Market Thinking

making sense of the narrative

Market Thinking March

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Rotating out of long Duration Assets

March is a key month for most asset allocators, as the options expiry on the third Friday of the month is one of the first major opportunities to ‘reposition’ portfolios by putting on new hedges, rolling existing ones, or allowing them to expire at ‘triple witching’. Most years, Asset Allocators go into Calendar year end relatively ‘flat’ against their benchmarks and spend the first quarter considering their big picture macro themes and the need or otherwise to reposition. Often an unwind of the year end rallies in whichever asset means the benchmark does the work for them, i.e. by the time their quarterly meetings come around the markets have already adjusted, but periodically a powerful new narrative appears that warrants action. This year, that narrative is one of inflation/reflation and a rotation to commodities and emerging markets and while it is difficult to separate cause and effect, it is no coincidence that as we run into the ‘decision zone’ Bond Markets have hit an air pocket, as, with no yield to speak of and the prospect of capital loss to replace capital gain, there seems little reason to own them, let alone buy more. The same might be said of a lot of tech stocks – no yield and the prospect of capital loss – and we see some of the biggest FANG names looking decidedly weak over the last week. In effect we are seeing a rotation from long duration assets – long bonds and growth stocks – to shorter duration bonds and yield/value plays.

In currencies and commodities, the $ remains trapped in a 90-92 range on the trade weighted DXY, while Brent Oil is up at $64.2, a far cry from the negative numbers last May when the retail speculators got caught in the futures markets. Other cyclical commodities like Copper and Timber continued to head higher while baskets of industrial mining shares continue to outperform gold miners by a considerable margin, the role of Gold as a stabiliser in portfolios against Fiat currencies seemingly having been taken by Bitcoin. Despite a little profit taking, the latter has still doubled year to date.

Thus, if the last weeks of January were all about the Peasant’s Revolt in the Equity Markets, then the last weeks of February have been all about the sell off in the Bond Markets. Within our framework, Bonds now represent the biggest Short Term Uncertainty, the biggest Medium Term Risk and the prospect of the biggest Long Term Theme for Investors.

Short Term Uncertainties

The narrative machine has rolled on from the US Election and, indeed, also largely from Covid, since while another quarter may seem an age for the population in ‘forever lockdown’, for markets it is now within their short and medium term time frame. Last year of course, the March Triple Witching  came within a day or so of the bottom in the equity market – albeit that arguably had more to do with the Fed actions in the Fixed Income markets and also came on the back of a powerful Q1 rally in US long Bonds. This year, Bond Markets have been quite spectacular in the opposite direction, with long bonds dropping more than 14% so far this quarter, unwinding all the gains of last year and going to levels not since September 2019 and before that 2016. This has helped shape the new narrative on inflation, as has the rally in Commodity prices, although this also reflects that fact that the noise traders have moved back to their favoured hunting grounds in FX and Commodities. As such the inflation narrative is leading to selling of $ bonds and buying Oil, Copper and Asian FX. The more they perform, the more ‘correct’ the narrative is seen as being, even though all that is really happening is that more people are, literally, buying into it.

This is all being picked up by our Model portfolio risk models. As the first chart shows, our weightings within our Global Bond portfolio have shifted from heavily overweight Long Bonds (via the TLT US ETF) a year ago to zero by q4 (where it still is). At the same time the steady contagion into Investment grade and TIPS has left us largely out of these areas as well, with only high yield and Global Aggregates.

Equally in the Core Equity Model, we see a shift to Value and Size and away from min Vol and momentum.

In traditional terms this is appearing as a rotation into financials, Industrials and Energy and away from Utilities, Consumer Staples and Healthcare as well as Tech.

Portfolio Concentration is helping reverse a few of the momentum plays

One aspect affecting some of the short-term trader favourites – often picked up in factors as momentum stocks – has been the portfolio concentration effect. Successful active managers with a heavy exposure to a small number of stocks (i.e. taking stock specific or idiosyncratic risk to generate returns) can often generate their own momentum as they backstop their major positions and as new funds come in they flow automatically into their particular ‘winners’. This works well for them when everything is going up but can work against them equally should they face redemptions, whereupon they move from forced buyers to forced sellers and the rest of the market prices accordingly. The rapid growth of ARK active ETFs over the last 12 months from $3bn to almost $60bn is a prime example of this, in particular with respect to Tesla. A wave of redemptions has coincided with a near 30% fall in Tesla for example, which is their major holding across multiple funds. Their 3D printing fund has fared even worse, with their two largest holdings off 55% from last month’s highs. Other (non Ark) momentum stocks from last year such as facebook and Zoom have also had a tough few weeks, with the latter two sitting right at long term support, while the biggest Covid winner of them all, Amazon, has broken long term support and looks to be in something of a ‘sell the rallies’ phase.

Medium Term Risks

What to do with Bonds is a key question for Asset Allocators

The big medium term risks for Asset allocators are thus two fold – whether to rotate within equities – across sector, style and geography – and what to do about Bonds. In equities, as the above graphics demonstrate, our systematic framework has been giving signals consistent with a rotation from momentum and min vol to value and small cap for a few months now, as the market is telling us that it sees a reflation trade coming. We suspect that Asset Allocators will find it difficult to resist following this trend rather than be left behind ‘underweight’. Those fully bought in to the ESG environment may be able to justify remaining underweight Energy and material stocks if they have an ESG benchmark or perhaps wriggle to re-define their terms to allow, say, copper for electrification and LNG because it replaces coal. Others however will likely rotate away from Green Energy, which benefited from a theme/meme phase in 2020 and back toward big cap, dividend paying Gas and mining stocks. Value investors like Warren Buffet are of course already there in the likes of Chevron. He has also recently bought into a number of the large Japanese trading houses, picking up a number of themes, such as, exposure to commodities, global trade and the reflation cycle as well as deleveraged balance sheets and reasonable valuations.

With the momentum stocks fading, the tech overweights are likely to be trimmed as well. The general reflation environment continues to play into our 5Cs arguments from last year of Commodities, Cash-Flow, Convertibles, China and Crypto Currencies and increasing exposure to these areas by default gives a shorter duration bias to equity portfolios, with Crypto acting as the new Gold at the moment. For those reluctant to buy China, Japan and Australia offer a way to play both Asia and a cyclical upturn, with the US and especially US tech an obvious source of funding. Meanwhile in fixed income, our systems have been retreating from long bonds, TIPS and Investment grade for a similar period and we suspect that most Asset Allocators are similarly back down at the very short duration end of the curve as well as looking to reduce the overall exposure to bonds if they can. While the US$ remains weak but range-bound we would expect them to largely stay focused on the US for liquidity reasons if nothing else, but should the $ break lower – possibly in response to a perception of an ‘official’ policy- then a move to Asian Bonds looks likely.

Long Term Trends

Bond fund managers have had a terrible start to 2021 and are now considering that perhaps their bear market may finally be here.

The real question for long term investors in Bonds has to be “What are the Bonds in my portfolio actually there for?” Since the start of QE 150(!) months ago, investors, regulators, academics and others have turned a blind eye to the fact that bonds long ago ceased to be about ‘risk free’ income and became about (relatively) low volatility capital gain. The definition of risk was adapted to suit the existing portfolio position; equities were ‘risky’ because they were volatile, not because the cash flows were relatively uncertain compared to sovereign, or even corporate, debt. As such, the vested interests could always justify buying yet more bonds, something that played into the risk intolerance of the all pervasive Precautionary Principle.

Asset Allocators’ dirty little secret has been that for the last decade bonds have not been there for Risk Free Income but for low volatility Capital Gain

Now, however, with the year on year numbers swinging negative, the prospect of no yield (negative in Germany) and a capital loss is finally challenging this approach and basically ‘inflation’ is likely to be the excuse for a change of direction. They will tell themselves that it wasn’t that they were wrong to hold so much fixed income up until now, it’s just the inflation that’s coming that will justify an asset (re)allocation.

But where to go? The default for a while has been ‘alternatives’ based on what are (in our view) equally dubious claims of lower risk, focusing on volatility and correlation but conveniently ignoring leverage and illiquidity – let alone high fees for a group that ironically is hugely aggressive on fees elsewhere. However, as we recently saw with the Australian Future Fund, the Sovereign Wealth Fund set up by Former Australian Treasurer Peter Costello, a 40% exposure to Alternatives instead of debt plus a 20% exposure to cash left the funds return last year at below 2% against a requirement of 4%. While the FT was incorrect to compare this to a 12% return in Global Equities (that was in US$, not Aussie $), the fact is that an exposure that was 32% (mainly local) equity, that returned around 2% in local currency terms was seemingly not helped in any way by the cash and alternative exposure.

There is also the issue that increasingly the ‘alternatives’ are in fact derivative products repackaging capital gain as income. If we can believe that having at last been given access to the Magic Money Tree that politicians are going to step away and allow the Central Banks to impose monetary austerity once more then we can perhaps make the case that Bonds can once again generate sufficient capital return to offset their lack of yield. But it’s difficult to see that happening, the regime change from monetary to fiscal policy looks to have occurred as Janet Yellen moved from the Fed to the US Treasury. Moreover, as we noted in an earlier post, she has announced that she will inject huge amounts of liquidity back into the monetary system in the next few months, making her a more important figure to watch than her successor at the Fed Jerome Powell. Controlling the economy through fiscal policy may or may not be better than the blunt instrument of lower short term rates, but it almost certainly means an end to the (almost) free money for structured and leveraged products implying another regime change; away from alternative financial assets and back to real world cash flows.

With the prospect of a steepening yield curve (and the associated hit to bond positions from a mark to market perspective) we are also starting to hear more and more about “Equity Duration”, which in reality is a fancy term for high(er) yielding equities where the payout is more certain – as opposed to growth equities where it is in the distant future. It seems likely that, necessity being the mother of invention, a new terminology is being developed to adapt risk models to allow investors to allocate more to equity if it is “Short Duration”. Thus we see the short term uncertainties about fixed income translating into medium term risks about bond positioning and ultimately long term trends away from fixed income until the vanilla coupon payments represents a realistic level for the risk free rate.

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