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.
[drizzle]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.
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.
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.