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A Week of Plenty: Parsing the Big and the Small

“A lot happens in our everyday life, but it always happens within the same routine, and more than anything else it has changed my perspective of time. For, while previously I saw time as a stretch of terrain that had to be covered, with the future as a distant prospect, hopefully a bright one, and never boring at any rate, now it is interwoven with our life here and in a totally different way. Were I to portray this with a visual image it would have to be that of a boat in a lock: life is slowly and ineluctably raised by time seeping in from all sides. Apart from the details, everything is always the same. And with every passing day the desire grows for the moment when life will reach the top, for the moment when the sluice gates open and life finally moves on.” – Karl Ove Knausgård, Norwegian novelist

There are a lot of interesting and market moving developments that have either transpired or come to light over the course of the last week or so. This week we take a break from taking a deep(ish)-dive into a given theme and instead parse through some of these developments.

US Market Breadth

As US markets have recovered and moved within a whisker of the year-to-date highs recorded in January, we have witnessed a growing chorus of criticism on the robustness of the recent rally. One of the more common criticisms is how only a handful of stocks – namely Facebook, Amazon, Netflix, Google, Microsoft and Salesforce.com – are responsible for the positive returns of the S&P500 Index year to date and were it not for these stocks, the market would be in the red.

To that we counter with two pieces of evidence.

The equally weighted index of the constituents of the S&P500 Index, as of Wednesday’s close, is 2.3 per cent from its January highs.

SPW Index (S&P 500 Equal Weighte 2018-07-26 13-45-34.jpg

The equally weighted index of the constituents of the Nasdaq 100 Index, as of Wednesday’s close, is above its January highs.

NDXE Index (NASDAQ 100 Equal Wei 2018-07-26 13-47-07

There have been and continue to be plenty of opportunities to outperform the broad market indices without the need to invest in the FAANG or other large cap tech stocks. You just need to do the work.

There are of course other criticisms including valuations, such as price-to-sales and price-to-earnings multiples, and the near record high net profit margins being achieved by companies, which critics argue should all mean revert over time and said reversion should lead to a sharp drop stock prices.

With respect to valuations, we counter with two arguments: (1) valuations can mean revert by either prices dropping or sales / earnings increasing, as the quarterly results of the current reporting season have demonstrated, valuations in many instances are adjusting on higher sales and / or earnings; and (2) rich valuations are not in and of themselves a precursor for market corrections, rich valuations are a necessary condition for equity market corrections but not a concurrent one.

Turning to record high profit margins as a bearish argument against owning US stocks, we counter that such arguments do not adjust for the change in the composition of major US equity market indices. Once the S&P500 Index, for example, is adjusted for the changes in sector weights, profit margins do not appear to be anywhere near as high as they appear to be without adjusting the index for changes in sector allocations. This is because the current heavyweights of the index, namely tech and healthcare stocks, tend to generate much higher margins than businesses in other sectors that dominated index historically.

The changes in the composition of the index also go some way to explaining the high level of the price-to-sales ratio the market is trading at – at risk of stating the obvious, higher margin businesses capture much more of their sales as profits than do lower margin businesses, and thus high margin businesses are bound to trade at higher multiples of sales than do low margin businesses.

Is Amazon the biggest threat to Google’s dominance in search-driven advertising?

Quoting Brian Olsavsky, Amazon’s chief financial officer, from the company’s quarterly earnings update:

“A big contributor to the quarter and the last few quarters obviously has been strong growth in our highest profitability businesses and also advertising.”

The CFO further added that Amazon is working to automate tasks for advertisers and to help media buyers measure the results.

Last quarter, Amazon’s revenue from the advertising sales category and some other items grew 132 per cent year-over-year to US dollars 2.2 billion. Quarterly revenue of over US dollars 2 billion is not to be scoffed at. More importantly, this revenue is coming straight out of Google’s share of the advertising market.

The appeal of advertising on Amazon for advertisers is obvious: customers searching on Amazon are already there with the intent of buying something. With Amazon controlling close to 45 per cent of total online sales in the US and perpetually increasing its product offering, it becomes progressively more convenient for online shoppers to begin their product searches with Amazon and not Google. If the propensity of consumers to being their product searches with Amazon over Google continues to increase, the proclivity of advertisers to spend their dollars on Amazon over Google is also likely to follow suit.

How Google responds to this challenge is something we await with much intrigue.

We expect Amazon to be the first company to achieve a trillion dollar market capitalisation.

Japanese Government Bonds

Global bond markets have been roiled by speculation that the Bank of Japan (BoJ) is considering tweaking its policy stance and could scale back its stimulus programme. Yields on 10-year Japanese government hit a fresh twelve-month high on Thursday, forcing the BoJ’s in making a rare intervention in the bond market to push yields on the 10-year government bonds back below 10 basis points.

In practical terms, the BoJ currently guides the yields on 10 year government bonds to be within the range of 0 to 11 basis points. The official directive, however, only states that “The Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain at around zero percent.”

We are of the opinion that the BoJ will take steps to widen the tight range of 0 to 11 basis points on 10-year government bonds associated with the ‘around zero’ directive. The objective of said widening being to allow Japanese banks to have more influence on 10-year rates and to steepen the curve ever so slightly to enable them to make their lending activities profitable.

Qualcomm / NXP Semiconductor

The two-year saga of Qualcomm’s attempted acquisition of Dutch chipmaker NXP Semiconductors came to an abrupt end after the deal failed to receive final approval from Chinese regulators ahead of the expiration of the companies’ agreement on Wednesday night. Had the transaction gone through, it would have been the semiconductor industry’s largest ever acquisition.

Unquestionably, the Qualcomm-NXP deal is collateral damage in the political game between Beijing and Washington and can be seen as retaliation for President Donald Trump’s tariffs on Chinese imports.

After Congress, earlier this month, decided against re-imposing a seven-year ban on ZTE, the Chinese telecommunications equipment and systems company, from buying equipment in the US market — a move that would have effectively put the Chinese firm out of business, it was widely expected that China would have cleared the Qualcomm-NXP deal quid pro quo. By effectively ending the Qualcomm-NXP deal, however, the Chinese leadership is essentially adopting an extremely hawkish strategy toward the US.

We believe the Chinese move to end the Qualcomm-NXP deal is a significant escalation of trade-related tensions with the US, and see it is as weakening the position of dovish officials on both sides: in this case, Steve Mnuchin for the US and Liu He for the Chinese. This should only further complicate US-China trade related negotiations.

Trump-Juncker Meeting and the Prospect of Improved US-EU Trade Relations

In a joint announcement after meetings in Washington on Wednesday, President Donald Trump and the EU’s Jean-Claude Juncker declared a truce on trade-related tensions with the aim of eliminating all tariffs, trade barriers and subsidies related to non-auto industrial goods.

The rosiest outcome, from the perspective of the global economy, following this joint declaration is that President Trump seeks to settle the US trade-related tensions with the EU, Canada and Mexico, and instead focuses his energy on China – something Peter Navarro, Robert Lighthizer and other security and trade hawks in the administration have probably wanted all along.

If the rosy scenario does indeed materialise then the EU is likely to join in on US efforts to back against China’s efforts to move up the industrial value, discriminatory tariffs and abuse of intellectual property rights. The US-China trade-related tensions would escalate and Qualcomm’s failed acquisition of NXP would not be the last casualty in this spat. Every major US and Chinese company and asset would become fair game and everyone loses – China more than the US we suspect.

Earlier this year, President Trump announced broad based tariffs on steel and aluminium imports. Following the announcement, however, there were clear signals given by his administration that many of the US’s allies would be granted exemptions. Given that this not only did not happen but that the tariffs were fully imposed on US allies, we assign a very low probability to the rosy scenario materialising.

Instead, we expect Mr Trump to keep upping the ante on trade, irrespective of the counterparty, right up until the mid-term elections. And only expect a coherent strategy on trade to materialise after the elections.

Uranium: Extension of Cameco’s Facility Shutdowns

In November last year, Cameco Corporation, the world’s largest publicly traded uranium mining company, announced that it was temporarily suspending production at two of its northern Saskatchewan facilities – Key Lake and McArthur River – for a period of ten months. The decision was driven by the oversupply of uranium and low market prices that have persisted ever since Japan shut down its nuclear reactors following the radiation leaks at Tokyo Electric Power’s Fukushima Daiichi nuclear plant in 2011.

Taking Cameco’s lead, Kazatomprom – Kazakhstan’s state-owned uranium mining company and the world’s largest natural uranium producer – announced in December last year that it would cut production by 20 per cent, representing 7.5 per cent of total global supply, over the next three years.

The impact of these two announcements was to send both uranium spot prices and share prices of listed uranium miners sharply higher. The euphoria did not last long, however. Spot prices gradually drifted lower, falling from just under US dollars 25 per pound at the start of the year to under US dollars 21 per pound by late April. And the stock prices of many of the uranium miners fell below where they traded prior to Cameco’s announcement in November.

As spot prices fell, expectations that Cameco would extend the shutdown of its two Saskatchewan facilities started to grow. And Cameco has not disappointed, announcing on Wednesday after market, along with its quarterly results, that it would be suspending production at the two mines ‘indefinitely’ and does not plan to resume production at the site until the company can commit its ‘production under long-term contracts that provide an acceptable rate of return’.

The corollary of the extended suspension is that Cameco will be a buyer of up to 14 million pounds of uranium from the spot market (or otherwise) over the next 18 months to fulfil its commitments under on-going contracts.

Prior to their quarterly earnings call on Thursday morning, Cameco’s shares in pre-market trading were marked at 7 plus per cent below their closing price on Wednesday evening. Cameco shares closed up 3.4 per cent by end of trading on Thursday and spot uranium prices jumped 6.2 per cent to year-to-date highs at US dollars 25.65 per pound.

The malaise in the uranium sector may turn out to be much worse than Cameco’s management anticipating and the rally in the spot could well prove to be fleeting once again. If, however, uranium spot prices can push above US dollar 26.25 per pound, the highs recorded in 2017, they have significant room to run much higher.

For now we remain long select uranium miners as well as commodity pure play Uranium Participation Corporation $URPTF.

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.

The Crisis Everyone Knows About

“There are decades where nothing happens; and there are weeks where decades happen.” – Vladimir Lenin

“There cannot be a crisis next week. My schedule is already full.” – Henry Kissinger

“When written in Chinese, the word ‘crisis’ is composed of two characters. One represents danger and the other represents opportunity.” – John F. Kennedy

“The crisis of today is the joke of tomorrow.” – H. G. Wells

On Tuesday President Donald Trump met with North Korean leader Kim Jong-un in Singapore and offered a significant concession: to halt the “tremendously expensive” joint US-South Korean military exercises. The North Korean leader in turn committed to the “complete denuclearisation of the Korean Peninsula”. While we think the meeting is a positive step towards reducing tensions in the Korean Peninsula, we remain sceptical – after all the US just recently did an about turn on the Iran nuclear deal and announced fresh sanctions on the Persian state. We suspect, with the possibility of US military action against North Korea diminished, that China and South Korea are the only parties truly satisfied with the outcome of the Trump-Kim summit.

On Wednesday the Federal Reserve raised the Fed funds target rate by 25 basis points to a range between 1.75 per cent and 2 per cent. At the same time it also increased the interest rate on excess reserves (IOER) – the interest the Fed pays on money placed by commercial banks with the central bank – by 20 basis points to 1.95 per cent. Finally, the Federal Open Market Committee (FOMC) raised its median 2018 policy rate projection from 3 hikes to 4.

The change in the policy rate projection from 3 to 4 hikes is not as significant as the headlines may suggest – the increase is due to one policymaker moving their dot from 3 or below to 4 or above. In fact, the mean 2018 rate increase is only 5 basis points. The median number of 2019 rate hikes remains at 3, while for 2020 one rate hike was removed and the median projection is now at 2 hikes.

On Thursday the European Central Bank (ECB) after holding a two-day Governing Council session in Riga announced its decision to halve the size of monthly asset purchases to €15 billion after September and end its asset purchase program by the end of the year. As a reminder, the ECB had already started implementing a step-by-step exit from its bond buying as follows:

First, in December 2016, the ECB announced that its monthly purchases would decline from €80 billion to €60 billion as of April 2017 until yearend.

Second, in October 2017, the ECB announced that the monthly purchases would fall to €30 billion as of April 2018 until at least September of this year.

Third, in March 2018, removed its easing bias by omitting in its statement a reference to the possibility of bigger bond purchases.

The ECB did not tighten monetary policy, however, and is committing to keeping interest rates at record lows for another year by adding that it expected rates to “remain at their present levels at least through the summer of 2019.”

Lastly ahead of the small matter of the FIFA World Cup kicking off in Russia on Thursday with the host nation playing against Saudi Arabia, Messrs Vladimir Putin of Russia and Mohammed bin Salman of Saudi Arabia had a meeting. The state of the oil market was unsurprisingly a key talking point during the meeting, what with the OPEC meeting in Vienna next week and Trump demanding concessions on OPEC-NOPEC supply constraints.

The events of this week may have brought about much for market participants to digest and could well shape the way markets play out over the remainder of the year. For now and in terms of prospects of global equity markets and the US dollar we, however, think that the events of this week only matter at the margin and that the prevailing trends remain intact.

Investment Perspective

As is the financial media’s wont, Fed and ECB pronouncements are followed by a flurry of commentary and analysis on the ramifications of the central bankers’ statements. In the flood of digital ink commentaries warning of either (1) a stock market crash that is surely to follow due to the major central banks shrinking their balance sheets, or (2) a US dollar shortage that will undoubtedly squeeze emerging markets, have become almost customary.

We address the concerns of tightening monetary policy leading to a stock market crash with some historical context. In 1928, the Fed started raising interest rates, taking them from 3.5 per cent in January to 5 per cent by July. Concurrently, the FOMC proceeded to drain excess reserves from the US banking system.

Instead of the stock market crashing, the Dow Jones Industrial Stock Price Index proceeded to increase by 82 per cent between 1 January 1928 and 1 September 1929. To further contextualise the performance of the stock market, the index had already increased by 160 per cent between 1 January 1918 and 1 January 1 1928, excluding dividends.

Dow Jones Industrial Stock Price Index DJI 1928.png Source: Federal Reserve Bank of St. Louis

Reiterating our message from The Bull Market is Not Dead from earlier this year, we consider the equity market sell-off in the first quarter of this year to be a correction and not the end the of the bull market. Adding to that, we think it is not the recent actions of the Federal Reserve or the ECB that will bring this bull market to an end, instead it will be a speculative over extension of the market driven by excessive optimism and greed that will lead to the eventual market crash. For now we maintain our expectation that the US equity markets will record significantly higher new highs before the party is over.

Stay long US equities.

The issue of a US dollar shortage is a little more complex. It is something both the IMF and the Bank for International Settlements (BIS) have repeatedly warned about. The warnings have been prompted by the Fed undertaking quantitative tightening and the Trump Tax Plan, which removes the tax loophole corporations exploited by keeping US dollar abroad. The argument goes that these two US-centric developments will result in US dollars fleeing from international markets and into the US. This analysis is not wrong, data from the Institute of International Finance shows that investors pulled out more than US dollar 12 billion out of emerging debt and equity markets in May this year.

While we acknowledge that short-term risks can arise due to US dollar shortages, we consider the risk of a broad based US dollar funding shortage to be technical not endemic in nature. And technical risks by design can be fixed by a few strokes of the pen. Again, we turn to history for some context. In October 2008, at the height of the global financial crisis, the Fed authorised temporary arrangements extending US dollar 45 billion in liquidity to New Zealand, Brazil, Mexico, South Korea and Singapore. Around the same time, the IMF launched a short-term financing fund to help emerging market economies weather the global credit crisis.

If there truly is a US dollar funding crisis, the Fed will find a technical solution to a technical problem. For now, we agree with the Fed in that there are no major concerns around US dollar funding in international markets. We quote from the minutes of FOMC’s meeting in May this year (emphasis added):

“While term LIBOR (London interbank offered rates) had widened relative to comparable maturity OIS (overnight index swap) rates in recent months, the cost of dollar funding through the foreign exchange swap market had not risen to the same degree. Recent usage of standing U.S. dollar liquidity swap lines had been low, consistent with a view that the recent widening in LIBOR–OIS spreads did not reflect increased funding pressures or rising concerns about the condition of financial institutions.”

Do not short emerging market currencies. Short the US dollar instead.

If you have questions about this post or generally on our views, feel free to email us or message us on Twitter at any time.

The Price of Growth

“To act wisely when the time for action comes, to wait patiently when it is time for repose, put man in accord with the tides. Ignorance of this law results in periods of unreasoning enthusiasm on the one hand, and depression on the other.” – Helena Blavatsky, Russian esoteric philosopher, and author who co-founded the Theosophical Society in 1875

“Intelligence is the ability to adapt to change.” – Stephen Hawking

“As soon as you stop wanting something, you get it.” – Andy Warhol

One of the universally accepted ideas in sport is that of home court advantage. The idea, after all, is not a difficult one to accept: Home teams have the crowd behind them, cheering them on, filling them with confidence; visiting teams, on the other hand, have to deal with the home crowd’s hostility, which saps energy. And the stats seemingly reinforce the idea. For example, over the course of the NBA’s history, home teams have won roughly 60 per cent of the games played in almost any given season.

The crowd is powerful.

When it comes to capital markets, the crowd has unquestionably been cheering on growth and mocking value. Leaving many a value investor confounded by the apparently unstoppable rise in the likes of Netflix, Amazon, and NVIDIA. While valuations may be stretched and fundamentals in some cases appear questionable, if we take a step back and consider the secular trend, the continued outperformance of technology becomes less puzzling.

Plotting total business sales of US corporates against the ratio of Nasdaq 100 Index to the S&P 500 Index, we find a strong correlation – 74.1% using monthly data – between the two data series. That is the outperformance of the technology focused Nasdaq 100 Index relative to the broader S&P 500 Index is positively correlated with US business sales.

Total US Business Sales versus Nasdaq 100 Index to S&P 500 Index Ratio Sources: Federal Reserve Bank of St. Louis, Bloomberg

Given the latency between data releases, this relationship does not provide a trading signal. The relationship, however, does appear to suggest that US business sales growth has largely been dependent upon the growth in sales at technology companies and the market accordingly has rewarded technology stocks.

Our goal here is not to espouse the merits of investing in technology or in growth. Instead, we want to focus on what we consider to be the most interesting part of the above chart – the period from 2003 through 2006. During this period US business sales grew strongly yet the ratio between the two indices flat lined i.e. the S&P 500’s price performance roughly matched that of the NASDAQ 100.[i]

Digging a little deeper, we plot the ratio of per share sales of the S&P 500 to per share sales of the NASDAQ 100 against the relative price performance of the NASDAQ 100 Index to the S&P 500 Index. Zooming in on the period between 2003 and 2007 we find that the comparable price performance of the two indices during this period coincided with the quarterly fluctuations in per share sales also being comparable. Similarly, during the years of significant relative outperformance by the NASDAQ 100 Index, we find that per shares sales of the index were increasing relative to the per share sales of the S&P 500 Index.

Nasdaq 100 Index T12M Sales to S&P 500 Index T12M Ratio (Quarterly Data)Source: Bloomberg

Next, we consider the relative performance of S&P 500 Growth Index to that of the S&P 500 Value Index. Comparing the performance of these two indices we find that while the Nasdaq 100 Index and S&P 500 Index achieved comparable performance during the period from 2003 through 2006, the value index significantly outperformed the growth index during this period. The value index peaked relative to the growth index in 2007.

Ratio of S&P 500 Growth Index to S&P 500 Value Index (Monthly Data)Source: Bloomberg

At the time of the dotcom bubble the ratio of the growth index to the value index, on a monthly basis, peaked at 1.56. Today the ratio stands at 1.47.

The crowd may well be at the cusp of switching loyalties.

We look for clues in and around the period between 2003 and 2007 to help us determine whether the time for value is coming or not.

The cyclical low in the effective US Federal Funds Rate registered a cyclical low in 2003.

US Federal Funds Effective RateSource: Bloomberg

The Commodity Research Bureau All Commodities Spot Index registered a cyclical low in 2001 and MSCI Emerging Markets Index started its multi-year ascent in 2003.

CRB Spot All Commodities IndexSource: Bloomberg

MSCI Emerging Markets IndexSource: Bloomberg

The US dollar had its cyclical peak in 2002, the same year in which the Bush Administration imposed tariffs on imported steel.

In 2004, Congress approved a one-time tax holiday for US corporations repatriating overseas profits.

In 2005, George Bush signed a USD 286 billion transportation bill.

If we compare the events and market action that preceded and coincided with the relative outperformance of value during the years from 2003 to 2007 to that of today, we find many similarities across both policy-making and market action. With growth’s outperformance relative to value reaching levels last seen during the very same period, the signs are difficult to ignore. It may not be time to bail on growth as yet, but it certainly is not the time to have a 100 per cent allocation to it either.

Investment Perspective

Human nature is such that we desire that which is rare and take for granted that which is common. In the recent past growth has been elusive – and that which has been available has been heavily concentrated in the US and in technology. It is no wonder then that investors have rushed into US technology names without abandon.

Growth is no longer as elusive. We can find growth in Asia, Europe and other parts of the emerging world and across both old industries and new. With its abundance the price of growth should de-rate. Value, however, has become hard to find and it is this scarcity of value, we believe, that will bring about the inevitable shift in market leadership away from technology to other sectors.

Forewarned is forearmed.

[i] The total return for the NASDAQ 100 Index for the period was 80.9% versus 74.05% for the S&P 500 Index.

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The Bull Market is Not Dead.

“Bulls do not win bull fights. People do.” – Normal Ralph Augustine

“Stocks fluctuate, next question.” – Alan Greenberg, former CEO and Chairman of the Board of Bear Stearns, in response to questions about the crash, October 22, 1987

“If you have trouble imagining a 20% loss in the stock market, you shouldn’t be in stocks.” – Jack Bogle

November last year, in Volatility Selling and Volatility Arbitrage Ideas Using Equities, we wrote:

Based on the tenets of Prospect Theory, the popularity of short volatility strategies is somewhat confounding. By investing in such strategies, investors are underweighting as opposed to overweighting a low probability event (a market crash). At the same time, they are giving preference to negative skewness, favouring small gains at the risk of incurring large losses.

During October, 2017, the VIX recorded its lowest monthly average since the launch of the index dating back to January, 1993. What makes this statistic even more remarkable is that autumn months are generally more volatile with October being, on average, the most volatile month during the year. The average level of the VIX for October, starting 1993, is 21.8 – more than double the 10.1 averaged last month.

…

With all that being said, we do consider the short volatility trade to be richly valued. That does not mean we expect the equity market to crash, instead the differential between implied and realised volatility has tightened to such a degree that this gap can easily close and invert. The trade can become loss making without a meaningful correction in equity markets.

Poorly structured short-volatility products and the limited – almost non-existent – down-side risk to going long volatility has, in our opinion, led to the emphatic short-squeeze in volatility witnessed over the last ten days or so. The tail has well and truly wagged the dog. That is, higher volatility has led to the sharp correction in the market. Not the other way round. The late-afternoon equity sell-off on Monday 5 February is indicative of as much.

S&P 500 Index on 5 February, 2018 SPX 5 Feb Source: Bloomberg

XIV, SVXY and other products of their ilk are not the first, and are almost certainly not going to be the last, poorly conceived investment products to blow-up. Think back to portfolio insurance, synthetic collateralised debt obligations (CDOs) and CDO-squared as a reminder. There has been plenty of commentary, and no shortage of memes, lambasting regulators of and speculators in short-volatility products alike – many of the critics make valid arguments that should give regulators pause for thought. For investors the time, however, is not to reflect on the flaws of these products but rather to focus on whether the blow-up of these products can lead to a contagion into adjacent markets or is this just a shake-out of weak hands.

The most convincing argument for the recent correction being a shake-out of weak hands comes from the US corporate bond market. US corporate spreads have been benign in the face of the recent spike in volatility – a first in a very long-time.

US Corporate Yield Spreads vs. VIX Index Corporate yields and VIX Source: Bloomberg

The narrative of rising inflation expectations leading to the correction in equity market has taken hold in some quarters. Firstly, looking at the USD 5-year, 5-year inflation swap rate, there has not been a sharp increase in market-based inflation expectations. In fact, the increase in inflation expectations was much sharper immediately after Trump won the election than at any time during the last year. Secondly, high inflation does not negatively affect equities. If inflation is high but stable, it is nominally positive for equity markets and is unlikely to cause any damage to the real economy. Moreover, historical data suggests that the highest levels of price-to-earnings multiples are witnessed during periods when inflation ranged from 2 to 3 per cent.

An unexpected acceleration in inflation followed by unanticipated changes in monetary policy, however, can have significant negative consequences for the economy. The Fed, to date, has not shown any signs of panic. As long as the Fed continues on the path of slow and steady rate hikes, we do not expect Fed rate hikes to derail the economy or the equity market. If, however, the US economy overheats in response to the recently passed tax reforms and the tight labour market, the Fed may be forced to react aggressively, which could be catastrophic for both the economy and equity markets.

USD 5-Year, 5-Year Inflation Swap Rate 5Y5Y Source: Bloomberg

The one change coming out of the recent sell-off, in our opinion, is that volatility has made its secular low. We suspect that retail investors are unlikely to return to short volatility in droves. We also have a hunch that private banks and wealth managers will not be offering short-volatility products to their high-net worth clients any time soon. Volatility, therefore, should stabilise closer to its longer-term average – we do, however, expect volatility to be structurally lower than the past due to the increased prevalence of passive and systematic strategies, which implicitly dampen volatility during a stable market environment.

A necessary corollary of higher volatility is that investors have to be more discerning in security selection. Active management may soon be back in vogue.

Investment Perspective

In the after-math of the recent market sell-off we have heard market legends claim that “macro is back” or that it is an “exciting turn for macro trading”. At the same time, we have heard old hands speak of the trauma of 1987 and how it shaped their approach to markets going forward. What we do not hear or read of enough though is that as traumatic as 19 October, 1987 was, it was also the buying opportunity of a generation. The S&P 500 compounded at an annualised rate of 18.9 per cent over the next ten years.

We do not expect returns from equity markets for the next ten years to be like those witnessed between 1987 and 1997. We, however, also cannot ignore that global equity markets had a major break out last year.

MSCI All Cap World Index MSCI ACWI Source: Bloomberg

We have one simple, singular thought when it comes to equity markets today. Until we come across evidence to the contrary, we think investors should figure out what they want to own and buy it with both hands.

Beyond the Minsky Moment: The Wisdom of Crowds or the Madness of Mobs?

“I must say a word about fear. It is life’s only true opponent. Only fear can defeat life. It is a clever, treacherous adversary, how well I know. It has no decency, respects no law or convention, shows no mercy. It goes for your weakest spot, which it finds with unnerving ease. It begins in your mind, always … so you must fight hard to express it. You must fight hard to shine the light of words upon it. Because if you don’t, if your fear becomes a wordless darkness that you avoid, perhaps even manage to forget, you open yourself to further attacks of fear because you never truly fought the opponent who defeated you.”

– Excerpt from Life of Pi by Yann Martel

Doctor: You do not fear death. You think this makes you strong. It makes you weak.

Bruce: Why?

Doctor: How can you move faster than possible, fight longer than possible, without the most powerful impulse of the spirit? The fear of death.

Bruce: I do fear death. I fear dying in here while my city burns. And there’s no one there to save it.

Doctor: Then make the climb.

Bruce: How?

Doctor: As the child did – without the rope. Then fear will find you again.

― The Dark Knight Rises (2012)

The Minsky Moment – a term coined by Paul McCulley of PIMCO that refers to the central concept underlying American economist Hyman Minsky’s theory on the inherent instability of financial markets – has been ubiquitously quoted by just about every major research publication and financial periodical in the aftermath of the Global Financial Crisis. Based on yesterday’s market action, we may have just witnessed another Minsky Moment. And it was not pleasant. Many of you will have experienced fear – we certainly did – and felt your neurologically programmed fight or flight reflex kick-in. While fight or flight responses have their benefits, such responses tend not to be helpful at times of stock market crashes. We overrode our urges to react, turned off our screens, silenced our Twitter feed and spent the rest of the day reading – everything and anything except the financial news.

As we immersed ourselves, once again, into the frantic and frenzied world of financial markets this morning some of the reactions from the media, sell-side, FinTwit and the like have been predictable, the usual suspects – risk parity funds, the Fed, Goldman Sachs, the US government and algorithmic traders – have all been blamed in one form or another. The question, for market participants, however, is not whose fault it is but what, if anything, should we be doing with our portfolios at this juncture.

In the process of portfolio construction we, as analysts, make, in effect, choices amongst several different competing hypotheses. Analysis of competing hypotheses involves:

identifying the evidence and assumptions with diagnostic value in assessing the likelihood of each hypothesis; and

outlining future milestones that may indicate whether events are following the expected path or not.

In our opinion, one’s view on the medium-term direction of the US dollar is central to the type of portfolio that one constructs today. So the hypothesis and its alternative in this case are:

Hypothesis: We are in a structural lower US dollar environment

Alternative hypothesis: The US dollar has bottomed and is headed higher

Over the last few months we have written about or initiated trade ideas related to a number of themes, most notably Europe’s domestic recovery, the potential for a strong rally in agriculture commodities, rising inflation in the US and higher oil prices. Central to all of these investment themes is the view that we are in a structurally lower US dollar environment. This view is predicated on a number of factors, including but not limited to:

The US faces a public pension funding gap estimated to be USD 3.85 trillion. This funding gap may never be filled but it certainly will not be filled if we have a strong US dollar and declining equity markets. History has shown time and again that elected officials and unelected rulers, alike, have long understood the benefits of tampering with the value of their currency. Given the choices available we expect President Trump to be an advocate of a weak dollar policy. A weaker dollar improves the profitability of US large caps, which in turn should be supportive of equity markets.

The weakening of the US dollar over the course of 2017 suggests that both US growth and higher short-term interest rates had been priced in; the market, however, did not fully appreciate the economic recovery underway in the rest of the world. The surprise was amplified by the prospects of earlier than anticipated tightening of monetary policy by the ECB.

The US budget deficit is forecast to exceed USD 1 trillion in 2019 and the Congressional Budget Office expects US budget deficits to continue to grow.

The US dollar is very much in a bear market at the moment. As with any bear market we should expect bear market rallies, which can be sharp and painful – especially when positioning is stretched in one direction. For our weak dollar hypothesis to be nullified we would need to see at least one of the following:

continued strength in the US dollar from now till the end of summer i.e. a period of at least six months;

a reversal in US fiscal policy; or

a sharp acceleration in monetary policy tightening by the Fed.

At this stage and given the sharp decline in the US dollar, cyclical rallies are par for the course. The recently enacted tax reform is likely to increase the flow of capital into the US and at the same time boost capital spending and the profitability of US companies. Moreover, if the Republicans are able to consolidate power in the mid-term elections, this too should temporarily strengthen the US dollar – somewhat counter intuitively we think a consolidation of power would strengthen the case of a weaker US dollar as President Trump would have more leeway in increasing fiscal deficits.

Investment Perspective

The question then is what type of portfolio should one have under a structurally weak US dollar environment. In broad strokes, our thinking is as follows:

US bonds have more value than other developed market bonds. Any bond allocation should be tilted towards the US with a bias towards shorter duration instruments.

International equities have more value than US equities. Use periods of intermittent US dollar strength to build positions in mid-cap equities in Europe and add to our exposure to Japan.

Within US equity markets, give preference to large caps over small- and mid-caps. A weaker dollar has an outsized impact on the profitability of large caps relative to domestically focused small and mid-cap businesses.

Commodity and commodity producers should benefit from a weaker dollar and, as previously discussed, higher capital spending arising both from the US and from China’s Belt and Road Initiative.

Oil, after speculative positioning re-adjusts to less frothy levels, should benefit from a lower US dollar and robust global demand.

Emerging markets to outperform developed markets.

In the final analysis, we consider the recent surge in market volatility as a signal for the shift in momentum as opposed to the start of a bear market. The analogue of the fifteen year US dollar cycle best captures our thinking:

Dollar Index Analogue – 15 Year Cycle (Normalised) DXY normalised Source: Bloomberg

Similarly, consider the fifteen year cycle analogue of the ratio of the MSCI Emerging Market Index to the S&P 500 Index.

MSCI EM Index to S&P 500 Analogue – 15 Year Cycle (Normalised) MXEF SPX Source: Bloomberg