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/

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.