It has been awhile since our last periodical outlook on the financial markets. With such an eventful past in the rear view mirror, we thought it would be good to let readers and subscribers have a glimpse of how we view the current landscape, and how we intend to capitalize on those views going forward.
The two top most seismic episodes in recent history has to be the alpha of Greece, and the omega of China. These dualities have caused mayhem in asset pricing across the field, having affected not just regional but global markets. For those interested, you can view our comprehensive 3-part series documenting the events surrounding the Greek-European debacle here.
While we have not formally spoken about China, the incredulous swings in its equity markets, and the official economic data being bluffed on an epic scale, China will always remain a dragon that the world cannot afford to turn its back against, in our opinion.
The Chinese proverb that opportunities lie in crises applies like calculus to a differentiation problem. A hot knife through butter reveals the soft innards of the markets, but it also brings fire sale prices to certain markets worthy of our consideration. This is precisely what a serial opportunist is looking for; and in our eyes, he would have found several.
Trends To Continue
The trend is always our friend when to comes to trading and portfolio management. Our books have been positioned in such a way that they welcome continuation of bellwether trends. We certainly see the recent flares in cross asset volatility serving as a much needed shakeup.
Frothy prices have leveled off somewhat, and the market is certainly playing it more cautions now. All these are textbook indications of trend continuation, and is healthy for everyone in the medium term.
We are always looking for strong and fundamentally sound trends across the global markets, because our career of having skin in the game has taught us that a few long-haul position hitting home run settles much of the year's P/L.
Our advice has always been to identify and jump on board trades for the longer run. Stretching it out in a secular bull or bear run has been one of the safest strategies. Surprisingly, many traders never do this.
Markets Take The Stairs Up, And The Elevator Down
This adage is as old as the first centralized exchanges allowed for mass trading. A couple of markets have fallen precipitously. Of these, some would have started fresh bear trends, while others have corrected well.
The fundamental bearings that prices are usually founded on over the longer run, have changed slightly. Nothing too radical, but even a small shift in a highly geared trade spells disaster for late comers. In the past 2 weeks, we have seen exactly this manifest in the currency markets.
We have 5 more months before the end of the year, and perhaps half that before the first rate hike by the Fed. If traders and investors want to be properly positioned for that eventuality (higher Fed Funds rate), they should be acting now.
Trends In Routing Commodities Should Persist
Commodities have been selling off across the board. For the purposes of this piece, we shall not go into the reason why they sold off. However, it would not be inaccurate to blame it on the instability in China, amongst others.
We remain bearish commodities in general, especially industrial metals, precious metals, and crude oil. In April, we correctly called for weakness in copper, an industrial metal closely tied to economic activity in China and Australian production, as part of our China play. There should be more downside to copper through the third quarter.
Chief reasons being China's precarious position in its cycle of economic transition, a strengthening dollar, and dovish policies of the RBA (Australia's central bank). A development which could negate this bias would be a massive stimulus program (fiscal or monetary) by the CCP, a program that should dwarf whatever is ongoing.
Besides copper, we feel it is difficult to go wrong finding shorting opportunities in other industrial metals such as iron ore, aluminum, and palladium. Price action remains very favorable for even lower prices; copper has successfully tested a trend line spanning more than a decade but has not seen committed buying.
This reaffirms our believe that the larger market participants are not accumulating long positions for the next bull cycle. At least not yet.
Our view on the precious metals gold, silver, and platinum remains materially similar to that of the industrials. They are however motivated by different factors. Chief of which is the path of monetary policy tightening by the world's most affluent central banks - The U.S.'s Fed, and UK's BoE.
We have noticed that throughout the latest conflagration in the Greek financial and solvency crisis, there was a sheets dearth of bids throughout the precious metals complex. It seems that the once rich history gold glimmered with for being a safe haven that investors fled to in times of uncertainty has been terminally tarnished in this secular bear cycle.
It speaks volumes about the sentiment towards precious metals in the current climate. We still shudder to know that individuals view gold as an "investment", and not as an commodity. This misappropriation in the most fundamental sense has cost retail investors a lot of pain in the last 3 years, and we suspect for more to come.
Hitting Home Run With Oil
Crude oil, the one commodity that has flummoxed the investing and trading community more than all other commodities combined. Back in January, we were one of the very few accurately calling a bottom in oil prices. While our initial call was on point, profiting heavily from our outright longs on WTI, we never committed to any upside objective that was north of $55/bbl.
What is new to the table is another glut on global supply. Last week, the P5+1 group of nations struck one of modern history's most significant deal with Iran. After almost 2 decades of isolation from much of the West, sanctions and embargoes previously imposed on Iran will gradually be lifted in exchange for Iranian corporation on its nuclear programs, at an international level.
Iran remains one of the world's largest producers and exports of crude oil, it sits above prolific oil and gas reserves that have only marginally been tapped. Before last week, Iranian energy exports were at their minimum. Now, analyst conservatively expect Iranian production to at least triple over the course of 6 months.
Adding insult to the injury of lower oil prices is the increased pumping by Saudi Arabia. The gulf state report almost a month ago that its production was near a record, despite prices having fallen from their May highs.
As a direct result, we cannot see any fundamental reason to be upbeat about oil prices. We prefer to be moderately bearish to neutral on oil prices. Underweighting WTI to Brent will be a wise move, as American producers are already reeling in CapEx from the most recent rout in prices.
The reason we are abstaining from being outright bearish prices is technical. The down moves are over extended according to our models, and we should be due for a sizable correction or a period of basing action. Any rally in prices should be corrective and will be promptly sold into by late comers.
Rather than going outright short crude oil, we prefer legging into weaker equity names and shorting currencies of countries that are heavily reliant on energy revenues. The Mexican peso, Norwegian krone, and the Canadian dollar have been victims. We remain bearish on these.
Fundamental Zen Amongst Currencies
The world's largest and deepest money pool has been offering some attractive prospects as of late. We believe there will be continued volatility across currencies, mainly driven by asymmetries in monetary policy, economic cycles, and risk appetite.
Starting with the U.S. dollar, we shifted from our interim bearish stance in mid June because we were convinced on both the relative and absolute strength of the American economy. We are now bullish the dollar.
The factor that still overshadows the currency markets is central bank policy. Our take that the Fed will only raise rates either in September or October at the earliest remains intact.
Economic data, especially coming from the labor market has been robust. Consensus expectations have been toned down, and we are not seeing the kind of misses we saw in the first and mid-second quarters as evidenced by the pickup in GDP growth to the tune of 2.3% (preliminary) for 2Q15, and a final 0.6% (revised from -0.2%) in 1Q15. Pretty assuring figures in light of what has happened in terms of price shock an and external disruptions.
Private payrolls continue to meet ebullient expectations, and jobless claims have fallen to levels not seen since 1974. The only sticking point for us and also for the FOMC remains inflation. The proverbial 2% inflation target remains unmet, but Fed officials stated on Wednesday that they believed this target would be attained as prices moderate further.
The market has probably discounted a great deal of the Fed's rate "liftoff" later this year. We expect at least one increase of 10bp in October, and possibly even in September. We feel it is not too late to be long the dollar. Technical factors such as price action and market positioning float below critical zones, giving the dollar room for further advances.
Moving on, another currency that we are bullish on is the pound sterling. Looking at macro data, the UK economy has trailed or even overtaken the U.S.'s for much of 2015. The MPC remains committed to reaching its price targets, but has hinted that the BoE might potentially raise interest rates before the Fed does.
While we do not believe that UK rates will rise before the first Fed liftoff, we remain convinced that their policies would be very much guided by those of their U.S. counterparts, as has been during the easing phases of 2009-2012. The only risk we see with our long bias towards the pound is expectations running ahead of themselves.
Local political risks are currently nonexistent, and the dying down of the Greek commotion should further bolster a higher pound. As with the U.S. dollar, expect sterling to be sensitive to key sets of economic data.
And that is pretty much all we are bullish on across the majors. In descending order, we are bearish the Kiwi dollar, Canadian dollar, Aussie dollar, euro, Swiss franc, and the yen. We are not betting that this order will hold, but as we own this note, it resonates well for us.
There are 2 central banks that are currently in outright easing mode: RBNZ (NZD) and BoC (CAD). The former has slashed its reference rate by another 25bp last week, marking the second consecutive decrease after a slew of rate hikes through the preceding years. The Bank of Canada unexpectedly cut its rates by 25bp in the middle of July, citing deflationary pressures creeping back into Canada's economy.
We expect both the RBNZ and BoC to remain accommodative at least for the third quarter. Low oil prices will not bode well for the Canadian economy, and will further pressure the central bank to stimulate prices. We believe New Zealand lags Australia in the classic economic cycle; RBA policy has remained on hold for 2 consecutive policy meetings while RBNZ policy has been eased.
Both these central banks have been advocating for their currencies to depreciate, and this has been going on for some time. Their wishes have materialized, but it is clear they still expect more. Housing prices in both these commonwealth nations remain soft, referencing to the lack of foreign buying.
Australia has obviously been negatively affected by the contagion stemming from China, and largely also from falling commodity prices. New Zealand dairy exports have fallen beyond expectations, and it clearly a concern for policy makers. Both the Aussie and Kiwi dollars have depreciated sustainably against most other currencies, even against the Canadian dollar up until recently.
One caveat we should express is that many of the prevailing trends in currencies look to be overextended in the short term. It would be prudent to take up pairs trades whilst waiting for respective corrections to go underway.
The euro is an interesting subject. There has been no Grexit, nor default on a payment. Greece has chosen to stay in the negotiating table with the troika. In short and as we put it 2 weeks ago, the can will continue to be kicked down the road. We have seen this before.
So back to the fundamentals. The ECB is very accommodative via its PSPP and negative deposit rates. €60bn in monthly purchases will weigh on the single currency, and we feel in a big way. There is no reason why we can logically be bullish the euro; the payoff is almost too good to be true.
The latest crisis in Europe saw the euro become significantly bid in the process. We were not surprised, and we actually called for that very scenario where a broadly de-risking market rushes into liquidity within the European markets.
Now that that episode has passed, normalcy should slowly return to the euro. We favor shorting the euro against the dollar, pound, and even the yen. It is not far fetched to expect the big figure of 1.1 to be broken on EURUSD. Parity may be achieved before Christmas.
On the macro economic side, the basis to long the euro are tepid at best. Earlier in the year, it became clear that Europe (Germany) was leading the pack in its recovery. That magic has since waned and you would have to look hard for any signs of improvement. Economic powerhouse Germany has been tripping over itself; PMIs have consistently missed expectations, and prices have cooled once again.
The gist how we plan to trade the euro is to gain the appropriate exposure to the short side whilst the majority of attention is focused on the materially irrelevant topic of Greece and other political shenanigans, riding on the back of the real fundamental trends which are all screaming short.
China's Bottom Might Be Close
Again, we never propose trying to catch a falling knife, or standing in front of a freighter running at full steam, however way ones wishes to caption the often painful act. However, like how we timed the bottom in crude oil back in January, it sometimes takes more than just instinct to safely nail it.
Much contradiction, one might say. Being able to safely nail such a call defies gravity of risk and reward. Skin in the game ensures that such acts of knife catching remain incredibly risky yet just as incredibly rewarding. One either catches the handle or the blade. Of course, we never do this blind folded.
Financial media has been ridden with hyperbole for the last 3 weeks. Yes, the rout in China coincided with the Greek debacle, and was fierce enough to almost make half of the Chinese retail investing scene Jurassic. It is difficult, nearly impossible to summarize the entourage through the last 2 months in Chinese stocks.
We will try our best to provide some down to earth context before going into the belly of this beast:
- Almost $4trn of wealth was vaporized from high to low across Chinese counters; enough to settle Greece's entire debt load more than 7 times over.
- Beijing scrambled so hard that it froze more than 1500 individual stocks at one point, banning trading on 93% of all stocks and preventing stock exchanges from facilitating trading.
- Up to 120 billion yuan worth of ETFs and trusts were to be purchased by brokerages to shore up flagging demand.
The list goes on but you get the point. Utter pandemonium. We suspect hundreds of thousands of misguided retail 'investors' were slaughtered in the process. A grim picture to say the least.
One thing is for sure: The Chinese government is committed to doing all it can to stem the sell off. In such a centrally planned market, it would be folly to challenge the very dictators of price discovery. And so a basis, that restraints us from being as bearish as most would be, surfaces.
Our experience with market manias and their subsequent fallouts have taught us that in these cases, the psychology of the market becomes the market's most important driving force. Just as a significantly one-sided boat would tip over, a market that hinges on extreme optimism or pessimism can tip over on a dime.
There is no dearth of anecdotes that serve to illustrate this:
- The run up to the subprime bust was predicated on most believing that prices would continue to rise, calling for a correction or a peak was taboo. We know what ensued.
- The optimism which fueled the bull run in the precious metals in 2010 to 2011 saw upside price projection that knew no limits. We also know what ensued.
- More recently in September 2014, the major correction in U.S. stocks managed to churn up enough fear amongst the trading and investing community, equities found a bottom just when peak pessimism had brainwashed the market's collective psychology. U.S. stocks then rallied harder than they crashed in what was literally a "V" shaped recovery.
- Even more recently was the bottom in global oil prices in January this year, something we touched on earlier in this note. We remembered many occasions where reputable names in investment banking and asset management were calling for ludicrous downside projections (in hindsight) in the ranks of $15-$20 per barrel. Few dared to go out on a limb to call a bottom (not is). We saw what happened next.
The question which we rhetorically ask ourselves is if China would be any different. Our baseline is that it would not. We are not calling for a reversal in prices, but rather a stabilization in momentum which should result in either a slight bounce or a ranging market.
We feel that conditions are close to ripe for the next phase of Chinese stocks. Fundamentally, there exists few reasons where we can justify this view, apart from the assumption that the Politburo will do whatever it takes to keep its markets in check.
Sentiment towards the Chinese markets has not been great. This past Monday saw one of the sharpest ever daily declines on China's main board. One would be lucky not to find a new article or stumble across commentary on the rout in China. Hardly anyone is bullish, and almost everyone expects prices to decline further.
As such, we expect to see either a deceleration in the pace of decline, or a sizable and abrupt bounce in the coming few weeks. We feel the most likely outcome is for Chinese stocks to begin trading in a range while remaining volatile on a day to day basis.