Market Thinking

making sense of the narrative

Fear of being out replaced by fear of being in (anything but $ cash)

The most crowded trade in markets at the moment is $ cash. Fear rather than greed is dominating sentiment for both retail and professional investors and, with yields approaching 4%, cash is back as an asset class once more. Of course, this time last year, there was also fear driving the markets, except then it was a case of FOMO, Fear of Missing Out ; of ARKK, or Crypto, or meme stocks, or SPACs. Everyone ‘knew’ they were overbought, but was confident they would be able to get out at the top and we know how that ended. The expression that markets climb the stairs but drop down the elevator shaft is well founded. We noted at the time that a key date was going to be around Thanksgiving, the effective year end for many Hedge Funds and that profit taking in the FOMO trades might crystalise a rapid reversal. With the CTA hedge funds absolutely dominating markets this year and with their tendency to herd behaviour, the same can easily happen this year with the $ trade and the associated shorts in almost everything else. For us, this makes the DXY the key chart to watch, when it turns, cash will flood out of the $ in order to book profits and history tells us that that cash will flow in search of cash flow.

When the $ turns, cash will flow…in search of cash flow

As the political and market narrative managers spin to their own advantage, investors should see that the UK is cheap

As all the drama unfolds in UK Politics, (my colleague has a young son who will have seen two monarchs, three Prime Ministers and at least three Chancellors before his first Christmas) it is important to remember that for all the attempts by the political narrative managers to say otherwise, this was not brought about by the markets – and thus future market movements will not really be a function of UK politics either. The mini Budget launched as the Truss government ‘hit the ground running’ occurred just before the end of the month/quarter and was used as a catalyst that allowed the market narrative managers to spike panic so as to exit their existing (already highly profitable) short positions in Sterling. Meanwhile the sell-off in Gilts that exposed the hidden leverage and illiquidity in a key part of the UK Pensions market had more to do with the BoE leading the markets to believe in 75bp of tightening and then offering ‘only’ 50bp (as well of course as being pat of a widespread sell off in Bonds globally that was the other huge quarter/month end trade for the hedge funds.) The good that was done by the Bank of England stepping in early was somewhat offset by the announcement of an early end to the help, which was unfortunate to say the least and helped foster an air of panic. The fact that the Governor of the BoE welcomed the new Chancellor as ‘like minded’ might lead some to speculate that the Bank wasn’t an entirely passive player in this drama.

Despite this not being about the Budget per se, the narrative managers in the political arena nevertheless spun things as being all about market instability and a vote of no confidence in the government, such that their plan to install a technocracy is seen as ‘calming the markets, when in fact sterling had already rallied strongly from an oversold position and the Bank of England had in reality restored stability in the bond markets.

One set of narrative managers created a panic to make a profit, while a different set of narrative managers exploited it for political reasons

As I said in a piece on Bloomberg TV this week (see clip here) perhaps more significant for investors was the statement by Private Equity giant Blackstone that “UK assets are absolutely a buy“, something we discussed in our October Market Thinking. Also (perhaps inevitably), so do these people who see great opportunity to buy discounted illiquid assets from the UK pension funds caught in the LDI trap (see Leveraged Dangerous and Illiquid for a refresh on exactly what that was all about). A cynic might of course observe that said Asset Management company have a very good idea what is in these structures on the basis that the investment bank with the same name advised on most of these structures in the first place (!) Upcoming market moves are likely to be about cash chasing good value cash flows, nothing to do with political headlines.

And its not just the illiquid assets from (semi) forced sellers. The strategy team at Jefferies estimate that the FTSE250 ex financials is trading on a free cashflow yield of around 8% adding “With the US dollar at least 15% over-valued versus GBP based on PPP – almost the same as the average takeover premium , UK companies offer excellent value as they are essentially self-funding purchases. Many of the companies also have a relatively high cash to market cap suggesting they exhibit significant under-valuation.”

In fact, if we are to look at currencies and the opportunities being offered to $ cash investors, then the real problem child/opportunity is not Sterling, but the Yen and hard as they might try, it’s difficult to blame that on Liz Truss. As discussed earlier this year, part of the problem for the Yen has actually been caused by the dramatic fall in the value of US Treasuries – off more than 30% year to date. While obviously this has been brutal for all long-only managers, for Japanese life companies (some of the biggest owners of Treasuries) there has been the extra complication of hedging strategies. Hedging $ exposure means that a Japanese life company is short $1bn of US$ cash for every $1bn of Treasuries, but with the drop in the value of their Treasuries they found themselves with only $700m of Treasuries but short $1bn of cash and thus ‘over-hedged’. The steady buying back of hedge positions has been a major factor in the $/Yen cross. Forced buying is as big a gift for traders as distressed selling is, and while we always search for (and are given) a fundamental explanation, the reality is that, as usual, it is the so called market mechanics that are driving much of this.

Japan is even cheaper

Indeed, three years ago this week, in the last days of the Old World (pre Covid), we travelled to the Rugby World Cup in Japan and even then found it surprisingly good value. A decade or more of price deflation had finally brought prices down by the 40% or more that closed the gap between everything being bought out of pre-tax revenue by corporates to being bought out of post tax revenue by individuals. Just like any other market, retail prices have been trying to reach a clearing prices for many years. That was at a rate of a little over 140 yen to the pound. This week, amidst the chaotic headlines about Sterling ‘collapsing’, we see that the rate is nearer to 170! This means that a McMeal at 700Yen costs the equivalent of GBP4 and, more importantly a pint of draught beer, at 600Yen is now the equivalent of GBP3.50!

Falling Yen makes Japan great value, even to the British

One thing is for sure, the upcoming winter Ski Season in Japan is going to be very busy, just as the number of overseas visitors to the US are going to be very low. Real money is already starting to arbitrage the exchange rates, financial market money, currently too fearful to leave the safety of $ cash, is going to follow soon enough.

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