Macro, Markets, and Malarkey

Stocks and Bonds
It feels like forever ago, but back in February, the S&P 500 hit its lowest level since 2014 as global growth fears spooked investors, leading to liquidations and deleveraging—most notably for sovereign wealth funds.

Fast forward to now…as of the end of July 2016, the S&P 500 closed at 2,173.60—up 7.5% from the beginning of the year. And, 10-year treasury yields started the year at 2.24%; as of the end of July 2016, rates were at 1.46%—a 35% decline in yield from the beginning of the year. These are big movements in both domestic stock and bond markets which investors shouldn’t take lightly.

Fig1_S&P+10yrTreasury

Also, more than $11 trillion in negative yielding bonds are outstanding, largely in Europe and Japan. The Financial Times wrote a great piece recently highlighting the post-Brexit surge in investor bond purchases.[1]

Fig2_GlobalNegYieldSovDebt

This means that if an investor holds one of these bonds until maturity, they actually lose money. They are also paying the issuer for the right to own these bonds, versus receiving some sort of payment in return—as Finance 101 teaches us should be the case. Governments with massive stimulus policies (ECB, Bank of Japan, and now the Bank of England) are buying up bonds, bidding up the price of these bonds and thus sending yields negative. Accelerating the decline in yields is the fact that the supply of such bonds is not ample enough to meet this demand. Negative yields are supposed to entice investors to invest in other assets, since they clearly lose money by investing in such bonds. This hasn’t happened. And yes, this is completely backwards and deflationary.

Currencies and Commodities
Currency markets have not been immune to this storyline; as Europe and Japan use monetary policy to help grow their economies, foreign investments flow to the US for its higher yields. Since May, foreign buying coupled with more hawkish Fed speak has strengthened the US dollar versus other currencies.

Fig3_USDollarIndex

If the US dollar continues to strengthen or simply stays strong on a relative basis, this has the potential effect of placing a lid on US inflation. The stronger the US economy gets versus its global counterparts, the stronger the dollar looks versus other currencies.

A strong dollar is usually a negative for commodities. And in fact, the strong dollar has kept commodity markets mostly in check since early May, as we wrote about in Commodities at a Crossroads. Of note, crude oil fell to under $30 a barrel earlier this year, sliding alongside the S&P 500, touching its lowest levels since May of 2002. It then spiked to above $50, and now hovers just north of $40 due to dollar related price pressure—nearly 20% below its peak in June of $50.11.

The US Economy and Election
That’s not all. We’ve barely discussed the domestic economy. Here at home, despite anemic GDP growth of 1.2% for Q2, economic growth is indeed expanding as evidenced by the latest payroll and hiring figures. Non-farm payrolls increased by 255,000 in July on a seasonally-adjusted basis, with the unemployment rate at a very healthy 4.9%. Wage growth and labor market improvements here in the US makes a strong case for the Fed to raise rates. Our view is they should raise rates in September, ahead of the election. Whether they will or not remains another question.

Lastly, and as an homage to Vice President Biden’s favorite saying, “malarkey,” rhetoric around the US election has truly captured the American public, including ourselves. We are seeing raw democracy at work here and elsewhere. People are voting against the establishment; it’s a small segment of the human race, but it affects us all. In the meantime, it may become clearer that at extremes, when enough of the populace is truly feeling disadvantaged, capitalism has to make some changes. Otherwise capitalism and democracy are not going to work when the rule of law favors a few as opposed to the many. While this line of thinking may be too philosophical for a financial markets blog, it merits consideration because it does affect one’s view on investing.

Thus far financial markets have not reacted to the election news melee, but investors should pay attention. Should the Republicans lose their majority in the House and Senate, and Hillary Clinton is elected, this could have a dramatic impact on GDP as government spending will very likely increase…then again, it will also increase if Trump builds his wall.

What Should Investors Do?
Stocks can be at record highs throughout the year. The reality is that it doesn’t take much of a move to set a new record high when you have just made one. Odds are we will see low growth for the rest of the year, maybe the rest of the decade. One should expect dispersion by country and company with thoughtful, well analyzed decisions to make on what to own. This is going to take real professionals who are either doing real fundamental analysis or machine learning or can take advantage of the volatility and the anomalies. It’s going to be a different market. We all know that global and country growth comes from demographics and technology (of which productivity is a subset if you can measure it). But, there is a payback when the easy money goes away, causing slower growth than the demographics and technology would suggest.

In light of this, our view is that investors should have two areas of their portfolio well covered. First, there are downside risks to the market right now. Ignoring this fact would potentially leave one’s portfolio without a buffer, and we believe every portfolio needs uncorrelated assets. While it is self-serving to advocate for managed futures, Altegris has a focus on managed futures because time and time again they have performed during some of the worst periods for traditional equity markets.
Fig4_PR_ManagedFuturesPerfDuringEquityMarketStress_1288-NLD-882016

Equity markets could continue to push for new highs, but we believe they are also susceptible to periods of steep losses. Managed futures performance has historically been uncorrelated to the performance of the broad stock market, and we strongly believe all investors with risk capital should consider this diversifying return stream, given the current macro picture.

The second bookend to investors’ portfolios, given the market environment, is private equity. Private equity was one of the few areas that didn’t sell off when investors panicked earlier this year, and whose returns can be orthogonal to the returns of traditional markets. Now, private equity is not a liquid investment option, so investors must be thoughtful in terms of just how much they allocate. But it is the forgoing of frequent liquidity that makes private equity attractive in our opinion. This is what is commonly referred to as the illiquidity premium, which is essentially the potential reward of enhanced returns—over time. This potential for enhanced returns may be particularly attractive for investors given the uncertainty in traditional equities at present.

The bottom line is that investors should aim to diversify portfolios. Look for ways to grow and preserve capital in your portfolio and seek returns in areas where investment managers have a real edge and understanding of the underlying investments. Pay attention, and invest for the future of your portfolios.

 

Data sourced from Bloomberg unless otherwise specified.

[1] Financial Times, June 29, 2016: http://www.ft.com/fastft/2016/06/29/negative-yielding-sovereign-debt-rises-to-11-7tn-globally/

Commodities at a Crossroads

Our CEO, Jack Rivkin, recently revisited his thus far prescient view of economic issues facing “The Rest of the Americas.” There are several key drivers one should pay attention to when evaluating the Americas, most of which ultimately lead to the commodity markets.

From the Fed’s decision on interest rates (which is highly data dependent), currencies, the dependence of Chinese demand for commodity exports out of Canada and Latin American countries, and nearly ubiquitous political disharmony, commodities are at an inflection point. Here is why:

 

US Economic Data and the Fed
April retail sales were up 1.3%. Job creation is improving and wages are starting to improve as well. Economic data is getting better, but it’s not necessarily good enough for the Fed to take action. What are the possible scenarios and impacts on commodities?

  • Good Data: If we continue to see decent economic data, it could spur the Fed to raise interest rates at the upcoming meeting in June. An increase in the Fed Funds rate generally leads to strength in the US dollar (USD) relative to other currencies. Conventional wisdom stipulates that a strong USD is typically a negative for commodity markets; the two are negatively correlated since commodities are priced in USD. If the USD strengthens, commodities tend to suffer because it will take more dollars to buy the commodities. While that’s been true the majority of the time, it’s not always the case as one can see below:

Fig1of3_Charts_USD+CommoditiesCorrelation_051916

  • Great Data: That said, if the data out of the US is very positive—one could view this as a growth theme. In this case, the Fed will almost definitely raise rates in June; the USD will rise; but if the US is consuming more, spending more, and on an improved economic growth trajectory, that could spur increased demand, which could actually push commodity prices higher.
  • Bad Data: The last scenario is if the US data gets worse. We don’t think this is all that likely, but low inflation could make the Fed blink. Where we may see bad data is globally. With global markets more intertwined than ever, it would be bold for the Fed to ignore any further and significant global weakness. Moreover, the big Brexit vote shortly after the June Fed meeting could give Yellen pause, ultimately postponing a hike until July.

 

China
According to both the World Economic Forum and the Wall Street Journal (WSJ), in 2015, China consumed “roughly an eighth of the world’s oil, a quarter of its gold, almost a third of its cotton and up to a half of all the major base metals.” In addition, as Jack pointed out in his Perspectives piece, China also produces about half the major base metals. One cannot discuss commodities without discussing China.

Fig2of3_WorldEconForumGraphic_low-res

All eyes are on Chinese growth to continue fueling this impressive demand. Chinese growth is less than it was in prior years but their growth target remains between 6.5%-7.5%. While momentum has slowed, 6.5%-7.5% is not insignificant. To give some obvious context, the U.S. economy grew 0.5% on an annualized basis for the first quarter of 2016.

As Chinese demand for and production of commodities vacillates and its growth moderates, we could see more idiosyncratic Chinese market movements. For example, during September of 2015, China’s National Administration provided new standards for the use of aluminum cables. Aluminum is significantly cheaper than copper and China is rich in aluminum resources—substituting aluminum for copper allows for lower costs and less importing. Prior to September of last year, copper and aluminum prices moved fairly closely together. Since this time, however, we’ve seen more dispersion, periods in which aluminum rallied and copper declined. Thus demand may be increasing right now for base metals, but one may continue to see more substitution versus base metals moving in concert.

The remainder of 2016 should be interesting. If China backs off stimulus or increases local production, it could spell trouble for commodities given their significant share of commodity consumption. We tend to agree with the team from Gavekal Research, who recently stated the following:

 

 

“Since GDP growth in 1Q16 remained above the 6.5% target, it seems likely
that policymakers will now focus more on averting a major bubble and
dialing back leverage, than adding fresh stimulus. This is not to say that
the central bank will cause another interbank liquidity crunch, but it will instead
focus on keeping rates low and stable. Hence, do not expect more easing
policies in the next 3-6 months; after accelerating for the last year credit growth
is likely to stabilize at the current level.”

Gavekal Research, Chen Long, The Daily—“No More Easing Likely,” May 15, 2016;
http://research.gavekal.com/author/chen-long

 

If this is true, we may not see more stimulus from the Chinese central bank. Yet, a complete economic slowdown followed by stunted commodity demand seems unlikely.

Political Unrest
With the exception of Trudeau’s white knight status in Canada, much of the rest of the Americas’ leadership remains on shaky ground. Democracy in its raw form is coming to the USA, Rouseff is on her way out of Brazil, while Mauricio Macri is still sorting out the pieces in Argentina—and he’ll be doing that for a long time. Any perceived weakness in leadership could be viewed by investors as a sign of a weak economy. This too matters because as faith in these governments declines, so may their currency as we witnessed several times last year. For example, one of Brazil’s largest exports is coffee. A weak Brazilian real led to lower coffee prices. In fleeting moments of real strength, coffee rallied alongside.

Fig3of3_Charts_Brazil Real+CoffeePrices_051916

For countries that rely heavily on commodities for exports, a weak currency is not necessarily a positive. Therefore the impact of political unrest on commodities could make for a bumpy ride, at least in the short-term.

Commodities Now?

One may ask, is this a good time to get into commodities? The reality is, it depends on what sector, what commodity, and when. The question also assumes that investors only have the option to go long commodities. Imagine if you could have been short crude oil over the last two years? Our preference is to invest in strategies that can go long and short, such as trend following managed futures strategies. These strategies are systematic in nature with the goal of following price trends. If gold continues to rally, trend following systems will likely add more and more long gold exposure. In fact, most managers we follow are positioned long after gold’s rally this year. If the trend abates, these systems will typically reduce exposure and if the trend reverses strongly, these systems will follow the price trend in the other direction. Investing in systematic trend following strategies allows for long and short investing while taking out the discretionary judgement of trying to time these often volatile markets.

Commodities are indeed at a crossroads with some dispersion likely. Much of what can move individual commodity markets for the remainder of 2016 remains to be seen, as various other cross currents make it difficult to predict. In other words, even if we get Fed clarity, China and other variables could remain uncertain. Investors may want to look for trend following managed futures strategies that have the ability to follow commodity markets directionally once the fog clears.

Paris, China, Russia and the Impact on Risk

The tragic events in Paris on Friday have not only raised the global risk levels of further terrorist actions, but will also produce behavioral changes geopolitically and locally. This will affect markets beginning now.

We are already seeing the pulling together of a more coordinated global action against ISIS by the western world. Europe, of course, may bear the brunt of change and would appear to be the most vulnerable to the impact of the increased risk levels on the broad economy, country politics, and societal reaction within the diverse elements of the population. Kim Wallace of RenMac made the observation this past weekend that 3% of the 7.3 billion people in the world are emigrating from developing countries to more developed environs. With the turmoil in the Middle East in particular, but also other closer areas, Europe, with a more open door policy—at least until now—is bearing the brunt of the disruptive emigration on its economies, its existing population and the social issues surrounding the clash of cultures.

In the meantime:

  • Russia is holding back from supporting what is likely to be a western world coordinated effort around ISIS, and will likely be a continued troublemaker relative to its own perceived interests.
  • The IMF staff is recommending the inclusion of the Renminbi in the basket of reserve currencies. The actual adoption or rejection occurs at the end of this month.
  • Commodities, including oil, have taken another downturn.
  • While US employment data looks reasonably strong, it certainly didn’t translate into strength in retailing.
  • The technicians don’t see much cause for recovery in the markets, at least through the data that was available through last Friday.
  • And, the probabilities regarding a Fed hike in December will likely move down.

There is much more that could be said regarding what has happened this past week and certainly opinions that could be expressed. I leave that to the op-ed contributors. It is hard enough trying to make sense about what this means for the markets. Let’s try to address some of the possibilities, starting with the effects on economies.

Almost all of these actions would tend to support a slowdown in activity in the euro region from a combination of the disruption caused by the terrorist action within Europe, the political dysfunction that may occur, and the actual reduction of incoming travel to the region. This is against a backdrop of the possibility that the decline in commodities is an indication of even slower global growth as opposed to simply an oversupply situation caused by the continued production of various hard commodities and oil as long as the operating economics provide cash flow to service debt and cover other costs. I have said this before, but it’s worth reiterating, that energy is a significant input cost to the extraction and refining of most hard commodities, as well as oil itself. As the breakeven drops, production can continue longer than one might expect. We recently discussed this point relative to the Bakken oil fields in North Dakota. We will need to look for other signals to determine whether this is a global growth problem or something more specific. The offset in Europe to the impact of the terrorist activity is the likelihood of continued, and possibly increased, QE or QE-like central banking activity as well as fiscal activity. In addition, the currencies of China and the US are likely to remain stronger than the euro as a result of the IMF action, and some signs of growth stability in China, combined with a possible flight of capital to the two large countries that are somewhat—I say somewhat—more isolated, with lower probability, from the possibility of terrorist action internally. Relatively speaking, these markets may do better for some period as a result of these flows and growth patterns than what we see from Europe. It specifically may hold down rates as money flows into US government securities. Ultimately, the euro currency weakness could begin to mollify that spread in performance.

So what does this say about the likelihood of a Fed move in December? I think that depends a lot on the November employment reports where the Fed will have another set of data before a decision is made. The October numbers were certainly robust as we have pointed out in some of our recent Altegris video and audio broadcasts. If there is actual evidence of a further global slowdown combined with weaker employment data—not our expectation—the Fed could delay. That puts them into next year with all of the uncertainties that entails. If the US numbers are good, combined with no significant deterioration globally, the odds are the Fed will pull the trigger and get started. The markets are to some extent reflecting this, although we will see what the Paris incidents do to the dollar, flows and, ultimately, market rates. As I have said, I don’t think December is a good time to change the rate picture—even modestly—while there are significant end-of-year activities around balance sheets and inventories of securities in the financial markets.

All of this reinforces our view that there will be increased dispersion within and among asset classes, combined with some financial accidents, away from a fluid geopolitical environment. Active management and less-correlated solutions are the likely better performers in the aforementioned economic climate that may be with us for some time to come. I don’t really have to ask, given recent events, for everyone to pay attention.

Awaiting the Fed—Does it Matter?

Portfolio Repositioning

We are still in the midst of portfolio repositioning, as not necessarily a cause of the market’s volatility, but in response to the markets initial decline triggered by China’s move to float its currency and introduce other measures to support the economy as capital flows out of the country.

Commodities

This has brought home the realization that commodity prices are likely to stay lower for longer increasing the odds of accidents, credit and otherwise in that sector of the global economy.

Recession

As I have said previously, I don’t think the gyrations; particularly those to the downside are forecasting a recession in the US or elsewhere in the developed world. The picture is more mixed for the emerging markets.  It reinforces the likelihood of continued QE in Europe and Japan.

Dispersion

It does support our view that the dispersion of winners and losers in various stock markets around the world will increase, and volatility, while coming down from its peaks, will remain relatively high in the US vs. the period of QE.  We are moving into a different regime than the period from 2009 to the present.  Portfolio allocations should reflect adding managers, active managers, who could take advantage of this volatility and mitigate some elements of risk.  Look at who is doing well this year vs. earlier periods.  You may be surprised.

Fed Funds

There are suggestions that the volatility itself pushes out the likelihood of a Fed Funds increase Thursday.  I am not sure.  I think we remain data dependent and the most important data is within the US – GDP growth and more importantly employment and wage data.  We expect the numbers and revisions to continue to be positive.  Whether the Fed increases the target in September or later, may be less relevant to the economy and more relevant to volatility and dispersion, which we think occurs whether the target increase is September, October or later.

Continuing QE

Let’s keep in mind that the rest of the developed and part of the developing world is continuing variants of QE.  This dispersion will continue until other economies see wage growth and capacity concerns.

Let’s take advantage of the dispersions.  This a time when more portfolio guidance becomes critical.  Pay Attention.

Managed Futures Update: Reversals or Corrections?

Managed futures performance can be frustrating for investors. After strong performance in 2014 and into Q1 2015, many may be wondering why the strategy has lost some luster in Q2. The reality is that some of the very strong trends from last year have seen changes in direction. The key to understanding what might happen next is in trying to assess whether those trend changes are corrections against the previous trend or have graduated into full-blown trend reversals.

There were price corrections across all four major market sectors in Q2—the US dollar, interest rates and equity indices (especially in Europe) all sold off while commodities (particularly energy) have rallied. The result was that no single market or sector was the cause for negative performance. Rather, each sector or even sub-sector therein, lost a small amount. Add these up and you get negative performance for many managed futures managers in Q2.

AssetClassCharts_MFBlog_draft061915_reformat

Below is a brief summary of some of the major drivers in each sector:

Currencies. In 2014 short positions in the euro, yen, and most other currencies versus the US dollar proved to be a very successful trading strategy for managed futures managers as central bank policies began to diverge. In Q2, expectations have shifted due to early signs of QE success in Europe. The EUR/USD trade has corrected and is heading back towards where it started the year. Short euro trades have logically resulted in losses. Most trend following managers remain short euro, betting that the trend of a stronger US dollar will resume.

Commodities. Short crude oil was, by far and away, the most successful trading strategy in the second half of 2014. Since the downward price trend was so strong, most trend following systems have regarded the price appreciation in 2015 as a correction within the overall downtrend, rather than a trend reversal. However, as the months roll forward without a resumption of the downtrend most managers have reduced short exposure to crude, and a few have begun to reverse their positioning to long. The longer the crude oil price holds above $60 per barrel and continues to tick higher, we expect more managers to view the market as having reversed.

Fixed Income Futures. Fixed income has been volatile—especially in Europe. German bond yields rose and prices fell quickly as market participants wised up to negative yields. Managed futures managers were largely long the bund and other European fixed income contracts, thus incurring losses (albeit most somewhat minor). Fixed income positioning has been reduced across the board as the market determines whether a new uptrend in bond yields has indeed begun. Some managers have begun to establish short futures positions.

Stock Index Futures. Long stock index futures positioning—both domestic and globally—have been a mainstay of portfolios for many quarters. Corrections in some of the strongest upward price trends such as Eurostoxx 50, the DAX and even S&P 500-miniFutures caused losses in Q2. Most trend following managers remain long in anticipation of an ongoing uptrend.

 

Will it Get Better?

Managed futures managers, particularly medium- to long-term trend following managers, do not reverse positions overnight. Timing depends on the parameters of their underlying trend identification algorithms. In general, most trend following managers require a sustained price movement before reversing positions from long to short or short to long. Even in 2008, a banner year for managed futures strategies, many trend following managers suffered several months of negative performance before their systems identified whether corrections were new trends. After a prolonged period of strong trends, it is very common to see markets experience reversals for either technical or fundamental reasons (or both). In today’s market, there is no unifying reason for these moves—markets appear to be simply retracing some of their price trends over the last 12-plus months. We believe these price reversals represent “normal” market behavior, particularly after a long trending period. Similarly, it is normal for managed futures managers to have periods of drawdown after a strong winning sequence like the one we saw beginning in mid-2014. Investors might be nervous that we are entering another extended period of stagnation in the strategy, but we believe the underlying market conditions of expanding volatility and central bank policy divergence remain supportive of the opportunity sets in managed futures, regardless of whether you view current price moves as corrections or new trends.