Wednesday, May 25, 2016

All Dressed Up with Nowhere to Go

In difficult times, fashion is always outrageous 
Elsa Shiaparelli

Trenched for severe weather, we’ve all donned the thick wooly coat at times. Oversized and tailored for the apocalypse, bear fur goes on easy – it’s taking it off that’s the hard part. With more than seven years of daylight from the throes of the financial crisis, past traumas still haunt perceptions, through scars both phantom and felt.
“The economy will surely be swept away by a tidal wave of corporate default” Albert Edwards 
Fool me once shame on you, fool me three times, well – that’s a trend.  Despite the incessant clarion calls from the deflationist’s camp that the waters are once again lapping at the levees, we see a more pragmatic outcome developing, one that turns the capital tide from our shores to theirs, on the back of a weaker US dollar and rising inflation expectations. “Theirs” – referring to those economies hardest hit over the past several years as the dollar became motivated by the apparent policy differential as the Fed slowly crept towards normalizing policy from their then leading crisis stance during the financial crisis. And while the hand wringing of a strong dollar has begun in earnest again as the Fed postures their next move, we continue to believe that the buck’s ship has sailed and is running downwind from its cycle high last year.

Jesting aside, these remain difficult times to navigate for investors and we understand why many believe that the table is set for another global crisis. Should the US dollar rekindle lasting momentum to the upside, we just might agree. But what we speculate they miss is the silver lining in greater market disequilibriums across the world in the wake of the financial crisis, that should help buttress growth and inflation expectations going forward as the US dollar comes off a cyclical high. While global growth certainly won’t benefit as robustly from the harmonic expansions of yesteryear, the collective capacity to turn down is mitigated as well, as we trudge across the transitional divide (see Here) to the next secular growth cycle. 


Whereas, in 2007 most of the largest developed and emergent economies where all cresting at the same time (i.e. constructive interference), today there’s much greater dispersion in growth tracks between developed and emerging markets, in part, because of the policy differentials set in motion during and after the financial crisis.

Whether it was cyclical happenstance or by design, these differentials have naturally affected economies primarily through the currency markets, with the US dollar exerting the greatest influence over the past two years, as the Fed gradually removed their extraordinary policy accommodations introduced and emulated during and after the financial crisis. As the dust settled, the net effect from this atypical and drawn-out process manifested with significant positioning and newfound strength in the dollar, arguably as extreme as the US Dollar Index exhibited at its secular peak in 1985. And while the deflationists have viewed dollar strength as the natural consequence of our collective and impending debt-ageddon, we view things more pragmatically as these market disequilibriums will invariably trend with greater cyclical frequency, as central banks modulate policy from extraordinary postures in the trough of the long-term yield cycle. 

From our point of view, the biggest secular trend these days is the drawn-out structure of the long-term yield and growth troughs, that will likely continue to try both investors and pundits patience and play-books when contrasted with the past several decades of economic growth and corresponding market performance. That said, we find the phrase "secular stagnation" a bit misleading, as it infers a more negative tilt towards future expectations, rather than the reality of where the US and global economy sit in the long-term growth cycle. Semantically speaking, we prefer "transitional divide", as it reflects the matured state of the economy  a natural condition, rather than a more pernicious economic malaise that many associate with secular stagnation. 

Essentially, stagnation is in the eyes of the beholder – considering the greatest threat to the global economy came during the financial crisis when the composite contraction was magnified significantly by the alignment of our respective economic cycles. Since then, shorter-term reflationary and disinflationary subcycles have waxed and waned  but overall, the broader deflationary threat to the global economy has receded since the height of the financial crisis. And while the most recent disinflationary cycle mimicked market conditions representative of deflation (i.e. declining prices/stronger dollar), we primarily view this as a currency effect manifested from the Fed's leading role in normalizing policy, which pushed the dollar and positioning to a relative performance extreme last year. As such – and assuming that the US dollar has crested, we continue to look to fade latent disinflationary conditions in the market, as we expect the pendulum will build on the reflationary trend already established this year.

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Despite recent strength in the dollar that was largely anticipated this month (see Here), we expect the buy the hype (the taper) and sell the news (rate hike) reaction to win out, even as the Fed looks to another modest rate hike this summer. All things considered, while the thought of a rate hike might impression the dollar over the short-term, we find the wider macro view still broadly bearish over the long-term.
Notwithstanding the relative structural symmetry leading into the yield trough, comparatively speaking, the dollar's move from Q2 2014 exhibited the performance extreme that in the past (1985 and 2009) marked exhaustion reversals.
Although much broader in timeframe today, using the dollar index's reversal profile from 2009 as our guide, the current retracement bounce developed along similar lines.  
Following the fractures in the dollar this year, long-term Treasuries continue to trade in a broad topping structure, that may point towards a significant breakdown over the coming weeks (see Here). 
Despite some that believe a modest rate hike would elicit another move higher in the dollar, we suspect the opposite will unfold as the deflationary cookbook that saw bonds, commodities and currencies reach relative performance extremes  completes the broad reversal that began last year.  
Not surprisingly, gold, which had led the broader reflationary trend since the initial rate hike last December, has retraced the entire move from earlier this month. Should the dollar begin to weaken again, we suspect that similar to the resumption of the uptrend in July 2009, gold will find support around current levels. Over the past several weeks, the inverse correlation between gold and the US dollar has begun to tighten again, which we expect will be bullish for gold and commodities in general. 

Thursday, May 12, 2016

The Next Market to Break Might Not be Stocks

After watching some markets develop over the past week, we thought it warranted a few thoughts on a possible outlier outcome in Treasuries over the next several weeks.

Since Treasuries made their respective highs in mid February, we held an intermediate-term outlook that yields could drift higher through the spring, before exogenous market pressures again arose pushing participants back into the safe haven shores of long-term Treasuries. Overall, yields have drifted above their respective lows from February, albeit modestly, and in a flagging and diminishing range from the highs in early March.

Figure 1
While the backdrop for long-term Treasuries has largely remained a benevolent place for investors this year, the markets have again traded in a descending range from their February highs, which in the past has presaged a subsequent trend shift lower. Taken in context with the broad range that long-term Treasuries have remained in since their momentum highs back in January 2015, a potential break below support extending from their late December 2013 lows – could accelerate downside pressures and markedly extend our outlook for a rising yield environment beyond Q2.  

Considering fund flows this year that have overwhelmingly remained out of equities and into bonds (see Here), a major breakdown in Treasuries could result in another rotation back into equities. That said, at this point in the cycle we're more comfortable speculating on the short-side of Treasuries here, rather than a derivative bet on this potential outcome.

Figure 2
One historical period that we have been following for possible insights is the market environment headed into the spring of 1987, where investors had pushed long-term Treasuries significantly higher over the previous two years on the back of a sluggish global economy and a collapse in oil prices. It wasn’t until the global economy stabilized and oil prices began moving higher that the Fed began to raise rates in April 1987. This shift, following several years of disinflationary market conditions that had greatly buttressed the trend in Treasuries – came to an abrupt end that spring. Headed into October, the price on the 30-year Treasury bond had fallen by over 20 percent.

Although we would never hold a position with commensurate expectations to an outlier outcome such as the bond crash in 1987, the levels of pessimism prevalent today regarding the state of the US and global economy could provide ample contrarian tinder should they largely go unfounded. Despite panning the prospects for equities here in the US and belief that monetary policy helped inflate stock valuations above their more fundamental underpinnings – we don’t buy into the deflationary thesis that sees the US and global economy sinking into another recession based on a more pernicious economic malaise.

As such  and considering the current set-up in long-term Treasuries going into Q3, we are now on the lookout for prices to test and break below support (Figure 1) extending from the late December 2013 lows. Should this occur, we'd speculate that prices could fall back to long-term trend line support extending from the 1987 crash low. In the five previous occasions that long-term bonds exhausted with a momentum extreme (as based on RSI - Figure 3), they eventually found support at this rising trend line. From our perspective, the current set-up that holds structural and momentum similarities with the broad top in bonds in 1986 and 1987, warrants taking a swing on the short-side of the field. 
Figure 3
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Figure 6
Figure 7

Tuesday, May 3, 2016

Connecting the Dots - 5/3/16

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After treading water through much of April, the US dollar index took another step lower last week after the BOJ declined to fire another salvo of stimulus at the markets – rocketing the yen higher by over 5 percent for the week. Taking their cue from the currency markets, hard commodities also rallied sharply to new highs for the year, with gold, silver and oil each tacking on ~ 5 percent for the week. 

Doing what they do best, markets successfully cut against the grain of the now apparent consensus expectation that the reflationary rally was due for a pause. Nonetheless, the rising tide that had lifted most boats since mid February did begin to recede, namely, in the equity markets that enjoyed a wider breadth of performance since the commodity markets found what we believe was a cyclical low.

US Dollar

While we remain steadfast long-term bears on the dollar and believe the majority of the move over the past two years will eventually get unwound, over the short-term we're more inclined to speculate the recent leg lower in the dollar index over the past week will be retraced, with the yen appearing most vulnerable to newfound dollar strength. That said, keep in mind the bigger picture headwinds working on the dollar both at home and abroad, that remain long-term bearish -in our opinion. Considering the recent move lower, we have adjusted our outlook for a more moderate retracement target in the US dollar index back to ~ 94.50.  

Yields

Since breaking below last year's low in February, the 10-year yield has bounced between ~ 2.0 and 1.7 percent. Over the intermediate-term we continue to believe that yields will drift higher, perhaps extending the range up to ~ 2.2 percent. Moreover, we see greater upside risk in European markets, with a target of ~ 0.6 percent for Germany's 10-year yield.

Commodities

What's interesting to note is that despite oil's massive rally since February, it has yet to realize a move above the highs (~50/barrel WTI) from last fall. Collectively, both precious and industrial metals indexes – as well as the agricultural commodity index have all achieved this benchmark. Considering the lag from the lows in oil, it wouldn't surprise us to see the rally extend above 50 before consolidating. 

Taking their cue from dollar, gold and silver surprised to the upside last month, resolving higher from their respective consolidation ranges. Moreover, silver strongly outperformed gold, fulfilling the positive momentum signal evident in its long-term ratio since the end of last year. 

Overall, this is broadly bullish towards silver and should delineate the beginning of a new cycle for precious metals. In the past, the silver:gold ratio has led benchmarks of inflation – as evident with the lag in the Fed's preferred measure of the core PCE index. Should the relationship continue, core PCE would make a new cycle low over the coming months, which would likely alleviate pressures on the Fed to again raise rates.
Similar to the firmness in the dollar going into June 2009 that allowed another consolidation decline in precious metals, the current market may work off the shoulder trend lines that extend from last summer's highs. 

Thursday, April 21, 2016

Connecting the Dots - 4/21/16

Following a mild winter whose bite never lasted longer than an occasional weekend squall, the lingering late frosts of April finally gave way to the warm breezes of a reluctant spring. For those of us who find bearings from the touchstones of the seasons: the pungent whiff of ozone, the clean crisp air of fall; the early daffodils – the receptive muddling leaves a strange and unfamiliar feeling. What month is it again? Did I change the oil in the tractor, yet? Why aren't the Yankees on TV...

With the Dow tagging 18000 for the first time since last July and the S&P 500 now flirting around 2100, it appears that more than the weather has changed for the better. Will it last  remains the hanging question. Like the weather whose seasonal transgressions occasionally bewilders, but ultimately is beholden by our position from the sun, we expect US equities will again be capped by the cycle whose own arc at times has appeared to wobble on its axis.

Since beginning the year deep in the red, both equity indexes have rallied sharply since mid February, erasing losses that had quickly fallen by more than 10 percent on the year. Accompanying and actually leading US equities in this reflationary move has been markets and sectors that in the past had heavily underperformed. Namely, precious metals, emerging markets, oil and energy companies and commodities and commodity producers – that collectively have enjoyed their largest rally in over 5 years. What they all have in common is a valuation sensitivity weighed against the broad counterweight of the US dollar, whose best days  as we’ve speculated, were in its past.

Will the dollar continue to trend down and will it be enough to sustain a broader move in equities above their respective highs – is the follow up question for investors and traders alike. Over the near-term, the major benchmarks for the dollar continue to flirt with the lows from last fall; a spot we have speculated would provide support for a retracement bounce. Considering the strengthening inverse correlation that equities and the dollar have trended with since that time, the S&P 500 is now bumping up against its highs from last fall as well. Although the bounce in the dollar may move first, we do not believe the rally in equities is sustainable or represents a major breakout from the range the markets have remained within over the past 2 years.

A weaker dollar has been increasingly viewed as a welcomed condition for the economy and for the markets, following a long span of tighter financial conditions – discretely sustained through a much stronger US dollar and rising real yields. Despite hiking the fed funds rate a quarter percentage point in December, financial conditions have actually loosened as nominal yields fell but inflation expectations have firmed. This is the opposite dynamic of the taper tantrum in 2013 where real yields spiked as inflation continued to soften and nominal yields rose sharply. Commensurately, the commodity markets have benefited this year from this macro shift; one we expect over the long-term will continue to tilt the balance in favor of hard assets versus equities.

Looking back at the cycle for perspective, real yields began to rise shortly after the US dollar and short-term yields troughed in 2011 and began their ascent over the next several years. As the dollar strengthened with short-term yields, assets like gold and commodities became highly unattractive as inflation turned down and shorter-term yields rose. This critical differential created a virtuous market environment that strongly favored equities, as disinflation is generally a welcomed condition for stocks by boosting growth and price/earning multiples and kryptonite for commodities as investors chase securities with actual yields.

Although the cyclical rise in the dollar culminated with a push to a relative performance extreme last year, the notion by some that the buck is under a more secular persuasion flies in the face of the long-term yield cycle, which continues to follow a relative proportional retracement decline that would indicate a lower for longer market environment - perhaps much longer than most would suspect (see Here). It remains our suspicion that until the next secular growth cycle commences and yields begin a more perennial rise, the dollar will continue to follow yields lead (from 2014) and back into the trough of its own long-term cycle. This general market perspective in which yields lead currency moves – which lead equities, impressions us to suspect that a secular breakout move for equities is still far out on the horizon and that returns for long-term equity investors will likely be subpar for the foreseeable future.

While a rise in inflation expectations should be a net positive for the economy over the next phase, the end of the Fed’s virtuous disinflationary cycle that helped push equity valuations up to the ceiling of the last (i.e. CAPE) - will likely not be as benevolent to equities over the long term as another pulse of inflation works through the system. All things considered, this has already been the case, as stocks have gone relatively nowhere since the end of quantitative easing and will likely not benefit collectively as monetary policy becomes even less certain and as the Fed’s willingness to intervene with major policy initiatives continues to diminish from their crisis stance.

Although the relationship between stocks and inflation is nuanced and dynamic at different points in the cycle, the sweet spot (i.e. disinflation) in which equities became overwhelmingly attractive to investors and hence, richly valued – is likely over. While the broad-based reflationary trend out of the February lows has lifted all boats to-date, we suspect the anticipated bounce in the dollar over the short-term will cap the move. Looking out a few months, it’s hard to imagine a market environment – either one in which the dollar takes out the highs and resumes its uptrend (unlikely) or where gathering inflation expectations rekindles more hawkish posturing (more likely) – where equities outperform. Currently, we view the markets in limbo between these respective outlier outcomes and fears, where the benefits of inaction by the Fed has allowed a more correlated return on the back of a weaker dollar.

  • Postscripts

Despite treading water through much of April, over the near-term we view the dollar as the main instigator in the markets and still see upside risks outweighing a continuation lower. As such, we are looking for the stall in gold that has extended into its second month of churn, to eventually resolve down and complete its retracement decline. 

Just this past week, industrial metals - led by the cusp asset of silver, caught up with gold's leading move and broke above its highs from last year. While we remain bullish over the long-term, similar to the subsequent consolidation in gold since March, we suspect silver will consolidate lower with the broader commodity complex as the dollar's retracement rally runs its course. 

From a comparative perspective, our IBEX/Nikkei series that we've followed over the past two years for good reads on momentum in perennial asset declines, is now trading at a level we expected the retracement rally to exhaust. And while the IBEX is a higher beta index to US markets, a correlated pivot with other developed markets worldwide appears more likely than not. That said, should the IBEX continue to rally from here, we would approach it as a bullish proxy overall towards equities. 
This applies to Japan as well, where the Nikkei this year has backtested the long-term breakout from 2014. 

Should risk appetites recede again worldwide, it wouldn't surprise us to see the Nikkei continue to test this declining trend line through the next few quarters, before resuming its breakout move towards the end of this year. Considering the dollar's coincident set-up and the yen and Nikkei's crawl from their negative correlation extreme, both the yen and the Nikkei could trend lower for a spell, before both resolving higher.