strategy.
We continue to believe that 1) US Dollar cash is now both a credible asset class in its own right and an existential threat to the sustainability of a large number of spread and carry trades that have worked extremely well for the last decade of QE and 2) that when asset allocators reduce abnormally high precautionary cash balances they will look to diversify away from the US into Asia rather than a traditional Emerging markets benchmark. This will apply particularly to those able to ignore or stretch traditional structures and obviously also apply to high net worth individuals and family offices. The fact that growth in the latter two categories is fastest in Asia will of course also introduce a considerable home market bias effect. 3) A focus on traditional asset classes means a focus on income generation and Asia is well placed to provide a meaningful contribution to any global investor looking for cash flow from equity or credit.
To conclude, as we approach year end books are flattened and liquidity becomes tighter. Some of the big relative trades of the year such as long FAANG and associated stocks and short low volatility stocks have now completely unwound, while other speculative trades, such as long Oil and short Treasuries are being rapidly closed out amid ongoing deleveraging. Of course the hype stories at the end of last year like China Tech stocks are down heavily while Bitcoin, which has a history of collapsing heavily (2011, 2013, 2014) was true to form and has fallen around 75% so far this year and almost 90% from its peak. In fact very little has done well except US Dollar cash which means that 2018 looks to be playing out like 2014, not just in terms of stronger dollar and weaker emerging markets, but one where as we described it at the time we had a year when nothing worked. We will look ahead to 2019 in a little more detail next week, but in the meantime we would caution that, as ever, the unwind of noise trades risks confusing the narrative about the strength or otherwise of global economies. Here’s hoping for a few bits of positive news and a modest return of animal spirits.
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