Market Thinking April 2023

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April 7, 2023
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Ironically the SVB debacle in March produced only a modest sell off and then a sharp squeeze higher in equities, leading to an overall positive return for the quarter, with big Tech stocks doing most of the heavy lifting in month and quarter end. This has left valuations at the upper end of their range, but It’s fair to say it was a volatile quarter for equities as even though the implied Volatility measure (VIX) was relatively low, the S&P 500 moved by more than 1% in 29 trading sessions during q1, which is more than double normal levels. Meanwhile the MOVE index of bond market Volatility continued to hit new highs, while as the markets moved into Q2 commodities joined in the fun with a sharp squeeze higher in Oil, completing a 'difficult' quarter for last year's big winners, the Macro Hedge Funds and a much more comfortable one for last year's big losers, the 60:40 funds. Our view remains that after the first, valuation driven, leg of the bear market in 2022, the jury is still out on whether or not we get a second, earnings driven, leg. Meanwhile, the China re-opening narrative continues to play out, as does the multi-polar de-dollarisation story and as Japan looks to be the last country to embrace the new New Normal on Monetary policy, its role as provider of savings capital to the rest of the world also looks to be changing. The medium to long term implications of that are going to be a key part of the backdrop for markets in general.

Short Term Risks

Aggressively sideways

Markets began the year with some aggressive short covering and ended the quarter in the same way. In between we saw some diversification away from US assets and US$ in February and some tail risk hedging and profit taking in early March, such that we went into the key march options expiry week in a technical set up that meant they could either break down, or squeeze higher. In the event, while the direction initially appeared to be decided by the collapse of Silicon Valley Bank (SVB) the weekend before, which fuelled a narrative of 2008 redux and a scramble for protection amid high volumes,  the markets did not in fact fall very far before bouncing aggressively. Indeed the S&P 500 rallied over 6% and the NASDAQ by almost twice that by the end of the month, leaving the major US benchmarks positive for q1 and with bonds also rallying hard into quarter end, this presented a much more comfortable backdrop for the 60:40 funds than they could have hoped for, especially after a torrid 2022.

By contrast, the CTA macro hedge funds, who had a tremendous year in 2022, have found it a lot tougher year to date. Many were the wrong side of the January short squeeze and then mis-read the February rebalancing and subsequent profit taking as being all about their bearish macro thesis, going short again (and getting caught again). As Q2 started, an announcement by the Saudi's on oil production produced a short squeeze in commodities with Oil prices spiking 10% such that they too are now back in the middle of their short term trading range. In fact, the term we used to use for Japan - "moving aggressively sideways "- seems appropriate for most markets right now, with the exception of Gold, which is challenging its recent highs above $2000.

However, to the extent that all of this recent rally is not just another short squeeze, but is predicated on a 'Fed Pivot' we would be wary, for in our view this is not going to happen. We remain of the belief that central banks, long aware of the distortions produced by Zero Interest Rates, are not going to pass up the opportunity to 'normalise' things. Crises like SVB are being met with provisions of liquidity, in the manner of lender of last resort, not with market-distorting changes to the cost of capital.

The end of yield curve control (YCC) in Japan is a key long term issue (see below) that will get increasing attention with the new BoJ governor Ueda taking over this month. Given Japan's role over the last 30 years as a provider of international savings flows, this will likely have some important long run implications for the financial plumbing of Global markets, should it lead to repatriation of assets to Japan. Particularly in fixed income. In the short term speculation about YCC ending  has driven the Yen higher (stronger) against the $ and is dragging in both long and short term flows into Japan.

Medium Term Uncertainties

Hidden leverage and unwinding 'the everything bubble'.

If low rates caused inflation, we would have had it a decade ago, or in Japan 30 years ago. Interest rates are neither the cause, nor the cure. In fact, the inflation we are currently facing was not triggered by Zero Interest Rates, but by Zero Covid - government policies managed to both collapse supply chains and then, via massive stimulus being monetised by the Fed expanding the money supply, they managed to boost demand into that falling supply. Result, higher prices. The Fed knows this -which is why it started tightening monetary conditions this time a year ago, not just by raising interest rates, but more importantly by reducing the money supply and it was this liquidity drain that triggered the bear market of 2022., just as the rapid expansion had produced 'the everything bubble' in 2021. The fact that the Fed is still raising rates - albeit now closer to the end than the beginning - is in our opinion less about inflation (despite the rhetoric) than about getting interest rates back to 'normal' and reducing/removing the distortions to capital markets produced by holding the cost of capital below its 'natural rate'. This is something we discussed in the new New Normal. . As such we are less bothered by the 'theatre' around US labour statistics, PMIs and all the high frequency data, believing the financial stability is always the over-riding focus of the central banks. Perhaps that's why the Fed is relaxed about putting out the non farm payrolls on Good Friday?

We believe that the Fed are fully aware that the impact of monetary policy has been much more pronounced on Wall Street than Main Street and thus are conscious of the unwind of carry trades. The problem is in knowing where they are. We can guess of course, and a policy of seeing who has grown the fastest and made the most money might be a pretty good heuristic, but , as SVB just demonstrated, the market still has a capacity to surprise, not least because, as with FTX, it seems like everyone thought that everyone else had done the due diligence. We have seen this focus on Wall Street over main street before of course, which is exactly why over the almost 30 years of economists trying to use the Taylor Rule to forecast Fed policy on the basis of economic indicators, it has rarely proved to be accurate.

The move to tighten monetary policy, withdraw liquidity and invert yield curves was always going to lead to Warren Buffet's great aphorism about "when the tide goes out you can see who is swimming naked" and indeed we were not along in making those points this time last year. SVB was a child not so much of QE as of Zero Interest Rates and Zero Covid; as we discussed in more detail (First Slowly, then all at once) the former created a dependency on a single sector and corporate rather than retail deposits while the latter produced a flood of central bank liquidity as $5.4trn of new deposits hit the US banks at a time when there was little or no demand for loans, leaving banks like SVB lending not to Silicon Valley, but to the US government by buying Treasuries, in effect became a bond fund but with not even daily but instant liquidity. Evidently they didn’t manage their duration risk, their convexity risk or their redemption/liquidity risk and thus the ‘run on the bank’ pushed them into the equivalent of a fund crash. This then was an 'inevitable' consequence of the end of the Zero Interest Rates and Zero Covid environment that fuelled SVBs dramatic rise as rates rose and liquidity was withdrawn, the carry trade not only disappeared but also, as bonds sold off and the yield curve subsequently inverted, both the P&L and the Balance sheet were hit.

Credit Suisse has been in trouble for so long that it was barely still on anyone’s radar, while SVB was so new that it had never been on anyone’s radar. Combined, they have ended QT, but importantly have not re-started QE.

While CS was probably the longest running, SVB was the most rapid, bank collapse since Barings  almost 30 years ago, but combined their immediate impact has been to end quantitative tightening as the Fed’s Balance sheet has expanded rapidly once again. This was a necessary move, similar to that under-taken by the Bank of England last September when a not dissimilar situation occurred in the LDI space with UK pension funds and is actually what we should expect from our central banks – lenders of last resort really meaning ultimate providers of liquidity in the event of distressed buyers and/or forced sellers. However, this is not to say we are going back to a world where a bank like SVB can once again be the fastest growing bank in the US. We do not believe that this is ‘the pivot’ that bond traders are desperately wanting and ‘predicting’ – although we hope that the Fed will now pause; low rates did not cause inflation and high rates will not cure it, rather inverting the yield curve will clear out a lot of businesses that are effectively running carry trades.

The most obvious areas running a carry trade have to be in Commercial property, which most are regarding as the next problem and we have already seen some early signs , with companies like Blackstone seeing continued redemption requests from some of their real estate funds (and only granting about 15% of them according to reports). This is part of their structure (unlike SVB) and is designed to protect their long term investments, but it points to what we would regard as an extended bear market in the sector - all rallies will be sold, rather than all dips being bought. Blackstone's BREIT is a giant in the sector and the fact that they are facing redemptions will undoubtedly impact on pricing in the underlying; they were aggressive buyers in recent times, such that simply their absence on the bid (let alone their presence on the offer) is likely to cause some adjustments. Then of course we have the mark to market effect on leverage.

We should not overlook the leverage  that a number of countries have to residential property - especially in the so called PIIGS (Portugal, Italy, Ireland and Spain, as well as the UK, Australia and NZ, where floating rate mortgages are now

Long Term Trends

De-Dollarisation The long term shift towards de-dollarisation was really kick-started a year ago following the US decision to 'freeze' Russia's FX Reserves. Regardless of any opinion on the rights or wrongs of the policy, the implication was clear; to trade in the dollar and specifically to keep large FX reserves in the US $ banking system is effectively to accept US Foreign Policy diktats. As such, we started to see a number of initiatives to reduce $ dependency over the last 12 months, including a number of agreements for bi-lateral trade in Yuan, Brazil and Argentina discussing a common currency, various discussions on gold backed crypto currencies and of course central banks themselves buying Gold. This was something that we discussed in last month's Monthly and also in The 99 states of America . However, this subject has received a lot of attention recently with the news that the Yuan is now the biggest currency traded in Russia and as the original members of BRICs have all now basically announced that they will be settling part if not all of their trade in currencies other than the US $. A number of analysts have rushed to defend the notion of the US$ remaining the world’s reserve currency, but that is something of a straw man, what is important is that the amount of world trade done in $s will now shrink, perhaps by as much as half, removing the $s role as an intermediary in the majority of trade between countries outside the NATO/Fives Eyes bloc (plus Japan and S.Korea).

China trading partners outnumbers US by a factor of two

We like this map, because even thought it is quite old (from the great Visual Capitalist site), it makes a key point, that has only got stronger. China was the largest trading partner with twice as many countries as the US. If we go back only as far as  2000, 80% of the world traded more with the US than with China, so it made sense that almost 90% of trade was conducted in $. Now it is only 30%. of countries that trade more with the US than with China and it is thus natural that China will now increasingly seek to conduct much of that trade in its own currency, with the key advantage that if it can trade in Yuan, it can also print Yuan should it so choose and thus, crucially, it does not need to export so much to earn the $'s to buy its essential imports. Indeed, this is probably the key point for investors -the shift in trade patterns that will likely emerge. The west has long seen China as 'needing' to export in order to earn $s, if that is no longer the case, then Chinese economic resources can, and likely will, be re-deployed. The other point is the steady growth of Yuan invoicing for trade, which as this paper argues means not a replacement for the $ as reserve currency but a multi-polar currency world. The article highlights how countries that invoice in Rmb are increasingly holding reserves in Rmb, even though it doesn't meet the 'traditional' requirements for liquidity and convertibility. They point out the growing size of the offshore Rmb market, which at $200bn is extremely modest compared to the Euro$ market at $16trn, but that it is growing and more important the existence of swap lines and Chinese owned $ reserves should act as reassurance. In that sense, the Rmb today is not unlike the US in the 1950s and 60's, where the $ was backed by Gold, but not convertible in onshore US, while the Rmb is thus similarly backed by $s, but not convertible in onshhore China. As such the HK offshore Rmb market can function like the London Gold market in the 50's and 60's.

Of course, after the US dropped the gold backing in 1971, not only was the Petrodollar born, but so was the Eurodollar market and with it the re-birth of London as an international financial centre.. More than 50 years on, we are seeing the demise of the Petrodollar, and the rise of the PetroYuan. Thus we would expect to see a shrinking of the Eurodollar market, accelerated by the recent moves to replace Libor with SOFR. This, more than anything else will have profound effects on the Financial Plumbing of capital markets.

Kuroi hakuchō 黒い白鳥

Kuroi hakucho is Japanese for Black Swan and we can't help wondering if Japan is a bit like Credit Suisse, it has been 'troubled' for so long that we have rather forgotten about it, until it gets into more trouble. Japan has been central to so much of the 'plumbing' in financial markets for the last 30 years that we take it for granted, but if the failure of 'the S Class' (Silvergate, Signiature, Silicon Valley and Credit Suisse) tells us anything it is that contagion, carry trades, mark to market issues and liquidity can unravel very fast. History tells us that some of th e biggest market corrections occur when 'no risk' trades unravel and hedges don't work. The guys at LTCM for example were (self) regarded as 'the smartest guys in the room' and yet they blew up when a flight to quality pushed up the value of US Treasuries (which they were short), forcing then to try and liquidate a lot of 'low risk' assets, which were defined as such due to low correlation and low volatility, but when met with forced selling, proved to be neither.

In the same way that 'no battle plan survives contact with the enemy', no 'low risk' leveraged strategy survives contact with a changing cost of capital.

The proximate cause for our concern on Japan is the upcoming J, where Karuda San has been in charge for a decade of Zero Interest Rate Policy (ZIRP). He steps down this year and our first red flag is that his deputy, Amamiya, San, has turned the top job down, which is very unusual for someone in his position, prompting the question as to whether he is concerned that by exiting ZIRP his legacy becomes that of the man who broke Japan? Karuda's successor, Ueda San, takes over this week  has announced that he has 'ideas' as to how to exit ZIRP, but no clear plan and while many think nothing will be said until June, his first meeting is at the end of this month.

Central to the current policy is Yield Curve Control(YCC), a commitment to keep a cap on 10 year bonds at 0.5% by buying whatever amount of bonds is necessary to hold that level – akin to FX intervention in the old days. And just as an informal peg for an exchange rate works right up until it doesn’t, so the persistent high inflation in Japan is challenging the BoJ policy and leading to dramatic bouts of defensive buying of bonds in response to speculative attacks (as happened at the end of last year). As with the rest of ZIRP, this has distorted the market liquidity and should Ueda San take away the bid for JGBs, there is a clear risk that the mark to market hit for the private sector holders of bonds will cause some SVB like problems, not because of a run on deposits, so much as a hit to capital ratios in the banks and mark to market losses in the insurance companies. As with the European Banks story, Japanese Banks profits should benefit from a normalising of interest rates, but the market is concerned more about the balance sheets at the moment.

In fact, we think that this is less about the Japanese Banks sector and more about the role of Japan in the world’s financial plumbing; after decades of capital allocation distorting ZIRP, Japan’s savings have been recycled to chase yields all over the world and provided much of the ‘hot money ’flows in and out of markets. Last year those balance sheets were hit by capital losses on Treasuries, but this was offset by a weaker Yen – itself caused by a degree of over-hedging of the currency. (Briefly, holders of 10 year USTs were short an equivalent amount of US$ cash, capital losses in Treasuries meant Japanese Life companies were then short too many dollars and forced to buy back. The ensuing speculative attack on the Yen/gain on $ assets  more than offset the fall in bond prices.). Currently the cost of hedging US Treasuries exceeds the spread on relative bond yields and should the Japanese start selling overseas bonds, then another liquidity tide will go out and expose those who, in Warren Buffet’s expression, are swimming naked.

After decades of ZIRP, Japanese savings have provided a large amount of the liquidity chasing relative yields around the world. The risk is that this now reverses.

Speaking of Warren Buffet, we note that he is in Tokyo this week and it is worth remembering that some 18 months ago he invested in a basket of Japanese Trading companies, funded by issuing super low cost Japanese debt. A similar looking basket exists for investors (1629 JP) and that is up 33% over that period, a very nice carry trade!  Even in $ terms it has weathered the currency storms to be +15%. Many of these companies - like Mitsubishi, Mitsui and Itochu have yields around 3.4% and we can't help thinking that with the yen stabilising and possibly strengthening meaningfully as capital returns to Japan and with economic activity steady and rising in Asia, that a lot of US based international money may start to look at Japanese equities once again.

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