Tag: bonds

A Mix of Macro Charts

“The Federal Reserve has an official commitment to two different policies. One is to prevent inflation from getting too high. The second is to maintain high employment… the European Central Bank has only the first. It has no commitment to keep employment up.” ― Noam Chomsky

 

“A small group of people, they raise the price of oil and the whole world will suffer from this.” ― Ahmed Zaki Yamani, minister in OPEC for 25 years

A Mix of Macro Charts

In this week’s piece we share three macro charts that we hope will provide readers with an insight on how various risks are priced in markets by a seeming disparate range of instruments and indicators.

Short-Term Rates and the Yield Curve

YC 3m bills

The above chart is of the de-trended 3-month Treasury bill rate (inverted) ― de-trended by subtracting the 10-year moving average from the bill rate ― versus the US Treasury 10-year and 3-month yield curve. The chart dates from 1962 till today, suggesting that the de-trended 3-month Treasury bill rate contains information about the direction of the yield curve.

The two-time series have a correlation of -0.77 with an r-squared of 59 per cent.

(The dashed lines on the above chart are the average de-trended bill rate and levels one standard deviation above and below the average.)

The relation between the de-trended bill rate and the yield curve indicates a strong tendency of interest rates to mean revert. The wider the gap between the current de-trended bill rate and its long-term average, the stronger the markets expectation of mean-reversion. For example, the de-trended bill rate being one standard deviation above (below) its average generally serves as a guide post to position for a yield curve steepening (flattening / inversion). (The time series is inverted, so above the average means visually below on the chart.)

The de-trended bill rate recently reached one standard deviation above its long-term average and has since turned down, suggesting that fixed income investors position for a yield curve steepening, as opposed to a direct long or short position at either end of the curve.

 

Equity market investors can play a steepening yield curve by being long financials.

 

The Golden Period of Risk-Parity and 60/40 Allocations

stock bond correl

The above chart is the 6-month rolling US stocks-to-bond correlation and the 6-month rolling average of the annual rate of inflation, as measured by the consumer price index.

The relationship demonstrates (1) how the capital markets price in inflation and (2) the correlation between stocks and bonds is not static. The implication of the latter is that bond allocations do not always serve as a suitable diversifier for equity allocations. Rather, it is the prevailing market regime that determines the efficacy of bond allocations to lower draw downs and portfolio level volatility during equity market sell-offs.

Capital markets price in inflation ― outside financial crises when the safe haven demand for bonds can overwhelm implicit inflation expectations ― through an adjustment of the correlation between stocks and bonds. During the period from 1965 through to 1997, when inflation expectations experienced large swings, the stock-to-bond correlation was almost consistently positive. That is, changes in inflation expectations drove both stock and bond returns and during periods of equity market weakness bond allocations did not make up the difference. For example, in the sub-period between 1973 and 1981, during which there was a negative supply shock from the OPEC oil export embargo, multiple recessions, high unemployment rates and high inflation, equity market weakness coincided with a poor bond market performance.

To re-iterate the point again, it is market regime that determines whether Treasury bonds are a “wonderful hedge” or a “terrible investment”. Moreover, we can from the chart above why the last decade and a half has been a golden period for risky parity strategies and 60/40 allocations ― stock-to-bond correlations have been and remained at or close to 100-year lows.

The question then is, how does one determine market regime?

Market regime is just another way of saying inflation expectations. Rising inflation expectations equate to rising stock-to-bond correlations. Retreating inflation expectations translate to declining stock-to-bond correlations. By extension, something touched upon last week, the combination of stable, that is expectations of more of the same, and low-levels of inflation makes for the optimal investment environment.

Continuing to bet on more of the same when stock-to-bond correlations have been at 100-year lows for a prolonged period is surely asking for trouble. All the more, with political movements the world over nudging the global economy from being driven by negative and positive demands shocks to becoming one that will be driven by positive and negative supply shocks, a market regime change seems inevitable.

 

Demand shocks, either positive or negative, do not move the Phillips curve; supply shocks, however, shift it in and out. When the Phillips curve shifts in response to a negative supply shock, nominal bonds exacerbate losses suffered in equity markets. For example, an adverse supply shock in the form of the oil embargo by the OPEC in 1973 shifted the Phillips curve by increasing both production and distribution costs of almost all industries and led to losses for both equity and bond market investors.

 

That is why we think investors need to consider instruments other than bonds to hedge equity allocations. The Japanese yen, precious metals, Treasury Inflation-Protected Securities (TIPS), oil and energy stocks are some of the viable options. It is likely that there are others.

 

Why do we keep insisting on oil and energy stocks? Well because oil is the most obvious negative supply shock we can conceive of in the event of an Elizabeth Warren or Bernie Sanders presidency. Both Democratic presidential contenders have proposed to ban fracking altogether.

 

Europe Sovereign Risk Model

euro sov risk.png

The above chart is the ratio of gold, in euros, to the Euro Area all shares index versus the differential between 10-year government bond yields of the ‘fragile’ European economies and Germany. (For the latter we use the average of the yields on Spanish, Portuguese and Italian 10-year bonds and subtract from it the yield on 10-year German bonds.)

The two series are a means of measuring sovereign, or break up, risk in Europe. Rising ratios imply rising sovereign risks and a rush towards the safe havens of gold and German debt. Recently, with gold having rallied and some form of Brexit related agreement forming, the two time series have diverged. The yield differentials indicate a declining risk premium while the gold-to-shares ratio indicates a rising risk premium.

We think the two series should start to converge with European stock markets continuing to head higher.

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.

Trade Wars: Clearing the Way for a War of Attrition

 

“The two most powerful warriors are patience and time.” – Leo Tolstoy

 

“The primary thing when you take a sword in your hands is your intention to cut the enemy, whatever the means. Whenever you parry, hit, spring, strike or touch the enemy’s cutting sword, you must cut the enemy in the same movement. It is essential to attain this. If you think only of hitting, springing, striking or touching the enemy, you will not be able actually to cut him.” – Miyamoto Musashi, The Book of Five Rings

 

“Only an idiot tries to fight a war on two fronts, and only a madman tries to fight one on three.” – David Eddings, American novelist

 

A few updates relating to themes and topics we have written about in the recent past before we get to this week’s piece.

1. Two out of three companies we highlighted as potential value plays in Searching for Value in Retail in June have now announced that they are evaluating opportunities to go private.

The most recent of the announcements comes from Barnes & Noble $BKS which said on Wednesday that it is reviewing several offers to take the bookstore chain private. We are not surprised by this development and had expected as much when we wrote the following in June:

“Trading at a price to consensus forward earnings of around 10x and with a market capitalisation of under US dollars 500 million, $BKS remains a potential target for even the smallest of activist investors or private equity funds.”

The other company we discussed in the same piece was GameStop $GME, which at the start of September announced that it is engaged in discussions with third parties regarding a possible transaction to take the company private.

 

2. Following-up on Trucking: High Freight Rates and Record Truck Orders, orders for Class 8 semi-trucks increased 92 per cent year-over-year in September. Last month capped the highest ever recorded quarterly sales of big rigs in North America.

American trucking companies continue to struggle with tight capacity at the same time demand from the freight market remains strong.

We continue to play this theme through a long position in Allison Transmission $ALSN.

 

3. When the tech bubble popped at the start of the millennium, between 2001 and 2003, the S&P 500 and the NASDAQ 100 indices declined by 31.3 and 57.9 per cent on a total return basis, respectively. During the same period, Cameco Corporation $CCJ, the world’s largest uranium miner by market capitalisation, went up by more than 40 per cent.

Yesterday, as we witnessed global equity markets sell-off in response to (depending on who you ask) (i) tightening central bank policies and rising yields raising concerns about economic growth prospects, (ii) the accelerating sell-off in bond markets, or (iii) news that China secretly hacked the world’s leading tech companies, including Amazon and Apple, $CCJ closed up 5 per cent on the day.

Maybe history as Mark Twain said rhymes, maybe it is nothing, or just maybe it is one more sign of the increasing awareness of the nascent bull market underway in uranium.

CCJ.PNG

 

4. With the recent sell-off in the bond market, long-term Treasury yields have surged. Yields on the ten-year treasuries rose as high as 3.23 per cent on Wednesday, recording their highest level since 2011.

Does this level in yields make the long-end of the curve attractive for investors to start to re-allocate some equity exposure to long-term Treasury bonds? We think not.

Our thinking is driven by the following passage from Henry Kaufman’s book Interest Rates, the Markets, and the New Financial World in which he considers, in 1985, the possibility that the secular bond bear market may have come to an end:

“[T]wo credit market developments force me to be somewhat uncertain about the secular trend of long-term rates. One is the near-term performance of institutional investors, who in the restructured markets of recent decades generally will not commit funds when long when short rates are rising. The other development is the continued large supply of intermediate and long-term Governments that is likely to be forthcoming during the next period of monetary restraint. There is a fair chance that long yields will stay below their secular peaks, but the certainty of such an event would be greatly advanced with a sharp slowing of U.S. Government bond issuance and with the emergence of intermediate and long-term investment decisions by portfolio managers.”

 

In August this year, the US Treasury announced increases to its issuance of bonds in response to the US government’s rising deficit. This is the very opposite of what Mr Kaufman saw as a catalyst for declining long-term yields in 1985. Moreover, this increased issuance is baked in without the passing of President Trump’s infrastructure spending plan, which has been temporarily shelved. We suspect that Mr Trump’s infrastructure spending ambitions are likely to return to the fore following the upcoming mid-term elections. If an infrastructure spending bill of the scale Mr Trump has alluded to in the past come to pass, US Treasury bond issuance is only likely to further accelerate.

With the window for US companies to benefit from an added tax break this year by maximising their pension contributions now having passed, it will be interesting to see if institutional investors now become reluctant to allocate additional capital to long-dated Treasury bonds due to rising short rates.

The relative flatness of the yield curve, in our opinion, certainly does not warrant taking on the duration risk. At the same time, we do not recommend a short position in long-dated treasuries either – the negative carry is simply too costly at current yields.

 

On to this week’s piece where we discuss the United States-Mexico-Canada Agreement, or USMCA, the new trade deal between the US, Canada and Mexico that replaces the North American Free Trade Agreement, or NAFTA, and its implications on the on-going trade dispute between the US and China.

The many months of the will-they-won’t-they circle of negotiations between the US, Canada and Mexico have culminated in the USMCA, which will replace NAFTA. The new deal may not be as transformative as the Trump Administration would have us believe but nonetheless has some important changes. Some of the salient features of the new agreement include:

 

1. Automobiles produced in the trade bloc will only qualify for zero tariffs if at least 75 per cent of their components are manufactured in Mexico, the US, or Canada versus 62.5 per cent under NAFTA.

The increased local component requirement is, we feel, far more to do with limiting indirect, tariff-free imports of Chinese products into the US than it is to do with promoting auto parts production in North America. The latter, we think, is an added benefit as opposed to the Trump Administration’s end goal.

 

2. Also relating to automobiles, the new agreement calls for 40 to 45 per cent of content to be produced by workers earning wages of at least US dollars 16 an hour by the year 2023.

This provision specifically targets the relative cost competitiveness of Mexico and is likely to appease Trump faithfuls hoping for policies aimed at stemming the flow of manufacturing jobs from the US to Mexico.

How this provision will be monitored remains anyone’s guess. Nonetheless, the USMCA, unlike NAFTA, does allow each country to sanction the others for labour violations that impact trade and therefore it may well become that the threat is used to coerce Mexico into complying with the minimum wage requirements.

 

3. Canada will improve the level of access to its dairy market afforded to the US. It will start with a six-month phase-in that allows US producers up to a 3.6 per cent share of the Canadian dairy market, which translates into approximately US dollars 70 million in increased exports for US farmers.

Canada also agreed to eliminate Class 7 – a Canada-wide domestic policy, creating a lower-priced class of industrial milk. The policy made certain categories of locally produced high-protein milk products cheaper than standard milk products from the US.

 

4. The term of a copyright will be increased from 50 years beyond the life of the author to 70 years beyond the life of the author. This amendment particularly benefits pharmaceutical and technology companies in the US. American companies’ investment in research and development far outstrips that made by their Canadian and Mexican peers

Another notable victory for pharmaceuticals is the increased protection for biologics patents from eight years to ten years.

 

5. NAFTA had an indefinite life; the USMCA will expire in 16 years.

The US, Canada and Mexico will formally review the agreement in six years to determine whether an extension beyond 16 years is warranted or not.

 

The successful conclusion of negotiations between the three countries, subject of course to Congressional approval, combined with the trade related truce declared with the European Union in the summer, should be seen as a victory for US Trade Representative Robert E. Lighthizer.

Earlier this year, in AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market we wrote (emphasis added):

 

Mr Lighthizer’s primary objectives with respect to US-Sino trade relations are (1) for China to open up its economy – by removing tariffs and ownership limits – for the benefit of Corporate America and (2) to put an end to Chinese practices that erode the competitive advantages enjoyed by US corporations – practices such as forcing technology transfer as a condition for market access.

Mr Lighthizer’s goals are ambitious. They will require time and patience from everyone – including President Trump, Chinese officials, US allies, and investors. For that, he will need to focus Mr Trump’s attention on China. He will not want the President continuing his thus far ad hoc approach to US trade policy. If NAFTA and other trade deals under negotiations with allies such as South Korea are dealt with swiftly, we would take that as a clear signal that Mr Lighthizer is in control of driving US trade policy.

 

Mr Trump and his band of trade warriors and security hawks are now in the clear to focus their attention on China and deal with the threat it poses to the US’s global economic, military and technological leadership.

 

The Big Hack

On Thursday, Bloomberg Businessweek ran a ground breaking story confirming the Trump Administration’s fears relating to Chinese espionage and intellectual property theft. The Big Hack: How China Used a Tiny Chip to Infiltrate U.S. Companies details how Chinese spies hacked some of the leading American technology companies, including the likes of Apple and Amazon, and compromised their supply chains.

Bloomberg’s revelations were swiftly followed by strongly worded denials by Apple and Amazon.

The timing of Bloomberg’s report – coming so soon after the USMCA negotiations were completed successfully – regardless of whether the allegations are true or not is notable.

Coincidentally, also on Thursday, Vice President Pence, in a speech at the Hudson Institute, criticised China on a broad range of issues, from Beijing’s supposed meddling in US elections, unfair trade practices, espionage, and the Belt and Road Initiative.

 

American Corporate Interests

The main hurdle for the Trump Administration in its dispute with China is the US dollars 250 billion invested in China by Corporate America.

We see the recent moves by the Administration in upping the ante on China, by disseminating the theft and espionage narrative through the media and new rounds of tariffs, as a means to provoke Corporate America to begin reengineering its supply chains away from China. Whether this happens, and at what the cost will be, remains to be seen.

 

War of Attrition

We expect US-China tensions to continue to escalate especially as we draw closer to mid-term election. And the Trump Administration to (threaten to) impose higher tariffs and use other economic and non-economic measures to pressurise the Chinese. The only near term reprieves we see from the US side are (i) a resounding defeat for the Republicans in the mid-term elections (not our base case) or (ii) a re-assessment of priorities by the Trump Administration following the elections.

From the Chinese perspective, the short-term impact of tariffs has partially been offset by the ~10 per cent fall in the renminbi’s value against the US dollar since April. A continued depreciation of the renminbi can further offset the impact of tariffs in the short run – for now this is not our base case.

The other alternative for Beijing is to stimulate its economy through infrastructure and housing investment to offset the external shock à la 2009 and 2015. However, given that Xi Jinping highlighted deleveraging as a key policy objective at the 19th National Congress, we expect fiscal stimulus to remain constrained until is absolutely necessary.

For now our base case is for China to continue to buy time with the President Trump and at the same time for it to work on deepening its economic and political ties in Asia, with its allies and the victims of a weaponised dollar.

 

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.