As The Tri Polar World Turns - February 2019

MACRO THEMES

We previously asked the question “V for Victory, V for V market bottom or V for Victim?” Now we can add V for Volatility for all the market timers out there as the worst December since the Great Depression gave way to the best January in 30 years or so. Wow.

So what comes next? To answer that requires recognizing what we have learned since Jan 1st. Here are three things to ponder. One, we have learned that investors have discounted weak economic data as shown by European assets rising in the face of almost universally bad economic data. Two, we have learned that the Fed is well and truly on hold and stands ready to preserve the US economic recovery. Three, we have learned that the Govt shutdown was a loser for the President but a winner for the markets as it helped seal the deal for the Fed while likely assuring a China trade deal since the US economy is unlikely to weather a doubling of tariffs. I would also suggest that we have learned that potential growth rates (PGR) and neutral rates of interest (NRI) are concepts investors need to better understand. Here, it's worth noting that both are important components of our Global Risk Nexus (GRN) Scoring System.

On the ECONOMICS front, potential growth rates and neutral rates of interest are economic concepts that describe when economies are running close to their steady state with stable growth & inflation and real interest rates that support that environment. Demographics and productivity are what drive the potential growth rates. According to Ned Davis Research, the developed economies (OECD) potential growth rate has declined to roughly 1.4%, down approximately 2/3s from levels prevailing in the 1980s-90s. Thus, thinking about Europe’s current growth slowdown can be viewed not as a collapse but rather a decline back towards its natural level - a very different take than economic collapse as various headlines have blared. Europe and Japan are likely close to their PGR at roughly 1% real growth while the US is decelerating towards its PGR of roughly 2%.

Having a sense of what the steady state growth rates might be in turn helps one to understand the interest rate structure that will support such an outcome. This understanding can help clarify why rates at this level, which seem so low relative to history, can be damaging to the economy. The NRI concept is more art than science but understanding that in a low potential growth (relative to recent history), low inflation world interest rates will be lower than history might suggest is an important insight.

Back on more familiar terrain, we continue to focus on the consumer which is the main growth driver in the developed economies and increasingly so in the emerging economies. The health of the consumer, consumer sentiment, confidence etc. will go a long way to arresting the slide in global production which has generated so much attention. On the consumer side, the news remains quite good: very low unemployment coupled with rising wage gains in the US, Japan & especially Europe (Chart 1). In China the Govt is cutting taxes, easing pressure on the key property market, and is rumored to be prepping for a VAT cut. All this in the service of stimulating consumption and rebalancing the Chinese economy.

Chart 1: A Quick Reversal in EU Fin Conditions

Source: WSJ

The POLITICAL environment remains somewhat stale; most worries have been aired for quite some time and like weak backward looking economic data seem pretty fully discounted. The US Govt shutdown sets the stage for a China trade deal from the US side of things while China’s slow economic deceleration pressures the Chinese side of the table. A “deal” is likely to be reached but one hopes it is not an extension a la the shutdown as continued uncertainty would hurt sentiment, the consumer, and the global growth story. The Mueller report is likely to come out in the next few months; minus a smoking gun it may have limited effect on asset prices given how much of the story has already been told. Continue to watch the Republican Senators - if they start to edge away from the President then risk grows. Also don’t forget about the Southern District in NY which will investigate the President’s business and personal side, something he has explicitly warned against.

Across the pond, Brexit is likely to be finalized is some form during the coming month and yet the outcome remains quite uncertain - hard as that is to believe. An extension here is probably a pretty good outcome. The other interesting note in EU politics is the potential for May’s Parliamentary elections to be a bit of a damp squib in terms of the populist uprising so often painted in the press. A close reading would suggest little likelihood of a populist get together and note that the Euro and the concept of the EU itself remains very popular in Europe.

On the POLICY front, the V for Volatility could just as easily be attached to the Fed’s change of direction in the past few months. My sense is that the Fed has taken on board the importance of financial market implosions in setting the stage for the last several US recessions. Q4 asset price weakness was quite aggressive and so catalyzed the Fed to change direction quickly. The question now becomes what's next; the market is split between the next move being a cut or a hike - time will tell. The important point is the Fed is now even handed and can move to support or restrain the economy. Given the deceleration in train the odds lean to supportive rather than restrictive action.

Elsewhere the ECB and BOJ are in holding patterns while the PBOC remains active - a good set up for risk assets. Investors need to consider whether we are closer to the end of the rate tightening cycle than the beginning? As Chart 2 implies, history would suggest we are closer to the beginning of an easing cycle with attendant implications for asset allocation.

Chart 2: Global Easing Cycle Ahead?

Source: Thompson Reuters, Datastream, Credit Suisse, WSJ (Data through 10/2018)

Fiscal policy remains in play in Europe and in particular in China where overall stimulus is estimated to be over 5% of GDP (Table 1). Europe’s fiscal ease will be much less but could be sufficient at the margin to stabilize growth rates. We don't expect much from the US on the policy side and would note that the US is in somewhat of a box between too strong growth that would bring the Fed back in play and too weak growth that would lead to EPS risk; the ROW by contrast would welcome stronger growth.  

Table 1: China Stimulus Should Lead to Growth Stabilization

Source: JPM

Thus to MARKETS. The December sell off and January’s rip roaring rally has left us with markets that seem bereft of compelling opportunities given how asset prices, technicals and sentiment have shifted.

A move higher would seem to require China trade deal confirmation (though a buy the rumor sell the news deal is possible given China equity up 10% ytd). Signs of growth bottoming in both China and Europe would also seem necessary for risk assets to move appreciably higher, especially in Europe given how bad the news flow has been. We expect all three in the coming quarter or so. The operative Q then becomes should one add to risk here or wait for a pullback, perhaps aided by a slip twixt cup & lip in the trade talks, poor EPS guidance or even worse economic data?

Recent equity price action suggests bad news is in the price whether looking at US bank stocks, semiconductor company results or European growth data. 2019 EPS estimates continue to come down, especially in Europe, but it's far from a blood bath as top line growth is still robust across much of the world. Leadership, both from a country and sector point of view, remains an open question as prices rise and fall in tandem. Answering some of the questions posed above should allow for differentiation to take place and correlations to break down.

On the fixed income side it's a bit of a split picture as UST failed to confirm recession fears while Bund yields have broken to new lows. Any signs of a growth bottom in Europe and Bunds will be for sale. In the US, the UST Supply/Demand picture is likely to offset a tendency for rates to rally as the growth slowdown plays out. This suggests a continued flat yield curve. Credit, particularly US HY, has had quite a rebound as fears ease over the BBB threat and Supply/Demand remains very supportive. The Fed’s change of pace supports both EM debt and FX.

The commodity segment is looking more interesting. Oil prices remain solid as OPEC and Russia continue to cut production (Chart 3) to support prices, while the US rig count remains well below its highs. Saudi Arabia’s willingness to reduce production says a lot about its internal state given that higher oil prices help its biggest enemy Iran. Gold also remains appealing and seems to be catching a Central Bank bid which is bullish gold short term but somewhat worrisome for what it says about demand for USD over the longer term. Finally if the world is indeed close to embarking on a rate cutting cycle the materials, metals and mining segment of the commodity space could be worth spending some time on.

Chart 3: OPEC Production Cuts Stabilize Oil Prices

Source: WSJ

PORTFOLIO STRATEGY AND ASSET ALLOCATION

We have made limited asset class portfolio changes this month as our view that Q4 weakness was overdone has played out. We remain neutral equity, underweight bonds and overweight alternatives & cash.

Within equities, we remain OW the non US equity markets. We maintain our lower risk profile within the US preferring risk positions in China, Latin America, and recently added global metals & mining exposure.

In Fixed Income we maintained our OW positions in US credit and continue to prefer the belly of the UST curve. We continue to hold positions in both EM USD debt as well as EM local currency as they benefit most from the Fed pause and a bottoming of EM growth. Our expectation for better EU growth leaves us with minimal exposure to DM non-US sovereign debt positions. We adjusted the currency exposure of all our non-US positions to reflect the impact of the Fed’s change in direction.

We remain overweight Alternatives with a position in broad commodity exposure and a tilt to energy via an MLP position. We have high conviction in OPEC, specifically Saudi, desire to maintain production cuts to ensure higher oil prices. We also maintain a gold position across our portfolios and expect gold to benefit from a Fed pause & subsequent dollar rollover.

We maintain cash positions as we await the economic & political signals noted above to add to our preferred risk positions.

GLOBAL MACRO SUITE PORTFOLIO CHANGES

Global Macro Multi Asset (GMMA)

• Within equities, we reduced our US High Dividend position as well as our broad European equity position. We added a Spanish equity position and a global metals & mining position.

• On the fixed income side we flipped our EM USD and LC debt positions while doing the same to our DM non-US Sovereign positions.

Global Macro Income (GMI)

• As in the GMMA portfolio, we flipped our EM USD and LC positions as well as our DM non US Sovereign debt positions.

Global Macro Equity (GME)

• We reduced our US High Dividend position as in the GMMA portfolio & added to our Innovative Tech position. In Europe, we reduced our broad holding and added a Spain specific equity allocation while also adding a global metals & mining position.

We hope you find this monthly piece of value and look forward to engaging with you on a monthly and quarterly basis as we go thru 2019.

Jay Pelosky, CIO & Co-Founder
TPW Investment Management

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