Market Thinking

making sense of the narrative

Market Thinking, September 2019

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  • The Fed temporally lost control of overnight rates, Ford Motor was cut to junk and the IPO money tree looks very sick. US interest rates are no longer about the economy, the Fed needs to tackle the US Shadow Banking System. Urgently.
  • Uncertainly about Brexit Policy has made the UK essentially uninvestable for the last three years. We are getting close to a time when that will change. It’s time we talked about Brexit and EU without the UK. Actual policy, not political emotions will drive returns now for investors.
  • While the disturbances in Hong Kong are to date far less violent than the Gilet Jaunes or even previous historic summer riots in London, they raise meaningful short term risks for the region. In particular they can not be separated from other geo-political risks around the new cold war between the US and China. In the meantime it looks like end of days for Hong Kong’s Property Tycoon led economic model.

I first started writing market commentary in 1989 when I published a weekly note called the Quant View while I was at broker Kleinwort Benson. At that time I was starting a career shift from bank economist to Market Strategist and had already experienced the ‘excitement’ of the 1987 crash in my first week as a stockbroker, the original firm I had joined succumbing a couple of years later. I used Quant as a means by which I could hopefully either confirm or counter the anecdotal driven approach to market memory. The 1974 crash was at that point nearer in folk memory than the dot com bust is today and many if not all of the participants in the new world post Big Bang viewed things heavily through that prism and yet nobody seemed to see the Japan crash coming that year, nor the ERM meltdown in 1992. Joining James Capel as head of UK Equity Strategy, in 1993 then UBS  later UBS Warburg as head of Pan European equity Strategy in 1996, I saw Asian financial crises, LTCM collapse and of course my second big crash, the Dot com bubble. By the time I moved to Commerzbank Securities in 2000 it was as Head of Debt and Equity Strategy, ie looking at markets overall. This may seem like a lot of firms over a relatively short period of time, but with few exceptions almost all the brokers of that era were merged or went under, not least because the management did not anticipate the direction markets were heading and, more often than not, their so called star traders turned out to be simply using the bank’s balance sheet in a “heads I win, tails you lose” fashion.

By then  the weekly notes all had titles with variations on Friday Equity Briefing, Friday Market Briefing and finally, on joining start-up Execution Limited as a Partner and Global Strategist we settled on Market Thinking. I liked the almost nominative determinism of Mark(et) T(h)inker, but more important was that Market Thinking was a title for the process itself, trying to understand what the market was thinking as a way of judging what was short term noise and what was longer term signal for investors.  Execution didn’t go bust ( it was taken over) but by then I had already been approached by Axa Framlington, part of Axa Investment Management, with an opportunity to manage a global equity fund, or as someone said to me at the time, to put other people’s money where your mouth is. Even better, they allowed me to keep publishing a note under the title of Market Thinking and over the last 13 or so years of almost weekly publication I am proud to say that it developed a significant following amongst my clients. 

I left Axa IM this June with a plan to establish my own Asset Management, Wealth Management and Consultancy business, once again hoping to put other people’s money where my mouth is, this time to hopefully benefit from the disruptions coming to the investment management industry. As part of a recognition that institutional, wholesale and Retail investment is converging into a consumer led ‘experience’ it seems clear to me that what consumer companies now term ‘an omni-channel approach is what is needed. As such I will be writing a Blog, called, naturally enough Market Thinking, but once a month I intend to publish a longer piece, c 2500 words, similar to the recent incarnation of Market Thinking to go out in PDF format to email and social media as well as sitting on the blog. 

This then is the first of these pieces.

The Fed needs to tackle the US Shadow Banking system as a matter of urgency.

Back in July, the US Federal Reserve cut interest rates for the first time since 2008 to a range of 2-2.25%, a move which Fed Chairman Powell described as a mid cycle adjustment to policy as opposed to the beginning of a lengthy cutting cycle. This statement was clearly aimed at the financial markets although Wall Street, somewhat churlishly, dropped, apparently having been hoping for an even bigger cut. From an economic point of view, with unemployment at 3.6%, underlying inflation at 2% and wages growing at 3%, this all seems a little odd. Growth at 2% on the latest reading may be below recent quarters but it hardly warrants what are in effect zero real rates of interest, or as President Trump appears to want, zero nominal rates of interest. This is a problem for the industry devoted to trying to predict the direction of interest rates on the basis of economic variables and the notion of ‘the output gap’, the idea that interest rates are set so as to achieve the twin targets of growth and low but sustainable inflation. When we are at that point, the theory goes, interest rates should be set at neutral. There was even an attempt to quantify and codify this relationship between economic variables and central bank rates back in the early 1990s with the development of the so called Taylor Rule. Unfortunately like so many econometric models, having backtested Fed behaviour quite admirably, it stopped working almost as soon as it was adopted, indeed it currently says the rate should be 3.7% and rising, not falling.

So, we might ask, “what’s going on?”. Some of the more cynically minded will point to the response from Wall Street as supporting the notion that the Fed has been captured by the markets. Certainly when Chairman Powell suggested that rates needed to rise back in September last year the somewhat counter-intuitive 20% drop in equities and 20% rally in bonds prompted a rethink. Similarly a swoon in May on talk of tightening only to be followed by a rally to all time highs in June and July as easing became likely suggests that rather than looking at the high frequency economic data, the authorities are nervously eyeing the markets themselves. 

I would agree that markets are certainly driving the Fed, but not in a cynical way, rather I think the Fed is aware of the monster that has been created by a combination of Quantitative Easing and non conventional monetary policy and is trying to manage the systematic risks in the system. 

Against this background, September saw a number of worrying developments, most high profile of which was that, following yet another move down in the Fed Funds target rate range, now 1.75% to 2.0%, the Secured Overnight Funding Rate, (SOFR) spiked to 5.25%, requiring the Fed to partake in some urgent open market operations to supply much needed liquidity via the Repo markets for the first time since the GFC. Some of the reasons given were prosaic, end quarter needs for banks and tax paying corporates, greater use by the Treasury of its general account at the Fed meaning payments to them were not going via the traditional banking system. Meanwhile some were more specific – the idea that the attack on Saudi Oil facilities and the subsequent jump in oil prices had triggered a series of margin calls, or that the interruption to cash flows to the Kingdom of Saudi Arabia meant a liquidity shortfall there, are entirely plausible, but again not exactly unprecedented such as to cause the first intervention for a decade. Perhaps its a combination of these factors, with the structural/cyclical addition of a US Treasury that is simultaneously issuing a lot of paper (and thus drawing liquidity) at the same time as the Fed has been trying to reduce the size of its own balance sheet and a regulatory environment that is limiting the ability of financial institutions to lend on the basis of needing lots of ‘risk capital’. For now, the Fed has dealt with the liquidity issue, also reducing interest paid on reserves held with the Fed, but it clearly now needs to get more up to speed with liquidity management.

This failure is just one of the consequences of a decade of QE and unconventional monetary policy and highlights the fact that central banks around the world are neither controlling inflation nor are they encouraging economic growth. They are simply trying to keep the financial system afloat. They can not wish away the distortions they have introduced, they can only try to unwind them slowly. Investors need to recognise that with $17trn of bonds with negative interest rates, these Bonds are no longer an investment asset, they are a tradeable price, like commodities or FX. Equally they need to recognise that over 50% of the US Corporate Bond market, that is around  $3trn of US corporate debt, is currently sitting at BBB. That is a 400% increase since 2007 and as we know, much of this debt has been accumulated to fund corporate balance sheet activity, not improve productivity. M&A and, of course, Share Buybacks have been the major drivers behind this US debt binge. But at the end of the day it is cash flows that matter. In September, Ford Motor Company saw its $84bn of debt cut to ‘High Yield’ status, or what used to be more accurately referred to as junk. As we always noted, this is far more important than a broker cutting its share price target, for Credit investors are essentially rules based. If it is downgraded to junk, you have to sell it. The problem of course is that the junk bond market is much smaller and less liquid, so finding someone to buy it requires a big price gap.

There is frequent talk of the problems that China has with its Shadow Banking System, an informal and still largely unregulated system of credit that was allowed to arise in response to a failure of the traditional banking system to provide credit where it was needed in the Chinese economy. What we are seeing here is the precarious nature of the US Shadow Banking System. Like China, it is an informal and still largely unregulated system of so called ‘alternative assets’ that, far from satisfying an unmet need in the real economy have largely crowded out traditional loans and credit. Private Equity, Private Credit, peer to peer lending, venture capital, leveraged loans, high yield bonds, real estate and all manner of structured products have exploded under QE as yield hungry investors have been encouraged out of traditional capital markets into these areas, largely on the grounds that because they have low volatility that they are ‘low risk’. The irony that the crisis that precipitated the QE was in Credit Default Swaps, a highly leveraged and illiquid structured product sold as low risk because of low volatility should not be lost upon us. Investors need to recognise that illiquidity and leverage are sources of risk as well as return.

September saw some important developments here as well. The woes of SoftBank and in particular its involvement with WeWork are an important indicator of the (lack of) Health of the IPO machine. For years, but particularly since the GFC, the ‘trick’ has been to ensure that every fresh round of funding from VCs and Private Equity/debt took place at an ever higher valuation leading to the ultimate arrival of ‘a bigger fool’ who would allow the founders and early stage investors to cash out with their billions. Sometimes it would be a corporate, but increasingly Nirvana has been promised in the form of an IPO, where passive investors will somehow be forced to buy companies still burning cash at fantastical valuations dreamed up by investment bankers. Uber was a classic example of this, having received less than $10bn of actual cash investment in bonds and equity (including from SoftBank), it was initially valued at more than ten times that amount by the IBs, before settling at a mere $81bn, allowing the company to raise $8.1bn by selling a 10% stake. As of end September the market cap is now just over $50bn. Good for the seller if not the buyer. Rival Lyft has a market cap of around $12bn and has fallen over 40% since its IPO, although at more than six times revenues, and, like most of the others, still losing money, it continues to look very expensive. The end of the month saw another flop, with Peleton, a maker of exercise bikes and treadmills that streams virtual exercise classes (and is thus a tech stock..obviously) also losing money but pitching for an eleven times sales valuation, while similarly loss making Hollywood talent agency Endeavour cancelled its IPO a day before it was scheduled to take place. However, probably the poster child for this headlong rush for (someone else’s) liquidity has to be WeWork. The last round of WeWork’s pre IPO funding came from SoftBank who added $2bn at a valuation of $47bn, but even prior to launching the IPO the valuation was down to below $20bn, completely breaking the ‘ever higher valuation’ model. The IPO was shelved through lack of interest leaving a lot of awkward questions to be asked (and answered), not least that the IPO was needed to release crucial funding lines, meaning that WeWork, now without its founder CEO, are going to have to go back to Softbank. Sooner or later that is a big write-down coming.

This then is the dilemma the Fed faces. The US shadow Banking system is a $9 trillion industry, most of which is dependent on cheap leverage and it is fundamentally unstable. The US authorities need to drain the excess liquidity without causing a collapse. To some extent, the system is slowly suffocating under its own weight – the IPO machine and the junk bond markets will start to deliver collateral damage, suggesting a focus on positive cash flows for any investment. Meanwhile the Fed needs to learn a few lessons from other Central Banks about managing liquidity expectations, but there is also a role for regulators. As a first step they need to stop the growth in so called alternative leveraged products and discourage traditional investors from migrating to leverage. Eliminating tax relief on leverage for new structures and putting a higher capital weight for institutional investors in new leveraged and illiquid products would be a good start. Only then they can start to push interest rates back towards a neutral level and we might just find that the Taylor Rule starts to work again.

We need to talk about Brexit.

My previous CEO was Swedish Italian, his second in command Dutch and with one (US) exception the whole of the rest of the management board were French. Suffice to say then that writing anything about Brexit was not really encouraged. While this had bothered me at the time of the referendum itself, since in my view on the evening before the vote Sterling was priced to perfection as they say, regardless of the outcome, it has not mattered very much since then because the extra-ordinary manner in which things have unfolded over the last three years has essentially made the UK un-investable to anyone without UK liabilities. This however is changing and it is the developments here, rather than the lifting of any restrictions on my writing that prompts the call for investors to start to do some homework now, as the time for becoming active in the UK may be close at hand.

The first point is a key pillar of the concept of Market Thinking, Sterling is not forecasting, predicting or even ‘voting’ on anything. Rather it reflects hedging and other flows and, to a large extent ‘noise’. The currency markets are highly leveraged, extremely short term and act on the bigger fool theory, buy (or sell) on a piece of ‘market news’ then make a lot of noise to get the next person down the line to buy off you at a slightly higher price (or allow you to buy back your short at a slightly lower one). The moves are relatively modest in the real world, but when you are 50 to 100 times leveraged they are clearly meaningful. The point is that the narrative becomes increasingly one sided the more the momentum develops in the trade and the noise becomes louder to get the last person into the trade. As such the story or narrative is the most compelling just before the market turns. 

So it has been so far with Brexit. Going into the referendum, which most people expected to be a win for Remain, Sterling had squeezed up to $1.50 on the “remain is good’ narrative”. As such that night it was priced for perfection, everybody who had bought in to the narrative was committed and even if they were right and Remain won, there were no further buyers, while if on the off chance they lost and Leave won, then the downside was meaningful. As of course it turns out to have been. It is these risk/return skews that are so important to investors who often get caught up in the compelling narrative and lose sight of price moves already taken place. Importantly in saying people should have been selling sterling the night before the referendum I was not making a statement on who was going to win, even less on who should have won, just that the risk/return was all the former and likely none of the latter.

Right now, Sterling has fallen back close to the post referendum lows, but not because leveraged bulls have been cleaned out as in 2016, but because the bear story that ‘no deal is a disaster’ has gathered momentum in the same way “remain is going to win” did in 2016. Predictions that Sterling is going to Parity with the $ remind me of the ‘Oh so certain’ FX  trader at RBS back in 1985 who told me and my economics team colleagues that our fundamental views on FX were worthless compared to his market knowledge. The reasons he listed were all valid, but those were also the reasons it had got close to $1.05 in the first place. That day was literally the bottom for sterling and the start of my education in noise trading.

With no other meaningful investment flows, sterling has been given prominence as the arbiter on Brexit and the sterling bears are currently shouting it the loudest, picking on headlines about “crashing out without a deal’ and “cliff edge disaster” to press their case. Often it becomes circular, as political resistance to Brexit takes its cues from Sterling as somehow proving they are right, creating a false certainty around their predictions. And this is the point. Possibly for the reasons I myself encountered, there is very little written to counter the doomsday merchants about Britain’s economic prospects, the narrative has become very one sided. Thus to counter the argument is to look at risk and reward again even though it mainly attracts brickbats rather than bouquets. And that is why, to borrow from author Lionel Shriver, we need to talk about Sterling, or rather we need to talk about Brexit.

The subject of Brexit has become highly politicised and largely about opinion rather than fact, not least because literally no-one knows what will happen next, there are just too many branches on the decision tree. Hence apart from short term noise trading in currencies, market thinking has so far put the UK in the ‘too difficult’ box. Now despite the quite extra-ordinary behaviours of the British Political Classes, it still looks (to me) like the UK will leave the EU, with or without a deal, if not at the end of October then by January next year, which basically puts it in a three month investable time horizon. Importantly leaving without a deal does not mean trade will stop, nor does it mean that a deal can not be reached at any point in the future. In fact if we are to be technical about it, theEU has always insisted that the UK can not do a trade deal until it has left. The deal under discussion is about any future political relations with the EU. On trade, it is of course possible that the UK government will make a series of poor decisions on tariffs and trade that damage the economy as set out in the no deal disaster scenarios, but the probability is actually extremely small. Indeed the UK government has already announced a temporary tariff regime that would eliminate tariffs entirely on 87% of products, leaving protection only really for some agriculture. It is probably equally unlikely that they will produce a series of deals and policies that transform the UK economy overnight, but from a market point of view they don’t have to. Not being a disaster is all that is needed. The stock and sector winners and losers from post Brexit policy will only become evident as those policies are announced, but one place to start looking is those multi-nationals who have been lobbying most vocally for Remain, not just in the UK but elsewhere in Europe. Not unreasonably they are likely to believe that there is risk to their business model, most likely from increased competition if the UK leaves the Customs Union. In the meantime, while currently equity markets everywhere are feeling weak and uncertain, UK blue chip dividend stocks are currently offering yields close to 7% while 10 year gilt yields are offering 50bps.

Finally a few thoughts on events in Hong Kong. Shortly after I moved here in 2013 we saw the emergence of what came to be known as the Yellow Umbrella movement, as Hong Kongers, mainly students, protested the process of selecting the Hong Kong Chief Executive. The protests were largely peaceful, if disruptive, but ultimately actually left the people of Hong Kong worse off, for in demanding the ability to select the list of candidates as well as the already promised universal suffrage, they ended up with neither. Hong Kong’s Legislative council remains largely selected by business interests, particularly the ultra wealthy property tycoons, whose control of the available land for development is behind Hong Kong’s stratospheric property prices, which in turn lie at the root of many of the economic problems facing the people of Hong Kong that are currently being highlighted. These latest protests however were different. The mass turnout at the beginning was a genuine social media phenomenon, people saw how many others were (peacefully) marching and flocked to join. One country two systems is very important to the ordinary people of Hong Kong and the clumsy proposal of legislation on extradition was rightly seen as a threat to it and, through marching, the people effectively stopped it. Clearly now it has morphed into something different. The numbers are vastly reduced, a few thousand perhaps, not millions,  but are still significant as they are wildly different in nature with many openly seeking confrontation with the police. The mainland Chinese authorities are talking about ‘black hands’ of foreign interference and while that may or may not be the case, there are certainly foreign interests who are keen to use the disruption to further their own agendas. 

One obvious one is the current government of Taiwan, which is facing a General Election in January and has recently recovered sharply in the polls following a crushing defeat in last year’s regional elections after a strident anti Beijing campaign. Portraying the opposition as dangerously friendly to Chinese interests they have sought to position themselves as defenders of democracy and sovereignty and have struck some recent arms deals with the US. (Ironically it was the Taiwanese demanding that Hong Kong hand over a man who had admitted killing his girlfriend in Taiwan that triggered the original legislation that started the protests). Meanwhile, many US politicians of course have been using the unrest as part of their anti China rhetoric, and several have met with some of the higher profile protesters, while US NGOs are admitting to funding ‘democracy activities’. The Hong Kong human rights and democracy act that is now proceeding through the US congress requires the US government to assess Hong Kong’s level of political autonomy on an annual basis to determine whether the country should continue to have special trade status. This is rather like the ability to declare China a currency manipulator and is quite clearly part of the ongoing New Cold War that Hong Kong is now, sadly, caught up in. Third, there are, and always have been, elements in China opposed to the Xi regime and they also have an interest in keeping the disruption going. Note, as with the comments on Brexit, none of this is commenting on the rights and wrongs of the protests, rather it is to highlight the various actors driving the narrative both politically and from a market point of view. 

In markets, China bears are out in force again, still pushing their story of the need for China to devalue their currency to prevent their economy collapsing and wrapping it into stories about the protests. Others are pushing the old ghost cities and over investment stories from a decade ago and claiming that the trade war will damage China more than the US, ignoring the fact that China’s GDP is now driven mainly by consumption. Moreover, unlike the traditional emerging market model, it is not driven by a credit binge, rather by income growth. Chinese retail Sales growth slowed in July, to ‘only’ 7.6%, from 9.8% in June, meaning it dropped from three times the rate of US retail Sales growth to only twice. Ironically it is pursuit of those consumers that is driving western corporations. The fact that exports to China have fallen sharply is a major factor behind the serious slowdown in Germany, while US demands that China allow US companies into the Chinese markets are a clear hurdle in the trade war talks. The trade war is being presented as a win for America at the moment, but that is not the reality for western companies, many of whom are struggling badly. In fact, little noticed is the fact that the latest round of tariffs in the US have been postponed after frantic lobbying by US retailers.

Probably the biggest concern for China from an economic point of view right now is that as mentioned, the Hong Kong protests are used to justify a suspension of Hong Kong’s separate economic status, with the US killing the Hong Kong Economy as a way of getting at China. While at Handover Hong Kong was 27% of China GDP, today it is less than 3%, but it is still important, it is seen in Beijing as the inter connector between “the rest of the country and the rest of the world” and the legal aspect of one country two systems is a clear part of this. As such, I believe that the system currently works for the mainland and that creeping regulations will be dialled back. Meanwhile I am encouraged that China has so far resisted provocations and  while the start of the new student term has reduced the scale of the mobs it is unsettling that they have turned more violent and disruptive. While not of the scale and duration of the Gilet Jaunes in France, the economy of Hong Kong is suffering badly. Tourism in August was down 40% and in the hospitality industry a reported 70% of employers are on unpaid leave. Sunday nights in particular are a no go area as small numbers of rioters are throwing petrol bombs and police are using water cannon.

Watching and listening closely, we can detect a major shift in attitude from Beijing towards the current ‘rulers’ of Hong Kong, the Property Tycoons. These billionaire businessmen were effectively left to run the country after handover and until now the distortions they cause through their monopolies and limiting supply in the property market, and thus making every aspect of business excessively expensive, were tolerated because they ensured stability. Now that trade-off doesn’t look so good. The inequality caused by the ridiculous price of property did not trigger the protests, but is certainly providing the ‘nothing to lose’ aspect that is sustaining them. We already hear of proposals for taxes on new build properties left empty or unsold and increasingly it is mainland builders bidding on new sites. It only takes a small change in supply at the margin to shift prices and there is certainly a risk that there could be panic selling in residential property if the Hong Kong middle classes figure that their wealth is concentrated in way too many overpriced apartments.

Meanwhile, competition is starting to come into other Tycoon monopoly areas like Telecoms, albeit slowly, and when the system of only two supermarket chains and western food priced at literally 5 times the UK equivalent is finally broken up, we will know that things are finally changing for the better!

To conclude

Political tensions in the UK and Hong Kong are being used to feed existing narratives in markets and in some instances becoming echo chambers driving the noise markets in FX and fixed income in particular. This has left extreme pricing, both sterling and gilts versus equities for example are pricing in an extreme post Brexit scenario which, while possible, is a low probability. Meanwhile, with an actual leave date likely within a three month investment window, some homework should be done now on who will win or lose under likely post Brexit environments, most notably the competitive outcomes of not being in a customs union. In Hong Kong, the protests have led to exaggerated claims about the fragility of China, Hong Kong and the whole region that should be carefully weighed against the actual data. The fact that the US markets rallied into a rate cut in July and then fell sharply should be a warning for us here that while value is appearing around the world, the growth stories that seem to need a never ending source of cheap money are looking more and more vulnerable, especially as the IPO markets struggle and the Fed seems to be having to rethink its approach to system wide liquidity. The US has evolved a shadow banking system far larger and far more fragile than the Chinese version we hear so much more about. An institutionalised  false confidence that reducing volatility and benchmark correlation via illiquid and leveraged private markets was the key to reducing investors’ risk has led a charge into so called alternatives which is fraught with potential problems. While commentators obsess about trade wars and European political theatre, the big story is that the financial crisis was never fixed, merely delayed and how the Fed is trying to navigate this should be our key focus in coming months.



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