$TLT Archives - LXV Research

Confusing the Cyclical with the Secular | The Iran-China Strategic Partnership

“The reason a lot of people do not recognize opportunity is because it usually goes around wearing overalls looking like hard work.” ― Thomas Edison

“The most important lesson I’ve learned is to understand and to trust abstractions. If you can learn both to see and to believe in life’s underlying patterns, you can make highly informed decisions every day.” ― Nathan Myhrvold, former Chief Technology Officer of Microsoft

Confusing the Cyclical with the Secular

We have, since late last year, been bullishly positioned in precious metals and have reiterated this view on several occasions over the course of this year. That being said, however, we are not of the view that precious metals have entered a new secular bull market and will be making a run for new highs, in US dollar terms, in the near term.

Similarly, in last week’s piece, we highlighted cyclical factors indicating that long-term US bond yields were likely to rise, in the near-term, as opposed to going even lower. Once again, this is a cyclical, not a secular, view.

Below we share two passages that provide a framework for understanding the conditions that would lead to a bond market rout and a new secular bull market in precious metals.

The following passage in an excerpt from The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money on the discussion between the author, Steven Drobny, and his (unrelated) colleague at Drobny Global Advisors, Dr. Andres Drobny (emphasis added):

Many people think there is a limit on public debt, but I am not so sure. Apart from a country constrained by a gold standard or fixed exchange rate, the only scenario where the government might bot be able to fund its debt is an inflationary scenario. However, the scenario only seems likely to emerge after the policies succeed in promoting growth. One of the reasons that a much-anticipated financing problem has never materialized in Japan is that reflationary policies failed to stimulate a sustained rebound and a return of inflation. Interest rates have remained low and fund the deficit has been surprisingly easy.

Consider what happens if the public debt and financing fears prove correct and bond markets start to tank. This is an issue that came up during a debate at our recent conference in London. Without inflation, rising nominal bond yields push up real yields and deflate the economy; bonds become more attractive again and buyers bring yields back down. Without inflation, it is hard to get a bond rout. It is only when inflation rises that government financing becomes a real and sustained problem for bond markets. That is when bonds no longer get cheaper as they sell off and nominal yields rise, which is when you get a real bond crisis.

The key takeaway from the above passage is that a secular turn in the bond market will only occur when rising nominal yields do not translate into rising real yields, that is when the rate of inflation outpaces the increase in nominal yields.

RR10CUS Index (Real 10 Year Yiel 2019-09-11 15-57-15.jpg

In the 1960’s and from the mid-1970’s through the early 1980’s, rising nominal yields in the US coincided with sharply declining real yields. Until such a disconnect begins to manifest, the secular bull market in bonds is intact.

The following passage in an excerpt from Peter Warburton’s essay The debasement of world currency: It’s inflation but not as we know it (emphasis added):

An excessive expansion of credit can create an environment where the factors of production — land, capital and labour services — appear to be in infinite supply. If sufficient (borrowed) financial resources are made available, then sterile, parched and polluted land can be fertilized, irrigated, cleaned up and turned to productive use. Similarly, more factories, kilns, assembly lines, steel mills, semiconductor plants and so on can be built using state-of-the-art technology. Idle and untrained workforces can be mobilized and organized into productive units. A rich country, with plenty of collateral assets against which to borrow, can indeed face a supply curve that is seemingly infinitely elastic. I can assure you that consumer price inflation will not be a problem for such an economy.

The United States still has plenty of collateral assets to borrow against. The US dollar hegemony may be on its last legs but there is no credible alternative making it still too early to bet against it.

BBDXY Index (Bloomberg Dollar Sp 2019-09-11 17-08-03.jpg

In the chart above, the magenta line is a custom index tracking the relative performance of US liquid assets (equities and investment grade bonds) to that of global liquid assets ex-US. The orange line is the Bloomberg Dollar Index ― the index is broader than $DXY, which is just a proxy for the EURUSD cross.

The continued out performance of US capital markets relative to the capital markets of the rest of the world is supportive of the US dollar and indicative of the superiority of US collateral relative to ex-US collateral.

The Iran-China Comprehensive Strategic Partnership

Speaking of the end of the US dollar hegemony, it was reported last week that Iran’s foreign minister Mohammad Zarif paid a visit to his Chinese counterpart Wang Li at the end of August to present a road map for the China-Iran comprehensive strategic partnership, signed in 2016.

As part of the deal, China will invest US dollars 280 billion in developing Iran’s oil, gas and petrochemicals sectors. There will be a further US dollars 120 billion of investments made by China in upgrading Iran’s transport and manufacturing infrastructure. Notably, the deal also includes “5,000 Chinese security personnel on the ground in Iran to protect Chinese projects, and […] additional personnel and material available to protect the eventual transit of oil, gas and petchems supply from Iran to China, where necessary, including through the Persian Gulf,” according to Iranian sources.

According to reports, the deal also includes a long-term commitment by China to buy Iranian oil. Based on these reports, Iran has agreed to sell its oil and gas to China at a guaranteed discount to prevailing market prices of at least 12 per cent, plus a further discount of up to 8 per cent to account for the risk ― presumably of a backlash from the US. China, of course, will pay for the oil in renminbi.

The benefits of the deal for Iran are obvious. It receives much-needed foreign direct investment. It secures a market for its hydrocarbon output. And secures a deterrent against possible military strikes by Israel or Saudi Arabia and its allies. Iran, though, does not simply want to be China’s discount oil dealer. It wants more, it wants a strategic alliance. Iranian foreign minister Mohammad Zarif penned an op-ed in the Global Times clearly articulating what Iran wants. It is unclear, however, if they will get it by “looking east”.

The benefits to China are somewhat mixed. Cheaper energy imports paid for not in US dollars but in local currency eases China’s dependence on the greenback and furthers its ambitions to form an independent monetary bloc. Buying Iranian oil and defying of US sanctions, on the other, is only likely to infuriate President Trump and further complicate ongoing trade negotiations.We see China’s willingness to defy US sanctions as a signal that its leadership is unwilling to do a deal with President Trump that it does not deem to be fair. By agreeing to buy Iranian oil, China is either hedging itself and preparing for a new economic reality or it is posturing to show strength in its negotiations with the US.

Aside from trade, the most interesting near term takeaway from China’s agreement to buy Iranian oil is that it did not lead to sharp pullback in the price of oil. Rather oil has moved higher, suggesting oil could move higher still.

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.

Safe Haven Bid: Ahead of Itself?

Marilyn: Thank you for coming over, Mr. Baer. Welcome back and forgive me if I wade right in, but forgetting for a second your bureaucratic checklist, I’m trying to get undigested information, so if you could give me a reading of the temperature over there?

India is now our ally. Russia is our ally. Even China will be an ally. Everybody between Morocco and Pakistan is the problem. Failed states and failed economies, but Iran is a natural cultural ally of the U.S. The Persians do not want to roll back the clock to the 8th century.

I see students marching in the streets. I hear Khatami making the right sounds. And what I’d like to know is if we keep embargoing them on energy, then someday soon are we going to get a nice, secular, pro-Western, pro-business government?

Bob: It’s possible. It’s complicated.

Marilyn: Of course it is, Mr. Baer. Thank you for your time.

Intelligence is the misnomer of the century.

Bob: They let young people march in the street and then the next day shut down fifty newspapers. They have a few satellite dishes up on roofs, let ’em have My Two Dads, but that doesn’t mean the Ayatollahs have relinquished one iota of control over that nation.

Distinguished Gentlemen: Mr. Baer, the reform movement in Iran is one of the President’s great hopes for the region and crucial to the petroleum security of the United States.

Terry George: These gentlemen are with the CLI.

Distinguished Gentlemen: The Committee for the Liberation of Iran, Mr. Baer

Bob: We’ve had Iran in embargo for almost thirty years, we backed their neighbor, a neighbor we invaded twice, in a ten year war against them, we’re hanging on by a thread with a massive occupation force, so I got news for you… Thomas Jefferson just ain’t that popular over there right now.

― Syriana (2005)

Iranian foreign minister, Javad Zarif, made a surprise visit Sunday to the the Group of Seven summit, meeting with a delegation including French President, Emmanuel Macron, as leaders grappled with how to defuse tensions and salvage the landmark nuclear deal after a US pullout.

Mr Javad Zarif did not meet with the US delegation in Biarritz, France, although President Trump has indicated that he is open to meeting Iranian officials without preconditions.

The narrative in the noughties when oil was rallying and the spectre of peak oil (supply not demand) was of popular concern ― the BBC even produced a film titled The Crude Awakening: The Oil Crash in 2007 to warn of the end of life as we know it because the world was running out of oil ― was that of the US’s need to ensure hydrocarbon security. Today, the narrative is that the world is awash with oil and the US is energy independent, affording President Trump the luxury to scrap the deal with Iran and to re-impose economic sanctions.

As it relates to oil, the truth lies somewhere in between the fears over peak demand and peak supply but almost never, barring a energy paradigm changing supply- or demand-shock, at the extremes.

As it relates to geopolitics, should oil prices rise sufficiently, driven by a flurry of bankruptcies in the US shale patch or US shale production plateauing, it would be of no surprise to see the US either return to the negotiating table with Iran or to ease sanctions.

The overarching consensus for oil appears to be that of lower oil prices. With some even calling for a crash to below the US dollars 30 per barrel level, that would lead to global deflationary bust. In our opinion, these calls seem premature. Rather, if anything, we see the greater risk being to the upside.

We often use the 48-month moving average, for commodities and major currency crosses, to guide our trading strategy. For now, WTI crude prices remain above the moving average, albeit just barely. Given the proximity of the current price to the moving average, the best course of action may be to be on the sidelines. That being said, as long as prices do not meaningfully breach the 48-month moving average, our bias is to be long in expectation of prices climbing the ‘Wall of Worry’ over the next 6 to 12 months.

USCRWTIC Index (US Crude Oil WTI 2019-08-26.png

Has the Safe Haven Bid Got Ahead of Itself?

In the below chart, the magenta line is the ratio of the price of gold to the Merrill Lynch 10-year Treasury Total Return Index. The orange line is that of core price index.

XAU Curncy (Gold Spot $_Oz) GL 2019-08-26 11-47-07

The US dollar price of gold, loosely an inflation hedge, rising relative to the 10-year Treasury index generally coincides with rising core inflation. There, of course, are periods that the ratio over- or under-shoots core inflation but over time the roughly coincident movement of core inflation and the gold-to-ten-year Treasury index tends to reassert itself.

In recent months we have seen safe haven assets, government bonds and precious metals, get bid up. Notably, gold has outperformed 10-year Treasury bonds in 2019 even as core inflation has witnessed a sharp drop. Between early 2017 and early 2018 we saw a similar dynamic play out, when long-term bond yields rallied (long bonds sold off) and gold remained steady while at the same time core inflation moved sharply lower.

In 2018, core inflation eventually moved higher and caught up with the gold-to-Treasuries ratio. Suggesting that markets had correctly anticipated the move higher in core inflation.

We will know in time if the markets have got it right again or not. If core inflation does not move higher, it is likely that the safe haven bid, specifically in gold and other precious metals, has gotten ahead of itself and investors are better off owning government bonds over precious metals.

With long-term bond yields near all-time lows, it is difficult to make a strong case for bonds, however.

The below chart is that of WTI crude (magenta) and gold (orange). The two commodity prices tend to, over the long-term, have the same directional move. Oil does not have the safe haven characteristics of gold and therefore has stronger moves than gold both to the up and down sides.

USCRWTIC Index XAU (US Crude Oil WTI 2019-08-26.png

Much like the relation between the gold-to-Treasuries ratio and core inflation, a gap has opened up between the price of gold and that of oil, much like it did in 2017. In 2018, the gap was closed with oil moving higher. Will that also be the case this time around?

Finally, the last chart in this week’s piece. This one compares the price of oil to core inflation.

USCRWTIC Index PCE.png

The price of oil is one of the primary drivers of core inflation, albeit with a lag. Should oil prices move higher from here, core inflation will be higher 6 to 12 months down-the-line; justifying the move higher in gold and likely proving the current rally in government bonds to be a bull trap.

On the other hand, if oil prices make new lows, gold should be sold in favour of government bonds.

The price of oil is probably the most important price in capital markets today. The next move in oil will drive many of key tactical decisions for asset allocators.

If oil moves higher, portfolios will be found to be lacking allocations to assets that do well in periods of rising inflation ― resource and mining companies, resource rich emerging markets, high yield credit and precious metals ―and over exposed to high duration assets such as loss-making technology companies as well as utilities and long-terms bonds.

If oil moves lower, the stampede into developed market government bonds, technology stocks and utilities is likely to continue unabated.

We will be following the oil price ever so closely hereon out.

Market Puzzles

“People who work crossword puzzles know that if they stop making progress, they should put the puzzle down for a while.” — Marilyn vos Savant, listed in the Guinness Book of World Records under “Highest IQ” from 1986 to 1989 and entered the Guinness Book of World Records Hall of Fame in 1988.

English engraver and cartographer John Spilsbury is said to have invented jigsaw puzzles during the second half of the eighteenth century. He was concerned, allegedly, with promoting a new way of teaching geography. We suspect, he is unlikely to have envisioned how his invention would evolve to become a form of entertainment for the masses.

Jigsaw puzzles as a form of entertainment for adults emerged around the start of the twentieth century and by 1908 a full-blown jigsaw craze had started in the United States which quickly spread across the Atlantic to Britain, and then around the world. The trend is said to have started in Newport, before spreading to New York, Boston and abroad. Adults across all rungs, except the very lowest, of society were sucked into the craze and puzzles became a primary form of entertainment in high society house parties in Newport and other country retreats. Although the fever eventually subsided, puzzles remained a regular source of adult amusement for the next two decades.

The onset of the Great Depression in 1929 coincided with a resurgence in the popularity of jigsaw puzzles. Sales are estimated to have peaked in early 1933 at a remarkable 10 million units per week. Puzzles, it seems, offered an escape from the financial woes of the times, as well as providing a sense of accomplishment during a time when jobs were hard to come by.

For us, price charts and evolving relationships between macroeconomic variables are the pieces of a puzzle we are continuously striving to put together in order to have a clearer picture of the market.

In this week’s piece we run through some charts and macroeconomic relationships that dominate our thinking at the moment.

US Credit Flows and the US Dollar

Prior to the Global Financial Crisis, the year-over-year change in the broad measure of US money supply, M2, was a very good proxy for trading the US dollar. Essentially, if the expectations were of credit to flow at a faster clip in the US economy, it paid to be long the dollar. If one the other hand, if the expectations were of credit conditions to tighten, it was better to be short the dollar.

The chart below plots an adjusted measure of year-of-year growth in broad US money supply, with the US dollar index, $DXY. The relationship worked swimmingly till the run up to the financial crisis. Following the crisis, there has been a disconnect that has largely remained.

DXYM2 wo ER

What we think changed following the crisis is broad money supply no longer being a suitable proxy for the flow of credit in the US economy. And the source of that change was the Fed’s large scale asset purchases in response to the financial crisis. The purchases were funded through the increase in reserve balances in excess of regulatory reserve minimum requirements. Essentially, the growth in the broad money supply following the crisis was not translating into increases in the flow of credit because banks were parking money with the Fed.

The below chart further adjusts the money supply time series for increases and decreases in the supply of excess reserves — the year-over-year growth (decline) in excess reserves is deducted (added) from (to) M2 to obtain a better estimate of the flow of credit in the US economy.

DXYM2 w ER

We think this chart captures the recent resilience of the US dollar. Although credit in its traditional forms, as depicted in the first chart, has remained tight, the draw down of excess reserves due to quantitative tightening has supported broad money supply growth. This in turn has been, we think, supportive of the greenback.

Given this adjusted metric, we can now hypothesise on the ways forward for the dollar.

For now, given the Fed’s intention to stop shrinking its balance sheet from September onward, the dollar’s continued resilience will hinge upon other sources of growth in credit. The reemergence of President Trump’s infrastructure bill could be one such source — should it materialise, it is likely to draw capital to the US from the rest of the world and push the dollar to new highs. Till it transpires, however, the risk-to-reward ratio is not in favour of dollar bulls.

Large scale infrastructure spending in the US may also be the scenario under which commodities and the dollar strengthen in sync while US Treasuries do poorly.

Emerging Markets

Given the crackdown on shadow banking in China, the waxing and waning of Chinese shadow financing is no longer a primary driver of emerging markets.

MXEF Index (MSCI Emerging Market 2019-04-11 15-37-39.png

Standalone and relative to the S&P 500, emerging markets do not look bearish at an aggregate level.

MXEF Index (MSCI Emerging Market 2019-04-11 15-38-38

Russia is increasingly looking like the market to own in emerging markets. (The bottom panel is the MSCI Russia Index relative to the MSCI Emerging Markets Index.)

MXRU Index (MSCI Russia Index) R 2019-04-11 15-55-30.png

The gains in oil this year, however, have not fully been reflected in the Russian equity market’s performance. (The bottom panel is the MSCI Russia Index relative to WTI crude.)

MXRU Index (MSCI Russia Index) R 2019-04-11 16-54-28.png

While those long $ARGT should be looking to sell into Argentina’s inclusion into the MSCI Emerging Markets Index at the end of May.

ARGT US Equity (Global X MSCI Ar 2019-04-11 15-56-57.png

London-based emerging markets asset manager, Ashmore Group $ASHM.LN, has had a great run even relative to the emerging markets index. It is up 30.3% year-to-date in US dollar terms.

ASHM LN Equity (Ashmore Group PL 2019-04-11 16-02-52.png

Long Term Yields in China and the US

The below chart compares China’s purchasing managers’s index (advanced by three months) to the yield on 10 year Chinese government bonds.

Despite China’s inclusion into global bond benchmarks and record foreign inflows, yields are no longer moving lower suggesting that long-term yields in China may have bottomed — the recent pickup in PMI indicates as much as well. If yields have bottomed, or close to it, it is also likely that economic activity in China, too, is set to pick up.

GCNY10YR Index (China Govt Bond 2019-04-11 16-17-13

Long-term yields in China have over the last decade largely mirrored movements of long term yields in the US. If Chinese yields have bottomed and economic activity is picking up, we would not be surprised to see US long-term yields move higher from here as well.

GCNY10YR Index (China Govt Bond 2019-04-11 16-13-38

China Shadow Banking | US Foreign Funding

“[H]ope is by nature an expensive commodity, and those who are risking their all on one cast find out what it means only when they are already ruined.” – Thucydides, The History of the Peloponnesian War

“Narrative is linear, but action has breadth and depth as well as height and is solid.” – Thomas Carlyle

Continuing on from last week, we share more market observations that have caught our attention as we think about investment ideas and themes for 2019. This piece, too, will be chart heavy.

Please note this will be this year’s last weekly update, we will be back with our next piece during the first week of January.

China Shadow Banking

China’s leadership, at the end of last year, made it abundantly clear that reining in financial risk was an economic priority for the next three years. With the centenary of the founding of the Communist Party of China (CCP) in 2021, Chinese leadership would be loathe to witness the run up to the milestone be marred by an economic collapse precipitated by spiralling debt.

About the CCP it is sometimes said “to watch what they do and not what they say”. At least in this instance, they have done exactly as they said they would.

Chinese shadow finance has collapsed and there are no signs of reprieve – the drop in shadow finance has not been cushioned by stimulative fiscal policies undertaken by the central government. Monetary policy, too, has remained neutral for much of the year. It is only in recent months that we have seen some loosening of monetary policy at the margin with the reduction in reserve requirements for banks.

According to Reuters, by the end of September, 25 Chinese issuers had defaulted on
payments for 52 bonds worth a total of 60.6 billion yuan. Compared with 20 issuers defaulting on 44 bonds worth 38.5 billion yuan during 2017, and 35 issuers defaulting on 79 bonds worth 39.9 billion yuan in 2016.

China Shadow Banking

The Chinese leadership’s resolve in sticking to its financial de-risking policy is being tested by both the Trump Administration’s hawkish trade policies and, what we suspect is, a much sharper slow down in credit growth and economic activity than anticipated. Despite the economic challenges, we do not think the CCP will relent – at least not when it comes to shadow banking. Too much effort has already gone into scaling back shadow finance and slowly ridding the system of bad actors.

Emerging Markets

The fortunes of emerging markets are closely intertwined with those of China – the Mainland is, of course, the leading trade partner of the majority of emerging markets. With the collapse of shadow financing and economic slowdown in China, we have seen emerging markets fall quickly out of favour amongst investors. At the end of November, the MSCI Emerging Market Index was down 12.2 per cent for the year.

MXEF Index (MSCI Emerging Market 2018-12-14 14-08-40.jpg

In last week’s piece we highlighted that we are seeing initial signs that emerging markets may well have formed an interim bottom in October and are well placed to outperform US markets in 2019.

How do we then reconcile our expectation of emerging market out performance in 2019 with the continuation of financial de-risking in China?

Consider the following chart, which plots the 12 month moving average of year-over-year Chinese social financing growth with the Commodity Research Bureau (CRB) Spot Raw Industrial Commodities Index. The three instances since 2007 when Chinese social financing growth has bottomed and accelerated have each been preceded by a bottoming of the CRB Index.

The CRB Index peaked in January and witnessed a sharp drop from May on-wards. Recently, however, the index has started to rise again. While it is early days still, the rising CRB Index may be indicative of China once again beginning to stimulate its economy.

Instead of social financing picking up, however, we may have to look for confirmation elsewhere.

In August, China’s Ministry of Finance said local governments should complete no less than 80 percent of their special bond issuance quota by end of September. Local governments in China issue special bonds for such purposes as highway projects and shanty town redevelopment. Local governments were set a quota of 1.35 trillion yuan of special bonds issuance this year. During the first half of the year, however, local governments had utilised less than 25 per cent of their quotas.

We will be monitoring infrastructure investment growth and local government bond issuance closely to anticipate a recovery in Chinese economic activity and by extension to time an entry into emerging markets.

China Infrastructure Investment YoY

Infrastructure investment and local bond issuance aside, the Chinese economy has received some much needed relief from the recent drops in oil and semiconductor prices. In 2017, China spent US dollars 260 billion semiconductors imports, according to the China Semiconductor Industry Association. In comparison, China spent US dollars 162 billion on importing oil.

ISPPDR37 Index (inSpectrum Tech 2018-12-14 18-59-38.jpg

US Foreign Funding and US Dollar Implications

In “Is the United States Relying on Foreign Investors to Fund Its Larger Budget Deficit?“, a piece issued on the Federal Reserve Bank of New York’s Liberty Street Economics blog, the authors write (emphasis added):

“Data for the first half of 2018 are available and, so far, the country has not had to increase the pace of borrowing from abroad. The current account balance, which measures how much the United States borrows from the rest of the world, has been essentially unchanged. Instead, the tax cut has boosted private saving, allowing the United States to finance the higher federal government deficit without increasing the amount borrowed from foreign investors.”

Just because the US has been able to rely on higher private savings to fund its deficit this year does not mean it will be able to continue to fund deficits without increased foreign participation. The authors speculate:

Of course, these are early days and it will be interesting to see how the increase in business saving will play out. For example, the increase in that saving component may diminish over time, perhaps because firms pass on some of their profit boost from lower taxes to their customers via a drop in markups. Firms could also use their higher after-tax income for salary increases in the current tight labor market. A third possibility is for firms use the jump in saving to increase their capital stock through higher investment spending. Indeed, this perspective suggests that a deterioration in the trade balance is a sign that firms are passing on the gains from the tax cut to their employees and consumers.

Finally, the additional downward pressure on government saving going forward will be from higher spending. It may turn out that future drops in government saving from higher spending translate more directly into higher borrowing from abroad.

As we have argued in the past, a rising US dollar environment and add to it a shortage of US dollar funding for non-US borrowers, which increases borrowing and hedging costs, are not the conditions under which foreign institutional investors increase their participation in US Treasury instruments. We are already witnessing Japanese institutional investors scaling back their exposure to US Treasury instruments.

The below chart shows the cumulative Japanese portfolio flows into the US:

Japan Cumulative Portfolio Flows US.jpg

The US’s current account balance has been unchanged despite Japanese outflows because of higher oil prices. Middle Eastern oil exporters have recycled their petrodollars back into US Treasury instruments as oil prices have exceeded their fiscal break-even levels this year. With oil prices having corrected recently, however, Middle Eastern participation is likely to diminish.

If, indeed, the US ends up requiring foreign participation to increase to fund its deficits we expect one or both of the following to happens:

1. The US Treasury will start spending from its General Account – much like it did in late 2016 / early 2017 in anticipation of a potential government shutdown – and this will release much needed US dollar liquidity into the global banking system.

2. The Fed starts offering foreign central banks unlimited (or very high) quantities for US dollar swap lines much like it did in the aftermath of the global financial crisis. The Fed has the ability to fix the quantity of US dollars available, this results in the price of US dollars rising when demand for US dollars rises, or fix the price of US dollars, this results in unlimited availability of US dollars. Today the Fed fixes the quantity of US dollars available not the price.

Both of the above would be US dollar negative and would provide a signal to short $DXY / go long emerging market currencies.

TGA DXY

The Hawks Have Not Left the Building

“Difficulties are meant to rouse, not discourage. The human spirit is to grow strong by conflict.” – William Ellery Channing

“Very few negotiations are begun and concluded in the same sitting. It’s really rare. In fact, if you sit down and actually complete your negotiation in one sitting, you left stuff on the table.” – Christopher Voss

The Hawks Have Not Left the Building

A “typical feature of conflicts is that […] the intergroup conflict tends to be exacerbated and perpetuated by intragroup conflicts: by internal conflicts within each of the two contending parties. Even when there is growing interest on both sides in finding a way out of the conflict, movement toward negotiations is hampered by conflicts between the “doves” and the “hawks” –or the “moderates” and “extremists” –within each community”. So wrote Herbert C. Kelman, the Richard Clarke Professor of Social Ethics, Emeritus at Harvard University, in Coalitions Across Conflict Lines: The Interplay of Conflicts and Between the Israeli and Palestinian Communities.

Kelman – renowned for his work in the Middle East and efforts to bring Israel and Palestine closer towards the goal of achieving peace in the Middle East – identifies, in the paper he authored in 1993, the “relationship between intergroup and intragroup conflict” as a key hurdle towards building coalitions across conflict lines. According to Kelman, “doves on the two sides and hawks on the two sides have common interests”. The hawks, unlike the doves, can pursue their interests without the need to coordinate with their counterparts on the opposing side. The hawks simply “by engaging in provocative actions or making threatening statements” reaffirm the enemy’s worst fears and embolden the hawks on the opposing side. The doves, on the other hand, “tend to be preoccupied with how their words will sound, and how their actions will look, at home, and with the immediate political consequences of what they say and do.” Therefore, the doves tend to take a more measured approach in communicating their views and underplay their side’s willingness to negotiate – the kind of behaviour that plays right into the hands of the hawks and reduces the effectiveness of the doves

Kelman’s recommendation to increase the chances of resolving a conflict by means of negotiation is to facilitate greater coordination between the doves on the opposing sides and minimise the involvement of the hawks.

The lessons from Professor Kelman’s work, we think, are highly relevant today. His insights provide a framework for determining the possibility of success in each round of negotiations between the US and China in resolving the on-going trade dispute.

Subsequent to the working dinner between President Trump and President Xi in Buenos Aires following the G20 summit, the headlines have focused on the temporary ceasefire in the trade dispute. President Trump has pledged to suspend the increase in tariffs on US dollars 200 billion of Chinese imports that was to go into effect on 1 January 2019 for a period of up to 90 days. In return President Xi has pledged that China will buy more US goods, ban exports of the opioid drug, and offered to reconsider the Qualcomm-NXP merger that failed to receive regulatory approval in China earlier in the year.

The three-month period, before the suspension of the tariff increase lapses, provides the two-sides a window of opportunity to initiate a new round of talks to tackle some of the more sensitive issues surrounding the trade dispute, including ownership and access to technology and intellectual property.

Despite the announcements lacking details, capital markets have reacted positively to the news of the temporary ceasefire and the Chinese yuan, on Monday, posted its largest single day gain since February 2016.

We are not surprised by the bare bones nature of the agreement following the meeting between President Trump and President Xi. The last minute inclusion of Peter Navarro, White House trade policy adviser and prominent China hawk, to the list of guests attending the working dinner was, at least to us, a clear signal that meaningful progress on trade relations during the meeting was unlikely. After all, Mr Navarro’s role in the Trump Administration, as The Atlantic puts it, is “to shepherd Trump’s more extreme ideas into reality, ensuring that the president’s convictions are not weakened as officials translate them from bully-pulpit shouts to negotiated legalese. He is the madman behind Trump’s “madman theory” approach to trade policy, there to make enemies and allies alike believe that the president can and will do anything to make America great again.”

Moreover, we do not expect a breakthrough in negotiations to materialise during the next round of talks between Washington and Beijing before the suspension of the increase in tariffs lapses. As long as hawks such as Peter Navarro and Robert E. Lighthizer continue to have President Trump’s ear our view is unlikely to change. If, however, the dovish members of the Trump Administration, such as Treasury Secretary Steve Mnuchin and Director of the National Economic Council Lawrence Kudlow, begin to take control of proceedings we would become much more hopeful of a positive resolution to the trade dispute.

For now, we see the temporary agreement between the two sides as providing much needed short-term respite for China. More importantly, we see President Trump’s offer of a temporary ceasefire without President Xi offering any concessions on sensitive issues, such as industrial policy, state funded subsidies and intellectual property rights, to be a symptom of the short-termism that seemingly besets democratically elected leaders without exception. Had the US equity capital markets not faltered recently and / or the Republicans not lost control of the House of Representatives, it is unlikely, we think, that President Trump would have been as acquiescent.

Liquidity Relief

In June in The Great Unwind and the Two Most Important Prices in the World we wrote:

“In the 362 months between end of May 1988 and today there have only been 81 months during which both the US 10-year treasury yield and the oil price have been above their respective 48-month moving averages – that is less than a quarter of the time.

Over the course of the last thirty years, the longest duration the two prices have concurrently been above their respective 48-month moving averages is the 25 month period between September 2005 and October 2007. Since May 1988, the two prices have only been above their respective 48-month moving averages for 5 or more consecutive months on only four other occasions: between (1) April and October 1996; (2) January and May 1995; (3) October 1999 and August 2000; and (4) July 2013 and August 2014.

Notably, annual global GDP growth has been negative on exactly five occasions since 1988 as well: 1997, 1998, 2001, 2009, and 2015. The squeeze due to sustainably high US interest rates and oil prices on the global economy is very real.”

We have updated the charts we presented alongside the above remarks and provide them below. (The periods during which both the US 10-year treasury yield and the oil price have been above their respective 48-month moving averages are shaded in grey in the two charts below.)

US 10-Year Treasury YieldSource: Bloomberg

West Texas Intermediate Crude (US dollars per barrel) WTI Source: Bloomberg

The sharp drop in oil prices in recent weeks ended the 10 month streak of the 10-year Treasury yields and oil prices concurrently trading above their respective 48-month moving averages.

The recent drop in oil prices has coincided with the Fed weighing up the possibility of changing its policy guidance language. Several members of the Fed have suggested, according to the minutes of the FOMC’s November policy meeting, a “transition to statement language that [places] greater emphasis on the evaluation of incoming data in assessing the economic and policy outlook”. If the drop in oil prices sustains the data is likely soften and compel the Fed to dial back its hawkishness. With the base effects from the Trump Tax Cut also likely to recede in 2019, there is a distinct possibility that the Fed’s policy will be far less hawkish in 2019 than it has been over the course of 2018.

Lower (or range bound oil prices) and a more dovish Fed (even at the margin) are the conditions under which oil importing emerging markets tend to thrive. Although it is still too early to be sure, if oil prices fail to recover in the coming few months and the Fed is forced into a more dovish stance due to softer data, 2019 might just be the year to once again be long emerging markets.

Late Cycle Signals and Yield Curve Dynamics

“Everything turns in circles and spirals with the cosmic heart until infinity. Everything has a vibration that spirals inward or outward — and everything turns together in the same direction at the same time. This vibration keeps going: it becomes born and expands or closes and destructs — only to repeat the cycle again in opposite current. Like a lotus, it opens or closes, dies and is born again. Such is also the story of the sun and moon, of me and you. Nothing truly dies. All energy simply transforms.” – Rise Up and Salute the Sun: The Writings of Suzy Kassem by Suzy Kassem

“We say that flowers return every spring, but that is a lie. It is true that the world is renewed. It is also true that that renewal comes at a price, for even if the flower grows from an ancient vine, the flowers of spring are themselves new to the world, untried and untested.

The flower that wilted last year is gone. Petals once fallen are fallen forever. Flowers do not return in the spring, rather they are replaced. It is in this difference between returned and replaced that the price of renewal is paid.

And as it is for spring flowers, so it is for us.” – The Price of Spring by Daniel Abraham

“There are constant cycles in history. There is loss, but it is always followed by regeneration. The tales of our elders who remember such cycles are very important to us now.” – Carmen Agra Deedy

Late Cycle Signals

Each business cycle is unique. Certain patterns, however, have tended to repeat across business cycles with the ebbs and flows in the level of economic activity.

The late stage of the business cycle is often characterised by an overheated economy, restrictive monetary policy, tight credit markets, low unemployment rates and peaking corporate profit margins. These are not the types of signals that form part of our discussion on the late cycle this week. Instead we focus on behavioural clues from the financial services and investment management sector that signal that we may have potentially entered the late stage of the business cycle – often the most rewarding, but also the most precarious, phase of bull market for investors.

1. Liquidity events for investors in ride hailing services companies

Few opportunities have captured the imagination of venture capital investors over the last decade as the one represented by ride hailing services companies such as Uber, Lyft, Didi Chuxing and Grab.

Uber Technologies is the most prized of the Silicon Valley unicorns – start-up companies valued at US dollars 1 billion or higher – with a valuation of US dollars 72 billion at the time of its last round of fundraising.

Lyft, the number two player in the US ride hailing services market with a rumoured 35 per cent market share, doubled its valuation to US dollars 15.1 billion during its last round of fundraising in July this year.

Didi Chuxing, China’s equivalent to Uber and valued at US dollars 56 billion during its last fundraising, is the most valuable start-up on the Mainland and counts Apple, Softbank and Uber amongst its shareholders. The start-up is estimated to have raised US dollars 20.6 billion in funding over 17 rounds of financing.

Southeast Asia’s leading ride hailing services company, Grab, was valued at over US dollars 10 billion in a fundraising round in June this year and has received US dollars 1 billion in funding from Toyota.

With such eye-popping valuations it should come as no surprise that most, if not all, of the leading ride hailing companies the world over are weighing up potential liquidity events, be it an initial public offering or a trade sale to larger competitors or strategic investors. The investors in these companies are undoubtedly eager to convert their paper profits into realised gains in the form of cold hard cash.

Lyft has hired JP Morgan to lead its IPO and is aiming to beat its much larger rival, Uber, in becoming the first ride hailing services company to be publicly listed

Uber has reportedly received proposals from Wall Street valuing the company as high as US dollars 120 billion – almost 67 per cent higher than the valuation at its last round of fundraising

Didi Chuxing is reportedly weighing up the possibility of a public offering in 2019

Careem Networks, the Middle East’s leading ride hailing services company, and Uber are rumoured to be in talks for a possible merger or an outright acquisition of the Middle Eastern business by Uber. Careem was valued at US dollars 1 billion during a fundraising round in December 2016. Bloomberg reported in September that the acquisition of Careem by Uber would value it between US dollars 2 to 2.5 billion – a 100 to 150 per cent increase in less than 24 months.

In 2007, The Blackstone Group, the leading alternative asset management firm, successfully listed on the New York Stock Exchange, selling a 12.3 per cent stake in return for US dollars 4.13 billion. Blackstone’s listing was, at the time, the largest US IPO since 2002.

Although Blackstone was able to successfully list, many of its rivals – including Apollo Global Management, Kohlberg Kravis & Roberts and the Carlyle Group – missed the opportunity to float ahead of the global financial crisis and had to shelve their plans and wait for a more conducive environment.

We worry that a similar fate awaits the riding hailing services industry, where it becomes a case of one IPO and done and the remaining companies’ plans are delayed by an abrupt end to the current iteration of the US equity bull market.

2. INVESCO to buy OppenheimerFunds

INVESCO, the independent investment company headquartered in Atlanta, Georgia, this week agreed to buy rival Massachusetts Mutual Life Insurance’s OppenheimerFunds unit for US dollars 5.7 billion. According to the Wall Street Journal:

“Invesco will pay for the deal with 81.9 million common shares and another $4 billion in preferred shares, making MassMutual the firm’s largest stockholder. Including OppenheimerFunds, Invesco will manage more than $1.2 trillion in assets.”

In the summer of 2009, BlackRock acquired Barclays Global Investors, including its highly coveted iShares franchise, for US dollars 13.5 billion and created a combined entity with, at the time, approximately US dollars 2.7 trillion of assets under management.

BlackRock’s timing was impeccable: a near decade long equity bull market ensued and, even more importantly for BlackRock, the company put itself in the prime position to reap the rewards of the rise of passive investing.

The rationale for the OppenheimerFunds acquisition according to the Wall Street Journal paraphrasing INVESCO CEO Martin Flanagan is to: “strengthen Invesco’s position in some businesses that have been proven resilient to the move toward passive investing, including international and emerging-markets stock funds.”

We are curious to see if INVESCO’s decision today turns out to be as flawed as BlackRock’s decision in 2009 was impeccable.

3. Middle market alternative asset managers selling stakes

In recent years, seemingly successful, mid-sized alternative asset management firms have started selling equity stakes to their much larger, more established competitors such as Neuberger Berman, The Blackstone Group and the Carlyle Group.

Dyal Capital, a unit of Neuberger Berman, has closed 30 or more transactions acquiring stakes in alternative asset managers over the last 2 to 3 years, including a strategic investment into Silver Lake Partners. Dyal presently manages three funds with US dollars 9 billion in assets under management and is set to complete fundraising over 5 billion for a fourth fund.

The most recent of such sales comes from New Mountain Capital, which manages private equity, public equity and credit funds with more than US dollars 20 billion in assets under management. The company has reportedly sold a 9 per cent stake to Blackstone Strategic Capital Holdings.

We wonder: what are the chances that highly successful private equity and alternative investment firms would sell their stakes at anything but close to peak valuations?

Yield Curve Dynamics

Given that we have discussed late cycle signals above, we wanted to touch upon the historical dynamics of the Treasury yield curve when it has either gone (i) from inverted to flat or (ii) from flat to positively slopping.

Prior to sharing our findings, we wanted to share some analysis for the period starting 1959 and ending 1984 from Interest Rates, the Markets, and the New Financial World (1985) by Henry Kaufman:

“If the risk in investing in the long market is still great immediately following the point of maximum inversion, when does the long market offer the best opportunity? To answer this question, it is necessary to examine the swings in the U.S. Government securities yield curve during the past quarter century.

These swings are:

from extreme negative (short rates above long) to flat

from flat to extreme positive (long rates above short)

from extreme positive to flat

from flat to extreme negative

The results are as follows:

1. When the yield curve for government securities swung from extreme negative to flat, long yields actually increased with one exception – the 1980 cycle. In one of these cycles, there was greater rise in long yields than in short rates. In all other instances, however, short rates fell while long yields rose.

2. When the yield curve moved from flat to extreme positive, with long yields going above short, in all cycles long yields fell in conjunction with a more sizable drop in short rates.

3. The swing from extreme positive to flat can be quite dangerous in the long bond sector. In the four complete cycles… yield increases average 104 basis points for long-term issues, ranging from 40 to 220 basis points.

4. The most dangerous period of all for investors in long bonds, however, occurs when the yield curve moves from flat to extremely negative, with short rates moving up above long.”

Interestingly, the period around the time of publishing of Mr Kaufman’s book was the exception for how the long end of the curve reacted when the yield curve went from extreme negative to flat. And Mr Kaufman speculated in his book if the long-running bond bear market was over or not. With the benefit of hindsight we know that the bond bear market had indeed ended during the early 1980s.

For the period from 1980 till date and with respect to cycles where the yield curve went either (i) from inverted to flat or (ii) from flat to positively slopping, we make the following observations (based on the yield differential between 2 and 10 year Treasury securities):

1980 – 1982: the yield curve went from extreme negative to flat with both short and long rates declining. Short rates declined faster than long rates.

1988 – 1992: from flat to extreme positive with both short and long rates declining. Short rates declined faster than long rates.

2000 – 2003: from inverted to flat and then to extreme positive with both short and long rates declining. Short rates declined faster than long rates.

2005 – 2010: from flat to extreme positive with both short and long rates declining. Short rates declined faster than long rates.

In recent weeks we have witnessed the yield curve correct its flattening trend due to a sell-off at the long-end. The yield curve has steepened due to higher long-term yields – a phenomena last witnessed in the 1970s. These are still early days and the recent sell-off at the long-end may be nothing more than a blip. If, however, the yield curve continues to steepen due to increasing long-term yields it would be an ominous sign for bond bulls.

Much like Mr Kaufman speculated that the bond bear market may have ended in the early 1980s, the recent shifts in the Treasury yield curve and the forthcoming supply of US Treasury securities have us wondering if the multi-decade bond bull market is over.

Tightening Only in Name

“We cannot control the way people interpret our ideas or thoughts, but we can control the words and tones we choose to convey them. Peace is built on understanding, and wars are built on misunderstandings. Never underestimate the power of a single word, and never recklessly throw around words. One wrong word, or misinterpreted word, can change the meaning of an entire sentence and start a war. And one right word, or one kind word, can grant you the heavens and open doors.” – Rise Up and Salute the Sun: The Writings of Suzy Kassem by Suzy Kassem

In November 2010, esteemed investors and academics including Cliff Asness (AQR Capital), Jim Chanos (Kynikos Associates), Seth Klarman (Baupost Group), Paul Singer (Elliot Associates) and Michael J. Boskin, the T. M. Friedman Professor of Economics and senior fellow at Stanford University’s Hoover Institution, sent, the then Federal Reserve Chairman, Ben Bernanke an open letter warning him of the consequences of undertaking a second round of quantitative easing: “The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.”

Monetary policy transmission mechanisms are amongst both the most confusing and most important concepts for financial market participants to come to grips with. Many of us misunderstood quantitative easing. We do not want to repeat the same mistake and misinterpret quantitative tightening.

For starters, quantitative tightening in not what is “rattling markets”.

One of the best explanations we could find on why quantitative tightening is not tightening in the normal sense comes from The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession written by Mr Richard Koo, Chief Economist at Nomura Research Institute. We quote (emphasis added):

“Under quantitative easing, the Bank of Japan supplied liquidity to the market. It did so by purchasing government bonds held by commercial banks, and crediting money to their current accounts. This process was repeated until the aggregate value of banks’ current accounts had risen to more than ‌¥30 trillion. To terminate the policy, this process had to be reversed. In theory, this would involve the bank selling government bonds to commercial banks to absorb the excess funds in their current accounts.

Selling government bonds should cause their price to fall, driving up interest rates. In practice, however, abandoning quantitative easing was not a “tightening” of monetary policy in the ordinary sense. In a standard tightening phase, the Bank of Japan responds to an overheated economy by selling bonds to commercial banks to mop up market liquidity and reduce the volume of money circulating. Commercial banks, on the other hand, normally try to maximise income on available funds by reducing liquidity on hand to the statutory minimum or thereabouts, and lend or invest the rest of their funds. Under these circumstances, commercial banks would not have the surplus funds needed to buy bonds from the Bank of Japan – their only option would be to sell other assets. In some cases, they might even consider calling in loans. So when the Bank of Japan starts selling bonds to commercial banks, banks are prompted to sell other financial instruments, driving down the price of financial assets in general (and thereby pushing up interest rates). This chain reaction of selling has a restrictive impact, and serves to cool economic activity.

But in terminating quantitative easing, the ¥25 trillion in surplus funds that the Bank of Japan sought to mop up was already sitting in commercial banks’ current accounts with the central bank, which pays no interest. Facing an absence of private-sector borrowers, the commercial banks could do nothing else with these funds. So when the Bank of Japan asked the banks to buy ¥25 trillion of government bonds, they paid for the purchases with money already on deposit with the Bank of Japan.

Because the banks did not need to raise funds elsewhere, the operation had none of the negative impact of a normal tightening operation, and interest rates did not rise significantly. Quantitative easing – the great non-event of the fifteen-year recession – vanished without a trace.”

For good measure, we also quote from Dr. Manmohan Singh’s article from FT Alphaville in April 2017, where he argues that the unwinding of the Fed’s balance sheet “may not be tantamount to tightening”:

“Deposits have taken too much balance-sheet space of the banking sector with excess reserves of the banks at the Fed are presently over $2tn. This inhibits financial intermediation and in turn, monetary policy transmission. As an analogy, oil is only needed for lubricating a car’s engine; similarly, excess reserves, are needed only to smoothen out the need for reserves in the financial system. They were close to zero before the Lehman crisis. Now instead of an “oil change” we are carrying the oil in the car trunk, in our homes, everywhere.

Markets currently can digest duration of good collateral. As seen in the past year, policy rate hikes may not percolate to the long end of the yield curve and vice versa, because the investor base is very different for the short and long end.

For example, from the time of the Fed’s 25 basis-point rate hike on Dec 16, 2105 until the eve of U.S. elections on November 8, 2016, the yield on the 10-year US Treasury note actually declined, to 1. 8 per cent from 2.3 per cent, as markets digested duration despite sizeable sales of Treasuries by many emerging markets throughout 2016.

So the unwinding of a central bank’s balance sheet may not result in tightening. Collateral that will be released (from the asset side of the Fed balance sheet) to the market, with reuse, is a far better lubricant for the financial system than the reduction in banking system deposits, (i.e., reserves balances on the liability side of the Fed balance sheet). Although the Dodd Frank Act and Basel III make it more expensive for collateral to be reused, the increase in the balance sheet space of the banking system (due to the central bank unwind) may more than neutralize the regulatory cost. Thus, a leaner central bank balance sheet, if it doesn’t result in a tightening effect, could justify a much higher policy rate in this cycle than currently being anticipated.”

Investment Perspective

If quantitative tightening is not tightening in the normal sense, this begs the question of what has gotten into global stock markets this year. The simple answer is: we do not know for sure. It could be any one of a number of reasons or a combination of them. Some of the commonly cited explanations we have come across for the recent selloff include the escalating trade dispute between the US and China, the Chinese yuan breaking 6.9 to the US dollar, contagion from the selloff in emerging markets, fallout from the bond market route and, our favourite, that “TINA” (there is no alternative) no longer applies to stocks as the short end of the yield curve is now viable investment opportunity.

We think it may simply be a case of temporary exhaustion after accelerated pension contributions and cash repatriation by US corporations bid up US asset prices. With the deadline for accelerated pension contributions having passed and the rate of cash repatriation by US corporations slowing, the presence of ‘price insensitive’ buyers is likely to have diminished.

Regardless of the drivers behind the recent selloff, we think there still are compelling reasons to remain long US stocks. To expand on our reasoning, we return to Mr Koo’s book and present his yin-yang cycle of bubbles and balance sheet recessions:

Yin yang.png

We think, with the capital spending incentives in the Trump tax cuts, low employment and strong consumer spending, the US economy is in stage six of Mr Koo’s framework. US corporations are finally showing signs of increasing capital investment and there is a growing chance that the borrowing needs of the US Treasury are going to start crowding out the private sector. This could exasperate the situation for the US private sector, which is already under pressure to invest in increasing productivity to counteract tightness in the labour market and the pressure on margins from rising wages.

We think that under present conditions, the US economy can quickly accelerate from stage six to stage nine – the US fiscal deficit is expected to accelerate in 2019, even excluding any potential boost in spending from a revival in President Trump’s infrastructure spending bill.

We remain long US equities and are increasingly looking for opportunities to allocate capital to the industrial sector. We also think the time to increase allocation to non-US equities is upon us – for now we defer that discussion to another update.

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.

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.

Financial Misery and the Flattening Yield Curve

“Every day is a bank account, and time is our currency. No one is rich, no one is poor, we’ve got 24 hours each.” – Christopher Rice, bestselling author

“He tried to read an elementary economics text; it bored him past endurance, it was like listening to somebody interminably recounting a long and stupid dream. He could not force himself to understand how banks functioned and so forth, because all the operations of capitalism were as meaningless to him as the rites of a primitive religion, as barbaric, as elaborate, and as unnecessary. In a human sacrifice to deity there might be at least a mistaken and terrible beauty; in the rites of the moneychangers, where greed, laziness, and envy were assumed to move all men’s acts, even the terrible became banal.” – Excerpt from The Dispossessed by Ursula K. Le Guin

“A bank is a place that will lend you money if you can prove that you don’t need it.” – Bob Hope

Before we get to the update, just a quick comment on the New York Times op-ed “I Am Part of the Resistance Inside the Trump Administration” written by a hitherto anonymous member of the Trump Administration, which we suspect many of you have already read. Our reaction to the piece is that an “elite” politician issuing an editorial in a highbrow broadsheet and talking of resistance against the President is far more likely to stoke populism than to weaken it. Moreover, as angry as President Trump may appear to be about the editorial on television, it gives him just the kind of ammunition he needs to drum up the “us against them” rhetoric and rouse his core supporters to turn up to vote during the forthcoming mid-term elections.

Moving swiftly on, this week we write about US financials.

Financials have not had a great year so far. The MSCI US Financials Index is up less than one per cent year-to-date, tracking almost 7 per cent below the performance of the S&P500 Index. While the equivalent financials indices for Japan and Europe are both down more than 11 per cent year to date.

At the beginning of the year, investors and the analyst community appeared to be positive on the prospects for the financial sector. And who can blame them? The Trump Tax Plan had made it through Congress, the global economy was experiencing synchronised growth, progress was being made on slashing the onerous regulations that had been placed on the sector in the aftermath of the global financial crisis, and banks’ net interest margins were poised to expand with the Fed expected to continue on its path of rate hikes.

So what happened?

We think US financials’ under performance can in large part be explained by the flattening of the US yield curve, which in turn can result in shrinking net interest margins and thus declining earnings. The long-end of the US yield curve has remained stubbornly in place, for example 30-year yields still have not breached 3.25 per cent, and all the while the Fed has continued to hike interest rates and pushed up the short-end of the curve.

Why has the long-end not moved?

There are countless reasons given for the flattening of the yield curve. Many of them point to the track record of a flattening and / or inverted yield curve front running a recession and thus conclude with expectations of an imminent recession.

The Fed and its regional banks are divided over the issue. In a note issued by the Fed in June, Don’t Fear the Yield Curve, the authors conclude that the “the near-term forward spread is highly significant; all else being equal, when it falls from its mean level by one standard deviation (about 80 basis points) the probability of recession increases by 35 percentage points. In contrast, the estimated effect of the competing long-term spread on the probability of recession is economically small and not statistically different from zero.”

Atlanta Fed President, Mr Raphael Bostic, and his colleagues on the other hand see “Any inversion of any sort is a sure fire sign of a recession”. While the San Francisco Fed notes that “[T]he recent evolution of the yield curve suggests that recession risk might be rising. Still, the flattening yield curve provides no sign of an impending recession”.

Colour us biased but we think the flattening of the yield curve is less to do with subdued inflation expectations or deteriorating economic prospects in the US and far more to do with (1) taxation and (2) a higher oil price.

US companies have a window of opportunity to benefit from an added tax break this year by maximising their pension contributions. Pension contributions made through mid-September of this year can be deducted from income on tax returns being filed for 2017 — when the U.S. corporate tax rate was still 35 per cent as compared to the 21 per cent in 2018. This one-time incentive has encouraged US corporations to bring forward pension plan contributions. New York based Wolfe Research estimates that defined-benefit plan contributions by companies in the Russell 3000 Index may exceed US dollars 90 billion by the mid-September cut-off – US dollars 81 billion higher than their contributions last year.

US Companies making pension plan contributions through mid-September and deducting them from the prior year’s tax return is not new. The difference this year is the tax rate cut and the financial incentive it provides for pulling contributions forward.

Given that a significant portion of assets in most pension plans are invested in long-dated US Treasury securities, the pulled forward contributions have increased demand for 10- and 30-year treasuries and pushed down long-term yields.

Higher oil prices, we think, have also contributed to a flattening of the yield curve.

Oil exporting nations have long been a stable source of demand for US Treasury securities but remained largely absent from the market between late 2014 through 2017 due to the sharp drop in oil prices in late 2014. During this time these nations, particularly those with currencies pegged to the US dollar, have taken drastic steps to cut back government expenditures and restructure their economies to better cope with lower oil prices.

With WTI prices above the price of US dollars 65 per barrel many of the oil exporting nations are now generating surpluses. These surpluses in turn are being recycled into US Treasury securities. The resurgence of this long-standing buyer of US Treasury securities has added to the demand for treasuries and subdued long-term yields.

Investment Perspective

A question we have been recently asked is: Can the US equity bull market continue with the banking sector continuing to under perform?

Our response is to wait to see how the yield curve evolves after the accelerated demand for treasuries from pension funds goes away. Till then it is very difficult to make a definitive call and for now we consider it prudent to add short positions in individual financials stocks as a portfolio hedge to our overall US equities allocation while also avoiding long positions in the sector.

We have identified three financials stocks that we consider as strong candidates to short.

Synovus Financial Corp $SNV

Western Alliance Bancorp $WAL

WAL

Eaton Vance Corp $EV

Don’t wait for the US Dollar Rally, its Already Happened

“Don’t cry because it’s over. Smile because it happened.” – Dr Seuss

“Republicans are for both the man and the dollar, but in case of conflict the man before the dollar.” – Abraham Lincoln

“Dark economic clouds are dissipating into an emerging blue sky of opportunity.” – Rick Perry

According to the minutes of the Fed’s June meeting, released on Thursday, some companies indicated they had already “scaled back or postponed” plans for capital spending due to “uncertainty over trade policy”. The minutes added: “Contacts in the steel and aluminum industries expected higher prices as a result of the tariffs on these products but had not planned any new investments to increase capacity. Conditions in the agricultural sector reportedly improved somewhat, but contacts were concerned about the effect of potentially higher tariffs on their exports.”

Despite the concerns around tariffs, the minutes also revealed that the Fed remained committed to its policy of gradual rate hikes and raising the fed funds rate to its long-run estimate (or even higher): “Participants generally judged that…it would likely to be appropriate to continue gradually raising the target rate for the federal-funds rate to a setting that was at or somewhat above their estimates of its longer-run level by 2019 or 2020”.

The somewhat hawkish monetary policy stance of the Fed combined with (i) expectations of continued portfolio flows into the US due to the interest rate differentials between the US and non-US developed markets, (ii) fears of the Trump Administration’s trade policies causing an emerging markets crisis, and (iii) the somewhat esoteric risk of ‘dollar shortage’ have led many to conclude that the US dollar is headed higher, much higher.

Of all the arguments for the US dollar bull case we consider the portfolio flows into the US to be the most pertinent to the direction of the greenback.

According to analysis conducted by the Council of Foreign Relations (CFR) “all net foreign demand for ‘safe’ US assets from 1990 to 2014 came from the world’s central banks”. And that “For most of the past 25 years, net foreign demand for long-term U.S. debt securities has increased in line with the growth in global dollar reserves.” What the CFR has described are quite simply the symptoms of the petrodollar system that has been in existence since 1974.

Cumulative US Current Account Deficit vs. Global Foreign Exchange HoldingsSources: Council on Foreign Relations, International Monetary Fund, Bureau of Economic Analysis

In recent years, however, global US dollar reserves have declined – driven by the drop in the price of oil in late 2014 which forced the likes of Norges Bank, the Saudi Arabian Monetary Agency, and the Abu Dhabi Investment Authority to draw down on reserves to make up for the shortfall in state oil revenues – yet the portfolio flows into the US continued unabated.

Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings and comparing it to the cumulative US Treasury securities issuance (net), it is evident that in recent years foreign central banks have been either unable or unwilling to finance the US external deficit.

Cumulative US Marketable Treasury Issuance (Net) vs. US Treasury Major Foreign HoldingsSources: US Treasury, Securities Industry and Financial Markets Association

Instead, the US has been able to fund its external deficit through the sale of assets (such as Treasuries, corporate bonds and agency debt) to large, yield-starved institutional investors (mainly pension funds and life insurers) in Europe, Japan and other parts of Asia. The growing participation of foreign institutional investors can be seen through the growing gap between total foreign Treasury holdings versus the holdings of foreign central banks.

US Treasury Total Foreign Holdings vs. US Treasury Major Foreign HoldingsSource: US Treasury

Before going ahead and outlining our bearish US dollar thesis, we want to take a step back to understand how and why the US was able to finance its external deficit, particularly between 2015 and 2017, despite the absence of inflows from its traditional sources of funding and without a significant increase in its cost of financing. This understanding is the key to the framework that shapes our expectations for the US dollar going forward.

We start with Japan. In April 2013, the Bank of Japan (BoJ) unveiled a radical monetary stimulus package to inject approximately US dollars 1.4 trillion into the Japanese economy in less than two years. The aim of the massive burst of stimulus was to almost double the monetary base and to lift inflation expectations.

In October 2014, Governor Haruhiko Kuroda shocked financial markets once again by announcing that the BoJ would be increasing its monthly purchases of Japanese government bonds from yen 50 trillion to yen 80 trillion. And just for good measure the BoJ also decided to triple its monthly purchases of exchange traded funds (ETFs) and real estate investment trusts (REITs).

Staying true to form and unwilling to admit defeat in the fight for inflation the BoJ also went as far as introducing negative interest rates. Effective February 2016, the BoJ started charging 0.1 per cent on excess reserves.

Next, we turn to Europe. In June 2014, Señor Mario Draghi announced that the European Central Bank (ECB) had taken the decision to cut the interest rate on the deposit facility to -0.1 per cent. By March 2016, the ECB had cut its deposit facility rate three more times to take it to -0.4 per cent. In March 2015, the ECB also began purchasing euro 60 billion of bonds under quantitative easing. The bond purchases were increased to euro 80 billion in March 2016.

In response to the unconventional measures taken by the BoJ and the ECB, long-term interest rates in Japan and Europe proceeded to fall to historically low levels, which prompted Japanese and European purchases of foreign bonds to accelerate. It is estimated that from 2014 through 2017 Japanese and Eurozone institutional investors and financial institutions purchased approximately US dollar 2 trillion in foreign bonds (net). During the same period, selling of European fixed income by foreigners also picked up.

As the US dollar index ($DXY) is heavily skewed by movements in EURUSD and USDJPY, the outflows from Japan and Europe into the US were, in our opinion, the primary drivers of the US dollar rally that started in mid-2014.

US Dollar IndexSource: Bloomberg

In 2014 with Japanese and European outflows accelerating and oil prices still high, the US benefited from petrodollar, European and Japanese inflows simultaneously. These flows combined pushed US Treasury yields lower and the US dollar sharply higher. The strong flows into the US represented an untenable situation and something had to give – the global economy under the prevailing petrodollar system is simply not structured to withstand a strong US dollar and high oil prices concurrently. In this instance, with the ECB and BoJ staunchly committed to their unorthodox monetary policies, oil prices crashed and the petrodollar flows into the US quickly started to reverse.

Notably, the US dollar rally stalled and Treasury yields formed a local minimum soon after the drop in oil prices.

US 10-Year Treasury YieldSource: Bloomberg

Next, we turn to China. On 11 August 2015, China, under pressure from the Chinese stock market turmoil that started in June 2015, declines in the euro and the Japanese yen exchange rates and a slowing economy, carried out the biggest devaluation of its currency in over two decades by fixing the yuan 1.9 per cent lower. The Chinese move caught capital markets by surprise, sending commodity prices and global equity markets sharply lower and US government bonds higher.

In January 2016, China shocked capital markets once again by setting the official midpoint rate on the yuan 0.5 per cent weaker than the day before, which took the currency to its lowest since March 2011. The move in all likelihood was prompted by the US dollar 108 billion drop in Chinese reserves in December 2015 – the highest monthly drop on record.

In addition to China’s botched attempts of devaluing the yuan, Xi Jinping’s anti-corruption campaign also contributed to private capital fleeing from China and into the US and other so called safe havens.

China Estimated Capital OutflowsSource: Bloomberg

The late Walter Wriston, former CEO and Chairman of Citicorp, once said: “Capital goes where it is welcome and stays where it is well treated.” With the trifecta of negative interests in Europe and Japan, China’s botched devaluation effort and the uncertainty created by Brexit, capital became unwelcome in the very largest economies outside the US and fled to the relative safety of the US. And it is this unique combination, we think, that enabled the US to continue funding its external deficit from 2014 through 2017 without a meaningful rise in Treasury yields.

Moreover, in the absence of positive petrodollar flows, we suspect that were it not for the flight to safety driven by fears over China and Brexit, long-term Treasury yields could well have bottomed in early 2015.

Investment Perspective

Foreign central banks show a higher propensity to buy US assets in a weakening US dollar environment

Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings, we find that foreign central banks, outside of periods of high levels of economic uncertainty, have shown a higher propensity to buy US Treasury securities during phases of US dollar weakness as compared to during phases of US dollar strength.

Year-over-Year Change in Major Foreign Holdings of Treasury Securities and the US Trade Weighted Broad Dollar Index Sources: US Treasury, Bloomberg

The bias of foreign central banks, to prefer buying Treasury securities when the US dollar is weakening, is not a difficult one to accept. Nations, especially those with export oriented economies, do not want to see their currencies rise sharply against the US dollar as an appreciating currency reduces their relative competitiveness. Therefore, to limit any appreciation resulting from a declining US dollar, foreign central banks are likely to sell local currency assets to buy US dollar assets. However, in a rising US dollar environment, most foreign central banks also do not want a sharp depreciation of their currency as this could destabilise their local economies and prompt capital outflows. And as such, in a rising US dollar environment, foreign central banks are likely to prefer selling US dollar assets to purchase local currency assets.

European and Japanese US treasury Holdings have started to decline

European and Japanese US Treasury Holding Source: US Treasury

The ECB has already scaled back monthly bond purchases to euro 30 billion and has outlined plans to end its massive stimulus program by the end of this year. While BoJ Governor Haruhiko Kuroda in a testimony to the Japanese parliament in April revealed that internal discussions were on going at the BoJ on how to begin to withdraw from its bond buying program.

In anticipation of these developments and the increased possibility of incurring losses on principal due to rising US inflation expectations, it is likely that European and Japanese institutional investors and financial institutions have scaled back purchases of US dollar assets and even started reducing their allocations to US fixed income.

Positive correlation between US dollar and oil prices

One of the surprises thrown up by the markets this year is the increasingly positive correlation between the US dollar and the price of oil. While the correlation may prove to be fleeting, we think there have been two fundamental shifts in the oil and US dollar dynamic that should see higher oil prices supporting the US dollar, as opposed to the historical relationship of a strengthening US dollar pressuring oil prices.

The first shift is that with WTI prices north of US dollar 65 per barrel, the fiscal health of many of the oil exporting nations improves and some even begin to generate surpluses that they can recycle into US Treasury securities. And as oil prices move higher, a disproportionality higher amount of the proceeds from the sale of oil are likely to be recycled back into US assets. This dynamic appears to have played out to a degree during the first four months of the year with the US Treasury securities holdings of the likes of Saudi Arabia increasing. (It is not easy to track this accurately as a number of the oil exporting nations also use custodial accounts in other jurisdictions to make buy and sell their US Treasury holdings.)

WTI Crude vs. US Dollar IndexSource: Bloomberg

The second shift is that the US economy no longer has the same relationship it historically had with oil prices. The rise of shale oil means that higher oil prices now allow a number of US regions to grow quickly and drive US economic growth and job creation. Moreover, the US, on a net basis, spends much less on oil (as a percentage of GDP) than it has done historically. So while the consumers may take a hit from rising oil prices, barring a sharp move higher, the overall US economy is better positioned to handle (and possibly benefit from) gradually rising oil prices.

As Trump has upped the trade war rhetoric, current account surpluses are being directed away from reserve accumulation

Nations, such as Taiwan and the People’s Republic of Korea, that run significant current account surpluses with the US have started to re-direct surpluses away from reserve accumulation (i.e. buying US assets) in fear of being designated as currency manipulators by the US Treasury. The surpluses are instead being funnelled into pension plans and other entitlement programs.

To fund its twin deficits, the US will need a weaker dollar and higher oil prices

In recent years, the US current account deficit has ranged from between 2 and 3 per cent of GDP.

US Current Account Balance (% of GDP)Source: Bloomberg

With the successful passing of the Trump tax plan by Congress in December, the US Treasury’s net revenues are estimated to decrease by US dollar 1.5 trillion over the next decade. While the increase in government expenditure agreed in the Bipartisan Budget Act in early February is expected to add a further US dollar 300 billion to the deficit over the next two years. The combined effects of these two packages, based on JP Morgan’s estimates, will result in an increase in the budget deficit from 3.4 per cent in 2017 to 5.4 per cent in 2019. This implies that the US Treasury will have to significantly boost security issuance.

Some of the increased security issuance will be mopped by US based institutional investors – especially if long-term yields continue to rise. US pension plans, in particular, have room to increase their bond allocations.

US Pension Fund Asset Allocation Evolution (2007 to 2017) Source: Willis Tower Watson

Despite the potential demand from US based institutional investors, the US will still require foreign participation in Treasury security auctions and markets to be able to funds its deficits. At a time when European and Japanese flows into US Treasuries are retreating, emerging market nations scrambling to support their currencies by selling US dollar assets is not a scenario conducive to the US attracting foreign capital to its markets. Especially if President Trump and his band of trade warriors keep upping the ante in a bid to level the playing field in global trade.

Our view is that, pre-mid-term election posturing aside, the Trump Administration wants a weaker dollar and higher oil prices so that the petrodollars keep flowing into US dollar assets to be able to follow through on the spending and tax cuts that form part of their ambitious stimulus packages. And we suspect that Mr Trump and his band of the not so merry men will look to talk down the US dollar post the mid-term elections.