In a great interview with the Financial Times, John Burbank of multi-strategy hedge fund Passport Capital this morning explains the reasoning behind his firms large wagers against commodities and emerging markets:
Mr Burbank said years of QE had caused a misallocation of capital across the world, while the end of QE last year triggered a dollar rally with consequences that were only now beginning to be realised.
“The wrong people got the capital — emerging markets countries and corporates and a lot of cyclical companies like mining and energy, particularly shale companies — and this is now a major problem for the credit markets,” he said.
Investors were not recognising the risks, Mr Burbank said, and Passport was not pulling out of its bearish bets.
The dollar rally caused by “asynchronous QE” — the early end of money printing in the US relative to Japan and the eurozone — and the economic fallout from a slowing China guaranteed a financial crisis in emerging markets that would rebound on the US, he said.
“All of that turmoil around the world will come back and slow down capex and hiring and consumer buying in the US, and that will make the Fed realise they should be easing and not hiking,” he said.
“I think we are on the precipice of a liquidation in emerging markets, and this feels the way that the fourth quarter of 1997 felt.”
That’s a pretty bold statement, and if true, many investors (and central banks) will get caught offsides.
The big question is how does one trade this? Emerging Markets and commodities have already crashed for all intents and purposes. Was that it? Or is there a second leg with liquidation and credit crises. Burbank obviously thinks there’s another leg lower from the spillover effects. What’s the trade here in EM and Commodities?
Larry McDonald, Head of U.S. Strategy at SocGen, referenced the aforementioned FT / Burbank interview in an email this morning:
“Chances of QE4 have gone from 0-5% to 25-35%, I have been very vocal with this view on CNBC over the last 2 months. We continue to see respected CIOs talking QE4 up, this was NOT in the discussion in June – July.”
The way we see things, under most circumstances including a one and done rate increase, or the potential for material deterioration in the global economy, U.S. Treasuries appear to be a decent own at current levels. Possibly as a place to park some cash that has come from equity holdings, but also potentially as a hedge. Consider the spike we saw last month in the TLT when the SPX saw a quick 10% drop.:
Remember that since the “Taper Tantrum” that started in mid 2013 (after the FOMC hinted that they would Taper their purchases of Treasuries) the TLT saw a 20% drop, before bottoming in early 2014.
But then what happened in early 2014? Global equity markets were roiled by growth fears and Treasuries rallied. Then in October of 2014 the world got freaked out by the potential of an Ebola epidemic spreading from Africa, and what did investors do? They sold stocks and bought U.S. Treasuries. And at the start of 2015, global stock markets got roiled by growth fears once again and investors sold stocks, and bought U.S. Treasuries once again, with TLT making multi-year highs. It has since been in a fairly large downtrend from $138.50 down to as low as $115:
Of course, if we’re about to go into a period of global economic stabilization (possibly even see a reflation of growth), then our economy would be ready (and it would be necessary) for the FOMC to materially raise rates. At that point US Treasuries would be in trouble.
But if you believe as Burbank does, and that stuff is about to get real globally, then you want to own TLT at least as a form of diversification from stocks & commodities, and possibly as a hedge. $115 appears to be very decent near term technical support, but it may not get back there soon if equities re-test the lows from last month.
A defined risk way to get some long exposure in the TLT between now and December expiration. The risk here is that last week’s FOMC meeting was a headfake and the Fed will get Hawkish quickly. Which is one big reason to define risk. Here is the trade I am considering but not pulling the trigger on just yet:
Hypothetical TLT trade ($120.15) Buy Dec 120 / 130 Call Spread for $2.50
-Buy to open 1 Dec 120 call for 3.15
-Sell to open 1 Dec 130 call at .65
Break-Even on Dec Expiration:
Profits: between 122.50 and 130 make up to 7.50, with max gain of 7.50 above 130
Losses: of up to 2.50 between 120 and 122.50 with max loss of 2.50, or about 2% of the etf price.