With summer over, the work begins
(This is the final part of our weekend blotter, please find thefirst part here.)
Some Key Questions for the next couple of months
Firstly, with Chinese equities underperforming the SPX by 25% this year, are additional tariffs in the price for Chinese stocks? The weakness of Chinese equity is even more pronounced given the blatant efforts by Beijing to stabilize the economy through a monetary, targeted fiscal, and currency stimulus, via a lower trade weighted RMB. It is impossible to get inside mind of the Chinese retail investor, who dominates price movements, but I am convinced that China offers significant longer-term value and the risk v reward of being underweight Chinese equities is poor indeed.
Secondly; Is there any alpha to be generated outside of emerging markets? While I am not in the camp that US equities are expensive, I get the impression that the search for equity alpha is a difficult one and that exposure is more about beta than smart, idiosyncratic stock ideas. The Russell looks fairly valued but where are the strong single stock recommendations that are getting equity investors excited?
The Russell looks fairly valued but where are the strong single stock recommendations that are getting equity investors excited? Emerging markets are clearly cheap, but valuation is irrelevant until sentiment stabilizes. This is the key mistake that I have made when I bought EM, especially China into weakness over the last several months. On a 2-3-year view, I believe this approach will work. Relevant for the family offices amongst you. Useless for shorter duration investors.
Thirdly, when, or do, the broader markets start to focus on Brexit or Italy? I suspect that even hard Brexit isn’t going to derail global equity and credit from the pre-determined path. Play Brexit via short the GBP against everything, long FTSE volatility and long UK Gilts. A negative outcome regarding the Italian budget would be a beta event and a widening of Italian spreads would be enough to knock US 10-year yields outside of 2.80% - 3.10% range that has prevailed, effectively since January.
Finally, do markets care about the US mid-term elections? It seems inevitable that the US House of Representatives will return to Democrat hands. The question only seems to be he margin of victory. While the Senate is numerically much more difficult, a “blue wave” / large anti-Trump swing could well see safe Republican Senate seats fall to the Democrats. Why does this matter? The impeachment of President Trump would be on the agenda, Supreme Court appointments would stall and the pro-business agenda of President Trump, a key reason for equity strength over the past 22 months, would fade. Regardless of the eventual outcome, US asset volatility will rise over the next several months.
The conclusion I would make is that volatility must rise over the next several months. This should start in September given a lack of corporate announcements to reinforce the narrative about the strength of corporate profitability. While US stocks aren’t expensive, an absence of catalyst driven buying should be the rationale for lower equity prices during the months as the geo-political events I have outline above, dominate the narrative.
How are we preparing for all this?
Over the course of the last week, we executed the following trades for the thematic model portfolio:
- Sold GBPJPY @ 145.00. Short GBP due to Brexit debacle. Long JPY as global volatility picks up. Very straightforward rationale.
- Bought December puts of SPX, FTSE and NKY on a hedged basis. Again, a means of expressing a volatility pick up.
- Sold a small amount of December EM currency volatility. INR, IDR, MXN, BRL, ZAR at exorbitant levels. Dramatically reduces the cost of long DM equity volatility.
These new tactical positions are designed to take advantage of any re-calibration of volatility for any or all of the reasons outlined in this report. I find it difficult, given all the event risk that we have for the balance of 2018, that the VIX does spike north of 20 for at least a period. That said, it is vital that you take profits of long volatility strategies when the opportunity arises. Knowing when to liquidate long volatility positions is so important. Have a plan and stick to it.
This week will be a quiet one with the US Labor Day holiday marking the official end of summer. The RBA, Bank of Canada, and Swedish Riksbank will meet this week. Mark Carney in front of the UK Parliament with the key question being whether he plans to stay on for another year. Argentina and Turkey will be front and center.
On Monday, a PMI’s around the world are released. On Tuesday South Korea prints GDP and CPI, and the US and Canada release manufacturing PMI. Australian GDP on Wednesday. US Durable Goods Orders on Thursday. On Friday, Germany Industrial Production, the EU GDP, and the monthly US payroll report.