The Noise Coefficient versus Long Term Fundamentals
(This is an excerpt from last week's flagship report)
As much as we try, research firms cannot be all things to all people. We have clients with different investment timelines and as such, what a hedge fund looks at is different from an endowment. It all boils down to factors such as risk management parameters, capital lock-ups and tolerance for drawdowns / volatility. There are effectively short-term narratives, longer term narratives, and noise, and those who are successful, regardless of their investment duration are those who can weight each of these accordingly, work out exactly which is dominant at any given time and act. View from the Peak tries to provide you with a mix of tactical themes and longer-term drivers, but I appreciate that very few of you care about the whole lot. That is why each meeting is so different and there is no one size fits all approach to research.
The “Noise Co-efficient” is how I describe all the irrelevant news that is distracting investors from focusing on the true fundamental drivers of asset returns, regardless of their investment timeframe. At the core, this is the outlook for economic growth and corporate profitability. Noise comes and goes but it can often hijack the underlying narrative. Geopolitical risks have consistently been responsible for sharp, violent equity corrections only for markets to snap back when investors realize that a particular event is going to have no impact on global growth, corporate or consumer sentiment and therefore profitability. Noise changes the near-term valuation for assets while rarely changing the outlook for profits or cash flows. Time and time again, noise creates buying opportunities in risk assets by making them somewhat cheaper versus the prevailing fundamentals.
Now, determining what is noise is the true art form. Noise can morph into a market driving thematic and it is this transition that turns a buying dip mentality into a flawed strategy. Being negative about global trade at the start of the Trump Presidency was a great example of this. Time and again in 2017, President Trump would create negative headlines via twitter with comments about unfair trade practices from say China or Mexico which would create a firestorm over the course of a day or so. However, markets quickly rebounded because it was nothing more than talk.
So, throughout the course of 2017, a company like Boeing saw some short term selling pressure but quickly recalibrated as investors focused solely on the tremendous profit outlook. However, on March 20th, as the threat of US tariffs on Chinese goods became a reality, Boeing’s stock peaked as the threats of a trade war evolved from noise to a growing reality. Appreciating the nuance of when noise becomes a theme unto itself is vital to alpha generation.
The Noise Coefficient is currently elevated and distracting many investors from, what I feel, is a tremendous longer-term outlook for risky assets, especially in the emerging world. Now, many of you may disagree with my view on inflation, the outlook for interest rates, the length of the global upswing etc, but I think we can all agree that there are multiple cross currents that are distracting from whatever fundamental framework you are using. Folks are challenging the sustainability of the synchronized global upswing and making arguments for higher rates. I may disagree but we all have the following in common:
Determining what is noise and what is fact is vital to alpha generation. Stripping out the irrelevant from the true driver of asset prices is our primary goal.
The following is a list of factors that will keep the Noise Coefficient high throughout the summer. Some of these have the potential to evolve into themes that can affect growth and sentiment, but the majority are probably nothing more than distractions that will provide opportunities for investors with an investment duration long enough to deal with small drawdowns if they eventuate.
US / China trade relations
While there isn’t a lot new to add here, the headline shocks will diminish over time. I suspect there are two more damning headlines to come. Firstly, when President Trump announces the $100bn of additional tariffs on Chinese goods, taking the total to $150bn. The second and likely final will be China’s retaliation, likely to be equal to anything measures taken by the US. Now, this is more than the $135bn of total US Exports to China which is symbolic, but I suspect this should see cooler heads prevail. The reason why I believe this is as follows. With Chinese tariffs covering, at least on USD terms, a wide range of US imports into China, the only realistic alternatives for China in regard to escalation would be; a) US investment into China, b) US investment currently in China, and c) US Treasuries. US investment into China is already greatly restricted and while the Committee on Foreign Investment (CFIUS) has effectively shut down all inward Chinese investment of any consequence, the chances of China easing restrictions any time soon are basically zero. US treasuries are the nuclear option for the Chinese and probably off the table because no one wins.
This leaves domestic investment in China, i.e. the targeting of Apple and Starbucks to name a few. Apple looks particularly vulnerable. With ZTE being banned from importing US components and Huawei likely to see the US Justice Department take a similar hard line, any escalation by the United States must put not only iPhone sales in China under threat, but also the entire Apple supply chain. President Trump and his team must be concerned about this because of the inevitable impacts that this would have on the SPX. As we are aware, President Trump believes that the stock market is a score card on his presidency and pressure on Apple’s share price would be a concern. Therefore, I do believe that the US is not going to push China a point where they start targeting large cap US companies directly.
Again, a lot of noise surrounding trade, but I am convinced that both sides will eventually negotiate a face-saving settlement. Timing? It would take months and therefore the headline risk will fade over time.
Chinese military expansion in Asia
The one geo-political factor that has the potential to elevate over the course few months is the narrative about China flexing its muscles militarily. It is no coincidence that the weaponization of the Spratly Islands, the disputed territory in the South China Sea, has come within days of the détente between North and South Korea and within weeks of a proposed trip by new National Security Advisor, John Bolton to Taiwan in June. A visit by Mr. Bolton, a long time China hawk and Taiwan advocate, would infuriate the Chinese, who now have to deal with the prospect of US troops on near its Northern border without the buffer of the “formerly” nuclear ambitious Kim Jong Un. This story is only just developing and will create volatility, especially if there is a naval skirmish between the US and China, but like most geo-political conflicts, it should create buying opportunities. I am currently discounting the outlook for China using force to reunify with Taiwan at zero for the foreseeable future.
North Korea nuclear talks
This is an undeniable positive for the region except for what I mention above regarding China flexing its muscles in the region. It is impossible to predict whether any deal will hold because we have seen the North Korean’s come to the bargaining table before, only to see them go back on their word. While this outreach appears more sincere, the long term outcome is impossible to predict. The news flow should be positive for at least the next few months. The meeting between President Trump and Kin Jong Un will be a circus but that is fine because near term, the symbolism is as important as the discussions themselves. It is difficult to see how the meeting goes badly which implies that we spend the balance of the year with this issue off the radar screen as the negotiators do their work.
In my humble opinion, much of the rally in the oil price in 2018 has been driven by the prospect of President Trump ripping up the Iran nuclear deal and the re-imposition of sanctions on Iranian oil exports. With Venezuelan oil productions spiralling towards irrelevance and global crude demand remaining robust, the oil markets will find it difficult to absorb the loss of some, if not all, the 4.4mm barrels of Iranian production without the potential for sharply higher prices. Higher oil prices as we head into the US driving season is something President Trump has wailed against, yet it can be argued that much of this is of his doing.
May 12th is the date when the White House has said it will makes its decision on the prevailing agreement. With the Israelis demanding action and long-time detractors of the deal John Bolton and Mike Pompeo taking senior foreign policy roles, it is difficult to see how the deal is not altered in some way. The President also must feel emboldened by the success of his North Korean strategy and this should imply that some Iranian crude is coming off the market.
What is the impact on oil prices? I suspect that this lost production is somewhat in the price. I am certainly less bullish on crude prices than many of my peers because I still remain convinced that US Shale production has room to grow. Not enough to cover the loss of up to 4% of global supply, but I do believe that investors are underestimating the prospect of increased US production. Given that Iranian sanctions will have a direct impact on oil supply, this is not noise, but a true narrative that must be observed.
Technology regulation and the implementation of GDPR
This theme will be with us for several years to come. While some complications could occur with the implementation of the GDPR later this month, the negative headlines regarding the regulation of mega-cap technology companies probably peaked with Mark Zuckerberg’s theatrical appearance in from of the US Congress. There is little on the horizon that will distract investors away from their focus on earnings which have been stellar of late. Have we reached peak Facebook? I think so and while profits will remain robust, multiple expansion has probably come to an end as the scepticism over the model longer term remains
Pressure on the Argentinian Peso
Having followed emerging markets for the past two decades, I can make one clear observation. Contagion amongst emerging market economies is much less than it once was, and EM investors now calmly assess the idiosyncrasies of each economy, especially in times of crisis. Argentina has its own set of unique problems, concerns that are simply not applicable to the likes of Brazil, Mexico and especially Asia. While the speed of this crisis has taken most of us by surprise, the assumption that a potential devaluation of the Peso will spread to the rest of the emerging world is flawed.
Recent USD strength has spooked some emerging market types who are naively taking a 1998 framework and placing it on emerging markets, that are simply in a new paradigm. They are much less reliant on USD funding, more consumption driven, and less dependent on global exports and their foreign exchange positions, especially in Asia are much more secure. Throw in the mix that equity valuations are cheap with the MSCI EM trading at 12 times forward and the prospect of Argentina leading to global contagion is remote.
Argentina will create an incredible buying opportunity for both emerging market currencies and equities should markets get spooked in the next week or so.
The Mueller Investigation
I have no idea when his findings will be announced or what they will say, but my base case is that it will not be good. I am not in the impeachment camp and frankly think it would be politically damaging for Democrats to go down this route in 2019. That said, bad news for the President is coming and with it, a 5%-7% correction in the SPX.
You cannot time this. You cannot pre-empt this. Buying puts to hedge yourself is sub-optimal because we have no clue on the timing. This is the ultimate noise and unfortunately, risk adjusted returns will suffer because of this and there is little you can do about it. That said, like all things related to President Trump, Washington dysfunction appears to have little impact on the trajectory of US activity or Fed policy and as such, this should be used to add risk in those companies, credits and markets that you like.
General President Trump Shenanigans
Pretty much as above, but I would like to add one point. I believe that you can clearly define two distinct periods for the Trump administration. 2017 was market friendly (tax cuts and deregulations). 2018 is not market friendly (Tariffs, oil sanctions, deficits and immigration). While the President’s tweets should be treated as noise, do not lose sight of the fact that policy has shifted negative.
Regardless of your views, positive or negative, do not be fooled into changing your stance based on off the cuff remarks or twitter tirades. President Trump is noise personified.
My negativity towards the UK over Brexit has been, by far, our worst strategy in the past 2 years. I have messed this up and the fact that we were stopped out of short GBPUSD trades within 2 days of a two year high before a 5% correction is testament that I needed to give up on this. That said, UK politics remains a mess and headline risks remain. The resignation of the Home Secretary Amber Rudd shows how tenuous the whole situation is. Bad headlines will continue to emerge.
UK assets do remain strongly tied to both the fortunes of the USD and the outlook for US rates. While the model portfolio remains long UK fixed income (10 year segment), I appreciate that this has less to do with the economic fortunes of the UK and more on global rates and Fed policy.
(Next week we will publish the second half of this report, where Paul discusses what does matter.)
Founder, View from the Peak
IND-X Advisors Limited