Are we there yet?
Markets are asking the same question as bored children stuck in a long delay at Dover “Are we there yet?” The second half of July saw yet another bear market rally and while we are not sure we are ‘there’, this one does look the most convincing to date in terms of putting in some sort of market low. Some of our ‘softer’ indicators, like Retail sentiment, Google word counts on topics like Bear market (down from index of 100 in June to 14 now) as well as opposite searches for terms like ‘new bull market’ (up from 16 to 94) are clearly more optimistic. Equally our more robust confidence indicators that fuel our model portfolios are also at the highest levels year to date (albeit 3 out of 5 and not that widespread.) We see the emerging stability in bond and currency markets as key, since it is volatility here that has led the medium term asset allocators to continue their deleveraging during H1. Leveraged traders look to have taken profits across the board (shorts as well as longs) and volumes suggest retail are back buying on dips. Thus a number of negatives for markets have abated, albeit there remains relatively low levels of confidence.
Moreover, several false breakouts mean that we (and others) will be a little more cautious than normal about re-entering Equity markets aggressively, not least as August has low liquidity and poor seasonality and the tradition of an ‘October Surprise’ is perhaps more pertinent than ever given the unstable political background, not only with new leaders in UK and Italy in September, but also the CCP meeting in China in October and of course the US Mid terms in early November.
Short Term Uncertainties – fading headwinds
The Macro Hedge Funds appear to have taken off their ‘bear market bet’ on Bonds back in June and in doing so have helped stabilise the bond markets and by turn reduced the need for deleveraging from the min vol Quant funds. (Bond volatility forces deleveraging of both equities and bonds). This lack of deleveraging removes one headwind for markets. A second fading headwind is coming from currencies, which have also been highly volatile, especially the Yen. As we discussed last month, it was the need to unwind $ hedges by the giant Japanese life companies that was the likely cause of the ‘run’ on the Yen during q2. Put simply, a Japanese Life company with $100 of US Bonds in January was short $100 cash as a currency hedge. But by the end of q1, the bonds were only worth $90 and thus the funds were ‘overhedged’. The FX markets only need to see a steady buyer (in this case of $s) to run a momentum strategy, with the narrative swiftly developing to justify ‘King Dollar’. By the end of Q2 however, this steady buying was done, and thus the currencies have rebounded and the $ is down, leaving many scratching their heads as their ‘fundamental’ story (on real interest rates or GDP) hadn’t changed.
Oil was another reversal during July. As we noted during the month, the real issue was that the price of the Benchmark being traded by the CTA macro traders, was being hit by more supply and less demand, even though the demand for oil overall wasn’t much changed. Middle East countries increased their supply of ‘good’ Brent to the markets by replacing domestic consumption with ‘bad’ Russian Urals oil imports. Meanwhile, Indian and Chinese refiners imported ‘bad’ Urals oil and exported ‘good’ refined products at eye watering margins. Thus the spread between Urals and Brent collapsed. For some reason Bloomberg still shows a spread of $30+, even though Urals Crude averages around $87, not much different from WTI and $7 below Brent – if we assume Urals has been relatively stable around $87, the following chart essentially illustrates this convergence.
Efficient Commodity Markets; Brent is simply converging on Urals
The fact that Brent has broken below its 200 day moving average is undoubtedly leading to some technical and momentum selling, but the bottom line here is that; in the same way that a rally in bonds doesn’t mean an end to inflation, a collapse in Oil prices doesn’t mean an end to growth. Rather, both mean that short term traders are taking profits and unwinding positions.
Medium Term Risks – Politics and Policy
Asset Allocators are risk managers above all else and have been de-risking all year, In this sense they are the people most keenly influenced by the Fed activity, one step removed, via the bond markets. As bond markets have stabilised (thanks largely to the profit taking by traders who had been short), so the deleveraging has stopped and while not ‘risk on’, we appear at least to be in a halt to ‘risk off’. Understandably, the perception nevertheless remains that the Fed, after years of supporting markets with the so called Fed Put, are currently ‘selling calls’, seeking to cap the upside as part of their (equally misguided) policy of controlling inflation through a reverse wealth effect.
Retail, who sit somewhere between traders and asset allocators, have started to go back in, as seen in ETF flows and in sentiment measures such as shown in the AAII bull v bear index. This has recovered from the lows from end June (which were the lowest since the GFC) and is now moving to ‘neutral’.
Retail, not Bullish, but a lot less Bearish
The rest of Q3 is likely to be dominated by a mix of relatively low liquidity and politics. September will see new leaders in UK and Italy, but more importantly for global investors are the CCP meeting in October (where Xi is set to be confirmed as Paramount Leader) and the US Mid Terms in early November. All sides will be indulging in narrative management between now and then and the task for markets is to work out what is ‘new’ and what is ‘noise’.
Meanwhile against this background we continue to have the ongoing situation in the Ukraine, which, while slipping down the pages in the popular press, is still a key variable in deciding the nature of the upcoming economic slowdown. The self harm of EU sanctions on Russian energy is certainly encouraging ‘international’ – ie non US – allocations to go more to EM/Asia than to Europe, while the unacknowledged (by their own Central Banks) sensitivity to short term interest rates of the heavily mortgaged households in the UK, Australia/NZ and the PIIGS countries of Europe threatens more damage to disposable income as interest rates are hiked to fight inflation that was never caused by low rates in the first place.
The emerging reality is that weak balance sheets are going to struggle (corporate or household) and cash flow (not cash) is going to be king.
Long Term Themes
Economies remain constrained by the dogmatism of the Triple Zeroes; Zero Interest Rates (central Banks don’t understand shifting household balance sheets), Zero Carbon (politicians have not done any cost benefit analysis) and Zero Covid (ditto). As such, changes in policy messaging will be closely watched. On balance we suspect that the Fed will continue to try and normalise rates – which is relatively little problem for the US economy, while attempts to follow this new ‘orthodoxy’ by the UK, Australia or any of the so called PIIGS countries will lead to serious slowdown in consumer spending, given the nature of household balance sheets in these countries – large amounts of floating rate debt.
Normalising interest rates will help restore the role of fixed income in portfolios to some extent and, certainly, our confidence indicators on US fixed income, both Sovereign and Investment grade are back to neutral, having been negative all year. Long duration equities are also recovering a little, although the aftershocks of the Tech IPO bubble contimue to reverberate, with Softbank and Tiger Global competing with ARK for the most eye-watering losses in Q2 and H2.
On Zero Carbon, Europe, under greater pressure from the self inflicted Energy Crisis, may be more pragmatic than the UK, where the Green Leap Forward policies seem to be embedded with both candidates for Prime Minister. The delusion that high energy prices are good on the basis that they ‘create Green jobs’ is literally equivalent to the Keynesian illustration of employing men to dig holes and other men to fill them in. Jobs are a cost rather than a benefit and the recognition that economic growth is a function of cheap and reliable energy seems yet to be acknowledged in the Political west.
Also missing from a basic understanding of economics is the realisation that if we refuse to sell any goods to Russia (for example), they have no need to earn revenues in our currencies, so they don’t need to sell to us. Equally, if China can pay for energy (it’s prime strategic weakness) in Rmb, then it has no need to orient its economy to exports. The west thinks that China ‘needs’ the west. Increasingly this is not true. One of the last ‘uses’ the Chinese had for the west was western capital, not in terms of savings (China has a savings glut), but in terms of price setting at the margin. We would argue that this ended a year ago when the Chinese effectively killed the ADR trade, whereby they shattered the illusion that companies could be 100% Chinese owned and yet simultaneously 100% owned by international investors (see opening the Blind Eye). The announcement at the end of July that AliBaba would seek a primary listing in Hong Kong was seen as both a hedge to further US regulation and sanctions and as a way to access the new source of capital; Chinese investors.
Russia and China are becoming increasingly co-operative and need the West less and less, which is driving the long term theme of West v The Rest, including an alternative reserve currency. From an asset allocation point of view, China and Russia can probably now survive without the west, but is the reverse true? Western rhetoric continues to assume the west essential, but what if it stops being essential? Even more scary, what if it has already has stopped being essential and we haven’t noticed yet? Scarier still, if Russia actually stops exporting cheap energy and China stops exporting cheap goods, what does that mean for western economies? Smart investors are starting to diversify towards the BRICS countries.
