Thursday, May 21, 2015

Connecting the Dots - 5/21/15

This week, as hard commodities came under early pressure, participants may have asked themselves: 1. Is the rally over in oil, copper and precious metals; 2. Was it just a dead cat bounce - or, 3. Has the tide truly turned and a new uptrend just begun?

The same could be said with trends in yields and the euro - and conversely, in the US dollar index which bounced sharply through Wednesday's close.

Generally speaking, these assets have trended from the same motivational influence, namely their respective susceptibility to inflation and inflation expectations, which invariably has been heavily affected by monetary policy - both here and abroad.

Our long-term macro perspective remains that there's a greater probability that real yields will ultimately fall again, as inflation rises out of a 2-year trough and with greater range than the reach of nominal yields. This development would support positions in hard commodities, which have remained under pressure since a strong disinflationary trend established in the back half of 2011 - as the ECB moved to tighten policy while the Fed continued its broadly accommodative stance. Over the course of the past year, both the Fed and the ECB have reversed their respective policy postures, easing the considerable torque built up in the currency markets that recently has begun to subside (Figures 16-18). 

Although we're currently not bullish on the US or German government bond markets - and have leaned that way since the beginning of February, we maintain the opinion that the rise in yields will eventually be capped by the willingness of the Fed - and ultimately the economy, to sustain a rising rate environment.

This perspective was guided by our research of the long-term yield cycle (see Here), that depicts a protracted and historically low range (e.g. 10-year yield between ~1.5 and ~3.0 percent), as markets normalize with a less accommodative Fed and the over six year bull market in equities loses greater momentum. All things considered, we expect similar dynamics to unfold this time across the trough and continue to view the 1946 cyclical high in equities as a prospective parallel with the current market. 

That said, over the intermediate-term we remain in the rising yield camp, with a natural target for the 10-year yield of testing long-term overhead resistance which would come in ~ 2.6 percent later this year (Figure 20). This is largely dependent on growth both here in the US and abroad, which we suspect will support a reflationary basket of positions as we look for the US dollar to retrace the large move extended over the past year.

We continue to pan the US equity markets and would prefer certain Asian indexes along a longer-term timeframe, such as Japan's Nikkei and China's Shanghai Composite Index. This is guided in part by our historic reads of the US equity and long-term yield cycles (Figure 19), which we'd speculate will become less supportive of stocks as disinflationary conditions abate and the Fed creeps forward towards further normalizing policy. 

Figure 1
What upset the benevolent tide in the equity markets in 1946? The Fed and Treasury stepped away from their extraordinary support of the Treasury market and inflation found significant traction in the economy. Interestingly, investors didn't flee the bond market as if inflation would maintain its trajectory higher, but sold equities and eventually took shelter in the perceived safe-haven shores of the Treasury market. Why? Because of what investors had lived through over the past two decades. The Fed and Treasury might have succeeded at supporting the capital markets through considerable attenuating circumstances in the economy, but broader market psychologies were still entrenched and impaired from what participants had been through in the Great Depression. 

Milton Friedman and Anna Schwartz described these shifting market dynamics in A Monetary History of the United States.
"A rise in prices can have diametrically opposite effects on desired money balances depending on its effect on expectations. If it is interpreted as the harbinger of further rises, it raise the anticipated cost of holding money and leads people to desire lower balances relative to income than they otherwise would. In our view, that was the effect of prices rises in 1950 and again in 1955 to 1957. On the other hand, if a rise in prices is interpreted as a temporary rise due to be reversed, as a harbinger of a likely subsequent decline, it lowers the anticipated cost of holding money and leads people to desire higher balances relative to income than they otherwise would. In our view, that was the effect
Figure 2
of the price rises in 1946 to 1948. An important piece of evidence in support of this view is the harbinger of yields on common stocks by comparison with bond yields. A shift in widely-held expectations toward a belief that prices are destined to rise more rapidly will tend to produce a jail in stock yields relative to bond yields because of the hedge which stocks provide against inflation. That was precisely what happened from 1950 to 1951 and again from 1955 to 1957. A shift in widely-held expectations toward a belief that prices are destined to fall instead of rise or to fall more sharply will tend to have the opposite effect - which is precisely what happened from 1946 to 1948. Despite the extent to which the public and government officials were exercised about inflation, the public acted from 1946 to 1948 as if it expected deflation." - Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1963 

Today, as investors grapple with the more esoteric nature of monetary policy enacted in the trough of the long-term yield cycle, you'll find greater bi-polar reactions in the market and the media to economic data and various policy opinions within the Fed. Ultimately, we suspect the Fed will continue to err on the side of caution, which over the long-term supports a reflationary strategy in the market that favors hard commodities - such as oil, precious metals and copper - over what strongly outperformed over the past six years, namely US equities. 

Over the short to intermediate-term, we'd expect that the largest tactical threats to this posture would come from a more hawkish tone from the Fed that would favor an earlier move towards raising rates here in the US - or a sustained downturn in the US economic data that could reignite broader disinflationary conditions. However, all things considered, we expect the Fed will walk a more deliberate policy path, as the economy continues to mend from the financial crisis and the magnitude of any potential tightening regime is realized to be far less than anticipated or witnessed in more recent Fed tightening cycles over the past several decades. 

We continue to closely follow the SPX:Oil ratio through a comparative prism of the two major exhaustion pivots (1986 & 1999) that make up the asymmetrical disinflationary/reflationary construct that the ratio represents. Although both timeframes depict market environments that saw oil outperform equities over the subsequent year, there were notable differences in the magnitude of the moves relating to various intermarket relationships - namely, inflation and policy expectations which greatly determined the direction of yields for the year. 

Figure 3
In 1986, yields troughed through the balance of the year as the Fed moved to further ease the fed funds rate as the economy slowed. Conversely, in 1999 yields rose with oil throughout the year as the Fed began in June to tighten policy - eventually contributing to pricking the equity market cycle less than one year later.  
Figure 4
Figure 5
While the current relationship between oil and yields is more tightly correlated than both previous periods, we find greater similarities with 1999 - both with respect to Fed policy posture and the respective cyclical trends in the equity and commodity markets. 

We included comparative updates for these periods that were normalized based on the respective exhaustion pivots of the SPX:Oil ratio.

Figure 6
Figure 7

Figure 8
Figure 9

Figure 10
Figure 11
As shown above in the juxtaposition series between oil and yields (Figures 4-5), both 1986 and 1999 expressed lagged pivots between the two markets. In 1986, oil set the final low 7 weeks before yields and in 1999, yields reversed 10 weeks before oil. Measured along the same weekly timeframe, yields this year reversed 6 weeks before oil.

For comparison, the second series for each period was shifted to align with each low. 

10-Year Yield
Figure 12
Figure 13

Figure 14
Figure 15
In summary, although we wouldn't dispute that markets will inevitably take their own distinct paths through history, current market conditions display the potential for a more long-term downtrend in the SPX:Oil ratio, as found with greater similarities to the move in yields, the respective equity and commodity market cycles and policy posture by the Fed in 1999. 

Moreover, we believe current market conditions reflect more of a cyclical pivot - rather than the secular variety that was translated in the commodity and equity markets in 1999 and 2000, respectively. As such, we continue to find insightful market parallels, to the post depression/WWII era of the mid 1940's, where the Fed and Treasury slowly began to normalize policy after almost two decades of extraordinary intervention and support.
Figure 16
Figure 17
Figure 18
Figure 19
Figure 20

Sunday, May 10, 2015

Can China Save Europe - & Vice Versa?

Over the past decade, while US pundits and politicians soapbox their Kabuki laments over Chinese trade policy and misgiven currency regimes, Europe has quietly emerged as China's largest trading partner and strategic counterbalance to perceived US economic hegemony. 

Perceived, because just last fall the IMF recalculated its projection of China's 2014 GDP, returning the torch of "Worlds Largest Economy" - a handle China carried over 19 of the past 20 centuries. Factoring in the GDP of the runner-up (EU), the composite scale between China and the EU accounts for roughly a third of the world's economic output. 

As we look for China to continue to take the next steps in transitioning its maturing economy away from being driven by unsustainable construction and infrastructure growth to greater breadth of domestic consumption, Europe is well positioned to capture the lion share of trade spoils, with China also greatly benefiting from their deep financing relationship with its largest foreign investor base - Europe.  

With trade flows between Europe and China reaching over $1 trillion in recent years, the immense commonality of their vested interests in one another has only grown, primarily at the expense of more traditional trade partners - namely, the US.  

Below are a few highlights from a dated - but highly recommended, research note from Deutsche Bank (see Here), describing the burgeoning strategic economic relationship that exists between the EU and China - and which likely will strengthen over the coming years. 

  • Trade in goods between China and Europe has almost doubled over the past decade, with Germany strongly positioned as China's largest EU trading partner; accounting for roughly half of EU exports and a third of EU imports. 
  • Foreign direct investment (FDI) between the two economies has been disproportionate, with the EU emerging as the largest investor in China, while Chinese direct investment currently accounts for less than 1 percent of the EU's total inbound FDI. This investment asymmetry presents a large opportunity in Europe for Chinese capital, should further progress be made with a free trade agreement. Since 2011, Chinese investors have increased their FDI stock by more than four times within two years. 
  • Symbiotic process manufacturing relationships between the EU and China has continued to evolve to benefit both economies. Intermediate goods that need to be processed further for final consumption composed approximately 60 percent of EU exports to China. Moreover, Europe is China's single biggest provider of foreign inputs for its export industry, as China sources roughly a third of the value-added used in its exports from abroad. 
  • Europe is well positioned to benefit from the transition in the Chinese economy to greater domestic consumption, as consumption goods nearly doubled as a share of EU exports to China between 2007 and 2012. EU consumer goods have been supported by the demand of an increasingly affluent middle class in China, as many European car manufacturers realize China as their largest market.  
  • Europe presents a significant opportunity for China with further adoption of the renminbi (RNB). Infrastructure built through major financial institutions, will make it possible to foresee RMB settlement increase to as much as 40% of EU-China bilateral trade by 2024 from less than 10% currently.
With concerns of the slowdown in China continuing to build with each passing week's diminishing data dumps, we remain focused on the bigger picture narrative unfolding - that of remaking China's system of governance to potentially afford more sustainable economic growth in the future, while titrating the colossal hybrid economy further from communism to capitalism. 

In our opinion, the popular view by the policy wonks - that of a painful economic rebalancing at the foot of decades worth of breakneck growth and over-investment, largely ignores the capacity of the People's Bank of China (PBOC) to actively stimulate growth and mitigate liquidity concerns - through this inevitable slowdown, while continuing to develop greater interdependent economies of scale with their largest trading partner. The net effect - we believe, should go a long way towards smoothing this transition and shifting the world's balance of power further east.

Chinese President Xi Jinping has made the strategic partnership with Europe an early focus of his term, with Europe committing last year to bilateral talks on a free trade agreement with China. As trade disputes are often contentious and present real risks to further developing a common economic interest, the long-term benefits to both economies far outweigh whatever short-term political hurdles may emerge or are postured at the podium from tangential concerns. I.e. Germany may push Greece to the limits over a new debt deal, but ultimately will not risk a fracture in the fragile EU - as they clearly have the most to loose.

As both central banks move to aggressively loosen monetary policy, two overarching questions remain in the financial markets

1. Will a successful transition in China continue to build out the foundation for a lasting bull market in equities, and;  
2. Will it also provide Europe with another lifeline away from the deflationary conditions still swirling around the old world?  
Although we agree that in times of conspicuous central bank influence and intervention, the correlation between the relative health of a country's economy and their respective markets is increasingly difficult to discern, for both Europe and China today - their equity markets should play a leading role in foreshadowing the character of the next chapter of this massively influential bilateral relationship. 

Despite growing skepticism by equity analysts and pundits of the recent surge in Chinese stocks over the past year, we continue to like their prospects and view its equity markets as a leveraged position on China successfully engendering greater consumer consumption, as stocks provide a broad wealth transmission mechanism to a growing percentage of the population. 

Along these lines, we've approached the August 1982 consolidation breakout in the S&P 500 as a prospective roadmap for a sustained move higher in the Shanghai Composite index. To a large extent, the structure and momentum congruences have played out in the SSEC, with the index even exceeding our own expectations and doubling over the past year as a violent breakout rally confounds both the policy and equity bears. From our perspective, the transition in China is well on its way to maintaining their exceptional legacy of surpassing presumptions over the past four decades. Of course, not withstanding the considerable set-backs ushered in through Marxism in the mid-20th century, this is par for the course in China over the last few millenniums. 

Turning to Europe, while the German's clearly have the most significant inroads through trade in China, we suspect the more fragile economies - such as Spain, would also greatly benefit from a rising tide, if China successfully avoids a hard landing and stimulates greater domestic consumption. Over the next year, Europe's plight is tightly tied to whether recent deflationary conditions are in fact transitory or more pernicious in nature. While it's too early to declare a new trend, after falling for four consecutive months, euro-zone consumer prices remained flat in April - easing deflationary concerns.

As described in previous notes, the higher beta equity indexes in southern Europe - such as Spain's IBEX, continue to walk the equity high wire act of where the previous two major perennial asset declines over the past century have cyclically turned down. What the ECB is attempting to break with its recent adoption of QE, is the policy missteps that were compounded by each central bank in their respective cycles; both by the Fed in late 1936 into early 1937 and the BOJ in 1997. With hindsight 20/20, the powers that be worsened economic conditions by tightening monetary and fiscal policy, where they very likely should have eased. 

With China and Europe both aggressively moving to provide more accommodative monetary policies - while further developing crucial and strategic economic synergies, the Ancient and Old Worlds look to pen a new and more prosperous chapter. 

Although the economic data in China continues to sour, we expect the recent surge in Chinese consumer confidence on the back of a significant equity market rally, will soon translate into improving domestic consumption - buttressing a positive feedback loop to its largest trade partner. 

Assuming Germany ends their own Kabuki theater soon, it would appear that Europe's more fragile economies may now have a fighting chance of breaking the glide path of the major asset deflations of the past century. 

Monday, May 4, 2015

Macro Market Musings for May

The U.S. dollar index pulled back sharply last month from the relative performance extreme notched in March. Declining ~5 percent from the intra-month high on April 13th, the index gained considerable downside momentum in the backside of the month - following the performance pivot of arguably the last time it was stretched to a comparable performance extreme, three decades before in 1985.
Through last Thursday's close, the index recorded six consecutive daily losses and closed the month below long-term trend line resistance and its 50 percent retracement high - which also marked the cyclical top in July 2001 from the index's secular peak in 1985. 

To put it mildly, the dollar hollered - just not as most participants suspected.

Our expectations remain that the U.S. dollar is poised for a significant retracement of the move that began last spring, which should buttress a reflationary tailwind in commodities and a stiffening headwind in the government bond market; most recently on display last week with the biggest selloff since 2011 in Germany's 10-year bunds. 
With the large reversal, the market all but erased its gains since the ECB began buying debt on March 9th - and climbed out of the basement with a weekly close 1 basis point higher than Japan's 10-year yield. 

It would appear that the market is well on its way back to establishing a new long-term equilibrium, after following Dornbusch's overshooting model to levels significantly below most participants expectations. 

Although many participants believe that the actions by the ECB will continue to suppress yields and support the market; as described in previous notes, if the program successfully gains traction, we would expect yields to remain supported as inflation expectations improve. 

This perspective would support an overweight position in inflation protected securities relative to nominal Treasuries and a constructive market environment for hard commodities - such as copper, oil and precious metals.  

The SPX:Oil ratio continues to display the hallmarks of a major blowoff move and downside reversal, last witnessed in the two previous pivots (1986 & 1999) that make up the asymmetrical disinflationary/reflationary construct that the ratio represents. While the 1999 pivot exhibited a more long-term reversal in relative outperformance between asset classes, subsequent to the reversal - both market environments saw oil outperform equities over the next year. 

That said, considering how momentum in the reversal is unfurling and our thoughts on the U.S. dollar, we are more inclined to speculate oil will trade closer to the 1998/1999 analog than the 1985/1986 reversal.

The question remains how the U.S equity markets will adjust to rising inflation expectations, which we have speculated in the past could provide the spark for a cyclical move lower in stocks and the catalyst for another rising tide in commodities. 

This market environment would be similar to what transpired in the previous trough of the long-term yield cycle after the secular peak in equities in 1929. Both in 1937 - and again in 1946, the equity market rally exhausted as the Fed pivoted away from extraordinary monetary accommodation.
It's interesting to note that from a comparative perspective with the  previous exceptionally low yield environment of the long-term yield cycle and the violent fall into the trough, the market is currently situated where the Fed moved to tighten policy in the back half of 1936 and into early 1937, after economic and market conditions improved following the crash in 1929. 

While we know the lessons from that time period loom large in policy markers deliberations, we still consider the closest parallels to be from the mid 1940's when the Fed ended their extraordinary support of the Treasury market and moved to normalize policy. 

In either example, the course of Fed policy became increasingly difficult for participants to navigate as improving economic conditions muddled future market expectations, eventually destabilizing the broadly benevolent market conditions for equities. 

This is why we have found the parallels with more recent Fed tightening regimes so misplaced, as policy conditions, tools and market psychologies are vastly different today than where they stood in previous cycles over the past four decades.  

As a post script, we included an update of the 1979-1985 inverse secular pivot of 10-year yields (TNX), which we have followed with fascination over the past year and which pointed last winter towards the retracement level realized in yields in the first quarter. 

We shifted the series slightly to "tare-up" with the secondary low (high in the inverse) of the series, which would place yields on a glide path higher over the coming months. This pattern is supported by our analogs and retracement mirrors with the long-term yield cycle, which currently places the 10-year below its historic mirrored bearing ~ 2.40 percent. 

While we don't expect yields to sustain a prolonged move higher, the patterned momentum congruences continue to replicate on the inverse of the cycle. From a broad brush technical perspective, 10-year yields have ~ 50 basis points of room to move higher up to test and challenge longer-term overhead resistance later this year.