Market Thinking December 2023

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December 6, 2023
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The rally in Markets from the late October lows appears to be following some reasonable Santa Claus Seasonality, but the recovery in the Bond market is bringing forth a recession narrative as justification, making investors cautious about 2024. Market interest rates are set to fall, even if official rates are slow to do so. As traders struggle with mean reversal, asset allocators are looking to how to deploy cash next year and we reiterate our own view that means diversification, longer duration in fixed income and shorter duration in equities.

Short Term Uncertainties - traders suffering mean reversals

A lot of macro traders flatten books into the Thanksgiving Holidays, which tends to put in some slowing of momentum and even some reversals. The most dramatic of course has been in Equities, but it applies across most asset classes. For example, the relative strength in the Euro has faded, while the selloff in Japanese Yen has reversed. Sterling remains relatively strong, which means the DXY Dollar trade weighted index is looking vulnerable on technical trends. Meanwhile, Oil has been weaker, while Copper stronger and the Magnificent 7 have been rolling over at the same time as Gold and Bitcoin have broken out to new highs.

Might some new players with AI be messing up the CTA traders party?

It is clear that life has not been easy for the CTA Macro traders in the last month and we wonder once again if the crowded nature of their known trades is somehow being exploited by new players with some new AI toys to play with? In Global Equities, we were heavily in cash in October are comfortable to have reduced our cash positioning in the model portfolios into, rather than before, the rally, as the short squeeze has reduced the risks around distressed selling in a number of areas, helping our preferred thematics revert towards fair value. We also began including some new thematics to take advantage of trends we see emerging in 2024.

However, we think it was not trading flows and positioning, but the powerful asymmetric Bond maths that we discussed back in October, that drove asset allocators and long term investors to move along the curve in fixed income and that they were the main reason behind the powerful bond rally that we have seen, even as the narrative has evolved from saying that it is all about expectations of interest rate cuts from the Fed to now being about increasing predictions of a recession.

Currently, the traders are looking at momentum rather than another mean reversion in bonds. Having seen a classic 38.2% fibonacci reversal of the sell off between April and October, many are now targeting something closer to 100 (currently 92) and in order to get there, they will almost certainly be pushing a recession narrative. As such we see that for bonds, the three tribes - trader, asset allocator and long term investor are all pushing in the same direction for 2024.

Whether the narrative is leading or following markets is also a question for the Rmb, where months of relentless consensus bearishness on the Chinese economy accompanied di-investment by international investors has perpetuated a bear market in Chinese stocks and a weaker Rmb. Chinese equities still remain under pressure, but we see the narrative on China and the downward pressure on the currency both seem to be calming a little, probably linked to Elections in 2024, not only in the US in November, but also in Taiwan in January.

Medium Term Risks - allocators planning for 2024

If rates come down next year, cash will be one of the few asset classes that won’t deliver a capital gain.

  1. Thinking about what to do with their cash. As Asset Allocators contemplate the outlook for 2024, one of their pressing concerns is that they need to be moving out of cash at some point and need to have a plan of where to go. This is for two reasons; first that the asset allocators can’t justify holding cash for another 12 months while still charging a fee/salary and second, and probably more important, is that if, as most suspect, 2024 sees even modest cuts in rates, cash will be one of the few asset classes that won’t deliver a capital return.
  2. Thinking about what to do about the Magnificent 7 (M7) The second question for most asset allocators is of course related to the M 7. As we discussed (in will the Magnificent Seven ride again) , if you held them in 2023 and especially if you were ‘overweight’ - probably in a NASDAQ v SPX form - then you will need to decide whether to keep that trade on for 2024. To do so, you will have to answer (honestly) the question as to why you held them in the first place. Was it because you held them all the way down in 2022? in which case, having seen such strong mean reversion in 2023, why wouldn’t it happen again in 2024? On the other hand, if you bought it in early 2023 as an oversold growth play, then, since that is no longer the case, what are you going to do next?
  3. Thinking about diversification. The prospect of some cut in rates by the Fed next year is making allocators think about $ exposure and their heavy exposure to the US markets. One area that is starting to attract attention is Europe, and in particular financials. Partly, this is because an allocation to Europe is an allocation to financials as they are 20% of the index, and partly, as we have argued in the past, because the situation in European banks is very different from that in the US. In particular, the role of the European regulator in the wake of the Global Financial Crisis (GFC) was to prevent the banks from making bad lending decisions by requiring them to hold very high levels of regulatory capital - the smallest bank in Europe is regulated as strictly as the very largest bank in the US. They also prevented them paying dividends or buying back shares. This meant that balance sheets were not only repaired but also made sufficiently strong such that when the regulators finally allowed dividends and buybacks the European banks immediately started returning significant amounts of cash to shareholders, making the banks themselves the new marginal buyers.
  4. Thinking about EM and Asia. As part of the diversification strategy, we see asset allocators are looking at how to permanently carve out China from other Emerging Markets from a risk management point of view. We have seen how the pervasive view from the US that China is ‘uninvestable’ has led to capital outflow and rather than try and play individual stocks or even countries, asset allocators are looking at strategies such as EMXC - emerging markets ex China. This is something we addressed in our recent update on Model Portfolios.
  5. Thinking about Duration. In the same post we looked at Japanese wholesale companies as a play both on shorter duration and on Japan. Sometimes known as the Buffet Trade, after Warren Buffet issued debt at around 40bp three years ago to buy exposure to both Japanese and Global growth, but yielding 4% or more, the trade is now paying off. However, it leads to another thought for 2024, which is that, just as we extend duration in bond portfolios, we should be reducing it in equities. A greater focus on bond proxies and high, well covered yields.
  6. Thinking about Currencies. This links back to the diversification (point 3) and is certainly front of mid for a lot of allocators long $ assets. As, primarily US, investors look to increase non-US exposure, it obviously raises the question of whether or not to hedge the currency. We sense that at the moment, early diversifiers are starting to do things unhedged - even though the preferred ETF we are looking at - DXJZ -is quite a lot smaller than the unhedged version.
  7. Thinking about Geo-Politics has been a key part of asset allocators process in recent years, but not offered much guidance to portfolio construction. Brexit, Trump, Ukraine, Covid and Gaza - to pick the most high profile - were all, almost by definition, shocks, where the correct response depended on reacting to the traders’ initial reaction - and more importantly in many cases to the hasty policy reactions. Next year sees a huge number of Elections, with most focusing on the US, but we also see the January Election in Taiwan as important for China/US tensions

Long Term Trends - What are investors doing?

Longer duration bonds and shorter duration equities

After a year in which many investors were happy to hold cash, the prospects for 2024 are focusing minds on how to generate long term real returns beyond those offered by cash. They are also thinking about diversification away from the US and the US $. With bonds having pulled out of their swoon and with US long rates heading from 5% towards 4%, bond investors are feeling slightly better and have started to shed their re-investment risk to match long term liabilities with long term assets by extending duration. In equities, the role of Global Equities in offering compound return together with diversification is leading cash to be allocated to areas with shorter duration characteristics - ie high, but stable and growing dividends and strong balance sheets. Essentially Global Quality Dividends.

Looking at areas where higher rates are a tailwind not a headwind

The bigger questions about growth and inflation tend to dominate most macro and year ahead commentary (we will be doing our own version later this month), even if, like Geo-Politics, they often don’t lead to much insight into portfolios. For what it is worth, we suspect the Fed will be reluctant to do much in the way of easing next year, but the market will do it for them. Interest rates will fall, even if the short end remains pegged - a kind of inverse Yield Curve control - and the major economies will slow as the excess money pumped in during Covid comes out of the system. Hence the focus on quality, but also the diversification into areas like Emerging Markets and Japan, where either there was no excess money creation or where there are many areas with sufficiently strong balance sheets that higher rates are a benefit not a cost.

Most Asset Allocation is within Asset Class rather than Cross Asset Class

While it is common to think that cross asset management flows are the most important, bonds and equities are largely self-sufficient ‘walled gardens’, where the actual allocation is between the individual asset - be it bonds or equites - and cash. Thus in fixed income we see the cash already moving further down the curve as allocators chase the rally and many are also are recognising the re-investment risk they are facing to match asset and liabilities. Some are talking about buying corporate bonds as a better play than equities, but the reality is that equity investors who might otherwise apparently be tempted to buy High Yield Bonds are buying high yield equities instead in their own ‘walled garden. With many equities yielding 4% and on a P/E of 4x, rather than the other way around, the return on cash is now seen as a hurdle to beat rather than the cost of putting on leverage.

The importance of Geo-Politics is ultimately playing out through a new bi-polar banking system

In GeoPolitics it is increasingly making sense to think of the Middle East as West Asia, as their economic focus shifts towards China and importantly away from the Dollar. Even if, as we hope, tension eases somewhat between the West and BRICS+, most obviously China, the Money System Genie is out of the bottle. The ‘rest’ are not going to allow themselves to be controlled by ‘the west’. The argument that the Rmb can not replace the $ as the Reserve Currency is a straw man - it doesn’t have to. The important thing about De-dollarisation is the decline of the US Banking system as the medium of exchange, something that is going to have profound implications for the shape of financial markets.

As ever, none of this should be considered financial advice, it is for information purposes only. Please do your own research and consult an advisor. For further information on our model portfolios please visit market-thining.com and our investment partner Toscafund HK.

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Lightning Strikes and Butterfly WIngs

In the internet boom investors chased stocks like Nokia, Ericsson and Cisco to crazy sales multiples that required growth to be not just good, but parabolic to deliver any returns. A small disruption to those expectations led to a profit warning and a crash in the market. AI is the new 'internet' and investors are once again chasing picks and shovels. However, when a market is putting China stocks on less than 1x sales due to 'concerns over China/Taiwan while simultaneously paying 40x sales for a company where half its customers and all its manufacturing is done in the region, there is something of a disconnect in the risk management.

Market Thinking February 2024

The Bond markets have curbed some of their enthusiasm over rate cuts while momentum stays with US tech. Japan and EM ex China continue to behave well, although China continues to behave like a bear market, This has little to do with fundamentals like value or earnings and more to do with perceptions of risk and uncertainty that are driving liquidity flows. However, we would note that the stock market is not the Bellweather of the Economy that it is in the US and that intervention will take place only for stabilisation. They do not believe in the so called Fed put, or the wealth effect.

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