The weakness in bonds and the events in Gaza have so far served to offset the traditional strong seasonality in markets, but a short covering bounce in early November has revived hopes of a Santa Claus rally. With trader year-ends traditionally focused around Thanksgiving, we think it prudent to see if a short covering rally actually stabilises into a return by investors looking for value. ‘Recency bias’ leads us to think it is about ‘the latest thing’ which is Gaza, but we shouldn’t forget that the end of the September had seen some highly unusual behaviour across markets that was picked up in our model portfolios, where not only were the fixed income and equity thematics all registering the lowest levels of conviction, but so too were the factor models as well as things like Gold. Historically, this has been associated with market (di)stress and this time we think is most likely associated with the hundreds of billions in mark-to-market losses in bond portfolios globally. We are not convinced that these issues have passed so quickly.
The key to the outlook is when and where the trillions sitting in US money market funds, ultra short dated bonds and cash starts to move. We suspect the fixed income portfolio managers will move first – extending duration and closing the re-investment risk they are currently exposed to. Then, the cash that should be aiming to compound real returns in Equities will shift – although rather than going into ultra long duration tech stocks, we suspect that they will look for quality balance sheets, cash flows and dividends – a lot of bond proxies. As the title suggests, we suspect a move to longer duration bonds, but shorter duration equity.
Short Term Uncertainty - avoiding recency bias
The biggest short-term uncertainty is of course that which is also displaying the highest recency bias, i.e. the Middle East, which (literally) blew up as an issue in early October. The default reaction by allocators was, quite sensibly, to move what money that wasn’t already there to cash, while the traders followed the ‘short first and ask questions later’ strategy and it is their flow we suspect that is currently driving a short covering rally into early November. From an investor perspective, the risk focus is on the oil price and in particular the possibility of disruption in the straits of Hormuz. While on balance we don’t suspect that this is likely to happen, energy and energy infrastructure nevertheless remain attractive long term themes due to under—investment creating capacity shortages. (At this point we should perhaps include the usual caveat that this note is for information content only and should not be viewed as investment advice. Please do your own research and contact your investment advisor.)
However, elsewhere, we should not overlook the fragilities in the system that led to bonds melting down at the end of September, specifically the unwind of the Japanese yield curve control experiment, which has seen Japanese bond yields rise by 120% since the end of July. Forced balance sheet rebalancing in a manner similar to Silicon Valley Bank in Q1 or the UK pension system last September remain a serious uncertainty and the prospects of a subsequent bouts of balance sheet driven selling at the end of Q4 and/or Q1 next year need to be monitored closely. The unwind of decades of zero interest rate policy in Japan and the west is unlikely to be as quick and easy as we might like.
Medium Term Risks – where as well as when to deploy excess cash
Paradoxically, the biggest medium term risks for allocators and investors are to remain in cash when markets start to recover from the forced and distressed selling and as such their focus is on what to do next as well as when to do it. For bond investors, staying ultra-short exposes them to re-investment risk while for equity investors it raises the question of how to deliver compound real returns in the medium term. This is a time for planning where to go, which is just as important as planning when to go.
Plans are nothing; planning is everything
Dwight D Eisenhower
Asymmetric bond maths are starting to push bond investors out on the curve
We suspect that Bond Investors will move first. As previously discussed, most fixed income investors operate in a ‘walled garden’, where the decision is not whether or not to be in fixed income, but rather where to be on the yield curve at any given time. Currently, they are very crowded at the short end, aware of the re-investment risk of matching long term liabilities but fearful of a further capital loss if they ‘get in too early’. However, as we noted in a recent piece (Asymmetric bond maths), the risk return calculation is now shifting, thanks to a combination of high current yield and duration effects, such that a 50bp increase in yields from here would give a 12 month return that was basically around flat, but a (frankly much more likely) 50bp fall in yields would give a return in double digits. As such we think that Bond Investors, as opposed to traders, are already starting to shift out along the curve, knowing that as and when there is a catalyst – either from the Fed or a short squeeze – then the scramble to lock in long term yields for asset liability reasons will deliver most of that anticipated total return in a matter of days. As Eisenhower said, it’s all about the process of planning, not the plan itself.
As and when bonds rally, a recession narrative will appear in support
In support of this view, investors will talk of inflation and real yields, which means that they will likely focus on US bonds at the moment as that is where measured CPI is dropping fastest and it also means that we will hear increasing talk about a recession – and thus lower inflation. As with negative news about China emerging to support sellers of Chinese stocks, the narrative shifts to what people want to hear, and as the fixed income markets start to buy more longer dated debt, so the narrative will shift to support that for ‘fundamental reasons’. The glass will once again be half empty.
In a similar way, we think unconstrained equity investors are looking at how and where as well as when to deploy their cash deposits, while those forced to remain invested who are currently looking for ways to mitigate downside while reducing beta are also wary of having either the wrong beta or no beta to the upside when the distressed selling in equities also ends. In this sense we note that when bonds do rally from oversold levels, there will be a scramble to lock in longer dated bonds leading to a bullish inversion of the yield curve and room for the Fed to normalise rates at the short end. However, we don’t believe that when cash moves to equities it will chase tech stocks in the same way that it did before the bond market correction. More likely, we think it will go for higher yielding, quality bond proxies with stable and growing cashflows, not least because of that ‘slowdown’ narrative that is likely to appear.
China – Creative Destruction in action. Focus on the creation, not just the destruction
After fixed income, we suspect that along with the other big Asia play, Japan, China remains the other likely ‘big trade’ for 2024. A relentlessly bearish narrative has steadily emerged on China over the last twelve months, which while undoubtedly having a Geo-Political element of trying to undermine the Chinese model as an alternative to the US ‘Rules based order’ for BRICS+ members, also reflects a misunderstanding of the policy agenda in China. By focusing on the downside of a collapse to the Shadow Banking system a few years back, western economists missed the upside of what the Shadow Banking system had done in terms of opening up channels of capital allocation before it was ‘collapsed’. Similarly with the property sector. Its flaws, particularly the use of deposits to fund the purchase of land for subsequent projects rather than for completing existing ones, were obvious a decade ago, but the imperfect structure served a purpose; it got homes built and it funded regional government as they put in place the necessary public goods and infrastructure required for economic development. However, the policy itself also had its flaws, including overbuilding and developers running out of cash. The picture shows a controlled demolition of one such project of 15 apartment blocks in Yunnan province that took place in 2021, after the uncompleted project had sat idle for 7 years. It tool less than 45 seconds and serves as a strong metaphor for China policy. Not bailed out or propped up, but subject to Creative destruction so something new can emerge.
Controlled demolition in China property markets
To extend the metaphor, the last three years has seen a controlled demolition of the whole inflated bubble as the authorities called time on the developers and their working capital mis-match model and the fact that 80% of the biggest holders of stocks like Country Garden, which are all but zeroed over that period, were Western financial institutions undoubtedly affects the Western perception of ‘the problem’. It’s not that the authorities don’t care about the owners of the equity, or indeed the owners of the high yield offshore bonds, who if anything have been even more vocal, but that their focus is on making sure the home owners get their homes built. Equally, a large part of the attraction of property for Chinese has been as a store of wealth, somewhat like gold. As such they do not suffer the same ‘mark to market’ psychological effects as the US, where the correlation between housing and consumer confidence and subsequently to the stock market is much higher. Nor for that matter is the stock market wealth effect itself that high. The key reason for this is that, unlike the West, China (and Japan) has an excess of consumer savings, not borrowings. As such, lower rates make them feel poorer not richer. Creating a proper savings and pension infrastructure is the current work in progress.
The same Geopolitics that is focusing on China’s glass being half empty is pushing Japan’s as being half full and we would suggest a sensible measure would be to mix the two. What is good for Japanese stocks may also be good for Chinese equivalents and vice versa. The decades of failing to understand Japan and the cultural differences between East and West, especially in terms of consumer behaviour, apply equally to China. Certainly both markets offer a combination of scale and value that is unavailable elsewhere.
Long Term Trends – breaking systems
While it is easy to get distracted by the immediate impacts of events such as Gaza, Ukraine, Covid and even the Global Financial Crisis, it is important to note the longer term consequences that often emerge from the secondary effects, in particular where they end up re-making or breaking existing systems. Because of the recency bias we discussed earlier, this means that when a particular crisis is ‘over’ we tend to assume that things will mean revert, without recognising the regime change that has taken place in reaction to said crisis.
For example, the decade or more of QE and Zero Interest Rate policies was ultimately more important than the collapse of Lehman that created them, while the collapse of global supply chains, the restructuring of the workplace and the vast amount of accumulated public debt will have longer term impacts than the actual lockdown. In a similar way, the war in Ukraine has broken the Petro$ system and is currently leading to a restructuring of the Global Banking system between ‘The West’ and ‘The Rest’.
In Japan, the end of Zero Interest Rate Policy (ZIRP) that came in the wake of the massive monetary stimulus that emerged from Covid is another secondary impact that continues long after the lockdown. In effect Japan has woken from a three decade long self induced coma and broken the spell of a policy that somehow believed that cutting the return on savings was going to stimulate a savings heavy culture to suddenly spend more and flip to a borrowing heavy culture. Higher returns (actually ‘normal’ returns) on savings are delivering consumption growth and inflation in Japan in a mirror image of the recommended policy.
It is too early to say what, if anything, will be broken by the Gaza conflict, but it is possible to say that at the very least it will enhance the significant shifts already underway, including issues around security of energy supply.
The broader point we are making about Recency Bias is that markets tend not only to focus on what is most recently ‘in focus’, but they also tend to move the narrative on such as to neglect longer term trends that were once their main topic. Circling round and revisiting those topics is thus very important.
For example, we suspect that for a combination of reasons, many to do with the US Election next year, the Ukraine Crisis will be ‘solved’ relatively quickly in the same way that the Covid Crisis was, but that the legacy of the policies enacted will remain, in particular the situation over energy security. Similarly, the Fed will likely stand back at some point in early 2024 removing uncertainty about rates one way or the other. However, even after the balance sheets of financial institutions are ‘re-balanced’, the ‘old’ story of the new ‘New Normal’ of higher interest rates remains, which has long term implications for private equity, private credit and much of the alternative space that relied on ultra low rates. That’s the thing about long term trends, they play out over a long time, even when we aren’t looking.