During May, the markets seemed to have been exploring the ranges they established during April, with bonds selling off then rallying, equities moving higher then retreating and Currencies bouncing around looking for a catalyst. This may come in the form of politics, as it often does, especially as we now move into a busy four or five months of Elections.

Otherwise, the emerging story in Q2 seems to be around commodities, and while Oil, after a strong run up to $90 this year, failed to make new highs and is back in the middle of its range, Copper, which really woke up during April, looks to be in a new bull trend, which is further helping the mining sector, currently also benefiting from the ongoing Gold bull market.

Looking slightly further out and through the usual political noise, the we feel that the biggest tail risk for investors is that a new White House will repeat the Plaza Accord of almost 40 years ago, with a focus on a higher Yen, but with Japan in the role of Germany in 1985 and China in the role of Japan, as the Challenger nation to be stopped, not by tariffs or propaganda, but by a sharply lower $. Interesting that while this might seem an unlikely idea at the moment to currency traders, the other markets seem to be already starting to hedge the possibility, especially overseas investors, with diversification into overseas markets, buying gold and other commodities and buying fewer US bonds.

Short term uncertainties - range trading, Politics and commodities

Equities bounced back in May, while Bonds range traded, as did Oil. Gold consolidated in an uptrend while Copper broke out. The Yen rallied and then sold off again and while it has not broken to new lows, nor has it clearly bottomed out. This remains one of the key mispricing in markets in our view and with what seemed to be unofficial intervention in the markets around the 160 level. Importantly, we suspect that other central banks, notably the Fed, will increasingly focus on this. And US politicians certainly will.

Are Bonds the New Nikkei?

Extending the Japanese theme, the Bond traders obsession with the Fed Pivot (or not) led to further aggressively-sideways moves in US Treasuries during May, which led us in turn to wonder if US Treasuries are going to be like the Nikkei in the 1990s - after a long Bull Market attracting huge institutional flows, index trackers and a misguided belief that having more than half of your international exposure in Japanese stocks was somehow ‘reducing risk’, we saw a dramatic correction in the early 1990s, followed by a decade or more of what were termed aggressively-sideways trading markets as long term investors exited, leaving the short term traders to chase the market up and down a trading range. It was entirely possible to make good money in Japan in the 1990s, but only if you actively traded it.

Bonds currently look somewhat similar, having ended their bull market, sold off aggressively and shifted their ‘risk’ status, all in the last two years. Moreover, having lost their status both as a diversifying asset, now that Bonds appear to be a ‘risk on’ asset, and also as low volatility asset (the MOVE index has been consistently above both the VIX and the realised volatility of Equities), some are asking “what are they good for?”, just as they previously questioned the need for owning Japanese Equities. Indeed, we wonder if the new bull market in gold and commodities is at least partly a function of the bear market in bonds and that Gold and other commodities may be taking some of the asset allocation previously assigned to fixed income.

Of course, after years of range trading, mainly by overseas investors, the Nikkei ultimately ended up being owned mostly by the Japanese government. Another parallel?

Currencies looking to Politics for a lead

Meanwhile, with Elections now looming - the surprise UK Election in July will now come after the Euro Elections but before the US Election - currency markets are twitching, trying to weigh up the downside risk of ‘bad’ elections and possible lower interest rates (Canada moved in early June), against the upside risk of funds flow as international investors seek to diversify away from the US$ and US assets in general. A particular concern is the narrow focus of the dominant US market, with the 5 largest stocks in the S&P500 now back up at 27% or so of the index and the US index itself at around 70% of the Global Benchmark, the passive revolution is making many allocators uncomfortable.

The US market seems like CTA v TikTok

Within the US market, things also continue to look unbalanced, with NASDAQ up but the wider markets less so. May saw yet another dramatic spike in Nvidia, reminiscent in our view of the seemingly relentless option-driven rally in Tesla during 2020 and 2021 (from $27 to $400) causing pain to closet index trackers and concern for any institutional investor trying to build a sensible portfolio. At the same time, apparently 7 out of the 10 of the most highly traded stocks in the markets by volume are so called penny stocks - trading under a $1 share price, further emphasising the CTA v TikTok nature of the US Equity markets at the moment.

The other strong chatter in the market is that China is going to devalue the Rmb - something that makes no sense to us, as China’s trade surplus is expanding and many of the highly rated US Global companies are having to cut prices to compete. Indeed, we suspect that the pressure will be in the other direction, a devaluation of the $ not in the Asian currencies.

Medium Term Risks - Politics and the Dollar

With a new US government coming into our six month window, the obvious discussion points about a second term for President Trump are also coming back into focus. His election pledges extend beyond MAGA, and include “Drill Baby Drill” - a factor certainly capping the oil price at the moment and “Build the Wall” - something that will certainly prompt discussions with the new female President of Mexico. He has also declared his intention to fix some of the US Foreign Policy issues, but the underlying tone is one of a focus on the US and a retreat from Globalism.

Both candidates are focussing on US re-industrialisation

Biden and the Democrats appear more keen on the Foreign Policy status quo, but are also focussing on re-shoring and rebuilding the US Industrial capacity. The ironically titled Inflation Reduction Act is actually a huge subsidy programme, that combined with tariffs such as the ones announced in May on Chinese EVs, solar cells and other goods, is going to raise prices to the consumer. But the real focus, as ever, is on the corporates.

Huawei is causing headaches for Nvidia as well as Apple. Both are having to cut prices to compete.

However, this is not to say it will be successful for investors looking to buy US stocks. Pricing power is also important as the CHIPS act in particular rebounds on some of the big US tech companies. Far from taking 5-10 years to come up with a competitor for Nvidia’s H20 Chip (the one that passes the sanctions and has led to Nvidia’s 90% market share in China) as ‘experts’ predicted only 9 months ago, Huawei has come up with the Ascend 910B, manufactured by SMIC using 7nm process. On a par, if not better than the H20, it is actually more expensive and yet Nvidia has been forced to cut its prices to compete. Huawei is also causing problems for Apple, which was forced to cut prices in China last month, while obviously BYD and others are making things tough for Tesla. With all the western carmakers struggling to compete with China’s EV makers in their own markets, (exports up from 20,000 a month last year to 140,000 a month now) and lobbying hard for tariff protection, the prospects of selling into third party markets are vanishing rapidly.

It’s the loss of third party markets that needs to be factored into a lot of share prices. While the US remains the largest consumer market in the world for most things, share prices of most Global stocks assume growth in overseas markets, where it is increasingly difficult to compete with China. It’s not just (or even really) about labour costs, EVs for example are highly automated and Chinese are ahead even of that standard, but network effects, integrated supply chains and of course, the, previously relatively unique to the US, combination of access to cheap energy and a large domestic market.

All of this challenges the current narrative of a Rmb devaluation.

With strong exports in higher value added products and a widening trade surplus, not only is one of the key talking points from a year ago (China’s collapsing export model) proved wrong, but the latest western commentariat meme of an imminent Rmb devaluation makes even less sense - unless it is against the Yen and the Won as in fact, against its main competitors, the Yuan has been appreciating - the chart shows the trade weighted index for the Rmb.

It’s not that the Rmb is weak and needs to get weaker, its that the $ is too strong, so the Rmb needs to get stronger. But in any event, China isn’t competing on price any more. And it’s still winning.

The Biggest tail risk to investors is the US Dollar - going down.

Predicting currencies is a tricky business, (statistically the ‘best’ forecast is today’s spot price) but that is different from considering tail risk. With the talking points around the Chinese currency needing to fall, it will be difficult to argue that it is being manipulated - the standard trick under the previous Trump regime to justify tariffs and sanctions. However, the currency that is obviously too weak is the Yen, so we would expect an early call to come from the new President for a new type of Plaza accord -essentially talking the $ down against the Yen, with the full expectation that the rest of the Asian currencies would rise with it.

At this point, we probably need to make our usual comment about this not being investment advice (please do your own research and speak to an investment advisor), but with this as a barely talked about issue it is worth considering how portfolios might behave.

In some senses, the other markets seem to be already anticipating a lower $

For international investors, there is the obvious diversification issue - with the US now an even larger share of the Global Index than Japan was at its height - there is a risk argument for diversifying into Europe, Japan and even China. There are also the impacts on commodities, Gold and Emerging markets, all of which tend to be inversely correlated with the $. If we look at markets so far this year, this already appears to be happening - with an interesting twist that the prospect of a stronger Yen is leading to some selling of Yen hedged products, especially equities, as the positions are closed. This may lead to some near term weakness before the prospect of attractive unhedged positions returns.

Bottom line

Traders are flattening positions ahead of the summer and despite low levels of risk indicators like the VIX, we would anticipate some increased volatility over the next few months as liquidity drops, especially from the currency markets as the political ‘noise’ intensifies. In our model portfolios we are already positioned for diversification away from the 70%+ exposure that the ‘low risk’ index trackers are currently holding, but are focused on a combination of value and cash flow growth that should deliver even if the tail risk event we are most concerned about (a lower $) fails to occur.

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