Saturday, 23 May 2009

Bear market rally (March - May 2009) R.I.P.

It takes nerves of steel to remain in cash, on the sidelines of a 30%+ equity market rally. With every 1% that the market moves higher, the greater the temptation to join the party for fear of missing out or being proved wrong. So it is strange that the recent rally coincides with a growing consensus that large amounts of cash await a correction before being invested. Thus, in the absence of improved economic data or company earnings, the market cannot move substantially higher while this cash pile remains uninvested.

An improvement in inter-bank lending alone, as measured by the falling TED spread, is not cause for a sustained bull market. Nor is the thawing of the primary credit market. What started as a financial crisis quickly spread to the real economy with devastating effect. Therefore, the problem is wider than the banks and is not solved, but rather one important part of the puzzle (the financial system) appears to be falling into place. However, there remains a lot to be done before we can say the financial system is fixed.

Since, this recession is unlike any other in living memory, it will take even more time to fix the real economy. What makes this recession different is the almost total collapse of the financial system coupled with a synchronised global slowdown in trade and growth. This combination will make this recession more severe in terms of both length and depth than any other in recent history. Whilst the worst of GDP and financial Armageddon may be behind us, unemployment and consumer deleveraging are likely to continue to deteriorate beyond 'normal' levels, extending the duration of this slowdown in the process.

On the plus side, the extent and speed of the response matches the severity of the problem. Trillions of dollars of toxic alphabet soup (CDOs, SIVs, CDS etc.) have been replaced with equal amounts of state-funded acronymed stimulus such as TARP, TALF, APF, QE... Excessive private sector debt has been replaced with public sector debt, something of which ratings agencies are well aware. Indeed, Moody's and S&P have put the UK on negative watch and this recession will undoubtedly claim more sovereign AAA ratings.

However, while the stimulus undoubtedly made the difference between depression and recession, we have effectively borrowed from the future to pay for the present. The huge increase in money supply and public debt: GDP ratio adds its own set of risks and will lower growth in the future. In an environment of higher perceived risk, investors demand higher risk premiums.

So, expect higher bond yields and lower p/e ratios, which will increase the cost of capital and constrict economic growth. Don't be fooled by the current euphoric bear market rally.

Wednesday, 13 May 2009

The trend is still your friend

The chart above shows the S&P 500 from May 1960 to May 2009 using a log scale. This raises the following obervations:
  1. Notwithstanding the bear market from 2000 to 2009, a clear upward trend is still in place
  2. The S&P 500 is currently -2 standard deviations from the trend, which, if still in place, suggests a buy signal as the bear market is now complete, having moved from +2 to -2 standard deviations versus their long term trend
  3. It is unsurprising that US equity returns have experienced a 'lost decade' given how out of line US equities were in the late 1990's (+2 standard deviations vs. long term trend)

Tuesday, 12 May 2009

Perspectives on commodities

Some recent eclectic thoughts from John Reade, of UBS Investment Bank:
  • China will buy those commodities that it considers strategic (i.e. required to meet centralised growth plan) as well as those that it does not produce a lot of. Therefore, expect these commodities to trade at a premium (e.g. copper is required for infrastructure growth & China is a net importer).

  • A suggested FX basket for playing commodities: NOK (oil), CLP (copper), AUD (iron ore) & BRL (oil, iron ore & aggregates).

  • ZAR is not as much of a commodity play as other currencies since it is unable to increase its commodity exports.

  • OECD industrial production (IP) is a good leading indicator for commodity demand. Expect IP to trough mid 2009.

  • Excluding oil, China is consuming 20-30% of annual commodity production and its GDP is c. 10% of global GDP. China is therefore 'punching above its weight' in term of commodity consumption.

  • Disagrees with peak oil theory since we are not yet at the point where there are no know exploitable oil fields.

  • The marginal cost of production for oil is $70 bbl, driven by other commodity prices essential to extraction (e.g. steel, concrete...). When the prices of those commodities rise, so does the breakeven oil price.

  • Having initially been a gold bear, he expects gold to average $1,000 in 2009 due to the sheer level of inflows into the commodity. Having initially benefited from risk aversion (see performance of gold versus TED spread or 2 year swap spreads), future performance likely to come from the inflation trade. However, he doesn't recommend buying gold yet, until scrap sales & risk appetite wane and jewelry demand increases. Ultimately, gold is a scarce asset and so only a small increase in demand is required for a large increase in price.

Monday, 11 May 2009

Little Wing Macro: April 2009 review

The portfolio rose +0.5% net of costs in April, which was disappointing given the 10%+ rally in equity markets.

Of the three risk 'buckets' - rates, FX & equity - equity was the only positive contributor. The portfolio's Chinese & UK equity call options rose 39% and 36% respectively. However, the decision taken at the beginning of the month to pre-empt "sell in May" with FTSE 100 June puts, reduced the equity contribution to the bottom line to c. +6%.

In rates, TBT (short 20+ year US Treasury ETF) turned around previous negative performance, adding 13% as Treasury yields went into reverse on renewed risk seeking. However, the portfolio's Gilt holdings offset this as Gilt yields rose above 3.5% on supply & debt:GDP concerns. With the 10 year Gilt yield at c. 3.7% and an additional £50 billion in the Bank of England's APF, the risk reward ratio appears skewed in favour of maintaining long Gilt positions. For further insight on the reassessment of the Gilt market, see Reassessing Gilts: don't panic Mr Mainwaring! and When in trouble, double!.

The portfolio's FX investments, namely long USDJPY and gold investments suffered at the hands of 'animal spirits' as save haven assets bore the brunt of the return of 'animal spirits'. However, the portfolio's USD hedge compensated as the Dollar fell 3% against Sterling, breaching 1.47 in the process.

Overall, it was a difficult month for the views expressed in the portfolio, although by no means a disaster since the portfolio was up on the month. Indeed, May is shaping up to be another good month with the portfolio up c. 4.5% month to date. Volatility declined over the month to 35%, and continues to do so, enabling the portfolio's risk budget to be increased. Short GBPNOK and extending Gilt duration look like possible candidates for implementation...

Thursday, 7 May 2009

Wake up & smell the coffee! China goes short duration

When the largest investor in any asset aggressively reduces their exposure, it's time to reassess that investment.

With holdings of $744.2 billion, China is the largest foreign holder of US Treasuries. This amounts to 24% of foreign holdings.

However, in a recent research note, Standard Chartered note that:

"Although bulk buying of Treasuries has ended, China is not reducing its stock of US securities. It is reducing its holdings of agencies and maintaining growth in its holdings of Treasuries, but is switching from long-term to short-term securities (tenors of less than one year)... holdings of short-term Treasuries surged to USD 182bn in February 2009 from USD 19.87bn in September 2008."
In portfolio management terms, this equates to an aggressive short duration position - standard practice if you expect yields to rise. Perhaps the scale of this positioning (25% of their holdings in sub 1 year paper) is a measure of how much they expect yields to rise. Indeed, Chinese officials have recently been vocal about their concerns regarding Treasuries and the US Dollar.

Could this mark the reversal in the 20 year bull market for Treasuries? Dr. Marc Faber certainly thinks so...

"The asset market that has the highest probability of having a made a secular high (such as Japan in 1989, or the NASDAQ in March 2000) is the U.S. long-term government bond market. Despite a still-weakening economy and massive quantitative easing, long-term bond yields appear to be on the verge of breaking out on the upside."

When in trouble, double!

Since the initial announcement and subsequent implementation of QE, Gilt yields have steadily risen (see above chart). Mervyn King has therefore lost money on his £52 billion of Gilt purchases. So, like any punter would do when faced with a loss, big Merv has doubled up.

At today's rate announcement, the Bank of England revealed that it will increase its existing QE facility by an additional £50 billion:
"The Committee also agreed to continue with its programme of purchases of government and corporate debt financed by the issuance of central bank reserves and to increase its size by £50 billion to a total of £125 billion. The Committee expected that it would take another three months to complete that programme, and it will keep the scale of the programme under review."
The 10 year Gilt yield fell 10 basis points. Could this be an inflection point in the 75+ basis point rise in Gilt yields?