Tuesday, March 3, 2015

Hot Cross Bunds

Hot cross bunds. Hot cross bunds. One a penny, two a penny, hot cross bunds. If you have no daughters, give them to your sons; one a penny two a penny, hot Cross bunds. - Mother Goose
We'd venture to speculate that not even the Puritan purse of Mother Goose would give her sons and daughters some hot cross bunds these days. Although the government bond markets at home and across the Atlantic were both white hot over the past year, the U.S. Treasury market cooled quickly throughout February, while long-term yields in Germany circled back and tested the lows last week. Considering the lay of the land in the markets these days, we're looking for the investor equivalent of German comfort food to cool off swiftly as well, as a major disinflationary trend attempts to exhaust. 

Friday, February 27, 2015

Looking Towards the Ides of March

Not surprising - considering the surge in the dollar since last summer, headline CPI for January posted its biggest drop since 2008 yesterday, falling 0.7% in January. Core CPI, however, exceeded expectations and rose 0.2% last month. The chart below that we've shared since last fall, shows 3 month Treasury yields less headline and core CPI (hashed), which has closely trended with the dollar - but with a several month lag. Despite the rise this month in core CPI, we expect to see more soft inflation data as the move in the dollar is further absorbed downstream.    
That said, we still view the reversal in gold last fall as a leading indicator of the inflation vane shifting north and look back at the more acute 2008/2009 deflationary impulse for reference - which also saw precious metals leading the pivot in the dollar and inflation expectations. This time around, the cycle has been more gradual, broader and shallower - but unfurling with similar dynamics between markets and asset classes. All things considered, we still very much like the prospects for gold and silver this year.

Since exhausting at the end of January, inflation protected securities have outperformed nominal Treasuries, following in the steps of gold and silver that pivoted higher roughly three months before.

Similar to the reversals in reflationary trends going into 2009, the latent pivot higher in the TIP:TLT ratio has also been made by markets such as copper and oil - which bounced roughly 10 and 20 percent, respectively, over the past month. A significant difference this time around has been the steady decline in the euro, versus a more broad and volatile structure of its low in 2008/2009.  

The U.S. dollar index is closing out February near its long-term 50 percent retracement high, which also serves as overhead trend line resistance from the July 2001 50 percent retracement high. As mentioned in previous notes, we expect the dollar to follow the lag in 10 year yields and back into the trough of its long-term range. 
The euro, however, appears poised to follow the current uptrend in U.S. 10 year yields and out of a trough low that's been tested over the past month. Similar to the lagged affect on yields from QE in the U.S. in late 2008, we expect the measures introduced by the ECB last month to begin to buttress European yields and the euro in March.
Outstanding of the oil crash in 2008, we have also closely followed the markets in relation to the supply driven decline in oil in late 1985 into 1986, which was primarily driven by a sluggish global economy while non-OPEC North Sea oil countries had increased production. Although there are similarities to what North American shale production has contributed to the global supply of oil, the 1985/1986 time period has been on our radar for years as a prospective mirrored shoulder in the
pattern below of the SPX:Oil ratio. Moreover - and quite dissimilar to 1985/1986, we feel the current move has been primarily driven by the currency markets, although there are similarities in underlying monetary policy that helped fuel a rebound in oil in the back half of 1986. 

While it was the Fed that eased aggressively in the first half of 1986, today it's two of the other major players in the balance of the global economy (Europe, China) that are loosening policy that should support a rebound in oil - as well as those markets that have contributed and correlated with its decline. E.g. - the euro and European yields.

Monday, February 23, 2015

Climbing the Great Wall of Worry in China

Like the Great Wall built by peasant hands over two millenniums ago, the current wall of worry in China - the foundation for any lasting bull market, has been steadily built and mortared since the financial crisis exhausted in 2009. While outlooks have brightened considerably in the west as equity markets have enjoyed stellar returns on the back of renewed confidence in a system that almost destroyed itself, the general investment opinion towards China has continued to sour as bricks of doubt have been laid higher and higher on the wall. 

Growth slowing, credit tightening - excesses weighing... Most weeks you'll find these three main underlying concerns sprinkled and punctuating research notes and market headlines with only one foregone conclusion: Buyers beware - because China's going down. Flanked by some heavy hitters like Jim Chanos, founder of Kynikos Associates, and academics such as Michael Pettis and Paul Krugman, a compelling case for betting against China has been rigorously argued and made. With many of their concerns recently borne out with weakening economic data over the past year, it would appear that the dominoes have started to fall and their equity markets inevitably poised to weaken. 

And yet since last summer, the Shanghai Composite Index has trounced world markets and risen over 60 percent. What gives?

As mentioned in December in our most recent note on China (see Here), we believe the bears have extrapolated too much from China's obvious growth downturn and given not enough constructive consideration to the significant efforts of President Xi Jinping's major reform initiatives that are squarely aimed at transitioning their financial system and economy through increased governance and without a protracted and painful "rebalancing" that the policy wonks have agreed is necessary. And although the skeptics will view the most recent easing initiatives by the PBOC as just postponing or even worsening the inevitable collapse, we're more inclined to side with the course of "recent" (last 30 years) history that has repeatedly witnessed the Chinese economy surpass expectations and raise the bar of what's possible in a colossal hybrid system titrating from communism to capitalism.

Moreover, besides the historic consolidation and breakout pattern in the SPX that initially caught our attention years before, there are now similarities in the rear view mirror with the broad policy affects on markets, between what then Fed Chairman Paul Volcker did to the U.S. economy in the early 1980's to root out persistent inflation and what President Xi Jinping's has done in China to purge entrenched corruption over the past two years. Despite vastly different economic ails and prescriptions, both initiatives strangled the system for a spell and set the stage for the next phase in their respective economies and markets. 

Proportional to the breathtaking breakout rally in the historic SPX comparative, the Shanghai Composite now sits below the pattern highs from 2009 - consolidating its gains over the past three months. Although Chinese markets have been closed over the past week in celebration of the Chinese New Year, we expect the SSEC to continue climbing like a sheep, goat or more appropriately - ram; rising with the wall of worry and above its six year pattern highs. 

Wednesday, February 18, 2015

Markets on Wire

When it comes to analogies on the market, the father of value investing framed it best:
Within our own research approach, we often compare and contrast different market trends with respect to a wide scope of history. Like Graham's observation, we've found "weighing" a trend with various metrics against the scales of history provides greater depth and perspective. For us, history provides identity for the present through congruences and contrasts with the past. And although the past is never a perfect fit, the weight of historical trends and their given market environments provide ample insight to help us better understand the markets we participate in. 

That said, comparative reasoning is certainly no crystal ball - just as last years earnings or economic data doesn't deliver present and future outcomes. What they both can provide is context - and a framework against which we can attempt to quantify and qualify the present. Stepping down from the soapbox - but keeping Graham's analogy in mind, we thought we would update some charts on Europe and Japan as well as flesh out a few thoughts on related trends. 

Our higher beta equity proxy for Europe - Spain's IBEX, continues to walk the tightrope of our historic comparative of the two major perennial asset deflations over the past century. As we laid out in previous notes over the past year, the ECB is attempting to break the glide path of where a cyclical downturn appeared and where deflationary forces caused a policy misstep on behalf of their respective monetary handlers. 
In both of these previous examples, the U.S. in late 1936 into early 1937 - and Japan in 1997, the powers that be worsened economic conditions by tightening monetary and fiscal policy, where they likely should have eased. While it's readily apparent that the Fed's European counterparts took their time in loosening policy over the past several years, the actions by the ECB over the last year runs antithetic to what the U.S. and Japan placed on their markets at comparative periods. 

That said, from a long-term perspective momentum still appears to be rolling over in Spain where cyclical tops were made in the U.S. in 1937 and Japan in 1997. 
Moreover, it's important to note that while hindsight provides historians with a more binary outcome to deduce causation and fault lines, the reality is that market trends within deflationary conditions have brittle underpinnings with an increasing degree of difficulty to navigate with policy. We find this is very much the case in Europe as brush fires continue to flare as the respective authorities juggle a disparate ledger of crises - both existential and structural in nature. In many ways Draghi is truly the Man on Wire, with what appears to be a long way to walk over the next year. 

Although it took  Japan nearly 25 years to crawl and stumble across its own deflationary span, it appears the Nikkei has succeeded and continues to put more space between the breakout we expected last fall. 
We updated our 1987/1988 Nikkei comparative that we've utilized since late 2013 and normalized a weekly study for duration and performance from the respective retracement high/meridian rejections. As shown below, the Nikkei is breaking higher around where its historic comparative pattern began another large leg higher. 
Over the past year, we've also followed a similar pattern that replicated in the SPX at previous meridian rejections in the U.S. in 1987, 1994 and in 2011. On each occasion, the low offered investors an excellent buying opportunity as the bears became trapped following the violent waterfall decline. We updated and normalized a weekly study for the most recent SPX pattern in 2011 for duration and performance from the respective retracement high/meridian rejections. 
This past November we looked ahead at challenging some inter-market assumptions, with consideration to the correlation relationship that existed between the Nikkei and yen - as well as our bullish leanings in precious metals. The general idea was that despite a strong inverse correlation between the Nikkei and yen and the tight correlation we had noted between the yen and precious metals, we still liked our respective equity exposure in Japan as well as our positions in precious metals - from both a hedged and absolute return perspective.  This idea hinged on what we perceived to be an extreme in the correlation relationship between the Nikkei and yen and the more likely probability that conditions would revert from the extreme in a fashion similar to the market environment going into 2009. While the lead in set-ups between these two assets were the mirror equivalent of that period, we expected the subsequent correlation reversion to translate along similar lines.
With consideration to the prolonged correlation extreme, unlike its corresponding equity market that broke above long-term resistance, we expect the yen will find support here and trend higher with the Nikkei - as well as with precious metals which have also led the pivot since early November. 
For those that have enjoyed powerful equity exposure to Japan through Wisdom Tree's novel currency hedged ETF - DXJ, a shift to iShares EWJ may provide superior returns in the next leg as the correlation relationship between the Nikkei and the yen looks to revert from an extreme.

Friday, February 13, 2015

Sizing up the next moves in the Market

Like any major move, the crash in crude oil was propelled by more than just one catalyst. Speculative positioning, production, demand - they all played a supporting role. And although the circumstances that led to its precipitous decline can be reverse engineered and neatly framed to lay at the feet of a more conspiratorial and geopolitical commiserator, such as the Saudis - the reality is the currency markets likely played the commanding part over the past year and were instigated by conditions that set sail long before the Saudi's could even look to turn the screws. 

As we have speculated, we believe the significant moves in the currency and commodity markets since last summer represent the blowoff tails from these respective trends. Our general belief is the two largest and most traded currencies in the world have been wagged by the divergent policy paths between the U.S. and Europe, which caused a strong disinflationary tailwind to develop in the markets since 2011 when the ECB raised its refinancing rate twice to 1.5% - while the U.S. maintained a zero interest rate policy, subsequently buttressed by additional rounds of quantitative easing. With the ECB finally finding religion and cutting rates below the U.S for the first time in a decade - as well as pulling up to the alter of QE, the torque in the currency markets from the differentials in policy paths should begin to back off. 

The blowoff move in the U.S. dollar index is butting up against long-term resistance at its 50% retracement level from the July 2001 high. Interestingly, this set-up was also where a long-term high was established in 2001 from the 50% retracement level from the February 1985 long-term high.     
As we showed last November, the dollar appears to be following with approximately a three year lag, the moves in yields. Similar to our expectations that 10-year yields will trough in a range between ~1.5 and 3.0% over the next several years, we still expect the dollar to follow the leading moves lower in long-term yields.
The disinflationary blowoff in the SPX:Oil ratio appears to be exhausting. Should the dollar finally turn lower, similar to our expectations with precious metals - we suspect the commodity will strongly outperform U.S. equities. 
To date, oil made a cycle low 32 weeks after turning down last June. Should the low hold, the duration of the decline would be equal to the crash in 2008/2009 and one week less than the move in 1985/1986. 

*The duration comparative was corrected to reflect an error we noticed on our last update that measured the move to the low in 2008/2009 to be 33 weeks. 

Although we expect yields to be supported over the next several months, we do not foresee a sustained move higher out of the long-term yield trough that would invariably come with the Fed significantly raising rates. Despite yields remaining historically low over the past 6 years, we are reminded that it took over twice that time in the previous cycle to traverse the transitional divide between secular growth cycles. While the Fed has succeeded at gestating a rich valuation premium in the U.S. equity markets, it has largely been maintained at the expense of raising rates. As much as we expect another pulse of inflation to make its way through the system as the economy improves and Europe and China hit the gas, as Larry Summers rightfully mentioned in an interview just yesterday, "We're in an extraordinarily uncommon and unusual place ... so this is not the time for the traditional central bank playbook." 

Considering what happened in 1937 (which Summers mentioned yesterday as well) or the cyclical top in equities in 1946 that took shape after the Fed ended their extraordinary program of significant Treasury purchases, we suspect the Fed will be tested and squeezed between their dual mandates. In either case - and despite the daily headline concerns with deflation, we believe those assets closely tied to rising inflation expectations should outperform in the next move across the trough. 
One of the current asset trends doesn't look like the other... Hint: rhymes with socks.