Currently, equity markets in general are stuck just below their long term moving averages and, as we might put it, look to be ending a bear phase but not yet entering a bull phase, similarly gold, while credit and Bonds are steadily recovering – albeit still well down on the year. As for much of this year, the real activity is once again in currencies, as interest rate expectations, having already achieved their effect on valuations through the discount rate, are now much more about the FX markets. What will be of particular interest will be if the central banks break ranks and start setting rates separately – a hint of which happened today with the ECB. If so, expect the Macro Hedge Funds to swing the narrative to support their new trades – likely to be weak $, bullish non US equity and Credit, including EM and also gold and commodities.
After another 50bp from the Fed, we believe that the major impact of changes in expectations of the Fed will now be via the $ rather than via capital markets – the discount rate already having had its impact. So too with the ECB; this time a year ago everyone’s favourite synchronised swimmer and Lawyer, Christine Lagarde effectively ruled out any rate rises in 2022, in contrast to market expectations, before, in synch swimming parlance, the ECB performed its part in a perfect Cadence Action of central banks raising rates all year. Today she said that the ECB now needs to do more on rates than markets are pricing in, seeming to indicate a break from the Fed. Judging whether or not there is any merit in either this statement or the one last year is not the point, however, the market response is already happening and the Euro, which had recently just broken up through the overhead resistance of its long term moving average against the $, rallied sharply, moving as they say by ‘A big figure’ (the second decimal place). While meaningful to a highly leveraged trader, this will of course have little economic effect – certainly not compared to the unusual multi percent changes in exchange rates seen in 2022 – but if the trend continues, then a currency effect will, in itself, help to reduce the domestic cost of commodities and especially fuel, which is priced in $ – a factor almost certainly taken into consideration by the EU policy makers. As such we would look for more hawkish talk from the ECB, although, we think that, somewhat counter-intuitively, this statement will actually make European assets look more attractive to Global Investors. In particular it supports our case for looking at European Banks.
This is because, as previously noted (December Market Thinking) we think that a weaker $ will be a catalyst for some asset rotation out of the US and into international markets. According to US brokers, the CTA Macro Hedge funds, who have dominated the tape all year, have already begun selling $ longs, chasing bonds and also selling some US Equities. The UBS macro team actually run a model that seeks to mimic CTA behaviour and estimated that at the end of November CTAs were bullish generally on Credit, not just in US but also in Europe and EM, bearish the front end of US and EU curves and bullish generally on Equities, notably, Japan, UK and Australia – something that would also be consistent (in our view) with the beginning of some rotation away from a strong bias to US $ assets.
But while CTAs are the focus, having had their best year in a long time, ultimately they seek to profit from forced buying or distressed selling by the medium term asset allocators and just as the CTAs have had an Annus MIrabilis, so the world of 60:40 funds has had an Annus Horribilis – one measure, the Vanguard 60:40 model portfolio ETF is down 18% year to date. Many are now sitting on cash and also an uncomfortable amount of illiquid ‘alternatives’, so pushing the buttons on their benchmarks may be a profitable trade. For example, for investors with a Global benchmark, Japan, the UK and Australia make up 9% of the benchmark and many have had little or no exposure over the last year, benefitting from a strong US$ cash position instead. The notion of big funds being forced to get ‘in line’ is probably one reason why the CTAs now like these three markets. Similarly with Emerging Markets.
Meanwhile, according to a note from Goldmans (via ZeroHedge), this year has been the worst sell off for Bonds on record and the only equity selloff since 1950 where 30 year bonds sold off as much as Equities. They also point out the following table, highlighting the ‘normal’ behaviour for 60:40 funds being a mean reversion.
Should that mean reversion indeed occur, then we would expect the CTAs to chase the new directional trend – something that appears to be starting. The Vanguard 60:40 ETF is actually up 3.4% over the last month. On this basis we would expect to see the narrative shifting to justify the new direction, with the aim of generating a set of equal and opposite directional trades to the ones seen in 2022.
