Three Macro Charts

 

“We can chart our future clearly and wisely only when we know the path which has led to the present.” ― Adlai Stevenson I, 23rd Vice President of the United States of America

A short piece with three macro charts and limited commentary.

1. Global Risk

Data validating recessionary fears have been the flavour du jour recently. The below is a chart of the MSCI All Cap World Index and the twelve-month moving average of the Citi Macro Risk Index, which suggests that a cyclical upturn in global equities is probable.

It is not the magnitude rather the direction of the risk index that acts as a cyclical indicator.

A similar sell-off to that witnessed in the fourth quarter of 2018 is not inevitable in the fourth quarter of 2019.

2. Cyclical USD

A custom leading index of global financial conditions suggests the cyclical trend for the USD is lower, even as the secular trend of the greenback remains intact.

 

3. Secular Trend in Real Yields

Quoting the National Bureau of Economic Research:

“The large and growing US current account deficits resulted from the large volume of foreign savings pushing in, as indicated by the declining US real interest rates, and not from US ‘profligacy’.”

The below chart is of the sum of foreign reserves held by China and Japan (inverted) and the real US 10 year treasury yield, for the period starting right after the Asian Financial Crisis.

The Asian Financial Crisis set in motion the trend of rising current account surpluses in Asia that were funneled back into the US. One major leg that furthered the trend, Chinese savings being recycled into US assets, has been broken by the protectionist policies of the US and economic challenges China is facing up to domestically.

The recycling of Asian current account surpluses into US assets is coming to end at the same time the US is entering a demographic driven inflationary phase, as argued by the Bank for International Settlements.

The secular tailwinds that drove down real yields in developed economies are weakening.

Thanks for reading and please share!

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

Clustered Volatility and the “Momentum Massacre”

 

“But, as with markets, in the ocean the interesting things happen not at the equilibrium sea level which is seldom realized, they happen on the surface where ever-present disturbances cause further disturbances. That, after all, is where the boats are.” ― W. Brian Arthur

 

Financial markets exhibit a temporal phenomenon known as clustered volatility. That is, the existence of periods of low volatility followed by periods of high volatility. Low volatility reigns supreme when the the outcome of the cumulative actions of market participants mutually benefits the majority. And, by extension, reaffirms the confidence the majority of market participants have in their forecast, “investment process”, algorithm or “analytical framework”  ― or, more crudely, heuristics that they use in making their trading or investment decisions. The majority continue to follow their “process” and among the minority that did not benefit in the run up all but the most stubborn gradually adapt their processes to implicitly or explicitly chase momentum. Low volatility begets low volatility.

 

High volatility often occurs when an external agent, such as President Trump tweeting about tariffs or the People’s Bank of China excessively tightening or loosening financial conditions, disrupts the seeming equilibrium in the market. All else being equal, which it never is, the impact of external agents on market volatility, however, tends to be fleeting. For example, the declining half-life of President Trump’s trade war related tweets impact on the US equity market.

 

A structural change in volatility generally occurs when some participants or a group of market participants alter their algorithm ― such as shifting from selling at the money puts to deep out of the money puts ― or investment process or by the entry of entirely new participants with a novel agenda ― like the Bank of Japan buying up ETFs as part of its QE programme ― to the market.

The changing of algorithms or processes may, of course, be in response to the actions of external agents or the impact said actions had on the market. Regardless, this “updating” allows the first movers to  front-run or anticipate the behaviour of the majority, which in turn causes other investors to re-adapt. This adaptive behavior, if it successfully percolates and propagates, moves the market away from its seeming equilibrium and into a state of ‘chaos’. It is this process of re-adapting that tends to precipitate longer lasting bouts of higher volatility.

 

Robert F. Engle, the winner of the Nobel Prize in Economics in 2003,  formally defined this process of random periods of low volatility alternating with high volatility in financial markets as the the generalised autoregressive conditional heteroskedasticity (GARCH) process.  (Heteroskedasticity is where observations do not conform to a linear pattern. Instead, they tend to cluster.)

 

Momentum Massacre

 

From the Financial Times on 12 September 2019 (emphasis added):

 

“The stock market may appear tranquil again after a rollercoaster summer, but many analysts and investors are unnerved by violent moves beneath the surface, reviving memories of the 2007 “quant quake” that shook the computer-driven investment industry.

 

The FTSE All-World equity index has rallied almost 3 per cent already this month, clawing back some of August’s losses. However, many highly popular stocks suffered a sudden and brutal sell-off this week, a reversal that analysts have already dubbed the “momentum crash”.

 

The blow was particularly strong in the US, where strong-momentum stocks — those with the best recent record — tumbled 4 per cent on Monday, in the worst one-day performance since 2009, according to Wolfe Research. Only once before, in 1999, has such a rout afflicted momentum-fuelled smaller company stocks, according to investment bank JPMorgan.”

 

This is massive,” said Yin Luo, head of quantitative strategy at Wolfe Research. “This is something that we haven’t seen for a long time. The question is why it’s happening, and what it means.”

 

The flipside has been a dramatic renaissance for so-called “value” stocks — out-of-favour, often unglamorous companies in more economically sensitive industries. The S&P value index has climbed about 4 per cent this week and, compared with momentum stocks, enjoyed one of its biggest daily gains in a decade on Monday.

 

The chart below is the ratio of the S&P Growth index to the S&P Value index. We are struggling to find the “dramatic renaissance”.

 

SGX Index (S&P 500 Growth Index) 2019-09-18 16-41-52.jpg

 

Of course we are being more than a bit flippant. Nonetheless, we do not think it is time to completely drop momentum or growth stocks and load up on value stocks. Rather we think the market is in a transient phase where participants are updating their algorithms and processes to go beyond momentum.

 

Our prescription from June remains valid:

 

We are increasingly convinced that a barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals on the other. And if tech and growth continue to rally, investors should re-balance  regularly to avoid any lopsidedness in their portfolios.

 

The above has worked well in the recent “momentum massacre” and can continue to work well as long as uncertainty remains high and sentiment viciously waxes and wanes between optimism and pessimism. A slight adjustment to the above, however, is warranted as follows:

 

A barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals energy plays on the other.

 

Do Not Drop Momentum ― Not Completely Anyway

 

Dropping momentum or growth completely would be akin to calling the end of the transition away from actively managed portfolios to passively managed allocations that has accelerated since the Global Financial Crisis. Passive allocations are implicitly momentum seeking strategies. A strong secular trend is not upended by a 4 per cent move, it will take a crisis or a severe re-think of strategic asset allocation by the managers of the largest pools of capital to bring about an end to the trend.

 

The rise of passive investing, along with systematic volatility selling strategies, has contributed to the dampening of volatility since the Global Financial Crisis. A growing share of passive allocations, however, is somewhat like increasing leverage. As passive flows now make up the lion’s share of capital market flows, the actions of active investors are spread over a smaller segment of the investment universe. As the size of the active universe shrinks, in terms of what could be described as, in the case of stocks, free float market capitalisation minus passive allocations, the actions of active investors begin to have an exaggerated impact and give rise to higher volatility.

 

Simply put, the passive flows versus volatility curve is convex. Initially, increasing passive flows dampen volatility but beyond some hitherto unknown level increasing passive flows lead to higher volatility.

 

Why Energy Over Precious Metals?

 

Without delving into the geopolitics of it, the attacks on the Saudi Arabian oilfield should remind major oil consumers ― airlines, refiners, transportation companies and emerging economies such as India and China ― to review their energy security and hedging strategies. To balance future energy needs and to not become hostage to a rising geopolitical risk premium in the price of oil. This should lead to a rise in demand for oil at the margin; commodity prices are, of course, set at the margin.

 

The other angle is that if anything is going to take down the almighty bond bull market its going to be either: (1) fiscal spending by the G-7 governments of the like that we have never seen; or (2) a sharp and sustained increase in oil prices.

 

Lastly on energy, if Iran is, rightly or wrongly, shown to be the perpetrator of the attacks, China may have to reconsider it decision to purchase Iranian oil.

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

 

Shifts in US Capital Flows and Positioning for a Steepening Yield Curve

 

A chart heavy piece this week in which we dig into the underlying shifts in the capital flows into the United States.

 

We had aimed to issue this piece last week but it took more work and longer to draw out coherent conclusions than we had anticipated.

 

The key takeaways we draw out from the analysis in this week’s piece are (1) the structural shifts in capital flows into the US since the Global Financial Crisis and (2) a flows based framework for charting the path of the US dollar.

 

“Total return has three elements: the interest rate differential, the exchange rate differential, and the capital appreciation in local currency. Since the third element varies from case to case we can propose the following general rule: speculative capital is attracted by rising exchange rates and rising interest rates.

 

Of the two, exchange rates are by far the more important. It does not take much of a decline in the currency to render the total return negative. By the same token, when an appreciating currency also offers an interest rate advantage, the total return exceeds anything that a holder of financial assets could expect in the normal course of events.

 

That is not to say that interest rate differentials are unimportant; but much of their importance lies in their effect on exchange rates and that depends on the participants’ perceptions. There are times when relative interest rates seem to be a major influence; at other times they are totally disregarded. For instance, from 1982 to 1986 capital was attracted to the currency with the highest interest rate, namely, the dollar, but in the late 1970s Switzerland could not arrest the influx of capital even by imposing negative interest rates. Moreover, perceptions about the importance of interest rates are often wrong.

 

The Alchemy of Finance, George Soros (emphasis added)

 

For those of you not wanting to run through the lengthy discussion, jump to the ‘Putting It Altogether’ section at the end of the piece.

 

One Quick Detour

 

Before going on to this week’s piece, a brief comment on bitcoin (or cryptocurrencies, in general).

 

We do not discuss cryptocurrencies or blockchain often and write about them even less. Even so, in our occasional discussions about cryptocurrencies we regularly come across statements along the lines of: “I am bullish on blockchain, not bitcoin,” or “The use case for blockchain technology far exceeds that of cryptocurrencies.” You too might have heard similar such statements from investors, venture capitalists, or other “authoritative sources” in discussions or interviews.

 

This line of thinking, we suspect, has driven capital and resources into developing private blockchains or proprietary databases that are based on blockchain technology. For example, banking behemoths of the likes of JP Morgan and UBS are spearheading efforts to use blockchain technology for settling cross-border trades worldwide with their own “Bitcoin-like” tokens.

 

The arguments in favour of private blockchains over public cryptocurrencies may yet prove prescient and the development of private database-like structures turns out to be the optimal use case for blockchain technology. The below passage from The Hard Thing About Hard Things written by Ben Horowitz, of Andreesen Horowitz fame, about the Internet and competing proprietary networks, is a reminder, however, that the public versus private implementation debate is not new. And a technology that appears to be inferior, insecure or volatile can evolve and supersede a seemingly superior competing solution.

 

“In retrospect, it’s easy to think both the Web browser and the Internet were inevitable, but without Marc’s work, it is likely that we would be living in a very different world. At the time most people believed only scientists and researchers would use the Internet. The Internet was thought to be too arcane, insecure, and slow to meet real business needs. Even after the introduction of Mosaic, the world’s first browser, almost nobody thought the Internet would be significant beyond the scientific community-least of all the most important technology industry leaders, who were busy building proprietary alternatives. The overwhelming favorites to dominate the race to become the so-called Information Superhighway were competing proprietary technologies from industry powerhouses such as Oracle and Microsoft. Their stories captures the imagination of the business press. This was not illogical, since most companies didn’t even run TCP/IP (the software foundation for the Internet)they ran proprietary networking protocols such as AppleTalk, NetBIOS, and SNA. As late as November 1995, Bill Gates write a book titled The Road Ahead, in which he predicted that the Information Superhighwaya network connecting all businesses and consumers in a world of frictionless commercewould be the logical successor to the Internet and would rule the future. Gates later went back and changed references from the Information Superhighway to the Internet, but that was not his original vision.

 

The implications of this proprietary vision were not good for business or for consumers. In the minds of visionaries like Bill Gates and Larry Ellison, the corporations that owned the Information Superhighway would tax every transaction by charging a “vigorish”, as Microsoft’s thenchief technology officer, Nathan Myhrvold, referred to it.

 

It’s difficult to overstate the momentum that the proprietary Information Superhighway carried. After Mosaic, even Marc and his cofounder, Jim Clark, originally planned a business for video distribution to run on top of the proprietary Information Superhighway, not the Internet. It wasn’t until deep into the planning process that they decided that by improving the browser to make it secure, more functional, and easier to use, they could make the Internet the network of the future. And that became the mission of Netscapea mission that they would gloriously accomplish.”

 

A parting thought, consider the oft-cited explanation for the superiority of open-source solutions: “Given enough eyeballs, all bugs are shallow.”

 

US Trade Balance and Foreign Portfolio Investment

 

The below chart consists of the de-trended US trade balance (magenta bars), presented in reverse order and defined as the quarterly trade balance minus the three-year moving average of the trade balance,  and the quarterly foreign portfolio investments into the US on a net basis (orange line).

 

US Trade Balance De-Trended vs Net Foreign Portfolio InvestmentNPI vs TB.pngSources: US Census Bureau, US Department of the Treasury

 

The US, over the last twenty-five years, has, more often than not, run a trade deficit with the rest of the world. That is, Americans have consumed more than they have produced. During the 1990’s and the first five years of the current millennium, a growing trade deficit coincided with increasing foreign portfolio flows into the US.

 

Ahead of the financial crisis, the US trade deficit shrank and was duly followed by a sharp drop in foreign portfolio inflows. During and a few quarters following the Global Financial Crisis, the trade balance and foreign portfolio flows relation was flipped on its head. The US started to run a trade surplus, more on that anon, yet foreign portfolio flows increased rather than retrenching. The safe-haven bid for US assets, specifically US Treasury securities, was sufficiently large to overrun the impulse for foreign capital to retreat as the US went from running a trade deficit to running a trade surplus.

 

In the chart below, international flows into US Treasury securities are plotted against the US trade balance.  The international bid for Treasury securities was strong during the Global Financial Crisis and, following a brief pause, remained strong all the way through 2011.

 

US Trade Balance De-Trended vs US Treasury International Capital FlowsTrade Balance vs Treasury InflowsSources: US Census Bureau, US Department of the Treasury

 

Following the Global Financial Crisis and up until the election of President Trump, the US no longer ran consistent trade deficits and even when it did, they were not as large as they were prior to the crisis. As a corollary, foreign portfolio investments, too, waxed and waned between positive and negative during the time period.

 

The Diminished Role of Oil in Dictating Foreign Flows

 

Prior to the crisis, US oil imports were on a steady uptrend, going from below 5 million barrels per day at the end of 1990 to a peak of more than 10 million barrels in 2006/07. Imports dropped sharply to below 8.5 million barrels per day during the crisis, spiked in 2010, then continued declining through 2015, picked up in 2016 and 2017, and once again started falling from the second quarter of 2018. In February 2019, US oil imports averaged less than 7 million barrels per day for an entire month for the first time since February 1996.

 

US Trade Balance De-Trended vs Price of Brent Crude Oil De-TrendedTrade Balance vs BrentSources: US Census Bureau, Bloomberg

 

The rise of shale and the sharp drop in oil prices in the second half of 2014 has shifted the source and structure of net foreign portfolio investments into the US. The US trade balance, particularly during the commodity super-cycle witnessed during the first decade of the new millennium, was strongly correlated with the fluctuations in the price of oil. Since 2012, however, the correlation has broken down.

 

US Net Foreign Portfolio Investment vs Price of Brent Crude Oil De-TrendedPPI vs BrentSources: US Census Bureau, Bloomberg

 

The US trade balance being less correlated with the fluctuations in the price of oil also coincided with the correlation between foreign portfolio flows and the price of oil declining.

 

The breakdown in the correlation can be understood through the shifting structure of foreign portfolio flows. From the 1990’s  through 2006, the growth in portfolio flows was predominantly driven by increasing international flows into US Treasury securities. Oil exporting nations, particularly those operating US dollar pegged currency regimes, and China, were recycling their US dollar windfalls back into Treasury securities.

 

The rise of shale and subsequent drop in the price of oil has meant oil exporting nations no longer have the kind of excess capital to re-direct into Treasury securities as they once used to. China’s dollar-shortage challenges are, of course, well documented. Consequently, foreign flows into US government bonds have become more sporadic and the relative share of foreign flows into other securities has increased. The relative share of US foreign portfolio flows from other pools of capital, specifically pension funds and insurance companies in Europe and Japan, has also increased.

 

Structure of US Net Foreign Portfolio InvestmentNPISource: US Department of the Treasury

 

The shift, however, in the correlation between the fluctuations in the price of oil and foreign flows into US Treasury securities has not been as dramatic. Suggesting that oil exporters continue to prefer parking excess capital into US government bonds and are not going out on the risk curve.

 

US Net Foreign Portfolio Investment vs Price of Brent Crude Oil De-TrendedTreasury Inflows vs BrentSources: US Department of the Treasury, Bloomberg

 

Putting It Altogether

 

We have gone through some of the high level dynamics of the US trade balance and foreign portfolio flows. To round off the discussion, we outline a framework that can be helpful in thinking about the US dollar and demand for US dollar assets in general.

 

US Trade Balance + Net Foreign Portfolio Investment De-Trended vs YoY Change in US Dollar IndexTB NPI vs DXY (1).pngSources: US Census Bureau, US Department of the Treasury, Bloomberg

 

The magenta line in the above is the sum of the de-trended trade balance and the de-trended net foreign portfolio investment. The line being above zero implies foreign demand for US dollars exceeding the supply of US dollars. For example, the demand for US dollars emanating from portfolio flows exceeds the supply of US dollars being created by the US running a trade deficit.

 

Demand outstripping supply, to state the obvious, places upward pressure on the US dollar.

 

Outside of periods of insatiable demand for safe-haven assets, this flows based framework works well as a tool to chart out a path for the US dollar.

 

Based on this framework, let us consider the scenario of the US undertaking a large fiscal spending programme following the presidential election. If such a fiscal spending programme greatly increases the US trade deficit, supply of US dollars should also increase substantially. This increase in the supply of US dollars will place tremendous downward pressure on the greenback unless accompanied by a commensurate increase in foreign portfolio flows into American financial assets.

 

An increase in foreign demand for American financial assets, in all likelihood, requires higher long-term interest rates. The optimal way for investors to position for it in the current environment, in our opinion, is to be long yield curve steepeners.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.