Wednesday, November 26, 2014

The World is Flat - at the Transitional Divide

One of the side effects of the financial crisis was that growth cycles across the world that had converged leading up to 2008, became untethered in the ensuing aftermath. We recall listening to an economist in the summer of 2006 wax poetic about how the 66 largest economies in the world were enjoying a historic and synchronized expansion. Naturally, his takeaway was broadly bullish - implying a sturdy and broad foundation was extended beneath the markets. While that was exceedingly true at that time, his observation of the cycle resonated for us in a very different way. If everyone was expanding on the same growth wave, the inevitable contraction would be greatly magnified. We found the statement so poignant, it remained written across the top of a whiteboard in our office for several years.

These same wave principals are taught in your high school physics class as a phenomenon known as constructive interference. When two waves of identical wavelength are in phase, they form a new wave with an amplitude equal to the sum of their individual amplitudes. Conversely, when two waves of identical wavelength are out of phase, they cancel each other out completely. Often, it's a combination of varying degrees of both destructive and constructive interference that determines the composite structure of the new wave - or in this case, the aggregate cycle of the largest economies in the world that had become highly synchronized. Needless to say, our greatest fears in the market were realized just two years later as momentum was translated and magnified sharply lower during the financial crisis. 

Back in the spring of 2011, we created a video around this concept (see Here) - that also played on the interventive policies that the financial system were increasingly reliant on. For us, Constructive Interference took on new meaning - which was summed up with three progressive assumptions at the end of the video.
  • The current financial system requires Constructive Interference by the worlds major central banks - the Federal Reserve acting as the principal director of policy and practice. 
  • Consolidation within the financial sector (i.e. Too Big to Fail) in the last 30 years has enabled central banks with the infrastructure to administer reflationary policies efficiently and with greater efficacy during illiquid periods of contraction.
  • The cumulative effects of Constructive Interference within the financial system has led to increased speculation, frequent financial bubbles and confidence within the monetary system to react (i.e. moral hazard).
It should be noted that from the cheap seats of the peanut gallery, we certainly would not have chosen or advocated the TBTF system and policy path that was taken over the past three decades. However, from a pragmatic perspective - it is the framework the system funneled towards and which greatly governs conditions in the markets today. Example being, while it's a step in the right direction requiring banks to significantly expand their capital cushions - for better and worse, we don't expect these enormous institutions to be dismantled any time soon. The dirty little secret: when it comes to administrating monetary policy - the bigger the better, i.e. easier. Subjugating that reality with counterfactual arguments has practically become a rite of passage for many journalists (e.g. Matt Taibbi) and pundits - and painful in the purse for those participants that have carried a strong bias with expectations of an even greater crisis in the future. Ever superior to ones opinion, it simply is what it is. 

While the crisis exposed the catastrophic dangers of the TBTF model, the massive pipes that were built through consolidation, did help quickly flood the system during and subsequent to the crisis. Would a dendritic banking system have been safer or failed with less collateral damages as the new paradigm? Certainly. Growth would have been constricted, more moderate, less synchronized - and therefore less amplified on both sides of this cycle. However, in many ways it's an anthropologic chicken-or-the-egg debate on markets and capitalism, that we suspect was as inevitable as it was predictable. Free will be damned, we cynically arrive at our collective and predetermined destination.

Although the TBTF system has only grown larger since the crisis, the varying policy responses by the four largest economies (US, Europe, China & Japan) has dispersed the correlation extreme in growth tracks that were present in 2006. Moreover, this has steadily eased the tight correlations across world markets that peaked in 2011. That said, for investors it's certainly no cornucopia - considering many economies now sit in the trough of their respective long-term yield/growth cycles. One way of looking at the bigger picture and where we may be headed, is that economies and markets became highly in phase leading into the composite yield/growth trough, which culminated with the financial crisis. Post crisis, varying policy responses have further dispersed growth tracks as the major global economies bounce in and along the yield trough with much greater destructive than constructive interference. Some might call it secular stagnation, or as the man who coined the phrase some 75 years before, aptly posited; 
"...passing, so to speak, over a divide which separates the great era of growth and expansion of the nineteenth century from an era which no man, unwilling to embark on pure conjecture, can yet characterize with clarity or precision." - Alvin Hansen, Economic Progress and Declining Population Growth, 1939
Works for us - and once again on this side of the cycle's trough, we can only speculate as to what the catalyst for the next era of growth will be and when to realistically expect it. Our best guesstimate, however, is that Hansen's transitional divide will extend much longer than most participants expect, as we bounce along the bottom of the trough. We speculated going into this year, the structure and performance extremes that were quickly translated at both the top (12/13') and bottom (7/12') in 10-year yields, might be implying a long-term range was being established as the great inertias of the secular trend in Treasuries entered the trough of the cycle.
As conveyed in our last note, this point of view remains supported by our research of historical trends that implies yields are not headed materially higher anytime soon. Last week we came across an interesting chart posted by Michael McDonough of Bloomberg, that resonated with this perspective and the significant expectation gap that still exists in the market today. We inverted 
Michael's chart - which shows that the trends in 10-year yields and the number of months in the fed fund futures market to reach the implied rate of 0.5%, were quite correlated going into 2014. Similar to the trend gap that now exists between 5 and 10-year yields, the shorter more impressionable end of the market continues to err on the side of sooner rather than later, when it comes to rate hike expectations over the next year. As framed in the Bloomberg chart and illustrated in the roadmap of the last transitional divide (see Here), we believe long-term yields are pointing the way when it comes to rate hikes over the next several years. All things considered, we still like long-term Treasuries - especially relative to the US equity markets.

In the equity markets, we suspect it will increasingly becoming a market-pickers market between the four different food groups (US, Europe, China & Japan), with sub-varieties tangent to choice. As mentioned in previous notes, despite instigating the catalyst for the crisis, the US had a head start of working and digging the fire lines, that eventually brought the economic disaster under control first. Relative to what the balance of the worlds major central banks were willing and capable of extending - and with the Fed acting as the policy lead, the differential of capital flows has disproportionally supported our equity markets and the dollar since the crisis spread in the summer of 2008. Are the US markets in a bubble today? In our opinion it's a semantic debate, but one we do believe has greater contrast than comparison between the two previous equity bubbles and their respective downturns. 

Nevertheless, we still expect that with Europe, China and Japan now hitting the accelerator as the
US coasts away from QE, the shear stresses that engendered a broad based positive skew in the US equity markets and dollar, should diminish over time. Although it's a short window to measure, from a relative performance perspective, we have already seen as much since QE wrapped up in the US last month. 

For everyone in the States and traveling this weekend, have a happy and safe Thanksgiving.

Monday, November 17, 2014

The Commodity Supercycle Ain't Over - Yet

As surprising as it might sound today, we believe the secular trend for commodities has higher elevations to travel, before eventually running its course - possibly as far out as early into the next decade. While in 2011 we became adamant that the thesis trade in commodities - specifically in its leading sector of precious metals, had become crowded and overhyped, those excesses have been wrung out of the markets over the past three and a half years and offer what we perceive to be extremely compelling long-term valuations going forward. 

This idea remains supported by our research that implies yields are not headed materially higher anytime soon - despite the anxieties surrounding the Fed raising interest rates over the next few years. Moreover, we expect that real yields (nominal - inflation) will remain suppressed and eventually retrace the rise that began in the back half of 2011. When the real yield cycle finds its zero bound and breaks below, commodities tend to outperform in the market over an extended period of time. All things considered, the death knell spike in real yields that has historically punctuated the end of major commodity booms in the past - has yet to appear for us on the horizon. 
Over the years we have shown a long-term Hawking view of the nominal yield cosmos, which depicts an antithetic and gradual troughing, versus the violent and exhaustive secular peak in yields the markets experienced in the early 1980's. While 10-year yields this year have retraced back to the mid point of our expected range (1.5%-3.0%), taking into account the symmetrical structure and mirrored return of the long-term yield cycle,  an estimated secular pivot higher would not take place until early in the next decade. 
When it comes to a roadmap for short-term yields going forward, we looked back at the last time 3 month Treasury yields broke below 0.5% in 1934 and troughed over the next 13 years until 1947. Notwithstanding the failed rate hike regime by the Fed in 1937, the current market has closely followed the historic comparative performance trajectory of that time. Interestingly, by normalizing a duration study to that period (see below), the estimated run below 0.5% would also extend early into the next decade. 

From our perspective, the broader cycle takeaways are:
  • Although the Fed may tweak short-term yields gradually higher at some point in the future, the expectations by participants of a one - and certainly two or three handle, in front of the fed funds rate - appear wildly optimistic over the next few years.
  • We believe the extended and gradual basing structure of the historic cycle reflects more realistic expectations for yields and the natural equilibrium that the Fed will ultimately be guided and constrained by - just as they were across the trough of the cycle last time around. 
As shown in our first chart that depicts both the long-term nominal and real yield cycles, commodities have outperformed along runs leading up to the nominal peak in yields and through the nominal trough of the cycle. From a comparative perspective, the 1970's commodity boom that ran commensurate with the yield peak was roughly half the duration of the commodity boom that ran through the trough in the 1930's and into the early 1950's. This makes logical sense to us, considering what we know of the nominal yield cycles structure - i.e. shorter exhaustive highs versus long drawn out troughs.

When comparing the performance of the CRB index between the 1970's supercycle and today, you might come to the initial conclusion that the current cycle hasn't been that super after all. In fact, the current cycle (as expressed by the CRB) would roughly fit within the performance envelope of the first leg of the 1970's market (71'-78') - despite being more than twice as long. Complicating the tea leaves of the current market was the major currency dislocations in the financial crisis, which caused an overshot on both the top and bottom sides of the performance ranges. 
That said, when we extrapolate a normalized comparative study - balanced by momentum (RSI and stochastics) signatures across the complete run of the 1971-1980 boom, we find an estimated comparative leg higher up to the early part of the next decade. Fittingly, this would roughly match the duration of the previous commodity boom that extended for ~20 years along the mirrored trough of the long-term yield cycle in the early 1930's and 1950's.

While the recent prognostications of $700/ounce gold and $50/barrel oil make for great hyperbole by the bears and in the punditsphere, we view them as the typical overshots that are thrown around during the final throes of capitulation. In as much as markets tend to overshoot significant moves, expectations soon follow - always in the same direction of where a market has been trending. With commodities remaining under pressure since Q2 2011, recency biases have entrenched towards further downside in the future. For gold to reach $700/ounce or oil $50/barrel, real yields would be pushed significantly higher - essentially repeating the performance declines for both assets that began in 2011. From what our anticipated range implies for nominal yields over the next few years and how eroded inflation expectations have become today, both targets appear grossly unrealistic. Contrary to conventional wisdom in the market today, we still believe hard commodities such as gold and oil will once again outperform - greatly supported by the tangential performance trends in catalysts such as China and emerging markets. 

You'll find that for many of the commodity cycle bears today, their theses hinge on a continued catalytic decline in China. This is predominantly because China had played such a pivotal role through the first boom of the commodity cycle in the massive demand created by significant investments in infrastructure and urban development. While the excesses in China have been well described and rigorously debated for the better part of this decade, the just how bad the crash will be expectations by the policy bears have so far been largely unfounded. 

Quite the contrary, although these concerns remain at the forefront of debate as growth in China has slowed, the leading edge in their equity markets have surprised (finally) many this year - and broken out from a 5 year consolidating range. 

As much as their arguments are well founded with cogent logic, the reality becomes that  increased capital flows and resurrected confidence in Chinese markets will have a mitigating effect on the immanent credit conditions that academics and strategists such as Paul Krugman and Michael Pettis have been greatly concerned with over the past several years - and whom largely expected significant pressures to remain on the commodity markets as China would be forced into a long and painful economic rebalancing. 

While it remains to be seen weather China has its comparative 82' awakening (see above) or its much anticipated bust, we do believe the recent positive developments in their capital markets will provide a constructive rather than destructive environment for the commodity sector over the next year. All things considered, we'll still take that bet and doubt we will ever see $700 gold or $50 oil again in our lifetime. From our perspective, $1400 and $100 appear more likely in 2015 - and by 2022... who knows - the super may have shown up again in this cycle.   

Wednesday, November 12, 2014

Marination Station

We've been preoccupied this week with another side project, but thought we could offer up a few charts for consideration. Food for thought.  

- Click to enlarge images -

Monday, November 3, 2014

Challenging Our Assumptions

As the contemporary chapters of quantitative easing mature into their second decade (est. 2001 Japan) of trials and tribulations, it's important to recognize that the policy influences have been applied in varying economic conditions - along different points of the market cycle. In the old growth valley of the long-term yield cycle, where monetary policy has run out of road, quantitative easing has just become an extension along the policy continuum - beyond the mystical plane of ZIRP. 

While anxieties have inevitably risen over the sheer size of these relatively unfamiliar policies, we expect as more economies come face to face with QE, a greater and more discriminative understanding will be made on the part of market participants, as QE is enacted - expanded or wound down.  A fascinating example of these distinctions can be found today, between policies in Japan, Europe and the US. 

Throughout the year, we have followed the market developments in Japan and expected as the year drew to a close, the Nikkei would break free of the nearly 25 year old range - that has defined its long battle with deflation. Back in April we summed up our thoughts in The Long Tail of Deflation:
Our general outlook for the Nikkei this year has been that the rally that began with the commencement of Abenomics at the end of 2012 became stretched to a relative extreme and that the breakout leg for Japan and perhaps its perennial battle with deflation would occur at a lower level (technically) and after another subsequent correction. That correction has materialized this year with the Nikkei underperforming almost every major market in 2014. - The Long Tail of Deflation 
With the Nikkei breaking through overhead resistance in September, a slingshot reflex materialized last week after the Bank of Japan expanded their scope of accommodative policy. From our perspective, it's important to recognize that unlike Europe - which is just beginning to belly up to QE as economic conditions have worsened over the past year, Japan is expanding policy while underlying fundamental conditions have mainly improved. While it's certainly not a panacea, Jeremy Schwartz over at Wisdom Tree has repeatedly and clearly outlined Japan's case, most recently in September (see Here). Similar to the US's expansion of QE during periods of economic stability, the policies can act as an accelerant within the market cycle as economic conditions broadly improve and buttress behavioral affects.

With respect to the Nikkei itself, since testing the lows in April, the bulls have been rewarded as upside momentum has been quickly restored as the comparative pattern suggested. Here's a quick snippet from a note in August (see Here) that described the set-up that was developing:
The 1987 Nikkei projection that we've followed throughout the year is completing the less mentioned, but more important - long-term patterned outcome the momentum comparative always implied. That market inertias would be quickly restored to the upside, once the retracement decline was completed.  
As mentioned in previous notes, this same pattern was replicated in the S&P as it navigated and was rejected by the Meridian in 1987, 1994 and in 2011. On each occasion, the low offered investors an excellent buying opportunity. Similar to the patterned reversal in the SPX in the fall of 2011, investors are getting one more chance to buy Japanese equities on sale before we expect Japan to overcome the pernicious tentacles of deflation, that has rejected their equity markets at long-term resistance over the past three decades.
Contrary to contemporary policy in Japan - but similar to where the Nikkei stood in 1996, southern markets in Europe - such as Spain's IBEX, are the leading fronts of where deflation is currently pushing up against the Old World. While Draghi appears to be making a college try at breaking where the deflationary cycle has typically turned down, the realities confronted in the political and structural arenas in Europe may prove too difficult to overcome at the current juncture. As mentioned before, we're not sure where the German's will find religion, but expect it will only be after pronounced pain in their coffers and weakness in their equity markets shows up at their front door.
As a postscript tie-in between our more bullish leanings in precious metals (gasp) and our continued favorable outlook in Japan, we believe the two market postures can be reconciled, when appraising the long-term correlation trends between the yen and the Nikkei. 
While the Nikkei has provided an upside hedge to the continued slide in precious metals, we haven't been able to eat much cake - as the yen has remained tightly correlated with gold and silver and negatively correlated to the Nikkei. So much in fact, that the last time the Nikkei and yen were coming off a comparable correlation extreme, was in the fall of 2008 - as the Nikkei caught fire during the financial crisis and the yen was bid sharply higher in a safe haven scramble. 

Today, while the correlation trends are quite similar - the market reflexes are inverse to that time. Should the nuances of the comparisons prove prescient, we expect the yen will find a bottom shortly and start moving higher with the Nikkei and precious metals, challenging the more recent assumptions by market participants this time around the block. All things considered, we still like the respective positions, especially from an absolute return perspective.