Market Thinking

making sense of the narrative

February Market Thinking

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Following the powerful bounce from the March 2020 lows and the strength of the Santa Claus rallies at the end of the year, it was perhaps not too surprising to see some backing-off from the major equity indices towards the end of January, not least as many investors and asset allocators will be reviewing the likely very strong fiscal year returns due for the year to end March, given the timing of the market lows. Profit taking and index ‘hugging’ are likely to appear and perhaps not surprisingly the 12 month laggards such as Value stocks like Banks and Energy all saw good inflows and good performance for the month.

January is often seasonally weak and there used to be a saying that “As goes January, so goes the rest of the year”, but as our favourite Chartist, Nick Glydon of UK Brokers Redburn, points out, in 8 of the last 9 times we have seen a down January, the market has actually ended higher for the year. So we wouldn’t actually read too much into it.

January is Often quite weak for Equity Returns

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Source Redburn Securities, S&P500 Index monthly returns.

The US equity markets were mainly down in January, while Europe and Asia were higher, although to a $ investor a small bounce in the currency meant that Europe was also down in $ terms. Asia by contrast was up in both local and $ terms, with Hong Kong leading the way at +6.1%, while China saw currency add an additional 1% for a monthly return of +5%. In fact, with China, Hong Kong, Taiwan and Korea between them making up almost 2/3rd of the benchmark, the case for diversifying into Emerging Markets is strengthening – even if it is really no longer a BRICS call but a Greater China one.

Chart 1: Emerging Markets now a Greater China/Asia call

Source Bloomberg

There is a similar case for diversification being made in the Bond markets, with Chinese Govt Bonds at 3%+ offering some yield cushion against capital loss, certainly compared with US bonds at a little over 1% and German Bunds still offering negative yields. The strength of the CNY (the offshore Chinese currency) is further adding to the attraction and undoubtedly an allocation to Asia/Greater China is a prime focus for many Asset Allocation discussions at the moment.

The value rally ran out of steam mid month, although Global Value was still the best performing factor over the month at +2%, whereas both quality and minimum volatility were down a little over 1%. Indeed, the positive returns seemed to be shifting to Commodities, with Oil up 10%. Bitcoin also saw a mid month correction, but was nevertheless still up around 20% on the month

Short Term Uncertainties

January saw the end of the uncertainties around the US Presidential Race with the inauguration of Joe Biden and the effective Political Banishment of President Trump amid somewhat hysterical claims of insurrection. That same emotional/political response has led to some hugely non-critical thinking about Biden’s first set of policy announcements, which were widely praised even if they were in effect identical to ones that had been roundly criticised months, if not weeks, earlier when Trump presented them. Alternatively, some moves were widely praised simply because they reversed Trump policies. In fact, what we see so far looks like a return by the Biden/Harris administration to the policies of the Obama administration. Over the next few months we suspect that some more objective assessment of policies will likely lead to a reduction in enthusiasm and an increase in uncertainty.

Meanwhile, some of the New Media that worked so assiduously to help the Democrats remove Trump may be wondering if they are any better off. By demonstrating their huge power and influence, the likes of Facebook and Twitter not only alienated the half of the US population that didn’t vote Democrat, they also frightened the politicians, not only in the US, but also the rest of the west, who now look nervously at that display of power. Looking at the price behaviour of FB for example suggests that the widely held growth portfolio of the so called FAANG stocks might be running out of steam, especially if regulators get involved. Something to keep an eye on, especially at the retail level, where emotions are running high at the moment in the US, with some strong parallels to the China markets in 2015 for example.

Ironically, with Trump no longer providing headlines with his daily populism inspiring tweets, the ‘little people’ provided their own headlines in January, with a form of uprising against the establishment, the battle fought from their laptops as they used their brokerage accounts to put an enormous short-squeeze on several of the big US hedge funds. The month therefore ended in a frenetic burst of activity and with accusations and recriminations all round as the (previously) highly popular Robin Hood trading app stopped individuals buying certain heavily shorted names. The reality was that by gathering in such size, the small traders effectively triggered the very protocols designed to prevent the large traders from manipulating markets and exposed the need for brokers like Robinhood to post collateral for their clients (which is the real reason for limiting orders).

Medium Term Risks

The GameStop debacle is an example of how, periodically, the mechanics of the markets work to provide an opportunity for some profitable arbitrage that then gets closed down, if not by regulators, then by the markets themselves. In this case, we cannot see how the regulators can refrain from stepping in to protect the integrity of markets and how the net result will likely be a forced deleveraging of the private investors. There will be margin calls and, likely, further moves to limit the selling of leveraged ETFs. While the Reddit Chat rooms will doubtless complain bitterly, the wider interest will be served if all participants have less leverage in the system, for this is not providing necessary liquidity, rather it is driving unnecessary levels of speculation. The risk however, as always, is that any forced de-leveraging can be destabilising as ‘distressed’ sellers have little say in pricing. This is not the same as a short squeeze being forced to cover, but can certainly produce distortions. Moreover, often it is the good (and liquid) collateral that has to be sold to meet the margin call, which is why equities are always at risk from leveraged trades in fixed income markets going wrong (as they invariably do).

Meanwhile, the moves by the outgoing Trump administration to limit US investment in Chinese firms deemed to have ties to the Chinese government appear to have done little more than transfer ownership back to Asia, with a concurrent upsurge in New Issuance coming through the Hong Kong Markets. Indeed it is highlighting the contrast between the (Asian) Industrial Capitalism model, where money is being raised for business expansion and investment and the Western Financial/Rentier Capitalism model, where money is being extracted on behalf of leveraged financiers. Capital in search of a return will naturally gravitate to the former.

Long Term Trends

Thus the big trend as far as we can see is a migration of western capital to the East in search of either normalised bond yields or opportunity to access growth. The mechanics of benchmarking will continue to ensure that trends, once established, persist, such that these flows attract their own momentum. The eventual normalisation post Covid is likely to coincide with a strong commodity cycle, given a combination of government spending of their new ‘free’ money on infrastructure as well as ongoing infrastructure spending in Asia and Emerging Markets. As always, lack of supply at early stages will drive both prices higher and enhance profitability for low-cost suppliers.

Meanwhile, the likely removal of access to leverage to retail investors/speculators is part of a longer term move of capital apartheid; those with plenty of capital will continue to be able to access more capital very cheaply, while the vast majority will not have access, even at high prices. This means that strong balance sheets will become ever more important, as will access to cash flows. The ‘Peasant’s Revolt’ against the Hedge Funds may lead to some helpful reductions in speculative leverage all round, but the smart money is backing the big money in this fight. As someone pointed out, this is all a little bit like a prison riot; they break out periodically, but ultimately we know how it all ends.

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