The Bank with a Soul

Baer Necessities 05/2018

Perspectives for strategic asset allocation

Observations Markets & News

Macro uncertainty will likely continue to result in market volatility above levels of recent years. Key managers run low risk. Many asset classes are at key inflection points, mainly US rates, US equities (global growth) and the USD.

Yet, optimism reigns, particularly in the US. The optimistic consensus may well prove right for several more years and asset prices could keep rising.[i] Worry about the absence of worry. Still, Caterpillar may have tainted the earnings season when CFO Bradley Halverson spoke of “high-water mark for the year”.[ii]

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

Trumpian theatre / negotiation tactics are a market risk.

European business confidence is seemingly unaffected by politics. Brexit remains a known unknown risk. Italian rates suffered.

China’s Xi Jinping consolidated his power with the 19th Party Congress. 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.

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 steady rate of around 200,000/month, as it has for the past seven years.

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.[iii]

Monetary Policies

Today, the market is pricing in almost equal odds of two or three more hikes in 2018. The labor market is tight, wages are trending up and inflation pressures are building. With the Fed likely to keep edging up short-rates, and the yield curve already flat, we expect US 10-year treasury yields to break above 3% in the coming months.

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

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

Equities

VIX back below ‘normal’ territory (13!).[vi] Sustained volatility will have a negative impact on the credit asset class, especially high yield credit.

Mining and mining services stocks generally outperform when bond yields are rising. Tech companies with growing revenue and earnings at high levels are independent of economic growth. The healthcare sector offers similar opportunities.

Fixed Income

Corporate bond ETFs stand at USD300B, more than seven times the inventory on bond dealers’ balance sheets estimated at USD40B.[vii]

USD yields could move substantially higher in order to entice international investors to finance the rising US deficit[viii]: US corporates need to refinance $4 trillion of bonds over the next five years (Wells Fargo Securities, May 9, 2018; $ca. $700 bn in 2018, $750bn in 2019 and $880 bn in 2020). About $3 trillion is investment grade, mostly in the lowest rungs BBB / Baa, with the rest in high-yield. Higher borrowing costs look to coincide with tigther credit conditions. If companies will be forced to refinance at higher rates, credit conditions could erode leading to a vicious circle of more downgrades and pushing bond buyers to seek out better-rated issuers. A positive is the Republican tax overhaul with the new legislation leaving some firms with more cash.

Emerging Markets Currencies & Debt

EM show symptoms of a broader weakness in the structure of global financial markets. Negative turn in EM debt since 2nd half of April.

EM currencies with large current account deficits and a large portion of their debt in foreign hands (Turkey & Argentina) have sold off steeply. Countries on borderline of economic weakness could get sucked into the vortex (e.g. Indonesia, South Africa, India, Brazil).

EM debt at a record USD11trn with liquidity at US$4.9trn in 2017.[ix] A rise in USD rates speeded by the turn of QE to being a net negative, could destabilize bond markets globally creating a serious headwind for all fixed-income asset prices.

Commodities

Oil is 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.[x]

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

Commodity producers are likely to outperform. With the US economy operating at close to capacity, continued US Growth in the run-up to a recession will lead to a widening of the US current account deficit, which will be positive for growth in the rest of the world. The pick-up in global growth relative to the US will weigh on the US dollar and reduce the chances of a near term flight to safety in US dollar assets.

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

May 15, 2018

Footnotes

[i] NFIB small business confidence is at a 40-year high with a more spectacular jump in optimism among large company CEOs immediately after the tax cuts last year. Business Roundtable CEO economic outlook survey index: “Business Roundtable CEO Economic Outlook Index Reaches Highest Level in Survey's 15-Year History” (https://www.businessroundtable.org/resources/ceo-survey/2018-Q1) and NFIB small business survey (https://www.nfib.com/surveys/small-business-economic-trends/)

[ii] Caterpillar Inc. (NYSE:CAT) Q1 2018 Earnings Conference Call April 24, 2018 11:00 AM ET; see also https://www.cnbc.com/2018/05/08/cramer-caterpillar-tainted-industrial-earnings-season-with-one-line.html

[iii] Karya

[iv] Equinox Partners

[v] 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.”

[vi] VIX data 2010 - 2018

[vii] Gavekal, May 8, 2018, “The Illusion of Liquidity, and Its Consequences”

[viii] Karya

[ix] Bank for International Settlements: between 2010 and 2017 the total value of emerging market debt securities outstanding more than doubled from US$5trn to around US$11trn. Yet over the same period, according to the Emerging Market Traders Association, trading volumes in emerging market debt fell, sliding from more than US$6.5trn in 2010 to US$4.9trn in 2017.

[x] Horseman Global, BBL Commodities

[xi] Regal Funds Management

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