Sterling is rallying for market reasons more than politics, but the DXY is rolling over suggesting a possible rotation back to non US Equities is coming. This also makes sense as and when Wall Street starts to at least partially price in Elizabeth Warren. While almost all her declared policies are bad for the S&P, it is her stance on fracking that threatens a genuine financial crisis and a mortal blow to almost the whole US ‘alternatives’ sector .

Since the August lows, sterling has rallied by almost 8% against the US $ and by a little over that against the Euro, but as previously cautioned, we do not see this as a vote ether for or against Brexit, nor as an incisive judgement about the prospects of a deal or no deal. Rather we see it as the FX market having over extended itself in one direction on a single narrative (Brexit = Sell, Remain = Buy) by an equal and opposite amount of around 10% to that which it did when buying so heavily into Remain on the eve of the Referendum.

Also interesting is to observe the behaviour of the $ itself. There is an old Soviet expression that “to a man with a hammer, everything looks like a nail” and there is no doubt that those wishing to see the cable rate as an opinion on Brexit (in any direction) are implicitly assuming that this is the only variable, which of course is clearly untrue. Watching the trade weighted index, the DXY, it is interesting to note that its recent uptrend has clearly run out of steam and it is threatening to break down through its long term moving average, something that last happened back in May 2017 at around a similar level (97) and was followed by a drop of around 10%. This of course was a particularly good time for Emerging Markets, reflecting their sensitivity to $ rates and particularly $ debt.

So could this happen again? Well, I think there is certainly a case to be made that the 12% rally in the DXY since early 2018 is due for something of an unwind, not least because it was associated with Politics; in particular a large one way repatriation of $s following the change in the tax regime for US corporates and the ratcheting up of a trade war with China. On flows, some $225bn was repatriated in Q1 of that year, a further $115bn in Q2 and $60bn in Q3. While acknowledging that much of these assets were simply kept offshore as $ (and thus did not need to ‘exchange’) it also coincided with a large portfolio shift to US $ assets and something of an ‘America First’ approach to overseas investments. The narrative shifted as it always does, from  the 2017 view of a weak $ so buy non US to a 2018 narrative of rallying dollar sell non US. After all, if the $ was going up again, why own foreign shares? Especially as Emerging Markets were now falling due to both higher $ debt costs and of course the trade war. In effect this has been a ‘de-risking’ rally by US international money and has meant basically that since the DXY started to rally in early 2018, non US equities have essentially gone sideways while US Equities have outperformed meaningfully. In this there are worrying similarities to the rally in the Yen and the large outperformance of the Nikkei that followed the 1987 crash as Japanese international money ‘de-risked’. And we all know how that movie ended.

So what could reverse this? Once again we can look to politics. At a conference I attended back in September, Frank Lunz, the well known US political pollster and analyst, declared that he thought Elizabeth Warren would win the Democratic nomination, something which looks even more likely now than it did then. And yet, seemingly Wall Street is not even factoring in the possibility. In addition to a series of highly redistributive policies that would affect Big Pharma and Big Finance, she is also going after the profit policies of Big Tech. Indeed it is an interesting phenomenon to hear many US politicians on both sides talking about the corrupting effect of money in US politics. Make no mistake, this is a push back against crony capitalism and, almost by definition, this will dent the monopoly rents being generated by the very biggest market caps in the US markets and start to upset the earnings estimates and by extension the earnings momentum algorithms driving a lot of the price momentum stocks. That alone is a reason to rotate a bit away from US domestic equity.

As noted before and elsewhere, a shift in political sentiment could also impact some of the privileges that venture capitalists and Private Equity have secured over debt financing, forcing some deleveraging of those inflated balance sheets, but to return to Elizabeth Warren for a moment, perhaps the most alarming thing she has said is that, day 1, she will ban fracking. This would be seismic (pun intended). For not only has fracking delivered the US a huge competitive advantage in low cost energy benefiting all sectors, but particularly associated areas such as Chemicals, but also because of the vast amount of debt that has been accumulated by the industry, a ban on production would trigger a financial crisis.

In the second quarter this year only 11 of 29 fracking focussed companies reported positive free cash flow according to Morningstar giving a grand total of $26m, ironically seen as positive news from a sector that has been cash flow negative for years, barely making a dent in the more than $100bn of debt they have accumulated, let alone provide any reward for equity investors. No surprise then that XOP, the ETF that tracks these types of companies is down 47% over the last 12 months. And it is not just the E&P companies, there is a huge hinterland of oil service and other companies dependent on this spending (many included in XOP). Fracking has been great for consumers, but very bad for buy and hold investors.

But it is the debt markets that should concern us; Moody’s point to around $240bn of E&P debt maturing through to 2023 while total debt for frackers is estimated to be nearer $300bn, Importantly, that is debt maturing, it needs to be refinanced. In addition there is of course the debt linked to the rest of the energy infrastructure, as well as the whole leveraged loans business ( the S&P leveraged loans index has basically been tracking the oil price). We already know of the fragility of the BBB space in US corporate debt, whereby a few downgrades will push tens if not  hundreds of billions into the much smaller and far less liquid High Yield (junk) markets. A few energy related BBB bonds downgraded and going into a junk bond market paralysed by a widespread default in fracking companies while the leveraged loan market implodes and day 1 Elizabeth Warren would basically put the US markets into meltdown.

At some point, markets are going to start to think about this and ironically the most vulnerable areas are likely to be those where the institutional investors have been chasing yield and/or hiding from volatility – the FANGs, and other US tech in liquid assets and alternatives like PE, PC, leveraged loans and High Yield bonds.

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