Calm Before the Storm

It was almost impossible for investors to lose money in the first half of 2014. Take your pick of any asset class at the turn of the year and you would almost certainly be in the black. The UBS index tracking 21 commodities has shown a total return of 7.1%. Long dated US Treasuries were a great bet returning 13% year to date despite the bearishness on long term bonds at the start of the year, whilst European periphery yields have fallen almost below US Treasuries. The S&P is up 7% so far continuing its stellar performance from 2013. Furthermore the CBOE Vix Volatility index, which is Wall Street’s so called “fear gauge” (using option prices to asses market volatility) has fallen below 11 indicating a market fearlessness. All this on the backdrop of continuing geopolitical tensions, European political and deflationary risks, expectations of a run on fixed income, China liquidity and growth concerns, a UK housing bubble and US stock bubble. I find it extremely hard to justify these returns and cannot see them continuing for the rest of the year. The BIS claim markets are ‘euphoric’ due to ultra loose monetary policy whereby liquidity rather than fundamentals is driving returns. Either way, I believe it will become increasingly important for fund managers to pick winners for the rest of the year. Below I focus on five areas where risks are being overlooked and threaten to destabilise the markets.

Geopolitical Risk

The most obvious place to start is geopolitical risks, which seem to be bubbling up ever more in the last few months. Despite the developments in Ukraine, the Russian Rouble is actually one of the best performing currencies in the last few months. That was until yesterday when Mr Poroshenko said, “we will advance and free our land” after the ceasefire was broken, sending the Rouble down 0.6%. ISIS insurgents in Syria and Iraq continue to advance towards Bagdad and at the time of writing had taken over Abu Kamal on the Syrian border, having previously declared the region held as a caliphate. A lack of Western intervention in Syria now leaves the West with the impossible choice between Asad and ISIS.  Islamic Extremism continues in Northern Nigeria and in Pakistan where the government are trying to flush out the Taliban. A Libyan civil war continues, hope for Palestian-Israeli talks hit a wall as teenagers died on either side and tensions with the new Egyptian president and the West reached a toll after the increasingly authoritarian General Sisi delivered harsh sentences to two pro-Muslim Brotherhood journalists. This follows the death sentences handed down to 182 Muslim Brotherhood supporters last month. 

The surprising common feature to most of the tensions is the market calm as if ultra loose monetary policy trumps all geopolitical risks. Oil barely touched $115 before falling back towards $110 after a pause in the Iraqi insurgency, as commentators believe ISIS are still very far away from damaging exports. Although the Rouble and MICEX suffered from Western sanctions, they were far too quick to recover following the brief ceasefire. The market optimism is staggering and it is hard to believe that all of these conflicts will fade away into the dust without damaging either commodity prices, emerging markets or even developed markets in the case of sanctions and commodity importers. All this before even considering the potential of a Black Swan sending this sectarian violence into full scale international conflicts. Building portfolios for the rest of 2014 will have to account for these potentially explosive collisions in the East and take the astonishing market optimism with a pinch of salt.

European Risks

Europe faces both political and economic risks. A rise Euroscepticicsm led to a damaging European parliamentary elections for the main national parties whilst a recent embarrassment for Cameron on the appointment of the Commission President, Jean-Claude Juncker, lead to the alienation of the UK worsening the prospect for the 2017 referendum. Along with a Scottish referendum later this year and tensions bubbling over in Catalonia, the future of the European Union has been thrown into doubt.

Economically, the EU still suffers high government debt, staggering youth unemployment, double-digit total unemployment and diverging economies at its very core. Diverging economies makes policy responses that much harder. France’s stagnating economy is filled with alienated voters and is in dire need of labour market reforms. Spain is faring better although still has a 25% unemployment rate whilst Germany seems to be leading the way with more optimistic data releases. The key issue in the Eurozone however is low inflation and policy responses. Eurozone inflation was unchanged at 0.5% this month well below its 2% target despite a negative deposit rate and new LTROs. Fittingly, yields have progressively fallen across Europe. Germany sits at a low of 1.29% and France at 1.76% whilst Italy’s and Spain’s ten year government bonds yield 2.93% and 2.64% respectively closing in on the US which stands at 2.63%. Even Irish yields sit below 3%.

The falling spreads between peripheral Europe and the US partly reflect economic outlook and diverging policy. The US is currently tapering off its QE and the UK is expecting a rate rise in the near future whilst a strong euro and threat of deflation has lead the ECB to expansionary monetary policy and the potential for its own form of QE. That said, these yields seem to be mispricing the inherent default risk in these countries. Low DM rates, high liquidity and high inflation in EM have lead the search for yield to Europe. Investors are betting on EU QE and a smooth recovery.  Yet Greek debt and Italian debt still stand at 175% and 132% of GDP respectively to name a couple. To give an example of the risk-off attitude, in April, Greece raised 3 billion euros after a five-year bond sale attracted 20 billion in orders leading to yields of 4.95%.

Investors know and understand these risk but excess liquidity is pushing yields down regardless. A change in sentiment is not the only inherent risk here but also low yields encouraging governments and corporates to scramble for debt can ironically amplify the debt crisis further.

 

Bubbles

A London housing bubble continues to threaten the UK’s recovery and has most recently been addressed by new powers handed down to the Bank of England. A bigger concern is the much-debated US stock bubble.  The 12 month forward p/e ratio stands at 15.6 compared to a 10 year average of 13.8. More striking is the Shiller p/e ratio (that compares prices to 10 years of profits) which is at levels only seen before the 1929 and dotcom crashes. Gains in US stock markets have been evenly distributed which is indicative of global liquidity rather than fundamentals driving prices. Despite the S&P at record highs the US economy shrank at an annualised 2.9% in the first quarter mainly due to bad weather. The concern however is if the market is attributing too much of the decline to bad weather and overestimating the size of the US recovery. If revenues and earnings do not rise in line with predictions we will surely see a large correction at some point. 

Even if 2014 returns are justified, it is unlikely this broad based rise will continue as US liquidity is reduced (especially if it is not replaced by Eurozone QE). It will be much more important to pick winners in the second half of the year which is all the harder when most stocks seem expensive.

Fixed Income & Commodities

The biggest surprise so far this year is the gains made on US 10 year Treasuries. Consensus was to avoid long dated US bonds at the start of the year as the Fed taper off their asset purchases. However long term yields have managed to stay low. The question on investors' lips is whether the second half of the year will bring lower bond prices (and higher yields) as the US finishes its taper and begins to think about rate rises. Intuition says losses are afoot as the US tightens but it is becomingly increasingly apparent that there is a disconnect between monetary policy and US Treasuries. Fed demand for Treasuries has been replaced some way or another thanks to geopolitical risk, emerging market sell offs and matching of long term liabilities at pension funds. Taking a step further, if you believe Dooley, Garber and Folkerts that the world still follows a Bretton-Woods system whereby periphery countries (such as Asia) are happy to underwrite US deficits to focus on export orientated growth then US bond yields may stay low for the foreseeable future as these countries target US capital.

As for tapering on emerging markets, focus will eventually be shifted back to the Fragile Five (India, Indonesia, South Africa, Turkey and Brazil) who have been rewarded since the summer sell off last year for improving their current accounts and productivity. Indonesia had gained a lot of ground thanks to a big step towards a current account surplus as well as optimism regarding the leading candidate and reformist Joko Widodo in the elections. That said, the country still suffers from high inflation and the nationalist Prabowo Subianto is narrowing the gap in the polls. High inflation reducing real rates of return and current account deficits may lead to capital outflows as global rates rise and the US reduces liquidity. Turkey seems most a risk having recently reduced their interest rate by 0.75% to 8.75% with the independence of the central bank being thrown into question. India has made huge gains since Modi’s win in the national elections but could face capital outflows if his reforms do not begin to meet expectations. The big issue facing fixed income markets is a run could cause a collapse in prices. ETFs with illiquid assets are eligible for daily redemptions and regulation in banking has reduced market making in these industries. Investors heading for the exits could cause huge panic and massive capital losses; hence the talk of imposing exit fees on fixed income funds.

As for commodities, gold is up 6.4% since the start of June due to geopolitical tensions, US inflation expectations and a weaker dollar. Copper shot up after concerns regarding Chinese financing deals faded and platinum saw some gains after the South African strike ended. Commodities are a real opportunity for the remainder of the year as their correlation (and general downward trend) from last year is broken down and investors can focus more on how supply and demand will be affected by these geopolitical risks.

Currency

Logic and reality do not always meet eye to eye when it comes to currency. The most recent bet is to be long the pound given the recent hawkishness of Carney and a strong UK PMI release. Sterling reached a six-year high yesterday. Expectations of rate rises this year have lead to a surge in short sterling contracts (i.e. bets on rate rises). That said, a week later the governor of the Bank of England released a dovish tone explaining rates will not rise unless wages advance. Perhaps he is trying to inject some unpredictability into the central bank to pop the housing bubble (in stark contrast to forward guidance). Either way, the UK is looking most likely to be the first to tighten hence the currency gains. That said, the pound trade is already looking overcrowded especially given the mixed signals from the central bank.

The Euro, whose strength was continuing to threaten a Eurozone recovery, was expected to fall dramatically after the ECB introduced expansionary measures. That said, the fall in the euro-dollar has almost been entirely wiped out due to poor first quarter results in the US  (weaker dollar) and reduced likelihood of QE in the Eurozone. It seems intuitive to believe that as policy diverges in the US and Europe that the dollar will strengthen against the Euro but this logic has been proved wrong again and again.

As for China, the recent depreciation of the Renminbi was a shock to all. The easiest trade last year was a carry trade in low yielding currencies, such as the Yen, to the Renminbi. Gains due to interest rate differentials were amplified by the appreciating Renminbi. The source of the depreciation is key to understanding the direction of the currency for the rest of year. It could be that the fall is market related. China is suffering from sliding house prices and slackening investment. Overcapacity in old-fashioned industries, dangerously high local government debt and a clamp down on corruption may be sending billions of dollars of capital out. More likely however is that is was a manoeuvre by officials to prevent a one way bet on the currency as they attempt to liberalise. After all labour costs are much more important in determining overall costs rather than a slight depreciation, China is still a large importer of inputs and officials would prefer to move up the value added chain boosting domestic demand rather than export orientated growth. Furthermore, growth was 7.4% is Q1 against the target of 7.5% and a Chinese liquidity crunch has been tackled by mini stimulus packages. Recent PMI data also shows expansions in manufacturing, all providing optimism that China’s growth run is not over yet. Strong data in China also benefits Australia and Canada. In fact a new carry trade from the US to Australia has been a big winner this year. The Australian and New Zealand dollar have gained 5.7% and 6.8% against the dollar respectively this year.

Conclusion

Investors and fund managers know and are concerned by these risks. Yet global liquidity, as the BIS argue, is driving returns. Broad based rises across all sectors and asset classes will surely have to end at some point this year, especially if the US finishes its taper and UK raises its base rate. It is time for fund managers to start earning their money…