Hugh Hendry’s Eclectica Asset Management cheat sheet for the year 2016.
Eclectica Asset Management remains cautiously constructive: Our 2016 cheat sheet
Equities represent just over half of our risk allocation. We have identified a series of hand-picked stock baskets both in Europe and Japan that we believe represent profitable trades capable of capturing the upside from the prevailing macro landscape; we have written previously on the merits of such trades.
We tactically hedge against these more constructive positions given the recent reset to higher equity volatility and their periodic outperformance of the wider market. And despite the very weak start to the year for stocks our risk management and the robustness of our positions has moderated drawdowns and allowed us to selectively add risk.
However, for this letter we would like to return to the four main concerns in global macro presently and review how the other half of our risk budget is attuned to such threats. The prevailing concerns are obviously…
- China’s slowing GDP growth, which sponsors the notion of a dramatic currency devaluation to alleviate the pressure linked to slower world trade and the nation’s profound overcapacity, with the associated domestic disinflationary pressures this creates.
- Europe. It’s always Europe! Take your pick: burgeoning migrant concerns that undermine political cohesion across the region and make the system still more fragile; worries about the banking sector whose profitability wanes the more that the authorities intervene to promote economic growth; and of course the known unknowns concerning any Brexit vote.
- The oil price collapse that we discussed in the last monthly newsletter and the inevitability of significant swathes of bankruptcies.
- And finally the notion that measured in dog years the US economic expansion is old and susceptible to an inevitable recession.
Let’s attempt to address these concerns in turn by looking at our risk positioning. We believe it is possible to demonstrate that such headline grabbing Armageddon scenarios can be addressed and hedged at a very modest cost, if not profit, whilst retaining upside exposure should, as we contend, such fears prove overstated.
China
The currency tail risk in China can be alleviated by “paying” interest rates in the offshore Chinese fixed income markets where capital flight would be the most pronounced in the event of a shock. As explained at length previously, it is possible to replicate a “payer” position using two FX forwards in what is the fourth largest currency market in the world. Rates typically spike higher if concerns in China heighten against a backdrop of weaker economic growth or further unease about the domestic banking system. Furthermore, the strategy accrues a positive carry should nothing alarming happen and the return series has been typically less correlated to the fortunes of global equities than orthodox hedges such as the dollar or the US Treasury market.
Europe
A euro break up does not feature remotely in our projections nevertheless we seek to prevail should such unforeseen cataclysmic scenarios come to pass. We believe that this could potentially be achieved by taking a: long position in the 10-year Bund and shorting the equivalent Italian BTP (see Chart 1 below).
The opposite trade, where one betted on BTPs narrowing their yield differential over German rates, proved spectacularly successful when the spread narrowed from c. 600 basis points to just 90 over the period from July 2012 when Draghi pledged to do whatever it takes to save the euro until March 2014.
Since then the spread has refused to make new lows and responds well to Europe-specific flares in volatility. Today it trades around 130 basis points. And whilst it does not enjoy positive carry, the holding cost is nevertheless low as despite negative rates the German curve is almost as steep as the Italian.
As we see it, the opportunities to benefit from such a position are twofold. Today’s markets are schizophrenic with risk assets plunging on fears of events that have not yet happened (indeed we would argue are unlikely to occur), only to recover slowly as no event risk validates the prevailing thesis. With the global economy still stuck in the growth doldrums this erratic behavior is likely to persist and accordingly we find it difficult to refute the notion that the BTP/Bund spread cannot reprice to 200 basis points wide with essentially nothing going wrong in the real economy; that is to say, the market just has to maintain its paranoid belief that a dead body will “eventually” rise to the surface.
On the other hand we have to contend with the proposition that we may be wrong. Bad things might happen after all. And if anything remotely close to the China bear scenario, or a political disaster in Europe stemming from Brexit or migration issues does play out, this spread will almost certainly explode to the upside. So it arguably represents a low carry “blow up trade” with asymmetric returns: underwriting the benign scenario that the spread returns to its lows (40 basis away) whilst capturing the inevitably huge spread widening if such pressures prevail.
Eclectica Asset Management – The oil price and the end of the commodity super cycle
We wrote at length last month about our view that falling oil prices are a benefit rather than a threat for the majority of the world economy. And for several years we have studiously avoided investing in companies exposed to industrial commodities and have been circumspect in sizing equity shorts mindful of the torturous upside price volatility (short squeezes) that has made monetization of the narrative almost impossible. Instead we have favored the FX markets for expressing this theme and its most likely enduring properties. As highlighted previously we favor those Asian countries which benefit from having larger consumer sectors and little commodity exports. Typically these currencies offer attractive positive carry. On the other hand we are short those nations which can be typified as being producers of increasingly commoditized goods dependent on world trade and vulnerable to a slowing China and its desire to capture more of the value chain. Typically these creditor nations already have low interest rates and seem likely to need further currency weakness if they are to defend their competitiveness.
Eclectica Asset Management – The rate of living theory and an enduring US economic recovery
The biologist Max Rubner first postulated back in 1908 that the faster an organism’s metabolism, the shorter its lifespan. This seems an important insight when considering the likely path of the US economy. The National Bureau of Economic Research defines eleven business cycles since 1945 to 2009, with the average expansion lasting just over five and a half years. Worryingly therefore, this expansion when measured using the NBER’s dog-life methodology is exceedingly long in the tooth. But of course this expansion has always seemed atypical with the differentiating factor of the private sector having deleveraged during the upcycle.
What if the hyper but short lived shrew like performance of previous US expansions has metamorphosed into the slothful giant tortoise that can live for 150 years? We think there may be life left in the old dear yet.
And this explains our inactivity in G7 government bonds. Price levels appear very unexciting in Europe and Japan where you probably need a lot of really bad things to happen to make money from here.
US fixed income markets would optically seem to offer more value given the large spread to other developed markets but we remain unconvinced. We have previously commented on the notion of a Chinese growth tax, whereby its insatiable appetite for commodity heavy economic expansion drove the super-cycle and persistently led to western headline inflation rates greater than core and by implication tighter monetary policy than was warranted. Today the opposite is the case: despite the ghoulish fascination with the decline in the oil price which is causing low headline inflation rates everywhere, a broader review of US inflation numbers suggests that there isn’t a lot of slack left. US consumer prices are already above 2% for first time since 2012, excluding energy, and services inflation has pushed on 3% for first time since 2008; wages are slowly starting to pick up. Essentially, therefore, it seems that you need a recession to appear to make money in US fixed income markets. And whilst we cannot rule this scenario out, with our predilection for giant tortoises we fail to find the current risk-reward proposition compelling.
Eclectica Asset Management – Where to play lower rates for longer
On the other hand, Mexican inflation recently dropped to all-time lows (2.1% year-on-year headline and 2.4% core), below the central bank target of 3%; again, as the “Chinese growth tax” unwinds, headline inflation tumbles everywhere. As a result real rates are high, and thanks to a steep yield curve with a large inflation premium baked in from the market’s memory of previous tequila crises, the carry is attractive. And whilst we are conscious of the maxim that EM rates should always be high given the risk of investing there, Mexican five-year rates at 5% look high compared with Thailand (with half the per capita GDP) where five-year rates are below 2% and Romania which has five-year rates of 2.7%!
Recent events come on the back of a period of profound Mexican peso weakness; indeed since the end of November the peso has been one of the worst performing currencies in the world. In a curious sort of way the cause of these recent problems seems analogous to those of the renminbi, in that too many speculators were lured in by an attractive, high carry fixed income market. But whereas in China this mostly manifested itself in corporate behaviour, in Mexico it was a different set of participants: overseas fixed income investors. Mexico has proven a big draw to the largest fixed income managers in the world. As G7 rates tumbled to zero the steep yield curve in Mexico proved one of the few credible places left to receive rates and allied to encouraging set of reforms of the political economy it seems that some investors neglected to hedge their currency exposure which left them exposed when the petrol-peso was dragged down by the tumbling oil price. And we cannot understate the size and influence of these players on marginal pricing: although Mexico has a low-ish debt-to-GDP ratio of c. 33%, perhaps 60% of that is in foreign hands and so the stock of debt held by overseas investors is around 24% of GDP; the flow from a significant number of these debt holders scrambling to hedge (or get out) seems to have been enough to exacerbate the sell-off.
And then in February they posted a poor inflation print that moved the core rate to 2.6%, raising fears that the weak peso was indeed starting to infiltrate the price series. We think to comprehend what happened next you have to appreciate just how incentivised the authorities are to tame inflation. Austerity seems logical when there is the carrot of lowering 6% nominal 10-year rates and allowing the domestic economy to refinance and reset at lower rates. The finance ministry seems determined to succeed. And so they came out all guns blazing. They hiked rates 50 basis points, on top of the recent increase of 25 basis points when they followed the Fed. They also hugely intervened in the currency and ended the old limited currency auctions.
The market’s reaction has been rather curmudgeonly. To some, the country has gone from a credible reforming sovereign play to one caught up in a 1998 Asian crisis like scenario where the level of the peso determines the tightness of monetary policy with the domestic economy punished by the consequences. Time will tell, but for now, we are again at odds with consensus opinion. Mexico still appears a very good source of receiving carry. If we are right then by some point international fixed income managers will have hedged their exposure making the system less brittle and with a credible austerity-driven finance ministry and the tantalising prospect that the oil price is stabilizing, Mexican fixed income would become yet more appealing.
Eclectica Asset Management – Hard hats and sunglasses
To conclude, our current views can be broadly summarised as follows. We are cautiously constructive risk assets through positions in equities, mostly in Europe and Japan. However, we note that there are a lot of things one might be concerned about in the world today, and whilst we disagree with some of the more apocalyptic commentary found in financial circles today, we cannot ignore the possibility we might be wrong. As such we have sought to find asymmetric macro hedges against these outcomes which shouldn’t cost too much if our base case proves correct, but can potentially provide outsized returns in the event that bad things do come to pass.
Hugh Hendry, Tom Roderick, George Lee
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