Market Thinking January 2021
December 30, 2020
As we look into 2021, we recognise that while on the one hand markets tend to extend their time horizon somewhat at the start of the year, on the other hand the world does not change simply because the calendar does. Indeed, we have observed that the big asset allocation changes often happen around March, specifically around the options expiries, where hedges are either rolled over or allowed to roll off. The first few months of a New Year therefore tend to see the conversations dominated by medium term asset allocators, but the activity dominated by the short term traders.
Short Term Uncertainties
Short Dollar, Long Commodities, especially Oil and industrial metals
Short Term uncertainties are exploited by speculators, traditionally using a lot of other people’s money in the form of borrowing (leverage), to turn a small move in the real world into a large profit for themselves. As such, they need to generate a lot of excitement about a small directional move in order to sell on to the next person. They drive the daily boom/bust narrative of the markets and while sometimes their actions spill over into the real world of investing, they (and their views) need to be treated with due caution.
Traders tend to cluster in the leveraged markets of Foreign Exchange (FX) and commodities, where they are leveraged anything from 10x to 100x. As such, they are prone to behave as what we would call ‘noise traders’, putting on heavily leveraged positions and then trying to encourage the rest of the market to follow them in – and thus allowing an exit for themselves. In doing so, they create a ‘narrative’, a plausible macro story as to why, for example, the $ will either go up or go down, say 20%, when in fact they are really only trading a move of one or two percent. Similarly, in commodity markets, where leverage is smaller, but still meaningful, the actual trade will be for a 10% move, but the narrative will call for a doubling or a halving of the price. Periodically, the traders will bring their bag of tricks into Equity markets, adding leverage to existing momentum and pushing the directional narrative. Here, the story is perhaps for how a company could double in value over the next six months or how a sector could drop (or gain) 30% relative, and history shows that this type of behaviour frequently happens in the first quarter, with an eye of the year-ahead narrative compelling the asset allocators to follow them in at the March options expiry and thus provide a window to exit.
So, as we look into Q1 2021, we would expect the traders to pick on several uncertainties to drive their narratives. First, and perhaps most obviously, the US$. As we have been arguing for the last few months now, the Trade weighted Dollar index (DXY) has been trending down steadily and looks to have no technical support. Continued uncertainty in US politics will likely be used as an excuse to drive the $ down further, perhaps with speculation that a weaker $ is now official policy, while the last-minute Brexit deal is being used to justify Sterling breaking out of its recent trading bands. Equally the trading deals done in Asia under the broad Regional Comprehensive Economic Partnership RCEP will be used to support a positive view on currencies like the Rmb and the Australian Dollar.
Commodity trades are often inversely linked to the FX trades, such that a weak $ often means oil prices go higher and indeed, as the US$ index has been dropping, the Oil price has been rising back above $50. This partly reflects the price dynamics of a rebound in China demand and a fading of the US Shale gas supply story, but it is also a function of an increase in commodity prices generally and will fuel a narrative of increased money supply leading to inflation and thus be used to try and prompt the asset allocators to ‘reduce risk’ by allocating to commodities. In particular we note from our four sector approach that the fact that it is the real world spending part of government that is expanding its balance sheet (as opposed to the Central Bank part) means that where it spends its newly printed cash will likely see a demand/supply imbalance and thus inflation. Hence a focus on infrastructure commodities like industrial metals and timber.
Medium Term risks
Being underweight Asia and the 5 Cs of China, Cash Flow, Convertible Bonds, Commodities and Crypto Currencies
Just as short term speculators are ‘Greedy’, focusing on maximising upside, so Medium term Asset allocators are ‘fearful’ and will focus on limiting (their) downside and will close out underweight and overweight positions against the benchmark if the combination of the narrative and market movement is powerful enough.
The aim of the traders will thus be to bounce the risk averse asset allocators into rebalancing towards a benchmark on account of areas that they are ‘underweight’ starting to outperform. The most direct link to the commodity and currency speculation in the ‘emerging market’ trade. Traditionally, since emerging markets have a lot of $ denominated debt (thanks to the wonders of the Washington Consensus approach to economic development), a fall in the $ tends to benefit them as an asset class, especially if they are not big importers of commodities. Today, this tends to mean wrapping in China as it is now part of the benchmark and of course South Korea – another beneficiary of RCEP. Meanwhile, quietly and with little fanfare, it should be noted that Japan, still a large part of the Global Equity benchmark – and now enjoying some currency strength – has been steadily creeping higher.
The reality is that most Asset Allocators are overweight US versus the rest of the world. As we noted when Australian Institutional Investors were reluctant to invest offshore in the 2000s when their currency was strong, this has partly been down to the strength of the $ – something likely to be challenged in q1. Secondly, with Asia seemingly having survived Covid better than the west from an economic as well as a human health perspective, the long standing, but largely ignored, observation that Asia has most of the growth opportunities will also be at the front of the asset allocators’ thoughts in q1. Indeed, if we look at the graph from the OECD on q2 GDP growth, the East West skew is very obvious.
Asia Growth looking better than the West
This pressure to rebalance will be strong, not least since it will bring back folk memories – if not actual memories – of important directional changes such as out of Japan in Q1 1990 and into the US, or out of US Tech in q1 2000 and into US Financials and Energy. Or out of US Financials in 2006 and US energy in 2010 and back into US tech. These big directional switches did not have to be caught right at the turning point but 50 or even 80% relative moves are career making or breaking (they are also quite important for underlying investors as well obviously!)
Long Term Trends
Avoid Mis-Allocation of Capital (ESG, Alternatives, bonds), Shrinking of Public Markets as source of wealth creation, de-dollarisation/decline of FX markets, Consumer de-leveraging
Long Term investors have the luxury of standing back from the noise traders and also of remaining indifferent to the quarterly return paranoia of the Medium term Asset Allocators. They should however be aware of the dangers of institutional trends in destroying returns on capital. In this we would caution against not only long term trends in terms of risk management leading to ‘investing’ in negative yielding bonds, but also the push towards illiquid and high fee ‘alternatives’ in private markets and also of the obsession with ESG, which in our view misrepresents the ‘success’ of the short energy/long tech trade as a long term active strategy delivering alpha.
One of the concerns about the response to Covid around the world is that it is ushering in a New Normal along the lines being promoted by the Men of Davos, but, in some senses, one could argue that this New Normal is already here. For example, one of the dominant trends in the Fund Management Industry (as opposed to actual investment) is for Environmental Social and Governance (ESG) funds, combining as it does a degree of political and social activism in the state or semi state sector with a desire to avoid the tyranny of the broader benchmarks that dominates thinking in the ‘active’ fund management industry. Thus, almost every state administered pension fund or sovereign wealth fund or any fund representing public sector employees now requires some form of ESG overlay, which in practice means an Environmental overlay, which for all the assumed complexity ultimately means no fossil fuels and an approved list of stocks that essentially conforms to the UN Sustainability Goals. In effect, the political activists have already nationalised a large part of private saving and are seeking to allocate capital according to their priorities rather than necessarily those of the underlying pensioner or saver. Currently they can claim that this is a costless exercise since ESG has outperformed, but this is largely down to a single pairs-trade of short energy and long tech. At its peak, energy was 12% of the index, now it is smaller than Microsoft. No ‘conventional’ fund would have been allowed to be 100% underweight an index constituent sector due to ‘risk’, especially not one that size, but ESG funds were, meaning that comparing their return with a conventional fund, or indeed the index, is an unfair comparison of risk/return.
This sleight of hand both explains the relative historic performance and the likely inability of the pairs-trade to continue to deliver meaningful returns, simply on the mathematics. Moreover, if, as it looks, Oil and Gas prices are set to rise this year then the energy sector may well be one of the better performers, putting the ‘success’ into reverse. What will not happen however is that the money will come out of ESG – even if less goes in.
A second trend already well established is also a favourite of the Fund Management Industry – alternative investments. Just as the risk management tool of the Index was used to deliver ‘superior returns’ for ESG by allowing them to take hidden benchmark risk, so the alternative sector was allowed to take different liquidity risk as well as to use leverage, with the lack of mark to market volatility touted as an advantage even if it meant that money was trapped. This has resulted in some serious distortions to markets as private equity, private credit, leveraged loans, Real estate and other high fee but illiquid assets are allowing market professionals and insiders to command most of the available investment returns. The latest example of this are Special Purpose Acquisition Companies (SPACs) which are essentially cash shells floated on the stock markets looking to acquire private companies and effectively IPO them, bypassing investment banks. In many cases these are the new exit routes for the existing ‘alternative market’ insiders in Venture Capital and Private Equity, but raise the prospect that most of the growth and cashflow will be extracted in private markets before ending up in public markets when they are little more than annuities. We would expect to see a lot more of this shift from public to private, especially for attractive cash flows
A third long term trend already underway is Capital Apartheid; some have almost unlimited access to low cost capital while some have almost none. Post Covid, we may well have an semi-permanent type of furlough for millions of people, essentially a rudimentary Universal Basic Income (UBI), since as we have seen with QE, once something like this is given, it is very hard to take away. The potential problems with this are twofold however. If, let’s imagine, this UBI comes in the form of a digital credit, (and we know all major economies are looking at Digital $s, Digital Yuan etc) then it can easily be made into a credit that can only be spent in a certain way on ‘approved’ items in the way that the US currently tries to do with food stamps. It could easily extend to approved stores or with approved online retailers (guess who). This not only increases the threat of a Social Credit Scoring system, so decried when seen in China but so secretly desired by many officials in the west, but obviously it removes the ability for most of the household sector to obtain much in the way of mortgage credit, forcing deleveraging and sale of assets to those with access to unlimited credit. In effect, the new oligarchs will own the assets and the people will rent them. There will be no high street inflation, since social credit will be spent on things with excess supply. As household balance sheets (ex Oligarchy) shrink, inflation will remain low and asset prices will be reset with respect to cashflow.
In fact, this all looks surprisingly like the situation in most of the ‘third world’ after the Washington Consensus had come in to ‘help’. A powerful political/industrial Oligarchy owning all the assets and extracting most of the rents and cashflows, while the ability to generate personal wealth is restricted to any except those within the new aristocracy. Rather like Britain in the days of Robert Walpole when the aristocracy built large gated communities at the end of long driveways to separate themselves from the peasants whose assets (land) they had just awarded themselves, we already see gated communities and ghettos emerging in the west, while the new laws governing freedom of movement and freedom of speech seem to be being applied very selectively. I can travel because I am an important person, but you can not. They can protest, because I approve of their cause, but you can not, since you seek to criticise me.
It is with some irony therefore that we look to our 5 C’s as a way to survive this shift already underway. Ironic firstly in that a focus on China is based on the fact that China is heading towards more open markets, just as the West is going in the other direction and secondly in that it has a focus on Convertible Bonds as a ‘lower risk’ but completely liquid way of playing equities at a time when investment advice seems to be for a combination of negative yielding bonds and illiquid private markets. With the west crushing growth as part of its political shift to control the allocation of capital, Asian markets look attractive generally, as do their currencies. It might be an exaggeration to say that the US looks today in a similar position to Japan in 1989, after all, as Mark Twain says, history rhymes rather than repeats, but the warning signs are certainly there. The other two Cs are cashflow – if attractive emerging cash flow is being hijacked by the SPACs, then already emerged cashflow at reasonable prices looks a good angle. Here we would probably prefer Quality earnings to, say, value, but as with another C, commodities, there is definitely some cyclical opportunity here as well.
Lastly, we have Crypto Currencies. Ultimately Bitcoin is the leading currency of the blockchain – itself a long term driver of creative destruction across much white collar ‘industry’ that has been overlooked in a year when the ability for white collar workers to ‘work from home’ has distracted from the fact that ‘home’ can now be offshore(d). One example among many, is smart contracts, which can and will reduce the price and available billable hours for many lawyers by perhaps as much as 90% – much as electronic trading and the Big Bang in financial services reduced the commission on stocks from 1% to 20bp in a decade and to almost zero today. Bitcoin becomes the expressway for using blockchain and then converts back to ‘normal’ sovereign currencies afterwards, with almost zero friction and transaction costs along the way. This is ultimately a threat to a lot of the banking and payment systems out there. Some have referred to Bitcoin as digital gold and it certainly offers a similar diversification benefit.
Covid, or rather the response to it, has accelerated a number of longer term trends already underway, notably the increased democratisation of savings in emerging Asia at a time of decreased democratisation in much of the west. Ultimately this will lead the directional flow of capital. Short term speculators will highlight this and medium term asset allocators will respond by ‘reducing risk’ and chasing the existing benchmarks. Longer term investors, if not constrained by top down politics and regulation, should focus on investment fundamentals like cashflow, liquidity and diversification (ex US and non market cap weighted) rather than be caught up with benchmarks and daily volatility.