If this week’s volatility has unnerved you, take a deep breathe, sit back and consider the following assessments courtesy of global macro strategy think tank Rareview Macro and extracts of this a.m. edition of “Sight Beyond Sight.”
The Puzzle
Today’s edition is not meant to be read as us preaching a gospel. Instead it is a collection of the thoughts we have gathered through a number of recent meetings/conversations with investors who take plenty of risk, and it has served us well in the past to just write down what people we respect are saying. Therefore, if at times the opinions below come across as too skewed one way or adopt the tone of a “bomb thrower” just take them with a grain of salt.
In the end, our biggest issue is that it is just a matter of a few hours to a couple of days before all investors catch up and put together a similar puzzle.
That is why you should read this entire edition even if it is lengthy and the only morning note you read.
Corner 1: United States
- Housing is recovering at 60% of the speed of past cycles. The current sentiment is that housing is ill.
- Autos peaked in August. It is not that the food chain will now reverse course to the downside with the same vigor as to the upside. It is that the rate of change is now slowing.
- Texas is the anchor to shale production, employment growth, positive real estate trends, and overall positive moral. With Crude Oil at or below the cost of production for many project, the State with the highest economic multiple needs to contract. The consequences of that are still unknown in many respects, including the financing impact on High Yield credit, Master Limited Partnerships (MLP) and the like. Of note is that investors up until now had not factored a lower crude price into spaces that have low liquidity like junk bonds and MLPs. This is a canary in the coal mine for High Yield.
- The confidence in the Federal Reserve communication strategy has reached a new low. International growth and the US Dollar are new variables and join the already convoluted debate around the DOTS, employment and growth. Sentiment is so negatively skewed that investors are waiting for the FED to confuse them even more by producing new indices for each variable, just as it did for employment.
- Earnings are now an unknown. While companies have not issued profits warnings to the degree that many single stock prices or risk proxies currently may be discounting, earnings have shifted to “guilty until proven innocent”. As management guidance is given over the next few weeks, the market needs to hear that the US Dollar appreciation and international growth concerns are under control for 2015. Otherwise, “dis-inflation” will be added into the narrative and that will lead to a reduction in both the earnings estimates and multiple on the stock market.
Corner 2: Europe
- The drumbeat that a recession is near is becoming louder. There are two legs: traditional trade channels and financial conditions. Historically, when both move down in tandem the impact on growth can be dramatic (i.e. -3 to -5% GDP). Fortunately financial conditions are very easy and protected at the moment by the European Central Bank (ECB). So while the speed at which a recession could come on may take many by surprise, the depth should be more limited (i.e. -0.5 to -2%) than in 2010-2012 when financial conditions were very tight.
- The ECB is done easing for 2014. While the ground work for sovereign QE to be added to monetary stimulus is being laid, that will not be implemented until 2015. Even though the ECB has taken some action at each meeting since last June the market still wants more.
- The ECB will strictly adhere to the methodology for the Asset Quality Review (AQR) later this month. That does not mean this will be an overall bearish event for the banks, especially the larger ones as this will not reveal major troubles. But what it does mean is that the ECB wants to be very thorough so that if the Eurozone becomes stressed once again politicians will not be able to shift the blame to the ECB for not governing the banks properly. That means there will be a series of capital raise in varying degrees.
- The ECB is shifting the onus on to fiscal policy makers (i.e. European Commission) to satisfy investor appetite from here on out.
- We learned this week that Germany has rejected Italy and French budget leniency which is a de factor call for austerity, and that will lead to even slower growth if the troubled countries actually take responsibility for their lifestyles.
- The German Bundesbank has explicitly criticized the ECB for implementing ABS and covered bond purchase and, like the ECB, has called on fiscal policy makers to do more.
- Germany’s 5 Wise Men said today that the ECB measures are useless and demand fiscal action on recession risk and deep reform in Germany. This is brand new to the narrative and reinforces the view the ECB is done until next year. However, if someone was looking for a bullish data point this is it because German politicians pay attention to the Wise Men. Article
- The Bundesbank has also rejected the idea that the European Investment Bank (EIB) should lend money for infrastructure projects due to the risks associated with it. Like the ECB, no one wants to take a loss on an asset or loan and lose their triple-A credit rating.
- The Euro exchange rate, the German Bund, late cycle equity sectors (Industrials, Energy, & Materials), dividend swaps (heavily weighted to banks), and high beta credit have already re-priced the above deterioration on all fronts or are in the process of doing so right now. What has not been discounted is the impact dis-inflation will have on corporate operating performance and that means stock prices still have to come down further.
Corner 3: Commodities
- A consensus is building for $90 Brent (vs. ~$90 last price) and $80 WTI (vs. ~$85 last price) crude oil for the remainder of 2014 and all of 2015. WTI will shortly join Brent and move to “contango” from “Backwardation” and there will no longer be positive “roll-yield” in the “barrel”.
- Enthusiasm does not return until 2016-17, when the free cash flow of oil company’s declines, capex declines and supply will be reduced. This is your new shale story and why any US state that has been a leader due to crude oil now has a different profile.
- Formal oil supply cuts by OPEC in November or stealth cuts by the Saudi’s before then will/can be offset by increased supply in Iran, Iraq and Libya.
- No one is willing to make a call on a crude oil bounce because, no matter how much supply is cut, if global growth deteriorates even further than crude oil will move down well below the newly formed investor consensus forecasts. That is like being short a naked put option with $10 more dollars of potential downside.
- It is way too early to answer the question of whether lower oil (i.e. gas prices) is good for US consumption (i.e. less of a tax) and provides scope for economic recovery to continue versus a lower oil price as a significant headwind for economic recovery.
While most estimates range from $1 to 1.4 billion in additional consumption for every $0.01 lower at the gas pump (yes, that is correct), that thought process is outdated. In the past, when the US was predominately reliant on importing foreign oil, that made a lot of sense. But because the US now generates ~50% of its oil onshore a lower price (i.e. think Texas again) starts to offset that because there is a negative economic impact for domestic producers. Now you can debate that one is good for the consumer (i.e. US GDP is 70% consumer driven) and one is bad for business, and that is fine. But in the end something has to net out somewhere.
What we would just say is that at some point lower crude oil prices will be a benefit but we won’t get there until we know where the prices settles first. In the meantime, we would argue that the speed and degree at which the price of gasoline is falling (i.e. RBOB gasoline futures entered a technical bear market yesterday down 20% off the summer highs) is more alarming at the moment because it signals there is a referendum on growth first.
- Beyond crude oil and outside a few idiosyncratic situations – Sugar, Nickel, and Palladium – the rest of the asset class is low quality in terms of risk-reward until the end of the year.
Corner 4: Currencies
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- There are two legs to a currency cross. Each leg is dictated by an interest rate differential. The Euro leg of the EUR/USD cross has been given a 75% weighting. The US Dollar leg of the EUR/USD cross has been given a 25% weighting.
- When the 25% US Dollar weighting needs to be adjusted because of a change in sentiment as a result of the FED’s poor communication strategy or weak US economic profile, it is still being traded through fixed income first. The key point being is that the “lower for longer” viewpoint is more correlated in lower fixed income yields and less so in a lower US Dollar.
- The negative backdrop outlined above on Europe, and the fact that investors are willing to use fixed income first as an outlet for adjusting their view on interest rate differentials instead of the US Dollar, are the reason why the EUR/USD is so resilient. Also, because short EUR/USD positioning is overly reliant on this view we do not seeing this profile changing.
- In an environment of even weaker global growth the Dollar-Yen (USD/JPY) is at risk of an even greater correction back to 105-106. Positioning in this currency cross is way too high as professionals simply do not have the same degree of conviction that they have on the Euro leg of the EUR/USD.
- Where are US Dollar longs wrong? Most estimates are that every 5% increase in the US Dollar will detract 20-30 basis points away from growth but that will not even show up for 2-4 quarters. If US earnings lead to a step-change in the perception that US Dollar strength will have an even larger impact on corporate earnings, and will show up in the next 1-2 quarters (i.e. more front-loaded), that will lead investors to believe that the FED will give the US Dollar headwinds a much larger weighting in their decision making. The US Dollar would be at risk of a 2-3% pullback and positioning would exaggerate the move in the short-term.
Estimates are that the spread of Ebola could negatively impact growth by 20-40 basis points. This would heighten the anxiety around growth even further because the flight to safety in the US Dollar would lead to even larger gains. This is not an event for Gold.
Investor Bases: Macro, L/S, Commodity, Real Money
- Macro Strategies: They are aware of the European and US Dollar profiles.
- Long/Short Strategies: They are aware of the US housing and autos profiles and quickly playing catch up on Texas.
- Commodity Strategies: They are aware of the Oil consensus and Texas/shale risks but have begun to try and handicap a floor in Oil prices once you factor in US housing/autos and European growth.
- Long Only Strategies: They are aware of the risk factors that are impacting the stocks they own. They are quickly trying to learn about the Oil, US Dollar and European factors now.
Our biggest issue is that it is just a matter of a few hours to a couple of days before all investors catch up and put together a similar puzzle.
The Pain Trades: Psychological and Actual
We are not advocating this but if today was your first day coming back from a three-month break, and you had to build a book with only five line items based on the information provided above, and you pulled up all your charts, here are the five psychological painful trades you would make:
- Short S&P 500
- Short EURO STOXX 50
- Long US 10-Year Bonds
- Short Crude Oil
- Long US Dollar
The “true pain trade” (i.e. the one that causes the most actual PnL duress) remains in the three places that have the most length:
- Lower S&P 500
- Lower US Dollar
- Lower Fixed Income (i.e. higher yields)
Welcome to Long/Short Hedge Fund Investing
As the S&P 500 moves down closer to the 200-day moving average (DMAVG 1904), the significance of that event grows.
The majority of real hedge fund managers historically have not genuinely hedged or reduced their “gross” exposure until that threshold is breached. Why? Because as long as equities trade above that moving average, the larger trend of the market remains intact and adjusting positioning before getting that technical confirmation on a “closing basis” historically leads to those same managers having to put their positions right back on. And that costs them money given the size and liquidity of those positions and increases the chance that they will miss out on the upside when the market bounces.
When the S&P 500 approaches the 200-DMAVG, the concentration in core positions become that much more visible to market participants as a result of increased anxiety over potential PnL duress.
The model of having your 10 largest positions make up 50-70% of your long portfolio, on the view that the trend is your friend, is fine until you get a market correction. The 200-DMAVG is the catalyst that historically leads managers to reduce concentration or start to hedge for the first time.
Additionally, the reason why these concentrated position start to underperform is because there is so much “piggyback capital” in this business now. The ones riding the coattails of those who actually do their homework, and take the real risk, end up forcing the moves even further as they are much more weak-handed and have to sell.
There are too many concentrated, deal-related or activist positions that fall into this category to list. However, three good examples in Energy include: Chiniere Energy (symbol: LNG), Williams Companies (symbol: WMB), and Kinder Morgan (symbol: KMI). You can say what you want about these being the best stories in their space but the losses and momentum can far overshadow anything positive in the short-term.
As the market moves closer to breaching the 200-DMAVG the greater the probability that the top 50 hedge fund stock positions will underperform the S&P 500.
Market Observations
- The rotation in US equities is becoming more visible.
- The value style is being bought on up days and the growth style is being sold on the down days.
- The Transportation Index (symbol: TRAN) has broken its uptrend. Not only does this have implications for Dow Theory but transports have been the flagship of the US equity market rally.
- Semiconductors are in everything and are a key input for global macro investing. Semiconductor activity historically leads industrial production by ~4-6 months.
The Philadelphia Semiconductor Index (symbol: SOX) is closer to breaking the 200-DMAVG than the S&P 500. Why is that important? Because semi’s has been one of the highest Sharpe Ratio investments over the last two years in global equities.
Last night, Microchip Technology Incorporated (symbol: MCHP, -10% pre-market) pre-announced earnings in a major way and said: “We believe that another industry correction has begun”. The full CEO comments are below in the Data & News section and are a MUST read. Remember, technology investors used to make a good living simply by listening to what the CEOs say because everyone else historically follows 3-months later.
MCHP’s closest peers are ATML, FSL, TXN and sentiment will also be felt in analog stocks (ADI, LLTC, MXIM). The iShares PHLX Semiconductor ETF (symbol: SOXX) and Market Vectors Semiconductor ETF (symbol: SMH) will be heavily traded today. CSR Plc (symbol: CSR LN) in London is already -10%.
- The dining stocks – PNRA, EAT, GMCR, etc. – traded positive yesterday. That is logical with crude oil on the consumption theme. This concept will be watched closely to determine if crude is helpful for consumption or whether it is negative for growth.
- Gold Miners (symbol: GDX -3.28%) were down despite spot Gold being up. That shows you this market is more focused on bringing down gross equity exposure regardless.
- European dividend swaps (symbol: DEDZ7 for 2017) have broken all key moving averages to the downside. This is a direct reflection of corporate operating performance in Europe (i.e. lower dividends), especially the banks with the upcoming Asset Quality Review (AQR) where the date/time has now been confirmed for release.
- MSCI Emerging Markets (symbol: EEM) outperformed yesterday in a down US equity market and with a stronger US Dollar. While that divergence is constructive and fits our view that emerging markets at this point should no longer be sold on an indiscriminate basis, many have still been left scratching their heads as to why this has happened.
The generic reasons are that EEM have already corrected by 11% off the high price in September and because so many professionals are short EEM, so as you reduce gross exposure the EEM has to be bought back.
- In Brazil, Petroleo Brasileiro S.A. (symbol: PBR) implied volatility is between 85 and 150 depending on which options contract you look at out to January. One view is that PBR is now pricing in a lower crude oil price and a higher probability of Brazil being downgraded, not just the upcoming elections.
Model Portfolio Updates
- Our Short EURO STOXX Index (VGZ4) position reached its 3000 price target this morning. We have added a new trailing stop to cover the short position for 3060 (2% higher) on a bounce.
- Reminder, our limit to begin to buy Sugar is 16.50. We are getting closer to that price (i.e. 16.52 low price today). If given the opportunity today we will likely start to build the position.