The Great Rotation

Since Donald Trump was elected president, US 10 year treasury bonds have sold-off drastically, pushing yields from 1.7-1.8% to currently 2.5-2.6%. Is this finally the start of “The Great Rotation” from bonds to equities? It almost feels like the boy who cried wolf here, given that people have been clamouring about the end of the bond market for, well, forever!

While I’ve certainly been on the bear camp for U.S. treasuries for far too long, the evidence here of an inflection point seems to be strong. And while many right now sing a song about how the market fears Trump’s fiscal policies will be inflationary, evidence seems to point another way for the true source of this inflection point: China.

From this USA Today article, Japan has overtaken China as the biggest owner of U.S. government bonds where at the end of October 2016 held $1.13 tn US government debt, above China’s $1.12 tn. China has been selling U.S. treasuries (on the record is ~1/3 of their $3.1 tn foreign FX reserves) in order to prevent a massive devaluation in their currency. Since October 2015, China has sold $139 bn of US government debt, or more than 10% of their holdings.

And the trend of China selling U.S. treasuries will undoubtedly continue. In the latest December Economic Work conference meeting, they emphasised the need to stabilise the Chinese Yuan (CNY). The most obvious method is liquidating their U.S. Treasury holdings and buying CNY.

But this trend in itself sets up a remarkable conundrum: as treasuries get sold, yields go up, the USD goes up, and the pressure increases for the CNY to depreciate even further. I can’t see how this doesn’t become an economic shock to the world, and potentially the start of the next crisis. If anyone can come up with an argument on how this gets resolved peacefully and without a crisis in China, I am sure the Chinese leaders would love to hear it.

The bond bears have growled and called wolf for many years (including myself!) and the evidence is increasingly compelling that they are going to see the big bad wolf show itself soon enough. 

Final Innings

                Over the last few years, candidates for being the harbinger to the end of this bull market have come and go. We’ve had the Grexit crisis, China collapse, tech 2.0 bubble, property bubble, and much more that have growled, only for the market to yawn and keep rallying. But over the last month, a more interesting candidate has surfaced, which has been overshadowed by the scare about a China collapse: high yield bonds, formerly known as junk bonds.

In mid-December, 2 high yield funds halted redemptions to avoid liquidating assets in a fire sale: Third Avenue’s $3bn Focused Credit Fund and Stone Lion’s high yield fund. In other words, there simply is not enough liquidity in the high yield space to meet any type of selling. Illiquidity in the bond market has been well flagged this year; if even the IMF warns about this (in Sep 2015), you can be sure everyone knows. While the market has more or less shrugged this incident off, it’s a warning shot to risk assets. There’s no need to panic just yet, but it’s become clear where the risk is.

The underlying cause for all of this undoubtedly is low interest rates and leverage. The risk curve shifted down and money went to all types of yield seeking assets, including property, dividend stocks, higher yielding currencies (ie emerging markets), and of course high yield bonds. Other examples of an outcome of ultra-low interest rates are unprofitable ‘unicorns’ as well as companies issuing debt for share buybacks. Simple reversal means money flows the opposite way. For assets which are leveraged, like REITs, high yield bonds, problems become magnified. Today one of the issues is energy prices collapsing from >$100 to <$40 in over 1 year, dragging down the high yield market where it is ~14% of the market. While energy high yield bonds itself may not bring down the entire market, increasing rates over the next year or two will undoubtedly cause problems for the high yield market.

While pundits continue to worry about the slowdown in growth in the USA, they really don’t need to with unemployment close to NAIRU and wage growth picking up. Walmart is a key example where they have raised minimum wage to $9 and then will further raise to $10 by February 2016. They didn’t necessarily want to, but they needed to with labor market competition increasing. While costs will rise for companies, ‘main street’ will benefit and start spending their excess savings. Add that onto savings from lower gasoline prices, the USA will be doing just fine. For now, they are dragged lower by big oil cutting spending, but in the longer run the rest of the economy will benefit, starting from the consumer.

Which brings me to my final topic of discussion, the Fed’s pace of tightening. For the next year, the dot plot projects 4 rate hikes, which is exactly what the overall market is currently factoring in. Last I checked 10 year treasuries are trading at ~2%, which means market isn’t factoring in much of inflation at all. This is a huge risk for the market with labor markets tightening and wage inflation creeping up, as it could imply rate hikes quicker than market expects. You can be sure the market will not like that.

For the near future though, the market continues to choose to ignore these warning signs and misplaces their fears. The market is nervous, but not about the structural issues such as an overinflated high yield market and higher inflation. They’re still worried about things like China, ISIS, OPEC, crude oil, things that make the headlines but not the ones that will bring down the market. The market will continue to climb the wall of worry, until it finally faces the problem children of zero interest rates - and you can be sure high yield bonds will be one of them.  

Credit Twist

I don't think I really need to talk too much about the possibility of the US Fed increasing interest rates earlier than everyone thinks. I've stipulated many, many times the end of near-zero interest rates and QE3 will cause some serious disruptions. Especially since the world has been so used to it for the last 5 years and so many little bubbles have been popping up all over (e.g., bitcoin, Asian housing prices, social media).

What I want to talk about today is 'credit' - a relatively simple and boring concept that will be the key driver to understanding this year's stock market. A smooth credit system is what allows individuals and institutions to live and prosper above their means. It allows economies to prosper, and equally to wither when it is disrupted.

The current market is in an interesting flux with credit as a vague idea being withdrawn from the market, ie. the withdrawal of QE3 which isn't directly a hike in interest rates or precise withdrawal of credit/lending. The US economy continues to grow steadily despite weather disruptions (see the Feb jobs number) and QE3 tapering continues. While this isn't exactly credit tightening, the withdrawal of money from the market will have intriguing consequences. For the forward-looking stock markets, even the expectation of withdrawal of money will be influential.

We've already seen early signs of this distress and disruption from more heavily debtor/deficit nations like India, Indonesia, Kazakhstan, Ukraine, Argentina, South Africa, being forced to hike their own interest rates to try to stem too much capital flows from leaving their countries. On the other hand, New Zealand became the first developed market to hike their interest rates by 25 basis points for completely different reasons (because they are doing well, too well for their central banker). All in all, credit is leaving this world and flying back into the world central banks.

In fact, the largest risk to the US stock market is an improving economy, in an indirect way. This is counter-intuitive logic. To the normal layman, a stronger US economy economy should result in stronger orders/demand for products/services for the rest of the world, pulling global growth upwards. But what will more likely happen as a twist will come back to the concept of 'credit'. As the US economy grows, QE3 continues to be pulled away, interest rate hikes start coming, and bonds/treasuries start selling off in expectation of higher inflation, the borrowing cost for the rest of the world will increase. Credit starts to get withdrawn from countries/institutions that shouldn't have received so much of it previously. Analogous to the sub-prime crisis in 2008, you can think of countries like Argentina, South Africa, Indonesia as being 'sub-prime' (the culprit, rather than the fall of housing prices, will be the fall of commodity prices). And when one or a chain of these sub-prime countries start running into problem, you can be sure it will affect the US stock market which doesn't trade particularly cheaply after being in a bull market for the last 5 years.

At the beginning of the year, many pundits claimed that a rising US economy would bring up the rest of the global economy. The opposite may just happen as credit tightens around the world. Instead of the US bringing up the rest of the world, the rest of the world has the potential to bring down the US stock markets.

What to do today then? You can play a trader and go long US equities until bond yields start spiking, and then start reversing your trade. Or you could hop on the emerging market bear train - being naturally contrarian, I sure hate going with the bearish-on-emerging markets crowd, but it looks like they may just win it out this year. Pick and choose your strategy wisely and don't forget to keep some cash, a great multi-year long/buying investment opportunity is coming full steam ahead!

Could Selloff Cause Fed to Slow Taper?

(see my last post "Rally On, Bull" for my talk on this diagram)

I watched an interview with Art Cashin of UBS (see link) who believes there's a possibility that the recent emerging market sell-off could prompt the Fed to slow down their 'tapering' of QE3. In my opinion, in recent years the Fed hasn't given a hoot! about emerging markets and they won't veer off course in their meeting next week. They didn't care that they indirectly caused easy money to go to countries and assets that shouldn't have attracted money the way they have, which is a long list. And next week, they will just look at domestic economic indicators and base their decision to cut QE3 on them. Other than a weak unemployment number in December, other indicators like ISM looked positively fine.

In any case, if they do cut back on QE3 as I think they will continue to, we will have gotten a lot closer to that intersection point I drew up in my post last October (and repasted above). This is an eventuality that will happen. So much for all the optimism the analysts had for the markets this year! If you paid me a penny for every report I read in December calling for a continued rally in the developed market I'd be pretty rich. Well, at least rich enough to buy myself a Big Mac at Mcdonald's.