In Market Thinking for July, we noted that, after one of the best ever quarterly performances for US equities, we thought that the choppy trading at the end of June signaled a changing of ownership from leveraged speculative traders to asset allocators. Furthermore we thought that the traders would opt to take their toolkit of leverage and narrative back to their more familiar hunting grounds in commodities and FX – at least those not intending to take the summer off in the Hamptons or the Med. And this indeed is what seems to have happened. Outside of US tech, most western equity markets have struggled to maintain upward momentum, while gold, silver and the Euro have all run strongly. Indeed, behind all the Covid noise, the weaker dollar generally is perhaps the biggest story for July, not just against the Euro, which saw a relief rally on what was effectively an (other) Italian bond bailout, but on a trade weighted basis more generally.
We have noted previously that there is a meme going round that in years to come historians will be asked which quarter of 2020 they specialise in and so far in q3 we have a new and different narrative from the previous two quarters. Where Q1 was originally about the emergence of the Covid virus in Asia and triggered a widespread precautionary cyclical sell off, it was largely ignored outside of Asia and the financial markets until mid February, when its arrival in Europe and New York and a margin driven market meltdown helped drive a widespread sense of panic amid unprecedented levels of civil intervention in the west. The second quarter however, saw a rapid rebound in markets thanks to financial authorities acting hard and fast – notably the Federal Reserve which moved quickly and aggressively to prevent a 2008 style meltdown in the illiquid credit markets. As such, while Q2, as just revealed, was one of the worst ever in terms of economic performance for the US economy, it was one of the best performing ever quarters for the US markets, So far in Q3 however, we have reverted to something more like early Q1, with July seeing increased levels of uncertainty driven almost entirely by politicians. With stop/start lockdowns and a thoroughly confused narrative in many countries about how and when to open up economies again, businesses are finding it almost impossible to plan and many have moved from writing off Q1 or even H1 to writing off the whole year.
Short Term Uncertainty
The month of July saw a re-emergence of Covid related uncertainty in markets, or, more precisely, an increase in uncertainty about governmental policy globally relating to Covid-19. It has long been obvious that the biggest risks are not from the virus itself, but from government policy in response to it. Despite the number of ICU admissions and deaths falling exactly as predicted early in the days of the virus – that it would follow a logistic function and would largely be gone by mid year -governments everywhere, except perhaps Sweden, seem to have transitioned from a policy of slowing the spread of the virus in order to prevent medical facilities being overwhelmed, to one of somehow believing that social distancing will ‘stop’ the virus. As a result, draconian measures are being brought in everywhere to ‘stop a second wave’ when the only real evidence of such a second wave is an increased number of cases rather than more hospitalisations, let alone deaths. This was particularly obvious in Hong Kong, where despite almost universal wearing of masks and two week compulsory quarantine for arrivals, cases still rose and deaths moved into (merely) double figures. Nevertheless in this new totally risk averse world, the HK government closed bars, restaurants, cafes, beaches, pools, gyms and schools. Similarly the UK government did regional lockdowns and introduced new quarantine restrictions at minimal notice and on the basis of higher test results rather than higher actual hospitalisations.
Increased testing produces increased ‘cases’ almost by definition, not least because if 80% or more people are asymptomatic, contact tracing will mean testing more of them. This is at least partly down to the promotion of the idea of a vaccine as ‘a cure’ which is worrying in that it focuses too much on a single event that may itself not be achievable.
August is traditionally a tricky month to navigate, with low volumes and general lethargy giving rise to headlines about the “Dog Days” of August (which is actually to do with the Dog Star, but often interpreted as meaning simply bad). With market breadth narrowing onto a few big tech names and the economic uncertainty remaining elevated, caution is once again in the wind.
Medium Term Risk
It is worth acknowledging that this increased short term uncertainty also has a strong political element to it, most notably in the US, where the Democrats appear to be following a strategy of maintaining as much economic disruption and fear as is possible, as that is what the polling gurus are telling them will win the Election for them in November. All Joe Biden has to do is stay alive – and preferably not say very much. The latest drop in US GDP, of minus 9.6% for the quarter, was actually not a surprise to forecasters, but was reported, not coincidentally, everywhere as minus 32.9% on an annualised basis to sound so much more dramatic, something that plays exactly into this narrative. Incidentally on the same basis, the Eurozone was actually slightly worse, but wasn’t reported that way.
Partly in response to this pressure on the domestic economy from Covid, the Trump administration are following an exaggerated policy of using a foreign war to distract from troubles at home. In this case it has been a notably escalation of the Cold War with China, which has undoubtedly increased risk premia in international markets. Secretary of State and former head of the CIA, Mike Pompeo has been driving the rhetoric higher, touring the world seeking to compel ‘allies’ to join the Blue Team of USA against the Red Team of “Tyrant China” to use one of his more moderate phrases. From an investor viewpoint, this key medium term risk, escalation of a New Cold War, has thus ratcheted several notches higher in July and doesn’t even look like slowing, let alone reversing, in the next few months.
Nor has the US let up much on its other campaigns against non conformity in countries like Iran and, notably, Russia, where the use of further sanctions to try and prevent the final completion of the Nordsteam 2 gas pipeline from Russia to Germany adopts a thin veneer of national security concern to disguise what is basically US economic interest. Germany in particular, who has largely had a ‘good virus’ compared to most other countries – certainly in Europe – is starting to push back and the longer term trend of Eurasia forming and the US becoming more isolated remains intact.
The agreement in Europe for a Covid relief programme is essentially kicking the Euro debt crisis can further down the road and Italy now has access to the funding it needs to keep its own show on the road. This undoubtedly helped European Bond markets in July and the Euro also rallied strongly as the prospect of another 2015 style crisis receded – at one point being up over 5% on the month. This was helped by a general malaise in the $ exchange rate globally and the trade weighted dollar fell almost 4% during July, with little or no sign of any technical support. As with all things foreign exchange, there is always a positive narrative and a negative narrative for any currency and the appropriate one starts to appear to chase the direction the market is already moving in. Thus as we look into August, the negative aspects for the $ – politics, poor economic data, too much money printing etc will start to be highlighted. A weak $ will undoubtedly be used as a stick to beat Trump with over the next few months – along with the weak economic data. All they really need though is for the equity markets to sell off sharply. Whether or not it succeeds, we would suggest that the prospect of a multi Asset attack on the US – not from the Chinese (who would doubtless be accused), but from the collective Anti Trumpers – is a genuine risk for August and early September.
Chart 1: Trade Weighted Dollar has cracked
Longer Term Trends
If the weaker dollar starts to become a longer term trend, then this will certainly help some of the emerging markets who have taken on far too much US$ debt. It will also likely result in higher prices for $ based commodities being consumed outside the US, notably Oil and copper, both of which have continued their strong recovery from their technically oversold positions back in March. The key driver of their demand of course continues to be China, despite the best efforts of the US to try and constrain its growth, and it remains important to watch the price of the offshore Yuan, or CNY as shown in the chart, which broke decisively down (strengthened) at the end of July.
Chart 2: China currency strengthening. Back below 7
At the close of the month, the CNY had broken down through the psychologically important 7 level and while the currency is not truly floating, the chart suggests little to prevent any further strengthening. A move back to the 2018 lows would represent a near 15% increase in prices for imported goods into the US, something that inflation estimates may not be taking into account at the moment.
Chinese growth in Q2 bounced back to run at 3.2% yoy, with Bloomberg Consensus projections of 5.2% for q3 and 6.1% for q4. Forecasts for 2021 are still for around 8% real GDP growth and interest rates are essentially ‘normal’ at 4.35% for benchmark 1 year lending. By contrast, the US, at a year on year minus 9.6% GDP for q2 is now forecast to grow 3.8% in 2021, while 12 month libor is maintained at a QE driven low of 0.45%. From a longer term perspective, it seems obvious that capital is going to flow eastwards.
Model Portfolios
We run our Model Portfolios primarily as a way of demonstrating how Market Thinking can translate into practical investing. We aim to diversify stock specific risk through diversification into smart beta funds. For equities this means liquid ETFs that look at the world through non traditional lenses – either through Global factors shown by academic research to deliver long term returns – Momentum, Value, Quality, Minimum Volatility and Size – or in the case of our new Global Thematic Portfolio, growth themes such as Robotics and Automation, Digitalisation, Digital Security, EM Consumption, Global Clean Energy, and Healthcare Innovation . Plus Gold.
We then blend these underlying ETFs according to our proprietary risk scoring system to optimise exposure to those themes that are ‘working’ at any given time. This Dynamc Asset Allocation allows us to mitigate some of the Macro Risk that passive investments and more static allocation processes are prone to. This is not a trading portfolio, but aimed for medium to long term investment. As such we report on them in detail quarterly rather than monthly.
On a monhly basis however, they are useful as a lens through which to monitor market behavior. Thus we can see from a global factor portfolio that Value has once again fallen heavily out of favour and is now at our highest risk score, while both momentum and Quality remain at the lowest (best) level. Interesting to note that the thematic basket has had a very strong month, up over 8% with all underlying themes currently at risk level 1 (lowest/best). In our equivalent bond Model Portfolio, which year to date is doing better than the Global Factor Equity Portfolio, the highest risk (and thus lowest weighting) remains in High Yield – which tends to coincide with higher risk levels for value and size in the Equity Factor portfolio.
