Markets are breaking Free.

Governments have been trying to fix markets for over a decade but reality is now biting. This, in fact, is the real “Great Reset’. Free Markets are not about political systems but are those that are free of government interference and monopolistic rent seeking corporates, something those who claim to be free market economies have been embracing for too long. Now, however, the Fed has abandoned QE and the ECB and others are following suit. The Japanese are still trying to ‘control’ the yield curve, but, here too, capital flows (plus speculation) are exerting huge pressure, not least on the Yen. Meanwhile, the G7, having created immense stress in the energy system with their economically suicidal ‘Green Leap Forward’, are now doubling down with self harming sanctions and trebling down with a spectacular misunderstanding of commodity markets in quixotically trying to fix the price of Russian Oil. As the old saying goes, “You can ignore Economics but (ultimately) economics won’t ignore you”.

June ended with one of the worst first half performances for capital markets for decades, representing a serious blow to wealth in that both Bonds and Equities have been hit badly. We continue to believe that the underlying stress is coming from fixed income markets, which remain the key area to watch as they unwind the excess liquidity pumped into them over a decade of QE and more recently at the start of Covid, when the Fed had to inject liquidity to prevent a run on the whole fixed income ETF complex. At the end of May/beginning of June we saw a few signs of stabilisation only to see them unwind rapidly in the first half of the month. Since then, however, while equities have continued to struggle, govt bonds have done relatively well. Largely for this reason, the narrative is starting to switch from inflation to recession which is supporting sovereigns over Credit and leading to deleveraging extending from bonds and equities into commodities, where we have seen significant liquidity outflows and recent price weakness, serving to reinforce the recession narrative.

We also continue to see strength in the $, with the Euro and Sterling now almost 15% weaker over the last 12 months and the Yen 25% weaker. This is consistent with the deleveraging story – as well as some important technicalities in Japan. The feeling is very much that traders and investors have decided to retire hurt for the (northern Hemisphere) summer and hope that somehow a lot of the uncertainties will resolve themselves.

Short Term Uncertainties

When ‘Sell the rally’ extends beyond short term traders to medium term asset allocators and long term investors, we have a pretty reasonable definition for a bear market. Equity bear-market rallies are then generally in the form of a short squeeze, as traders rush to cover as they fail to shake out asset allocators, but then the rallies themselves fail when they meet longer term investor selling. The second quarter saw several attempts at rallies, mainly technical and at month end, all of which have been met with selling, as the pressure to deleverage (particularly from fixed income and quant based risk-parity models) continues to dominate. As such, our confidence indicators remain at low levels and, having been burned a couple of times, we suspect the mood will remain a little more cautious than normal. The notion that it is ‘safer to buy it higher up’ is not as foolish as it might initially sound!

The bear-phase only ends when the long term investor stops selling the rallies, usually on account of a perception that ‘things have bottomed and that the, then existing, attractive valuations represent a good ‘in’ price. This of course tends to be narrative driven and as the inflation narrative fades – and with it the fears of an over-zealous Fed – we are alert for areas where they begin to ‘buy the dips’ again. This is what we try and capture in our confidence scores, where, once again, in certain areas, confidence is edging up, albeit modestly.

Because we believe that the main source of stress has been in Fixed Income markets, we are concentrating a lot of our attention there at the moment. The MOVE volatility index for bonds is still close to the extreme highs from 2020, when the Fed intervened to save the Fixed Income ETF complex, which is important because this forces many traders and investors to continue to reduce bond exposure since, with risk being defined by volatility, it is then deemed too ‘risky’. Unwinding of leveraged positions then creates further downward pressure and further volatility.

To this has been added a sharp increase in volatility in currencies – behaviour we usually associate with ‘something going wrong’. We saw something (a little bit) similar when the Swiss decided to end their informal peg to the Euro back in 2015 ( a classic example of governments being forced to abandon attempts to control the free market) and suspect that the key source for this latest volatility is Japan. Initially it appeared that a simple hedging trade was hitting the Yen at the end of q1; Japanese Insurance companies are huge buyers of US Treasuries, which are normally fully currency hedged – i.e they are short an equal amount of US$. However, at the end of the first quarter – after the worst sell off in Treasuries in decades – these funds were then ‘over-hedged’ as their bond holdings were now worth a lot less than their short positions, meaning they had to buy back a lot of $s. This caused a huge sell off in Yen and triggered a raft of speculators to not only sell Yen, but also to try and sell Japanese Bonds, challenging the Japanese Central bank to abandon its long standing policy of trying to keep Japanese interest rates low by manipulating the bond market. Right now, this so called yield curve control is under intense pressure from speculators. Here again, the market is trying to break free of government control.

If this all sounds a bit technical and esoteric, we apologise, but it is very important for investors not to confuse market positioning with some kind of economic forecast, or an alert to changes in fundamentals. It does mean however that we need to watch these markets closely, for if the Japanese Bonds reset and/or the Yen does indeed blow out to the extent that the Insurance companies start hedging again, then a trend reversal in the $ could trigger a scramble out of US (where everyone is heavily overweight) into international markets.

Medium Term Risk.

The short term uncertainties around bonds and currencies thus represent one of the biggest areas of potential ‘shock’ to the asset allocators over the coming months. In particular, the key long term theme of a Multi-Polar world and a parallel Reserve Currency (we notice a lot of comments about BRICS at the moment) would gather a lot of momentum as and when the $ starts to break down – even if it is just largely a technical unwind of the reasons for its recent strength. Just as everyone reinforced their views on inflation by referencing ‘Dr Copper’ and the ‘wisdom’ of the Bond Markets and then rapidly switched to recession when those markets appeared to change their mind, so their confidence in the sustainability of US hegemony and unique Reserve Currency status will start to disappear if the DXY breaks 100. Let alone 95, at which point broader asset allocation will likely kick in.

Equity markets regularly ‘have to climb a wall of worry’ and currently we have a pretty solidly negative narrative at work, albeit importantly it is starting to shift from a ‘runaway inflation’ narrative to a ‘global depression’ one. Value is thus concentrated in the areas with solid cash flow and stable earnings, where this depression narrative has thrown the good stocks out with the bad and increasingly we believe the focus will shift back to Asia and China as the zero Covid strategies start to fade (albeit painfully slowly for us in Hong Kong!) Also, the people that love volatility are the Hedge Funds and CTA strategies who can also separate winners from losers, unlike the passive funds who are currently stuck 100% invested in markets that are falling. They may be cheap, but nothing is free.

Aside from a sharp switchback in the Yen, the biggest medium term risk is probably a ‘surprise’ ceasefire in the Ukraine and some resolution of the self harm from EU sanctions, since undoubtedly, the biggest risk for Europe remains the ‘Sheriff Bart’ Strategy, named after the character in Blazing Saddles who avoided the wrath of the town’s-people by taking himself hostage with his own gun. They let him escape on the basis he might not be bluffing and may be crazy enough to ‘do it’. Unfortunately for Europe, Russia is more likely to be looking on bemused as the EU leaders continue to come up with schemes that harm Europe, while almost everyone else (including the US) is largely unaffected – indeed actually benefits. The West are talking about capping Russian Oil prices, but as we discussed last month, Russia is selling Oil in Rubles at around $80 equivalent, it’s just that the west insists on buying Brent $35 higher. Moreover, the issue isn’t even oil prices, it is diesel and gasoline and under current conditions, China and India look to be heading towards being some of the largest exporters of processed (and sanctions free) Russian crude at record margins – helped by the west shutting its own refineries in line with the Green Leap Forward agenda. And now they are having to revert to coal thanks to self sanctioning on gas. More, uncomfortable, Economic reality. Capital is going to have to return to the energy efficient parts of the energy sector, whatever the ESG funds say.

Long Term Themes

The biggest long term theme remains the momentum towards ‘The West’ versus ‘The Rest’ and an end to this latest phase of Globalisation. We see this much more as a step change up in price levels as excess supply is taken out of the system (mainly by China) and ‘just in time’ switches to ‘just in case’, meaning higher inventory and thus higher cost of production across the board. This is not the same as constant inflation, it is about resetting demand and supply. As such, old fashioned concepts such as Porter’s Five Forces – pricing power as opposed to overall inflation – and Dupont Analysis – working out what is driving Returns, margins, volumes, asset turn or the balance sheet are going to return and with it (we suspect) a push back against some of the more ‘passive’ strategies that end up with the losers as well as the winners. Less Beta, more Alpha. Beta will still work we believe at the Thematic and even factor level, which is why we have our Model Portfolios constructed to view Global Equities through these ‘lenses’. We also believe that we will see a welcome return to a focus on return on capital employed by the actual underlying businesses, rather than simply being dominated by financial engineering and cheap leverage. A return to ‘normal’ investing perhaps?

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