Tempest in a Tea Pot – What Does It Tell Us? From Itau’s Global Connections Oct 31, 2014:
The recent financial market correction came and went in what seems like the blink of the eye. Several gut-wrenching down weeks, across assets and around the globe, followed by several up weeks, likewise across assets and worldwide. US equities have been the clear leader in both directions, coming within an inch of a 10% correction before rebounding smartly (though on very light volumes).
Such price action generates a lot of questions. Questions such as, who are the winners and losers? What did we learn? Have markets discounted the end of QE and the impact of ECB stress tests? What does it mean for investment strategy and portfolio-positioning into year-end?
Winners & Losers
Let’s dive right in. First off, the winners would seem to include the trading arms of the big banks that got a welcome shower of activity after a very slow Q3. Other winners would include the regulators, who must be smiling to themselves as they read about how banks hold so little inventory of higher-risk credit paper. OK, they must be thinking, some asset owners got hit and some hedge funds took a beating – so what? Isn’t that exactly what is supposed to happen? Systemically important banks are safer, right?
The Fed must also be included in the winner’s camp, as QE ends without a fuss. Who would have thought 10-year USTs would be at 2.3% when it finally happened? What happens next, of course, may well be a different outcome, but that’s for later on down the road. The BOJ’s surprise stimulus expansion puts it in the winners’ camp as well.
Losers include those whose strategies were upended and those who panicked and sold in mid-October only to find that by month-end the indices in many instances were closer to levels seen at the onset of the selloff rather than the bottom. The ECB, in contrast to the Fed, probably ends up in the loser’s camp, given a very muted response to the introduction of covered bond buying and stress test/AQR results.
What Did We Learn?
From an economic perspective one thing we learned is that the low-growth world is approaching consensus status. From the policy perspective, we learned that the Fed will now go quiet amid hopes of escaping the political limelight. The ECB is also likely to be out of the news, while the BOJ made a lot of news just as we went to press. From the markets we learned that there were many crowded trades
across assets.
While the lower-for-longer growth world becomes accepted wisdom, the investment playbook for such a world seems less clear to many. It makes sense that equities bore the brunt of the recent selloff, given that fixed income and currencies had moved further and faster in discounting a low-growth world with no Fed-driven QE and the natural growth governors of a strong FX and high relative rates. Likewise, it makes sense that US equities rallied on the back of the third-quarter GDP print of 3.5% a day after the Fed stated that rates will remain low for a considerable period of time – the best of both worlds!
The good news about the lower-for-longer growth world is that it removes the risk of sharply higher interest rates, which remain the bête noire of financial assets and perhaps economic vitality. It does not preclude the likelihood of some slow, small rate increases at the front end as the Fed tries to build some ammunition for future crises. How investors respond to the potential for small, patient, Fed-led, good rate hikes at the short end, versus bad, sudden, sharp, market-driven rate hikes at the long end, will be important.
The risk to the low-growth world is a descent into flatline status as we have written about previously (see “You Can’t Always Get What You Want,” published on August 28, 2014). Should the global economy weaken sharply, earnings are likely to be affected and thus equities would come into the line of fire.
Concerns remain that the Fed is pulling back without a new growth model in place, either in the US or elsewhere in the world. Deflationary pressures exist in Europe, are not fully banished in Japan and lurk in many parts of the emerging economies. There is no global growth locomotive (look at US import data), and the Fed’s recent comments on strong dollar concerns signal that there will not be any free ride off the US.
This in turn takes us back to the every-country-for-itself world we noted last spring (see “Every Country for Itself,” published on May 30, 2014), where a domestic focus occupies the mindset of policymakers. Politically such a world is more partisan and less willing to compromise. Economically, it’s a fixed pie world where one competes on price; at the nation-state level, one’s currency is one’s price. It is also the logic of the commodity market as evidenced by the price action in iron ore and more recently oil, where the major players maintain or ramp up production in an effort to drive out smaller players and maintain market share. If such logic becomes more widespread, the risk of deflation will increase. Marketwise, it’s a beggar-thy-neighbor world, as the BOJ just reminded us.
It is interesting to note that the IMF’s recent pronouncements on the world economy suggest that the odds of a global recession next year are roughly 1 in 100, even though it gave 40% odds of a European recession. I think the odds of a global recession are significantly greater than 1%, perhaps something on the order of 15%-20%. I imagine if one took a Central Banker poll, the number would be well above 1% as well.
We also learned that this doctrine, “low economic growth = low financial asset volatility = spread trades,” needs to come with a notice that strong stomachs are required. As one who bases much of what I write on my personal investing, this investment theme has been tough to stomach recently, especially in US high yield. As we have learned, however, these past few weeks in high yield included some massive dumping of positions by the large banks that were leery of holding such positions in front of anticipated
stress tests. Whether HY has found a clearing price is an important question.
In discussing this with colleagues, we came up with the seaweed analogy – if one can be like a piece of seaweed moving with the tide in and out but not getting beached, then one can ride through these periods of perhaps intense volatility and even use them to one’s advantage. But it takes a strong stomach and a properly-sized, risk-aware book to make it through the days and nights!
Given What We Learned, What Questions Do We Have?
From a geo-economic stance, one question must be whether the US can go it alone without growth accelerating in any other region? The US should benefit from lower interest rates and lower energy prices, with gasoline prices at multi-year lows. Offsetting the potential benefit of low rates on the housing market is the run-up in prices over the past few years, such that the affordability index has rolled over.
The Fed must be hoping labor market strength boosts wages and offsets the disinflationary risk from a strong dollar and weak commodity prices.
This rolling over of house-price appreciation rates is visible in financial asset price performance as well as in the commodity space and thus may herald a more modest return environment going forward. For example, global equities are up roughly 3% year to date in USD, while virtually the entire commodity complex is down for the year. It was only in July that we noted that all assets rose in the first half of the year – the challenge to sustain such performance through year-end will clearly not be met. This suggests that investors may need to rein in their 2015 investment-return expectations.
A second market-related question is whether investors can go it alone without the Fed in active support? A corollary question would be whether one can expect an equity rally into year-end, as we saw a year ago? (See “Thanksgiving Comes Early,” published on October 29, 2013.) In rereading that piece today, the clarity that existed around the rally set up a year ago seems lacking now. Yet many were talking
about just such a rally a month or so ago, before the volatility storm caused such talk to subside. The sharp bounce-back, particularly in the US equity market (much of the rest of the world has bounced, but not as much, and remains down 3%-5% from end-September levels) may restore such thinking.
A third market question is whether US equity will continue to outperform the rest of the world? Going into rally mode a year ago, the S&P had been a laggard – currently it has been the leader. The past month or so has witnessed record outflows from the US based funds invested in European equity, while near-record short positions and clear undervaluation (over half the Topix trades under book value) suggest a very attractive entry point in Japan. The US is clearly seenas the best growth hous in a poor neighborhood and has maintained its relative leadership position. Yet, with the Fed now on the sidelines and the ECB and BOJ visibly more active, perhaps this leadership position is about to change. This leadership change whereby the US passes the equity baton to the non-US DM markets is a long-held strategic view.
Finally and in an attempt to square the circle, one must ask what has been priced in to financial assets as a result of all this activity? The Fed is on hold for a while, European bank asset quality is clearer, Brazil’s elections are over, Ukraine’s as well and portfolios have been stress-tested and right-sized. While it has been a turbulent year for single-digit gains, it now seems like much has been discounted.
What’s not priced in is any positive surprise, such as better-than-expected economic activity in either Europe or Japan. The BOJ’s overnight decision to increase its stimulus levels is a perfect example of a positive surprise. A much more distinct policy split between the BOJ/ECB and the Fed is likely to spur further weakness versus the dollar and an attractive opportunity to reload in hedged, non-US DM equity.
After several bouts of volatility, the risk-reward in US high yield seems more attractive than it has for a while. Other areas of the spread trade, such as EM USD debt, MREITS and Preferreds, have held in better than high yield and remain attractive. Real estate and infrastructure should continue to see large inflows of funds as major investors search for non-traditional yield opportunities.
As the Fed steps away, fundamentals should assume precedence, and earnings in particular will be drivers of stock appreciation. The better-than-expected Q3 earnings results are a big reason why US stocks have rebounded as strongly as they have. While the S&P is back to within spitting distance of its all-time high, it has rallied on low volume and many other parts of the market remain well below their
peaks.
While a year-end equity rally would be nice, the surprise might be that it is led from overseas. While damage has been done to many segments of the market and to many investors, there is more upside abroad. US equity valuation and the earnings picture are likely to become more challenging as we enter 2015. Without the Fed to provide ongoing liquidity, these fundamental issues should assume more
importance.
Much has transpired on the policy front as well as in markets and economies. The first order of business should be to reexamine portfolios in this light coupled with right-sizing for risk appetite. Should one want to add more equity exposure, look to Europe (including the banks) and Japan on a hedged currency basis. Maintaining one’s yield plays is also suggested. More aggressive positions such as in the commodity space have detracted from performance and should be carefully sized. The end of Fed-led QE and a likely strong dollar will continue to test gold and the energy complex.
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Jay Pelosky is Principal of J2Z Advisory, LLC, a global asset allocation and portfolio strategy consultancy for institutional investors. Jay advises clients and invests personally based on insights gained from 30 years of financial market experience in over 45 countries. For the past decade, he has invested his own capital in a global, multi-asset, ETF-based Asset Allocation strategy. He sits on the board of Franklin Holdings (Bermuda) Ltd. and serves on the advisory board of Carmel Asset Management. Jay teaches a graduate level course, The Art and Practice of Global Investing, at The George Washington University and is a founding member of the New America Foundation’s World Economic Roundtable. His formal Wall Street career spanned twenty years and included positions on both the buy-side and sell-side. At Morgan Stanley, he launched the Firm’s global asset allocation and global equity strategy research products. He also formed and co-chaired the research department’s asset allocation committee. Jay created the firm’s Global Emerging Market Strategy (GEMS) product and initiated its equity investment, research, and strategy efforts in Latin America.