Fixed Income Archives

The “Great Rotation” and Risk

The FundLogik Application continues to point towards a risk weighting. For most portfolios, that means a shift towards equities and away from fixed income.

Last week, we looked at one of the main currents of money flow which drives global financial markets. This week, we look at the factors which drive the money flows into one of the key asset classes available to investors: Equities.

How Wall Street views Equities

According to the collective judgement of investors on Wall Street, a dollar of earnings this year will cost $15 if you select the average Blue Chip stock from the S&P 500. And, for the optimists in the room, that $15 dollar figure for stocks falls to $12.30 if one looks forward to 2014 earnings rather than backwards to 2012 numbers. That same dollar of earnings will cost you $50 if your tastes run to 10 Year US Treasury Bonds. As bond interest is fixed, there is no need to calculate a rosy scenario.

To Wall Street strategists, this big price difference between equities and fixed income suggests an imminent “Great Rotation” from bonds to stocks as rational investors rebalance between relatively expensive bonds and cheaper equities.

Three Factors

3factors The “Great Rotation” and RiskAre they right? The answer is yes but probably not for the reason usually pushed to the front of the research report (stocks are cheap, bonds are expensive). There are three factors which drive stocks and stock markets: Earnings, Interest Rates and Risk.

Earnings: Supportive of Equities

If you limit your focus to quarterly earnings and consensus forecasts, you will see an exciting jump in expectations at the beginning of this year. The numbers that go into the overall S&P 500 estimate are important because most institutional money is benchmarked to the index or a close derivative thereof. If you are interested in some of the key biases which drive the consensus forecast process, ZeroHedge has an insightful article on the subject.

SPX Earnings The “Great Rotation” and Risk
Source: Bloomberg

Before one gets too excited, let’s step back and view a couple of years at once. The phenomenon highlighted with the small red arrows is known as “earnings roll.” Analysts, who are employed by brokerage firms in the business of selling stocks to clients, push their numbers up in the beginning of the year and then adjust them as quarterly reports come out.

SPX Earnings1 The “Great Rotation” and Risk
Source: Bloomberg

So, if you look at the red line on the second chart (which charts the running 12 month forward forecast), earnings are moving in a positive direction but not dramatically. This is supportive of the market but not enough to make the case for a “Great Rotation” on its own.

Interest Rates: Neutral for Equities

This is an easy call because all the Central Banks are working in concert to keep a lid on interest rates. These generational lows in US dollar interest rates have hardly spurred the borrowing and investment boom that some Keynesians had expected. But with debt levels reaching what some consider dangerous levels relative to GDP, few G-20 countries want to think about servicing their debts at high single digit interest rate levels. Rising rates are bad for stocks, falling rates are good. Interestingly, there are new studies suggesting that low and steady levels of interest rates do not correspond to above average stock market returns while high and steady do not necessarily mean poor performance. With no movement expected up or down, this part of the equation is neutral.

Risk: Positive for Equities

The Chicago Board of Options Exchange has an excellent index for measuring the level of risk in the short term (ie. a matter of a month or two) called the VIX. Although this is often cited as The Fear Index in the market, it is important to remember what it is actually used for on a day-to-day basis: pricing options. A high reading certainly does reveal high anxiety in the market and a low reading, relative calm but the measure is by design a short term one.

The risk we are trying to measure is the certainty of forecasts. To give a simple example, the range of expectations for a consumer products company like Proctor and Gamble are much narrower than they might be for United Continental. While the former may stumble in an emerging market or be subject to margin squeeze, the latter can see profits quickly turn to losses with an adverse move in jet fuel prices. Broadly speaking, the tighter range of expectations command higher Price/Earnings ratios (P/E) while the broader range means the company (or the market) is accorded a lower P/E.

Macro factors can also be measured in a similar fashion. When the range of possibilities are uncertain (think some of the hyperbolic commentary ahead of the “Fiscal Cliff”), investors respond with caution and P/E ratios tend to fall. When uncertainties drop away, investors are willing to bid up asset prices and P/E multiples expand.

With the European Central Bank commitment to support the Euro at almost all costs, the passing of the “Fiscal Cliff” and the realization that the trajectory of US Government Debt issuance is likely to pursue a more sedate upward trajectory while the underlying economy continues to grow at a lower but sustained pace, some of the big worries in the market are being calmed.

If one wants a proxy (rather than anecdotal assurances), a reasonable measure of longer term anxiety is the spot gold price. With the arrivals of ETFs, gold is certainly cheaper to hold but the shiny metal still provides no income. Investors buy gold because they are willing to forego income to hedge against the risks they perceive in other asset classes. The FundLogik application and just a cursory look at the charts show that the upward trajectory of gold has cooled dramatically.

Conclusion

The FundLogik application has been flashing “Buy Riskier Assets” since November last year. Now we are starting to see that the market has been a good leading indicator as the conditions for better earnings and a less volatile environment shape up.

Keep holding onto the riskier end of your watch lists…and as they say on the airplane, “sit back, relax and enjoy the ride.”

How long will “January Effect” last?

Now that the politicians on both sides of the aisle have decided to take a bit more of the private economy in taxes and keep piling up debts for future generations, it is time for markets to return to normal seasonality and resume weighing up the prospects for different investment classes without constant reference to the hot political winds gusting out of Washington.

The question most investors should be contemplating is whether we will see a repeat of last year when the equity markets extended the “January Effect” through the entire first quarter of the year.

The FundLogik application indicates that now is the time allocate a larger portion of your assets towards the “risk” end of the spectrum. Whether that momentum peters our in February or steams on until the beginning of April remains to be seen.

In the 6 ETF FundLogik Portfolio, Non-US large cap equities (represented by EFA) and the Emerging Market Equities (represented by EEM) are ahead of SPY, TLT and DBC with QQQ bringing up the rear. However, if the January Effect does stretch further into the first quarter, it would be logical to expect QQQ to move up smartly in the rankings.

In the sample bond portfolio, Convertibles and Emerging Market debt funds are leading the pack. This suggests an appetite for more risk and a reach for yield.

In the sample equity portfolio, European Equities ranks at the top while Emerging Markets replaces Developed Markets, largely mirroring the FundLogik Portfolio ranking.

In the Blended ETF Portfolio, China (FXI) and International Real Estate (RWX) come out at the top of the list. China was volatile for most of last year but picked up steam after the leadership transition was completed. Real Estate is both a yield play and a capital gains play.

Political Risks will resurface

There are still a few more “political crises” to come, all of them just as manufactured as the one that was “narrowly averted” in the wee hours of the New Year. Whatever one’s political leanings, most can agree that the resolutions are of the “kick the can down the road” variety. Despite the promises to do better next time, the bottom line is that the new political line up in Washington looks the same as the old line up. There is little reason to expect a different outcome next time.

So, what does this mean for investors?

“January effect” should be fairly well pronounced this year. A combination of tax loss harvesting from a volatile 2012, the rehashing of the Euro crisis, leadership change in China and the political drama in the US means that institutions entered 2013 with a bias towards safe assets. Don’t be surprised to see money flowing back into QQQ and SPY favorites as fund managers rebalance for first quarter optimism.

Last year, the “risk off” trade was US Treasuries, the US dollar and, at times, precious metals. But these asset classes have rallied hard in recent years. It is hard to see how there is much upside left in these assets, particularly US Treasuries. The conditions which support the high prices will persist: a still massive US current account deficit, FED purchases of Treasuries and the fact that many other major currencies, particularly the Euro, don’t look very promising relative to the US dollar. Since none of those conditions appear ripe for change in the near term, one can expect continued fund flows towards two of the largest asset classes. There will continue to be “worry pieces” in the financial media about China, Japan or Middle East sovereign wealth funds looking to “dump” their Treasuries. The outcome will be no different; these large holders can shift at the margin but cannot dump. US dollars flowing out through the Current Account will flow back into US Treasuries and other similarly overpriced assets for the foreseeable future.

That does not mean there will be no volatility. Given the fact that both the household and government sectors are still massively in debt, even small shock events will continue to be magnified by the excessive leverage that remains in the system.

The real question is that of rebalancing. Will institutions remain happy to add to their piles of low yielding US Treasuries and cash as well as their non-yielding hoards of Gold? Or will we see more shifting towards riskier assets? At the margin, it is not the foreign sovereign wealth fund that drives the asset allocation but the large US institutions. If a consensus forms that equities and real estate assets are a better value than US Treasuries (ie. not just lip service but actual shifts in asset allocations), then we could see a rise in interest rates combined with a strong surge of liquidity into the stock and property markets. The stock markets will react positively while the US real estate market would probably just accelerate the digestion of the inventory hangover of the last 5 years.

At this point it is hard to say which way the balance will swing. Low growth in the G-8 economies could give comfort to asset allocators that the lofty values at the long end of the Treasury market will be supported by the FED’s commitment to “twisting” the yield curve. A change to the delicate balance however could send investors scrambling. The bloated FED balance sheet plus Bernanke’s commitment to keep interest rates low for as long as possible may not be enough to stem the rush for the exits.

For now, the FundLogik application is pointing towards a healthy “January Effect”. Position yourself accordingly.

Buying Long Term Treasuries

“Don’t Fight the Fed” is one of the basic chestnuts of market wisdom that is impressed upon any newbie coming into the business.

Why don’t you fight the Federal Reserve? There are many good reasons but at the end of the day, the FED’s day job is to create and destroy US dollars at will in the pursuit of the dual mandate of maintaining price stability and promoting economic growth. Unless one moonlights as a counterfeiter, there is nothing big enough in one’s “bag of tricks” that one could conceivably bring to that fight.

When our simple 6 ETF Portfolio told us to swap out of QQQ (NASDAQ 100) for TLT (20 plus year Treasuries) a week and a half ago, my first reaction was to think that I was smarter than the system once again. Surely there is almost no chance that Treasuries could still go up further…

Ah, but then I scanned the news to find out that Operation Twist would most likely get a new lease on life (so I made the switch a few days late). The Wall Street Journal editorial sums up the main issue perfectly. Investors don’t want to fight the FED. So to play along, they need to divert investment funds towards long term Treasuries.

That’s what the Fund King System picked up the other week…that the investment tides were being pulled once again towards the long end of the US Treasury market. What have I learned?

“Dont’ Fight the Fed”

Carry Trade Ending?

When most people think of the carry trade they think of borrowing in Japanese Yen at near zero interest rates and investing in Aussie, New Zealand or Canadian fixed interest instruments to pick up the yield difference. (Click here for an excellent Financial Times illustration) If a hedge fund can wrangle 10:1 financing from its prime broker, that difference can be magnified tremendously. The risk in the trade is that exchange rates will move in an unfavorable direction (in the Yen carry trade example that would be a strengthening Yen).

However, the biggest game in the last two years has not been the Yen but the US dollar. There are actually two separate “carry trades” going on in the financial markets right now.

Carry Trade #1

The first is with the big “money center banks” which can borrow at less than ¼ of 1% in the short term from the Federal Reserve and lend it to the US Government by buying Treasuries that yield many times the borrowing cost. The trade is protected on the currency side because both are done in US dollars. The trade has been further protected by the Federal Reserve which has been using its QE2 mandate to buy up longer dated Treasuries in the secondary market. One of the unintended consequences in the US is that money center banks have actually curtailed their commercial lending operations as a result.

busloan Carry Trade Ending?
Source: St. Louis Federal Reserve

Carry Trade #2

The second trade is with currencies that are closely linked to the US dollar. In the case of the Hong Kong Dollar, the link is explicit (and the property market is booming) but throughout the exporting nations of Asia, the link to the currency of the biggest market for finished goods is well understood. The flows of money have been so strong as to kick off secondary waves of capital movement (eg. Chinese M&A and property purchases in Australia). In this second trade, the risk of currency movements is present but not significant (think Chinese reluctance to revalue the RMB) and more than made up by the trading opportunities in these markets. With short term borrowing costs well below the 1% mark, many projects look viable even at very inflated costs.

So, in one sense, the QE1 and QE2 programs have been a resounding success but thanks to the globalization of capital movements and bank reluctance to extend new loans, the beneficiaries have not all been in the US.

But, that looks likely to change. As we approach the end of the Quantitative Easing Program, Mark 2 (QE2), it is time to think about what might happen to interest rates and liquidity when the status quo changes.

The status quo to which I refer is the US dollar 3 month swap rate which is the rate at which major financial institutions around the world borrow US dollars from one another.

3mUSswap Carry Trade Ending?
Source: Bloomberg

As you can see from this chart, the rate has been kept at less than 0.25% for more than two years now.

And the game has not been limited to financial institutions. Large credit-worthy multinationals have also been able to borrow at very preferential floating rate terms (usually a small margin over 3m LIBOR) which has largely mirrored the 3m Swap.

3mLibor Carry Trade Ending?
Source: Bloomberg

What should investors watch for?

The question for investors is how long can these rates stay down at these levels? The advice given to all young traders when they first start in the business is: “Don’t fight the FED”. And the last two years have shown that the FED can still pull off the neat trick of reflating the global banking system. The question now is where will these rates go and how will the big financial players react when the cost of funding makes their more speculative positions unattractive?

Stability leads to instability

Hyman Minsky (1916-1996) was a neo-Keynsian economist who was the first to note that financial stability leads investors to gear up and sow the seeds of the next bust. The Minsky Moment (the tipping point coined by PIMCO’s Paul McCulley to describe the ’98 Russian financial crisis) may be a rise in short term interest rates once the FED stops pumping up base money with the QE2 program.

Mark your spot on the sidelines

Although the financial press and the regulators have been at pains to talk up the financial stability in the system, it seems obvious that much of the apparent stability and record profits at Too Big To Fail Banks have been secured on the back of a two year fire sale on short term money. When that sale ends and these two interest rates start to return to more realistic levels, investors may wise to spend a few months on the sidelines with cash waiting for bargains.

Presidential Cycles and Australia

This week, there will be no newsletter as we are on the road in Australia.

What does Australia and year three of the US Presidential cycle have to do with each other? Usually, there would not be much of a connection.

But this year, there is a connection.

To over simplify, we are in year three of the cycle, the time when an incumbent President has to make sure the economy is as stimulated as possible so that the voters will give him another four years in the White House. As a result, it is often a good year to invest in risk assets like equities.

In this cycle, growth is coming from government spending and monetary expansion. And, while the Republicans may still get to repeat their temporary government shutdown routine (maybe they can avoid the political backlash this time), the expansionary policies at the FED are harder to stop.

That means we will continue to see inflationary money creation in the world’s reserve currency. And, since the money cannot all be put to work in the US economy, it will continue to fuel asset and commodity price growth around the globe.

How does that money get around the globe and into local economies? Primarily through Central Banks’ efforts to keep currencies from moving up against the US dollar, the FED’s accommodative policy is being exported to countries (like China) where inflationary expectations have already taken hold.

Australia is one of the places where these pressures will become most evident. As a major producer of agricultural and industrial commodities, it is a secondary beneficiary of the FED’s inflation creating policies. Not only has China’s boom created strong demand for iron ore, coal and other resources, it has also sent a wave of investment capital towards the continent sized country. This has ignited a surge in M&A activity as well as frothy real estate markets. The Reserve Bank of Australia has moved short rates about as high as politically possible (mortgages are mostly floating rate) so the next thing to go is the currency which has just crossed the 1.05 mark (FXA). If the Aussie dollar continues towards 1.10 and 1.20 as local investors expect, that’s a strong signal that one’s investments need to be well placed for an inflationary environment.

This week, for example, the base metal ETF (DBB) nudged the S&P 500 ETF (SPY) out of the top 3 in the Seeking Alpha ETF Portfolio. The main aim of the Fund King System is to track major investment flows to keep one’s money deployed in the most promising corners of one’s investment universe. Right now, it looks like major investors are positioning even more towards the inflation trade,

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