As You Were…

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January 17, 2020
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The traders got handed their script for the New Year nice and early, with the dramatic escalation by the US of the tensions with Iran. However, while the spike in Brent following the unrest in the Middle East did not appear to be sustained, the ongoing rally in Gold appears to be, with XAU, the gold ETF hitting new five year highs.Equally the XLE, energy sector ETF, failed to break out of its long term weak trend. The trade weighted dollar has bounced from its weak opening to the year, mainly through a rally against the Euro, but still looks weak technically. Watching Euro support around the 110 level will be the near term focus now for traders as will its ability to break out to the upside through 111.50. (We should never forget that for an FX trader the ‘big figure’ is the second decimal place.)

In the meantime, the markets have started the year with a momentum chase into high yield credit and equities, notably the FANGs and other big tech stocks with a powerful squeeze on the short sellers in Tesla capturing the headlines. This certainly feels very frothy and the fact that the 5 biggest stocks in the US market now account for over 18% of total market cap – the highest level for 25 years – only adds to the feeling that the algos are doing the buying.

Market Thinking is based around the notion of markets at any moment in time being in equilibrium between different ‘tribes’ of market participants; principally short term traders, medium term asset allocators and long term investors. A sideways moving market can for example reflect a trader chasing short term momentum while an asset allocator sells into the strength as they rebalances into last year’s underperforming stocks anticipating mean reversion. Both actors are ‘rational’ but have different viewpoints and the aim of Market Thinking is to assess the balance between them. For example, if the asset allocator is underweight last year’s winners and wishes to rebalance in that direction at the same time as traders are chasing momentum and long term investors see no reason to sell, then we can see a ‘herd’ developing and prices moving to reflect the squeeze. Arguably this is what is happening with US tech right now.

A trader calculates their upside return if they are ‘right’ versus his downside loss if they are wrong and acts accordingly, making lots of noise along the way to try and encourage other traders and investors to validate their position. Currently we would say that after a brief run at geo-politics they are pushing US large cap momentum and a bullish Global Trade story.

By contrast, an asset allocator is mainly focused on downside risk, in particular relative to other fund managers. In other words they are managing their business risk more than the risk return of the underlying investor. This can mean perversely that they will buy into a sub asset class – such as emerging market equities or Japanese equities – not because they see a return from it going up, but because they wish to limit their relative downside if it goes up and they are underweight. ‘Buying riskier assets to reduce risk’ sounds crazy, but as always it depends on your definition of risk. In this case, the asset allocator is buying more volatile assets (one definition of risk) in order to reduce their exposure relative to a market cap benchmark ( a different definition of risk). Currently we would say that they are trying to maintain exposure to US mega caps while looking to rotate into benchmark level winners from last year such as China, while also trying to hedge into international (ie non US) exposure on expectations of a weaker dollar – good for EM – and valuation – Europe versus US. In fixed income, there are signs of some weakness after a great year of capital appreciation and suggestions of a risk aversion rotation into cash. Unlike high yield equity or bonds where you are paid to wait, the low, in some cases negative yield on sovereign bonds make them unattractive buy and hold instruments for those that have the choice to hold cash instead.

Long term investors meanwhile, tend to be less focused on benchmark returns and more on absolute returns. For them, investing is more about opportunity cost versus downside risk. They tend to understand that ‘under-performing’ an index that rises 30%, such as happened a lot last year, is acceptable if it reflects a strategy that does not lose a meaningful amount when asset prices correct. For them, a year of +30% returns such as 2019 helps offset some of the (likely) losses from 2018, but equally sets up a concern as to what will happen in 2020. Long term investors often have long term memories and mean reversion is a powerful teacher. There is of course no reason why the change of calendar year should necessarily produce a change in investment strategy, but we do observe the end of the January and certainly the options expiry in Mid march tend to set the ‘character’ of the year ahead and we would anticipate that this might involve both some selling into strength and some winding down of leverage.

We also noted at the beginning of the year that uncertainty would switch to the dollar and while volatility has yet to pick up, it remains probably the biggest near term risk to markets. Longer term, the pressure to move away from the Petro $ and ultimately for the US to lose its role as the world’s sole reserve currency has intensified. Both the Ruble and the Rmb have rallied against the dollar in the last six months as has gold and, with reference to a previous post, so has the Taiwan $, partly in response to renewed optimism about trade and partly in response to the upcoming elections. This latter move of course threatens some of the unhedged US credit ETFs being promoted onshore by Taiwanese insurers.

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