Market Thinking

making sense of the narrative

Are short term markets giving us a glimpse of longer term trends?

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Market Thinking looks for how the behaviour of short term traders can spill over into the actions of medium term asset allocators and ultimately long term investors. Right now, we are watching the behaviour of the Currency and Commodity markets – dominated by short term leveraged ‘noise traders’ and seeing a clear possibility that they are going to trigger the asset allocators. While the US equity market remains firm, both the Dollar and the long bond look weaker, suggesting that international investors are taking more money off the table ahead of the Elections. By contrast commodities tied to international growth, such as copper continue to strengthen. While these are short term moves it is worth considering if they might presage longer term trends.

Politics

The final debate was better than the first in terms of coherence with Trump looking considerably more “Presidential’ this time around. For investors there was little to grasp beyond subjective views on outcome probability. Interestingly for international investors, outside of immigration, foreign policy didn’t feature at all. The questions seemed largely constrained to the Biden campaign talking points of attacking Trump on race and Covid, followed by what was essentially a promotion of the Green New Deal. President Trump did manage to get a few points across from his term sheet – strong economy pre Covid, especially on job creation, as well as highlighting Biden’s tax proposals and teasing out a statement that was anti the oil industry. He also managed to get a response to the “laptop from hell” story, where the Biden defence – that the intelligence agencies think it is (another) Russian plot – is not going to stop it becoming more of a talking point over the next two weeks.

On balance, Trump did nothing to lose his base, whereas Biden, who doesn’t have an equivalent personal ‘base’, struggled to balance out the competing parts of the Democrat support beyond an appeal to “Never Trump”. Saying Obama care would come back as Biden Care won’t have helped either. As ever, it is about the swing voters in the swing states and objectively it feels like if any of them moved at all, it will be away from Biden on issues such as taxes and ‘shutting’ down the Oil industry. Trump also managed to portray Biden as a machine politician who has had decades to do the things he now claims he will do. The biggest risk to Biden is likely to be abstentions. The biggest risk now to corporate US should Trump actually win is going to be big Tech, who have abandoned any impartiality over news reporting and would undoubtedly face regulation. On that basis, they may prove to be the best ‘betting’ indicators over the next two weeks.

Short Term Uncertainties

Equity Markets are still largely in ‘neutral’ ahead of the US Election, but short term uncertainties are appearing in currency markets and volatility is picking up. As recently highlighted, the CNY, the offshore Chinese currency that we have been watching closely has now broken through previous resistance to move to new two year lows (strength) against the US$, while the overall trade weighted $ index itself has failed to rally convincingly and appears to have resumed its downward trend. US Long bonds, having performed very strongly this year on a flight to quality argument are also a lot weaker, having given up long term support, while the opposite side of the global reflation trade – Copper- hit new highs as Chinese growth continues to return and the supply demand balance puts on a squeeze.

Medium Term Risks

For asset allocators and medium term investors currencies only matter when they break out of trading ranges and the impacts move into percentages rather than the second decimal place. This is for the obvious reason that the short term traders are enormously leveraged while the asset allocators are not. The biggest medium term risk on currencies remains a deliberate Dollar devaluation policy akin to the move following the decision by President Nixon that cancelled the convertibility of $ into Gold in 1971, marking the end of the post war Bretton Woods system of fixed and semi fixed exchange rates. At that time, the Treasury Secretary, John Connally famously announced at a G10 meeting in December of that year that a depreciating $ was “Our currency, your problem.”

The reality is that, should the dollar weaken, the momentum feature that means a rising dollar attracts more assets into dollars, goes into reverse. And not just for equities. As noted, the US Long Bond ETF, TLT has just broken its long term support lines, having just completed a fibonacci 38% reversal of its 2020 rally.

The dilemma for Asset allocators is that while on the one hand they may concede that having almost 60% of your Global Equities in $ based stocks is taking an implicit currency bet on a something that could easily drop 20%, on the other hand being that far away from the benchmark is not anything they would risk. Thus, as we saw with Japan in 1989, when a similar weighting issue was keeping almost 60% of global Assets in Japanese equities, the ‘low risk’ strategy of benchmark hugging kept Asset allocators in the high risk, as in expensive, asset in the high risk currency – all the way down. Unconstrained investors may want to consider thinking about lower dollar exposure in advance.

Long Term Trends

De-dollarisation and digital currencies

The longer term trend would be that the short and medium term shift away from $ and $ assets produces a structural shift by longer term savers and ‘real money’ traders in FX and commodities such as corporates.

The end-game for this is de-dollarisation and the end of the dollar’s extra-ordinary privilege as De Gaulle described it. However tempting it may be in this current climate of shock and awe to see this as a one off event, we in fact expect this to emerge over time and would watch out for the incremental steps of evolution rather than revolution. One suggestion we have made before is for China to start to issue offshore bonds backed by and pegged to the SDR, the Special Drawing Rights ‘currency’ of the IMF. This would appeal to many institutions wishing to diversify their currency exposure – the SDR basket weights are : U.S. dollar 41.73%,  euro 30.93%,  renminbi (Chinese yuan) 10.92%, Japanese yen 8.33%, British pound 8.09% – while at the same time not forcing investors to put much more than 10% of their holdings into the Yuan. The lack of liquidity in the market means that the yields would have to be slightly higher, but that is hardly a big cost compared to the geo-strategic benefits.

A second, obvious, route already being explored is the utilisation of the bitcoin eco-system (ie the blockchain) to create digital sovereign ‘coins’. Think about this in the context of AliBaba and its financial offshoot, Ant Financial, shortly to be the world’s biggest ever IPO, where the plans for a digital Yuan would fit in seamlessly. A digital banking platform that allows anyone to bypass the current SWIFT based banking system, not just in Yuan, but in any currency. Digital banking has been creeping up for the last few years, but hasn’t yet really jumped to mainstream. This could be the ‘smartphone moment’. While corporates may be slow to change, the barrier to entry for individuals is a lot smaller – as our old friends at Gavekal point out, corporates still use Microsoft, but most individuals have switched to the Apple eco-system. We have already seen something similar with the world of investing, where many western Asset Managers continue to expect the asian savers to follow an insitutional low volatility, low tracking error model based on relative returns, when in reality they are much more focussed on absolute returns and are sat between high activity trading and ultra low activity buy and hold.

Shadow Banking continues to evolve

To this latter point, we note the latest iteration of the evolution of the US Shadow Banking system, with an article in the FT about Private Credit, suggesting that asset managers are looking to raise over $300bn from long term investors for these ‘alternatives’. In effect this means Wall Street gets to push out the traditional banking sector and take handsome fees with no credit or duration risk to themselves. The regulations are making it difficult for Small and Medium sized Enterprises (SMEs) to get access to credit – in the name of ‘risk’ – while simultaneously the financial engineers have almost unlimited access. The rules based system means that (primarily US) Shadow Banks, i.e the Credit Asset managers, get to take high fees from high(er) risk credits while the actual balance sheets at risk belong to the long term investors, who thanks to QE need the higher returns on offer to match their liabilities. However, since regulations mean that they are not allowed to invest in liquid public markets – because they are deemed too volatile and thus too risky – in order to achieve these returns the long term institutional investors are required to take on liquidity risk (the money is locked up) as well as , quite likely, some further embedded leverage risk as well.

It also raises the interesting prospect of, say, a French SME borrowing money from a Dutch pension fund or a Middle East Sovereign Wealth fund via a US asset manager with no European financiers – or in effect regulators – involved. Along with the Special Purpose Acquisition Companies (SPACs) designed to bypass IPO listing requirements, we have to ask if this regulatory arbitrage is in the market’s true interest.

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