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/

South America, PE, and the Fed

Watch Friday’s Employment Numbers

Last Friday, July 30th, I was invited back to Bloomberg Market Makers with hosts Matt Miller and Scarlet Fu. Katia Porzecanski, who follows the emerging markets, and Tracy Alloway, executive markets editor, joined the sessions. As usual the producers provide some topics a day or so before the appearances to prime the discussions. The questions were “What are you watching in South America?” “Hedge funds and Private Equity assets—what kind of strategies are you looking at?” and “What’s up with the Fed?” As in the past, below are the notes I sent to the producers in preparation for the segment.

 

South America: I’m watching three countries: Brazil, Argentina, and Mexico.

I don’t think we are close to a turning point on the negative GDP in Brazil. This is important as Brazil is critical to the rest of South America and accidents can happen on the corporate credit side and within the government. They don’t have a lot of levers.

Argentina, may look like a disaster, but is moving closer to an election which will bring in one of a couple of logical, policy oriented candidates, and Argentina will begin its every two decades cycle of recovery. I think the issue on their sovereign debt will get resolved. But, coming out of it may be a change in the covenants of sovereign debt in the future. For example, the ability to hold out from what a majority of creditors agree to on a settlement is likely to vanish.  This makes sovereign debt more expensive but hastens returns to the capital markets for renegers.  In addition, Argentina has phenomenal Shale-based hydrocarbon reserves, which it will be able to exploit once there are adults in the government.  A big part of the shale reserves are in the same area where Argentina’s conventional gas reserves existed. The gathering facilities and movement of the resources are already in place. This could happen quickly and economically.  Unfortunately, in the process, some of the best fishing areas in the Neuquén Province (where I used to fish!) may be destroyed. I hope not. Economically, shale extraction is a big plus. Let’s understand this will add significantly to global energy supply, and put more pressure on prices.

Mexico is, as I said on air, a shining star. The natural growth rate is 2 ½-3%. If Telecom and Energy reform happens, another 1 ½% would be added to the rate. Henry McVey, KKR’s Global Macro Head, discussed this recently on our webinar, “Investing in an Idiosyncratic World.”  Mexico could become one of the faster growing economies in the world with sustainable demographics. Energy reform there would also add to global oil and gas supply. I am pretty optimistic for Mexico.

In general, I like the Americas for opportunities—long and short. Canada is a little problematic right now given the oil patch and commodity producers may have a problem. If global growth picks up at some point, there is a cycle yet to come.

 

Hedge Funds and Private Equity: In general, given the market environment I expect over the next several years, I am in favor of active managers—non-benchmark-huggers, whether that is long-only or hedge funds that can generate alpha on both sides of the market.

Today, the best Private Equity firms have the most active managers among all managers. That’s because these managers can do more analysis and have more companies to choose from (than those operating in the public markets) in making their decisions. In addition, they are typically heavily involved after the investment is made and do not have to worry about specific quarterly earnings. There is truly an illiquidity premium, which could very well be widening.

I am more nervous about the Venture portion of Private Equity. It is reminiscent of the Dotcom Era. (BTW, when I first typed “dotcom,” spellcheck changed it to “sitcom.” In retrospect, that may have been appropriate.) My guess is that, as always, the top quartile performers in that space will remain at the top. One has to make sure they are investing with a top quartile performer.

I think that the five years after 2008 were hardest for hedge funds, in general.  Now we are entering into a period of low global growth but high dispersion.  One can’t count on beta to meet return requirements, and there is risk on the fixed income side—low yields, but principal risk and credit risk if rates rise. I would look for equity hedge fund managers that run a lower net long position most of the time, fixed income absolute return or long/short managers that fundamentally analyze credits. I also think while one can own real estate, I would like to have a hedger there, as well. The macro strategies may start working and uncorrelated strategies like managed futures do belong in a portfolio. I would actually like to create the core of a portfolio around all the alternative strategies and active management strategies that have been on the periphery for the last several years. On the edges, I would play around with passive strategies, hopefully moving in and out at the right time.

 

The Fed: In response to the Fed’s news this week, I think the Fed is saying that they will be data driven, but they really want to start raising rates. I would be surprised if the raise actually takes place before the Fed’s dots and the future’s markets get a little closer to each other. Right now the differences are more than a quarter point apart on where rates will be in December. When will the increase happen? If the employment number surprises on the upside next Friday that may move the dots and the market closer to each other and push the odds up on a September increase.

It could surprise. I would bet it will. Why? July is actually a lay-off month, with plant shutdowns and other changes. Unseasonally adjusted, the employment numbers go down by about a million people; seasonally adjusted ends up as a positive number. The unemployment claims, the job openings numbers, and anecdotal info say that there aren’t as many layoffs taking place. Companies are having trouble finding qualified workers and hanging on to the ones they’ve got and perhaps, they are starting to raise wages on the margin. I can’t make heads or tails of the seasonal adjustment factors, which always seem to be adjusted themselves.  If someone gave me some odds on a bet on the number, I think it could just as easily be 275,000 to 300,000 seasonally adjusted, but certainly above the 218,000 consensus estimate. I’ve never met a seasonally adjusted worker, but this could be a surprising month. If the number doesn’t surprise to the upside, then it’s December. Whatever and whenever it is, it really depends on what happens from there in terms of the size and how often the rates continue to rise. I have even said that maybe the first rise or subsequent increases are at 1/8 of a point instead of ¼.

As an added bonus, as I mentioned, Executive Markets Editor Tracy Alloway joined us in a second segment. At 6:30 am that morning Tracy sent over the three topics of the day that we would be discussing: the emerging markets pain, bad month for commodities, and a good month for Italian bonds. We did cover those topics as well. This link takes one to the Bloomberg clip.

Tracy pointed out that the emerging markets as a group experienced major currency declines in the month and some are actually raising rates. My view was that they should be focusing on growth and raising rates was not the way to do it. It was also a bad month for commodities with many blaming the dollar. There are many causes for low commodity prices—slower global growth and the strength of the dollar don’t help. My view is that lower commodity prices may stay that way because of the oversupply and low prices of oil/energy. Energy is a major input to mining and refining costs. As those costs fall the marginal cost of production may fall enough for extraction and refining to make a contribution to overhead, thus keeping the supply higher than it otherwise might be and prices lower. If mining assets actually change hands at wholesale prices (a coal property was described as selling for a dollar), that also lowers the bar on what the price of the commodity needs to be to produce a return on investment. That will certainly be happening in the energy space, and may occur elsewhere.

I didn’t have much to say about Italian bonds other than QE in Europe is likely to continue pushing yields lower than they otherwise might be. Investors are following the money.

Life may not turn out to be quite that simple. I do believe we will see significant dispersion in economic results, sector results and individual company results over the next few years. Active management will have its day. Pay Attention.