The Bank with a Soul

Baer Necessities 04/2018

Perspectives for strategic asset allocation

Observations Markets & News

Trade War: A US-China trade war would justify lower asset prices. Should we take Trump “literally but not seriously”? Trump’s ability to actually carry out his threats and promises are limited.

With monetary policies normalizing (tapering), market volatility will likely remain high and expose the negative convexity that has been built up in various types of assets, investment strategies, and portfolios during the past decade. As such, the current environment is an opportune time for investors to review and re-balance the convexity risk in their portfolios.

Politics

European business confidence seemingly unaffected by politics. Brexit remains a known unknown risk.

China’s Xi Jinping consolidated his power with the 19th Party Congress. He now has the political capital to promote his reform agenda. Expect structural reforms at the state and at SOE’s. He emphasized balanced growth, deleveraging and pollution control.

Economies

Economic backdrop downshifted, but remains robust. European growth rates are improving. Recent tech highfliers experienced correction. Risk assets should regain their footing for strong 2018.

We can state with confidence that macroeconomic conditions remain remarkably benign in the US and most major economies. Economic growth remains robust the world over. US employment is continuing to grow at a remarkably steady rate of around 200,000 monthly, as it has for the past seven years.

The US economy has entered a cyclical phase in which the main macroeconomic risks to financial markets will be posed by overly strong data. By contrast, weak data should be seen as bullish because they extend the length of the cycle and delay any risks of inflation or preemptive monetary tightening.

The era of low inflation, easy financial conditions and low volatility is ending as the US economy begins to face late-cycle, supply-side constraints, especially in the labor market.[i]

Monetary Policies

Inflation remains benign across major economies, although in the US annualized numbers are running at the policy target rate of 2%, and wages are gradually ticking up.

Euro rate rises to lag behind US. Credit growth remains robust.

The current situation for sovereigns was compared to Prince Rupert’s Drop[ii] (“larme de verre”), in that what is perceived as a strong, balanced system one day could blow up the next.[iii]

Equities

March showed vicious sector rotation and geographic dispersion in a downward market raises two questions: 1. Technical move or protracted correction? 2. Liquidation of trading positions or change in fundamental backdrop?

VIX back in ‘normal’ territory, end of 8-year bear market?[iv] While recent volatility has been negative for equities, sustained volatility will also have a negative impact on the credit asset class, especially high yield credit.

Fixed Income

Once there is an economic slowdown, high yield credit will suffer significantly as default probabilities increase sharply.

USD yields could move substantially higher in order to entice international investors to finance the rising US deficit.[v]

Currencies

  • USD: mostly bulls at start of the year but down with rates rising!
  • EUR: EUR multi-year bull run possible on back of large current account surplus, strong corporate and household balance sheets, early stage economic recovery, and receding political risks.
  • CHF: No bulls, few bears
  • Saudi Ryial: short betting peg would be adjusted or go[vi]

Commodities

Oil in a bull market. The extension of the OPEC cut through the balance of 2018 cemented a bullish underlying supply/demand balance. Risk of an oil spike has increased if EM demand improves and US production disappoints. Almost all oil capex has been directed toward US shale production.[vii]

Exploding demand in rare earths such as lithium, cobalt and graphite because of increasing popularity of electric vehicles.[viii]

Asset Allocation

Wise to look for diversifying assets and / or strategies. Long vol trades tend to be too expensive in equities and in bonds. Yet, implied vol is likely to move higher before long. Merger Arb or event driven strategies profiting from M&A offer attractive risk/rewards. Examples for hedges are long Japanese yen as a general risk aversion trade, short Australian dollar as a hedge against a China slowdown, short US high yield and CMBS due to deteriorating credit quality and an increase in borrowing rates, and short Italian government bonds as a hedge to escalating European political risk. Short sovereign debt or CDS on corporates could profit if either rates rise and/or spreads widen.

Roland Eberhard

April 23, 2018

Footnotes

[i] Karya

[ii] Equinox Partners

[iii] Wikipedia: “Prince Rupert's Drops (also known as Dutch tears) are toughened glass beads created by dripping molten glass into cold water, which causes it to solidify into a tadpole-shaped droplet with a long, thin tail. These droplets are characterized internally by very high residual stresses, which give rise to counter-intuitive properties, such as the ability to withstand a blow from a hammer or a bullet on the bulbous end without breaking, while exhibiting explosive disintegration if the tail end is even slightly damaged. In nature, similar structures are produced under certain conditions in volcanic lava.

The drops are named after Prince Rupert of the Rhine, who brought them to England in 1660, although they were reportedly being produced in the Netherlands earlier in the 17th century and had probably been known to glassmakers for much longer. They were studied as scientific curiosities by the Royal Society and the unravelling of the principles of their unusual properties probably led to the development of the process for the production of toughened glass, patented in 1874.”

[iv] VIX data 2010 - 2018

[v] Karya

[vi] Gemsstock; other sources; long-term short of Saudi Riyal vs USD after 31 year old Prince Mohammed bin Salman, son of octogenarian King Salman is now the next in line to the throne. Prince Mohammed has been entrusted with modernizing the Kingdom including diversifying the economy away from oil as evidenced by the decision to float Saudi Aramco. It is difficult to see how diversification can be achieved without introducing some flexibility in the currency. Position is for the SAR to weaken vs USD. Timing is highly uncertain but position has cheap carry and is asymmetric.

[vii] Horseman Global, BBL Commodities

[viii] Regal Funds Management

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