“There is no nonsense so errant that it cannot be made the creed of the vast majority by adequate governmental action.” ― Bertrand Russell (1872 – 1970), British Nobel laureate in literature
From The Toxic Bubble of Technical Debt Threatening America by The Atlantic:
“A kind of toxic debt is embedded in much of the infrastructure that America built during the 20th century. For decades, corporate executives, as well as city, county, state, and federal officials, not to mention voters, have decided against doing the routine maintenance and deeper upgrades to ensure that electrical systems, roads, bridges, dams, and other infrastructure can function properly under a range of conditions. Kicking the can down the road like this is often seen as the profit-maximizing or politically expedient option. But it’s really borrowing against the future, without putting that debt on the books.
In software development, engineers have long noted that taking the easy way out of coding problems builds up what they call “technical debt,” as the tech journalist Quinn Norton has written.
[…]
Almost everywhere you look in the built environment, toxic technical-debt bubbles are growing and growing and growing. This is true of privately maintained systems such as PG&E’s and publicly maintained systems such as that of Chicago’s Department of Water Management. It’s extremely true of roads: Soon, perhaps 50 percent of Bay Area roads will be in some state of disrepair, not to mention the deeper work that must occur to secure the roadbeds, not just the asphalt on top.”
The Federal Reserve cut interest rates for the third time this year while also signalling that it does not expect to reduce rates further barring a sharp slowdown in the economy.
Suppression of G-7 interest rates, particularly following the bursting of the dotcom bubble and then the Global Financial Crisis, enabled gross over indebtedness, severe misallocation of capital and moral hazards to build up globally. This leaves governments and central banks with little choice but to respond to any signs of instability with further stimulus, either fiscal or monetary, to avoid the inevitable asset impairment cycle that would lead to a deflationary bust.
Suppressing interest rates slowly erodes trust in the financial system by facilitating the survival of zombie companies and unstable financial structures. The complete obliteration of trust in the financial system ultimately begets high rates of inflation and rewards owners of real assets.
Ideologically, we understand and appreciate the case for a complete loss of confidence in the dollar-based financial system and the eventual breakout of high inflation. And barring a discovery that materially reduces energy costs and increases supply at the same time, or a step-up in global productivity of the like witnessed during the industrial revolution, we expect the end game for the current global order to be no different than to that of other regimes in history.
In the theory of complex systems there is a concept of the ‘adjacent possible’ ― the set of all possible states of the world that could potentially exist in the next time step, given the present state of the world. Understanding the current state of the world then drastically reduces the next possible state of the world from all possible states to a subset of possibilities that are conditional on the present.
Ideologies aside, our analytical framework does not yet consider a complete loss of trust in the global financial system in the adjacent possible. Rather, the next crisis, whenever it may be, and the response to it by governments and central banks is likely to sow-the-seeds for the obliteration of trust in global financial systems.
On to this week’s update.
Signs of Rotation: Geography, Sector and Style
Global equities are on track for a third-successive week of positive returns driven by easing financial conditions, diminishing Brexit uncertainty, prospects of a thawing of tensions in the US-China trade dispute, and US earnings season going better than anticipated. (US companies are beating earnings expectations by ~5 per cent; notably, the bar had been lowered heavily with consensus expectations slating earnings per share to decline 3 per cent year-over-year.)
In the recent upturn there have been some noticeable rotations across sectors, geographies and styles. With the short-term outperformance of value over growth getting the most airtime.
While notable on a shorter-term horizon, most rotations appear trivial relative to performance trends during this record-long business cycle. For example, over the past decade non-US equities have delivered returns only one-third of US ones, measured in USD terms, while the iShares Russell 1000 Growth ETF has delivered a total return more than 1.5 times the total return delivered by the iShares Russell 1000 Value ETF.
With that being said, we run through a series of charts of identify regions, sectors and styles benefiting from rotation, albeit in the short-term, and could provide tactical alpha generating opportunities.
The Rest of the World
Value is often discussed in terms of the value and growth indices in the US. Given, the relatively paltry returns from non-US markets over the last decade, one could argue that anything non-US is essentially a value play.
With a dovish Fed, the easing trade dispute and a cyclically weaker US dollar, we can envision a scenario where money managers look to shift allocations into non-US markets lured by any one or a combination of value, reflationary pressures or improving growth prospects. The one difference we anticipate in any geographical reallocations in this cycle versus previous cycles is investors no longer analysing emerging markets simply through the prism of China. Rather, we expect a more discerning, less-homogeneous approach to emerging markets as investors attempt to identify winners and losers of the fallout from the US-China trade dispute.
We expect the next two to three months to be favourable for the rest-of-the-world relative to the US and for non-US equity markets to match or better US equity markets.
Russia
Russia looks one of the most attractive markets relative to both the US (first chart) and the world ex-US (second chart).
Brazil: Long-Only and Relative to Mexico
Brazil is shaping up well against the broader emerging markets space (first chart) and long Brazil $EWZ with short Mexico $EWW is a pair trade (second chart) that we would look to put on.
Why? Because Brazil has pro-business government and the potential to increase agriculture sales to China should the trade-dispute once again escalate while Mexico has a socialist leader and is running a record trade surplus with the US.
Europe Relative to Japan / The UK Against Germany
Another pair trade that we like is long European equities $VGK and short Japanese equities $EWJ. Japanese equities need not go down but the Japanese could weaken relative to the euro as Brexit uncertainties are mitigated and the general risk-on environment gathers steam.
The above trade could combine well with long the UK $EWU and short Germany $EWG and hedge out some of the risks emanating from the continued industrial slowdown in Germany. However, an outright long in the UK (second chart) looks a better trade should sentiment continue to remain ebullient.
Sectors
Autos
The automotive sector has been one of the worst hit in recent years with the stringent emissions standards going into force Europe, removal of tax subsidies in China on auto purchases and the chaotic implementation of new emission standards in China this past summer. With comps likely to be easier on a year-over-year basis at the end of this year and early next year, autos could surprise to the upside in performance.
We are not quite ready to go long here but should the sector gather further momentum $CARZ could be a high beta long to play risk on sentiment.
Energy
Given the low long-to-short ratio in futures markets, CTAs limit short oil any positive trade developments, supportive crude demand from refineries returning from maintenance, and prospects of deeper OPEC+ cuts could prompt a sharp rally in oil and energy names.
In the chart below we can see the horrendous performance of $XLE relative to $SPY. Energy has been a long-running pain trade. The risk-to-reward is tempting especially with the number of active oil rigs in the US below 700 for the first time since 2017.
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.