Tightrope Walking
Investors face some big questions at the moment, and depending on which answer you pick, your asset allocation will differ substantially.
The big macroeconomic question can be summed up in a discussion about inflation v deflation. The global economy are currently affected by three deflationary head winds . Firstly, the need to repair balance sheets following the crisis in 2008; secondly, the slowdown in China and unravelling of investment tied up in the commodities space; and thirdly, rapidly ageing populations in Europe and Japan. Faced with such tremendous forces, you would argue that deflation would easily vanquish inflation any day. But it isn't that simple.
The cause and effect between stimulative macroeconomic policies are global in nature, and this creates a unique interplay between inflation and deflationary forces. For example, ZIRP and QE in rapidly ageing economies—Europe and Japan—are unlikely to prevent these economies from struggling with low nominal GDP growth and very low inflation. But such policies have the potential create bubbles elsewhere. It has long been the contention here that unconventional monetary policy and deficit spending in demographically "impaired" economies are near-permanent. They act as a constant externality to global financial markets by supplying pro-cyclical funding for carry trades and the formation of bubbles in higher yield jurisdictions. For investors, such bubbles take the form in an insatiable hunger for yield pushing interest rates down on fixed income instruments across global markets. As yield is saturated in one market, funds moves on, like a swarm of locusts, to another asset class in another country.
The embedded volatility of this process can be violent. During the good times, leveraged selling of volatility to fund carry trade positions will earn substantial excess returns. But when it turns, the denouement is swift and violent. We can say that the second derivative of volatility itself becomes more volatile, or, if you will highly pro-cyclical [1].
The corollary to the discussion above, from an asset allocation point of view, is the big question of whether the extreme bubble in fixed income can be unravelled without dragging everything with it. Take the Eurozone right now. It is really simple based on traditional asset allocation models. First, you look at stocks relative to overvalued benchmark bonds and "safe haven" assets and you conclude that equities are cyclically attractive. Then you need to determine the risk that we are about to plunge into a recession like 2001, 2008 or 2011, which would warrant such a downbeat message from the bond market. Right now, however, based on short leading indicators (sentiment) and long leading indicators (liquidity and money), the evidence currently points to an accelerating economy. This could very well be too simple. Gerald Minack, an Australian economist formerly with Morgan Stanley, and JP Morgan have recently mused that when interest rates are structurally low, the record low yields are not enough to drive equity prices higher through multiple expansion. Put differently, stock-to-bond ratios which is an important driver of most asset allocation models could be sending a false signal at the moment.
So, it seems that we have two scenarios here.
1) The unprecedented compression in yields forces money even further into higher yielding assets and equities; classic stock/bond rotation and portfolio balancing. Carry trade flows galore etc.
2) A taper tantrum 2.0.
These don't have to be mutually exclusive of course in the sense that you can have a bit of both, but if you think yields can rise as real money moves into equities and dumps some of their bonds, the resulting asset market implication suddenly looks very bullish. Meanwhile, we concede that the market is not trading well, and the deflationary forces mentioned above could still be the underlying forces that are pulling the strings. This is also, partly, driven by our view that the response we are currently seeing from central banks across the globe will eventually lead to a significant inflation scare, a risk which is currently scarily underpriced!
The market will tell us soon enough if we are right. But faced with a string of unpleasant outcome we remain, cautiously optimistic that the environment is still conducive for picking risks by choosing the right countries and sectors, even if this feels increasingly like walking a tightrope.
Portfolio Notes:
We are in the process of shifting broker, and this means that the portfolio is a bit in limbo at the moment with positions being liquidated and re-established. The bet on BP is still doing very well indeed, and we are warming to a similar bet on Total Sa. The combination of a reflexive bounce in oil and a squeeze in euro shorts could make it a winner. We must always keep an eye of course on a potential break down in the mighty Spoos, but our base case is that US equities can meander in nothingness even as other markets firm significantly. RSW is doing well too (but we expect this one to run out of steam very soon), CNA is starting to come back, but our Eurozone bank position remains the equivalent of a trainwreck in slow motion. One step forward, and three backwards. Finally, we retain a significant position in gold due to the considerations noted above, as well as cash in hand.
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[1] - Note here that while volatility in itself will tend to be pro-cyclical, it does not follow that its second derivative will be.