The more things change, the more they stay the same.
Gary Lineker synthesized the essentials of soccer in a memorable if somewhat simplistic quote. “Football is a simple game. Twenty-two men chase a ball for ninety minutes, and at the end, the Germans always win.”
When it comes to finance, the same postulate applies. Politicians, and Politburo members (read central bankers), or us fund managers and analysts of all kinds, come and go, but “Government Sachs” is the permanent result. As the French (Karr) would put it, “plus ça change plus c’est la meme chose”.
Trump is a teenage-minded social disruptor, not an economic game changer. Trumponomics, or reflation, are nothing new and are not going to be all that different. Expectations with Obama were even higher, and the economic result at the time was … more Government Sachs (with the Obamacare disaster as a poisoned heritage)! Trumpist honeymooners, please come back down to earth. Deflation or reflation, more QE, yield curve control, infrastructure spending, or some helicopter money, hardly matter -in the neglected long run.
No president can change deep secular trends. Like global warming, debt overhang, growth to debt increased dependency, the factual bankruptcy of not few sovereigns, aging society, technology-based job destruction, the deteriorated educational level of the workforce, or unfeasible promised entitlements. On these issues, Government Sachs people argue that the glass is half full. I won’t argue about it -it is not a worthwhile contribution to engage in estimating the degree of fullness or emptiness.
Half full or half empty, these issues are serious stuff. Changing the unnerving, deep structural trends, takes commitment, hard work, a couple of decades, and it sure implies turning things upside down. This US President and his Government Sachs team are certainly not interested in turning this “winner takes it all” economic model upside down. They want to remain on top. They are a club of smart, self-serving billionaires!
So, what’s all the market fuss about?
I talked about all those 2016 liquidity enhanced financial price swings in my last post, and I stated that the narrative follows the facts. I still think so. Let me add something else: behavioral economics runs the show today. The success of the ongoing (quasi aeternal) Central Bank put, and constant risk suppression by hyperactive POMO desks, has finally modified the behavior of economic agents. They feel that risk has effectively been outsourced to Draghi, Yellen, Kuroda, and Co. Consequentially, and for as long as we are in a context of negligible yields for IG bonds and Sovereigns, speculation with term premiums and equity will remain rampant. There is no alternative parking for the smart money, so the show must go on. We will bet the ranch on every twist and turn in whatever narrative “du jour“.
Sadly, it follows that liquidity pumped swings, fabricated credit booms (like the PBOC turbocharged credit boom in 2016), and outright POMO manipulation, have all but taken me to being “lost in translation”. So far, I still know where I want to go, but I wonder where and when the next surprising/unexpected move is going to flare up. Short term handling of the fund’s NAV has become exhausting -you never know what’s going to hit you next. Sometimes you are unable to find out what hit you last!
Market price swings are getting worse, and even more unpredictable. And it’s not a question of just being humble and looking up what somebody else has to say -in order to find the lost thread in your narrative. I do that daily, and, unfortunate as it is, I can see that I am not alone in my musings and contradictions. The latest “pissing” contest between Gundlach, Gross, and Minerd, on the TA limit needed to declare the end of the bull market in Treasuries, is a case in point. When it Is all about how to use the ruler to define your trades, it is an ominous sign for us all. With all respect to classic TA (I use it as a tactical discipline), rulers are becoming much too prominent. I crave for substance.
Thankfully, CNBC cheerleaders and some lobotomized Perma Bulls have a clear view: Keep calm and BTFD! If they flop, POMO desks will ensure they got it right. They are natural allies. It’s comforting to see a steady trading method that can easily be back-tested all the way back to 2009 -for foolproof results. Most like it. In this regard, I found backing suggested equity longs, with a Jeremy Siegel “stocks for the long run” kinda quote (in the latest Government Sachs report for 2017), exhilarating -and somewhat akin to the ruler drawing contest between some of our otherwise respectable (“first” or “second tier”) top guns.
For me, and many others, too many inexplicable price swings based on presumptive, but inconsistent macro or fundamental reasons, make our narrative ideologically incoherent to an unacceptable degree. I read that even Jeremy Grantham has lost a third of his AUM. Maybe he should just go hire Jim Cramer to replace Ben Inker as the new top asset allocator (sorry Ben). Cheer up Jeremy, paraphrasing soccer fans, “you will never walk alone!” Think about it. Most global strategists are in disarray. Some say we are going back to 2% Treasury yields fast, and others postulate some relevant follow through to the 2.6 or 3% level for 10-year yields. Some call to fade the equity rally, while others suggest going long “all in”. Some say 2017 is going to be the year of the cat(tastrophe) in bonds or stocks, others insist in another muddle through year.
Our investment results and the depth of the argumentation are hardly awe inspiring. We, active managers, are all an endangered species. When you exclude managers in the “long only” model, the rest of us are close to a Treblinka environment (see performance table above, via zero hedge). So, to be honest, we must accept that it makes survival sense that most opt now for a slow grind higher in equity prices -and it certainly looks like the path of least resistance (however crazy it may seem).
The crowd is now long everything. Anxious about bonds, while exuberantly certain about equities, and deeply enamored of the Trump and reflation story -or any other that predicts a status-preserving way out of this mess. The alternative is dire. Frankly, Corbyn, Farage, Sanders, Grillo, Le Pen, or Iglesias in Spain, are not in my top percentile of relaxing and enjoyable dreams. Given the choice, I’d rather stick to the Government Sachs regime -but it is as unsustainable as the Russian Tzar was a century ago!
Thankfully, at least for that end, recent data have cheered the crowd further -as the see light at the end of the tunnel. That should keep things going an extra couple of months. See, I told you we were short of skilled labor! We obviously need thousands of skilled ophthalmologists (or is that light-seeing a neurological disorder instead?).
An objective global PMI and ISM pick up have helped turn perception around. People think reflation is already working -even though we haven’t even started to reflate. And please remember that only four months ago, we thought a deflationary outcome justified negative rates in plenty 10-year sovereigns! Anyway, this is, notoriously, a business cycle extension. A short-lived and unexpected one (I didn’t see it coming), but it has a narrative behind it. What happened?
Keeping it simple,
- we are picking up the positive impact of the energy pricing turnaround (the energy sector was rapidly becoming a black swan)
- we are switching over to some cost inflation due to the lack of employable skilled workers (wage growth is concentrated in top tier workers).
- Also helping the reflationary play, is the impact of shelter costs in labor’s cost of living (almost everywhere), pressuring inflation of “what counts and is relevant to our cost of living” (not what we wish, and is testimonial within the monthly expense laundry list). Low-interest rates stimulate consumption and home buying, but then the cost of shelter goes through the roof. This is a conspicuously obsolete economic model!
- There’s something else at work. I think this PMI revival has roots in the massive Chinese stimulus initiated in the second quarter of 2016 (with their growth scare), and now officially terminated (November 2016).
This last issue is key. The size of their debt-financed fiscal stimulus is similar in size to the 2009 reflationary effort and comes on top of serious money printing by both BOJ and ECB. It is hardly the first time the Chinese bail us out. Nobody else has the courage (insanity?) to engage in 12% of GDP, credit financed, infrastructure spending. Particularly when their current debt to GDP ratios are already outrageous. Their debt to GDP figures have gone up by an additional 20% in just one year. A 2009 sized, reflationary effort, that has gone mostly unnoticed (even though the chart below is worth viewing).
Europe and Japan have been the major external beneficiaries of this spending spree. In Japan, that helps explain the extraordinary resilience of their economy to the USDJPY shock when it hit the 95 level. In Europe, it helps explain the increase in exports in the core. Commodities-based economies like Australia or Brazil have also been bailed out. Hey, to their credit the Chinese were a relevant force in the global quest to stabilize crude prices -creating strategic crude reserves to help deploy their reserves away from their traditional USD investments. Maybe we should give them a few artificial islands for free, as a well-deserved gratuity for their global economic services. They have bankrupted their country to help us all (and themselves)!
Explaining the past is not easy nowadays, but it is certainly an easier construct than predicting the future. If this Chinese last ditch effort to stabilize their economy is, as I think, relevant to recent improvement, then this was most likely the last hurray. Once the Chinese impulse fades (mid 2017?) only Trump spending might get things going again. Japan and Europe just can’t afford to engage in relevant fiscal stimulus. For once, I agree with Yellen: neither can the US. And no, I don’t know if Trump will finally do it -it’s difficult to read a teenager’s mind six months ahead. We shall have to see how it plays out.
Nevertheless, Trump fiscal stimulus included, or not, you never know how long they can keep this going. They can do that just adding more and more aggregate global debt, or, even better because of the deleveraging effects, adding outright base money. Helicopter distribution included in the pack or not, I sincerely doubt they will keep up the global printing by the end of this year. That 2.9% wage increase in the US is the canary in the coal mine. Regardless of the fact that it could well be related to some productivity measurement problem and/or reductions in work week effective hours. The essential issue is, that there is no slack left in the skilled labor market, and if that is the case, printing is kaputt (unless we want to crash steepen the global yield curves). Bulls must pray that the 2.9 print is an outlier! Maybe it is.
Reality is stubborn because underlying facts always remain -despite all the day dreaming taking place. It is my strong view -that has been explained many times over the last couple of years, that financial markets are grossly overpriced -and you are buying a lot of “air” in the pricing of your long-only portfolio. Losses have been kept at bay by POMO desks -and the herding complicity provided by the quest for yield. But there is no value embedded in long-only portfolios -other than the alpha you can accumulate. And even a low beta can wipe that out fast! This is the mother of all bubbles (yes, I know you don´t want to read that. Believing in Siegel-investing is reassuring, and definitely helps preclude episodes of cognitive dissonance).
However, before you read too much into my thinking, let me say that I find too many market moves jaw-dropping. That is not a good precursor to trading success. And, naturally, as I write, I find myself down close to 1.3% for the year. I will surely fight that, but I’m not happy, and it hardly speaks for the value of my thinking. To my surprise, I perceive my conviction remains intact, though notoriously time-worn, and somewhat dented by those sage words I underlined when reading Kahneman’s “Thinking fast and slow” – a great read.
“Confidence is a feeling, which reflects the coherence of the information and the cognitive ease of processing it. It is wise to take admissions of uncertainty seriously, but declarations of high confidence mainly tell you that an individual has constructed a coherent story in his mind, not necessarily that the story is true.”
Our market choices “du jour”.
“The Market” is that kind of concept that even Government Sachs people respect (after trying to manipulate it using all the means available to them). We must respect it as well. Capital preservation counts, and impedes a permanent strong short implementation. If it weren’t for that, I would just sell 100% of my AUM short and come back in five years time -to collect my capital gains.
Real life is always more complicated, particularly when you implement the details. I keep spending most of the trading money I generate in the markets, implementing equity shorts that have to be stopped out at a loss. I lost more than five percent of AUM doing that last year. Trading was good, so year-end results were acceptable. But it is discouraging. I can’t help thinking I am throwing good money at POMO desk bonuses, to no avail. Yet, there is no alternative to stops. They are to traders, what diamonds to girls: our best friends! And yes, they are economically and emotionally every bit as expensive! (Wow … I’m not sure women will appreciate the concept symbiosis).
But I have no other options left. Even arguing against the validity of the foundations of Keynesianism, I will admit to John Maynard being sharp-tongued and smart. To wit, let’s just recall his “inoubliable” phrase. The market can remain irrational for longer than you can stay solvent. Hardly comforting when you are short European banks and financials as I am right now (50% of AUM at the money as I write). When Mr. Market allows, I plan to bring my short up to 100% (current level is 120.5 for the Eurostoxx bank index). Timing is always tricky, but the European banks’ business model is broken, and the NPL risk and sovereign risk (holdings of EGBs) will only get worse in the periphery.
So, here comes the difficult part of being a fund manager that thinks beyond the crowd. When the market runs against you, you can’t fight the tape and stick to your guns (if you want to preserve capital), but you have to keep focused and strategy driven. You engage in small profit/loss trades, trying to get back into the fray to bid for the big money trades of the year, as soon as you possibly can. A tiring and costly procedure.
On the other side of the investment spectrum, my “long-only” investment manager colleagues have a better time. They stick to picking the best alpha they can find and accept the volatility provided by their beta, as “the hand of God” (save for Argentinians that really believe God gave his hand only to Maradona). Religion always provides that warm and cozy comfort that is key to its timeless success. Sticking to what you know is always soothing: most of us can select an alpha positive portfolio more than decently, and you depend a lot more on the quality of your work. The reward will hopefully be there. If the ecosystem cracks, you will “fail conventionally” (I always end up quoting Keynes). But you will likely keep your job.
Regrettably, though, uncertainty is still there and is never totally outsourced to your Central Bank. Sorry for bringing that up now, maybe destroying your wishful dreaming of “an endless surf of the bull wave”. The good thing about surfing is, you never have to dive and try to find out what is really going on. When you do, you just work your way to the surface asap. We should all easily understand why physical and intellectual surfing are both highly addictive! As Kahneman says (same wonderful book):
“We can be blind to the obvious, and we are also blind to our blindness. … Our comforting conviction that the world makes sense, rests on a secure foundation: our almost unlimited ability to ignore our ignorance.”
Anybody who thinks that this is a moderate risk environment that favors engaging in long-only strategies is being affected by the previous behavioral biases. Our global economy does not rest on a secure foundation. It is an obvious house of cards that can blow up with even the lightest morning breeze. It very well might not do so for a time (an eternity if you ask me), but it very well could, … any time. It pays to remember that daily -and try to at least not be blind to our blindness, however convenient it may turn out to be.
In the end, I guess we will have to live with that. And try to be practical as well: we must pay for food, energy, and shelter, monthly, however crazy the market might turn out to be. In Spanish terms, I feel like a bullfighter trying to do a good job at a basic cape pass, or even dare a “Veronica pass” with a bipolar, amphetamine-fed bull. Bullfighters rarely die of old age (unless they are lucky because the technique doesn’t play such a relevant role) It’s the same thing for fund managers. We need Napoleonic luck. You never know what Mr. Market may be up to next!
A currency market update.-
For a true eternity now (two and a half years and running), my clear advice has been to remain long, or at least flat, the USD. It was, and I think continues to be, the right call. But as I said in my last post, the party is in its late stages -and you can’t overstay. It has been nice while it lasted, it not only provided an anchor for your currency allocations but also a nice yield pick up as well (when compared to the rest of the DM currencies). But, as I said in December, it’s a crowded and dangerous trade now.
The arguments for a follow through on the USD run are still there, and nearly intact. Dollar shortage is conspicuous when you look at Eurodollar rates (LIBOR), or the cross-currency basis swap. But the world economy can’t handle the punch in the chin that a strong dollar implies. Government Sachs people know that. Regardless of a dearth of warnings by officials, we should read their lips. They will strive to tame the USD bull. They are at it right now -in a joint operation with the PBOC.
A riskier, more volatile, USD position, upsets me greatly (and is costing me money despite seeing it coming). I need to place my money somewhere. Going short USD is not an alternative. Other relatively safe currencies are not as liquid, and are, for the most part, negative yielders. The euro would be a practical alternative, at current levels, if geopolitical risk weren’t stratospheric -and its yield curve so outrageously “nirpy”.
India (INR), a promising story last year, is now the mess that we knew was coming when they de facto fired Raghuram Rajan. Sterling is a lottery ticket on Brexit negotiations. NOK, a blackjack, sorry crude oil, play. CHF, and the Kiwi are too expensive. SGD and AUD are, for different reasons, highly correlated to the CNY. And, sorry gold bugs, I have never trusted Gold as a store of value: it is the paradigmatic example of the law of diminishing marginal utility. With a very low starting point if you exclude jewelry.
Take the USD out, and we are left with no good choices. Some SEK is the only viable choice, and it didn’t work well for me last year. I have been finally vindicated by the last run from ten even in the euro cross, to the 9.50 level as I write. But SEK is not a free market, and it comes closer to an explicit politburo pricing procedure (it moves together with unanimity and dissent on the board). Anyway, at current prices, it is still cheap enough.
We can’t commit to SEK for most of our AUM. For the most part, we have to remain reluctant and uneasy USD bulls. I know I am not providing you with more valuable advice here: as I said before, I’m lost in translation. Next post in Cyrillic or Yiddish!
Lastly, whenever the carry allows you to do so safely (not easy), don’t forget the no-brainer trade of the year. Short the CNH. Whatever happens to the almighty USD, the CNH will be worse off. You can take my word for that, particularly if you average your longs using PBOC interventions. In the long run, there is only one direction for the renminbi. Timing and carry costs are the only “if”.
The bond directional trade.-
Wow! That sounded great. If only I -or anybody else- knew with a decent degree of certainty the direction of bond yields! Let me tell you something though. If this was Russian roulette, and I had to make a choice, I would remain short long-term bonds, particularly in Japan and Europe, but also in USD bonds. We might get a bounce in bond prices, but if we don’t … it will be the loss of the century!
I see two forces at play in global long bonds. I do not think sustained, decent global growth is attainable without a global debt reset -and other substantial changes in the model. That speaks for bonds, particularly in the context of an equity debacle. Recently I heard that thesis sustained by both Elbert Edwards and Raoul Pal. I wholeheartedly agree with them.
But current rates already factor that in. I think this last summer we just saw an overshoot due to the crowd perception of limitless “NIRP” and money printing, in what was thought as a perpetual deflationary environment. Even if deflation is perpetual, and deeply embedded in our economic prospects, those prices were not sustainable. There is a limit to everything, despite desperate and undoubtedly resolute CBs. I don’t doubt the Ice age. I just think there are limits to sustainable bond pricing, however freezing the economic environment might be. Negative rates, even for the short terms of the curve, cannot be enforced for long.
All in all, risk reward favors keeping duration low, playing for bounces in prices if that’s your hunch, but moderately. An extension of the bull market in 10y Treasury yields would hurt big. We can’t afford that risk in this meager return environment.
Credit spreads will be contained by the reflationary perception of achieving escape velocity in the global economy. But only for so long, because this perception will be trumped by reality (June-July at the latest). Term spreads are now really designed by CBs and implemented by POMO desks. They target the Sovereign curve and allow for a market pricing of the Mid-swap.
In the European periphery, sovereign spreads are particularly wobbly. Pay close attention to that. Buying the EU peripheral spreads is the trade that can make you rich in weeks. Timing and CB politburos are the usual spoilsports that might ruin your financial party. Nevertheless, I think you can safely buy the Italian 10 year spread to the Bund, below 150 bps -averaging down all the way to 140 bps if needed. I doubt there is a major risk below that level.
If you have the guts, and a profit cushion to use for that, I think going long jap equities (using futures to avoid JPY risk), and short 10y JGBs simultaneously, makes sense. My wife says don’t do it, but, you know, she is biased because she has heard a lot about the widow-maker trade. And funerals come expensive nowadays!
My never ending, always costly, attempts at equity shorts.-
I loved this chart, courtesy of Jesse Felder. Because of the switch from equity to debt, with massive buybacks paid by incremental leverage, it makes sense to look at the whole liability side of the balance sheet (debt plus equity), when valuing a company. It underlines how stretched valuations are. Of course, I can think a dozen valuation charts to frighten most of you, but this one is really relevant, and clearly, summarizes the US equity market folly. The rest of them are not that far behind.
I have two specific ideas on the issue of global equity market outrageous valuation. One is shorting European Banks (euro area). The other is implementing a Japanese equity long (hat tip Andrew Lapthorne) but only if against a short in JGBs or some other equity market. The Russell 2000, and the FTSE are my best candidates. More on that next month.
Thanks for bearing with me. This post was way too long. My apologies to all.