Will all these idiosyncratic risks lead to beta selling?
This is an excerpt from our flagship report published on June 5th
Does the concept of “death by a thousand cuts” apply to public market investing? While your morning reading is made up of numerous small stories affecting different parts of the investing universe, is it the aggregate total of these events or is it just one event that is the key driver? The financial media loves to boil down the days’ price action into succinct narratives that often assigns too much importance to one, over-riding headline. Different markets are driven by different news stories, but dominance of algorithmic investing means that there can be a” beta” element across equities, credit, sovereign fixed income, and emerging markets. Even certain commodity markets, for all their nuances, can be bought and sold on the back of broad global narratives. Were rig counts or the US employment data more important in determining the price action for oil for a given first Friday of the month? Often, it depends on who is writing the story.
When looking at a headline and determining its relevance, I ask myself the following question: Will this news item effect the outlook for US growth, profits, inflation, corporate defaults or the Federal Reserve? An article about Turkey’s economic woes will be bad for Turkish assets, but is it really going to stop a fund manager in St. Louis from buying Amazon? The answer to that question, 99% of the time is No, so negative emerging market headlines can generally be ignored by US or European centric investors.
Stories that directly affect US stocks are more important for global beta than those in Europe, China, Japan or emerging markets. US economic data will move asset markets around the globe as Friday’s strong payroll release exemplified. Fears over Chinese financial stability or concerns about Euro sustainability have upended markets at different stages in the past eight years but the impact has proven temporary because they were unable to knock the US economy off its prevailing economic path. If the US economy is strong and profits are good, foreign struggles are ignored.
At the end of the day, US stocks and US treasuries are the two most important drivers of all asset markets around the globe. While there are local factors in Europe, China, and all parts of EM that determine whether these markets will outperform or under perform the SPX, the reality is that it is very difficult for global risk assets to rally when US stocks are in a bear market and while foreign markets have produced negative returns in times of US strength, they tend to find a floor when US assets are in favor.
The Noise Co-efficient
I have spoken at length about the “Noise Co-efficient”, the level of distraction that investors face daily that are the headlines that, big picture, really don’t matter to the long-term performance of a broad, diversified portfolio. Much of the noise is geo-political and as much as I want you to care about this as much as I do, often discussions of trade wars, denuclearization, election meddling, the rise of populist governments and conflicts between regional rivals, don’t drive financial assets as much as an economic release or the guidance by Apple. It just is what it is.
Let me put it slightly differently. Global investors have become really good at ignoring those factors that just don’t matter to their portfolios. Does the likely election of a leftist President in Mexico lead to a structural change in the earnings outlook for Facebook? Clearly not but investors are looking at traditional “macro” sectors such as financials and making even more sophisticated assumptions about events in other parts of the world. Just because JP Morgan has exposure in Turkey doesn’t mean an earnings disappointment is coming. Investors are able to see the forest for the trees and instead of panicking on the back of negative stories, they are more prone to wait, patiently, assess whether or not the medium-term outlook for growth or profits has altered, and respond. Investors are much more discerning when considering contagion risk.
So, the fact that Turkey is heading towards an eventual currency crisis because of an authoritarian president who doesn’t appreciate basic economics, is not going to alter the path for US and therefore global assets for the balance of the year and beyond.
Trade rhetoric? Big picture it isn’t a big deal (but more later).
An assumed AMLO victory in the Mexican election? His policies are not as market friendly as many would like but even if Mexico faces some economic pressures, is it really going to derail Asian growth? Highly unlikely. Throw in NAFTA concerns? Probably the same result.
The point I am making is that a series of idiosyncratic risks in smaller economies is not going to alter the trajectory for US assets. Growth, profits, valuations inflation and Federal Reserve trajectory are what matters to US investors and while all this remains in solid shape, the aggregate picture will not change. Events in small economies won’t drive global beta regardless of how dire they become. In my humble opinion, the days of small emerging market economies upending other emerging market economies are over.
Problems in small markets don’t matter, but big markets threats do
Now, before my emerging markets clients pick up the phone to cancel their View from the Peak subscription, this is not me downplaying the extraordinary investment opportunities that existing in the emerging world or scuttling the idea that the average investor needs more EM exposure. The reality is, that as we stand today, global investors don’t have a lot of exposure to the likes of Turkey or Mexico, so therefore problems in those markets have negligible consequences on a broad global portfolio. Combine this with the notion that investors believe less in the ideas of contagion, and the results are that the majority of long duration, endowment / pension style investors are not that concerned about issues in emerging markets.
All that said, major problems, especially financial dislocations in large economies do matter. Specially, threats of financial instability in Europe and China will have an impact on global beta. It is simply about the sheer size and scale of both economies, the opaqueness and leverage in the Chinese economy and breadth of asset exposure that the generic investor has in Europe. While it makes for an alarmist headline, the fact that a fixed income legend like Bill Gross can have one of the worst days of his career due to the flow on effects of Italian bond liquidation is testament to the impact that concerns about the Italian economy and worries about Euro sustainability can have on global rates markets.
I am not saying for a moment that last week’s price action in Italy had to do with a true threat to the sustainability of the common currency. While many European economies still have structural hurdles to overcome, the Euro is a political institution as much as an economic one and the chances of Italy leaving the Euro at any stage are very slim indeed. The point I am making is that the size and scale of European financial markets force all global investors to think carefully and react to changes in the growth and stability outlook because their portfolio can face sizable losses should the situation deteriorate significantly. Those losses don’t exist due to specific emerging markets and therefore, no response is required.
Trade concerns are for pundits not investors
Thursday, May 31st was tit-for-tat tariff day. Mexico retaliated to the announcement that the US would implement steel and aluminum tariffs under national security grounds. The Canadians also hit back with comparable tariffs, delivered by Canadian Prime Minister Justin Trudeau in both English and French to make sure that everyone got the message. The Europeans look like slapping tariffs on jeans, bourbon, and motor cycles. If that doesn’t go to the heart of America, I’m not sure what does.
Does any of this matter?
While the naysayers will say this is the start of a trade war, the numbers involved are tiny and despite a small sell-off in US equities on Thursday, does anyone truly believe that these measures are going to lead to any adjustment in the growth and profits outlook for either the US or the aggrieved parties around the globe? For me, it remains a red herring; financial click bait that may move markets for a session or two but does very little to change the medium-term outlook.
Near term, Negative headlines regarding trade or Italy or Turkey or Washington dysfunction will not matter while US growth remains solid. The strength of Q2 activity may prove temporary but it has certainly provided cover for all the policy and geopolitical distractions that roil markets for a few hours before logical investors realize that they are not going to affect the true drivers of risk assets, growth and profits.
Contagion has never been more meaningless. I am not being dismissive of the negative consequences of true systemic risks, but financial markets have become really efficient / discerning when judging whether an event matters for a specific asset. Financials are a good example. Banks weren’t sold on Tuesday on the back of exposure to Italy. They were sold because bond yields collapsed around the globe. Why did yields collapse? The widening of Italian spreads will be given as the fundamental rationale, but the true reason was that the speculative community was simply too exposed to short interest rate strategies.
The Turkish Lira is a fascinating study in risk reduction. As I outlined above, Turkey is a disaster and if near term Italian risk where truly as extreme as market volatility led us to believe, that should not bode well for Turkish assets. But what happened? The Lira RALLIED on the back of risk reduction; value at risk related selling, driven more by risk managers than fundamental analysis. This is one of those instances where positioning and risk appetite drove the narrative of Italian political disfunction to appear much worse than it actually was in the near term. It is going to get much worse, just not yet.