Global Asset Allocation Update

By Joseph Calhoun of Alhambra

There hasn’t been a lot of change in our indicators since the last update and therefore, despite my discomfort with the altitude of this stock market, there are no changes to the Global Asset Allocation this month. For the moderate risk investor, the allocation between risk assets and bonds is unchanged at 50/50.

Bond markets moved around some during the last month but are today almost exactly where they finished at the last update. Other markets have moved to indicate a still ravenous appetite for risk but growth and inflation expectations are essentially unchanged. Stock and junk bond – I refuse to call them “high yield” with HYG yielding just a bit over 5% – investors seem quite a bit more sure of the outcome of the developing policy debate than the more sober Treasury participants. Commodities also moved a bit higher since the last update but the best performer was gold, not exactly a growth investment. It was very tempting to just move some out of stocks and into cash simply because valuations have gone completely off the reservation but our process requires something more than gut reaction to make a change. Momentum continues to favor stocks – US stocks mostly – and that has to be respected. Our allocation to stocks has already been reduced due to high valuations and absent more information I can’t justify moving the allocation even lower. I have decided though that I will consider making an intra-month move if I think it is necessary. That isn’t something I would normally do as I think one of the most common mistakes investors make is doing too much. But I think this market is so far beyond what is “normal” that one must make concessions to reality.

Indicator Review

  • Credit Spreads:   Junk spreads continued to narrow, down another 7 basis points since the last update. They are still about 60 basis points from the lows of this cycle and nearly 150 from the lows of the last cycle. There is still plenty of room for improvement and there is no indication right now that spreads are about to reverse. The most likely culprit, if last year is a template, would be a fall in oil prices. While inventory would argue that might indeed be in the offing, momentum argues for the opposite. And as we’ve seen in the past, oil market moves owe a lot to the direction of the dollar which has recently found upside hard to come by.

Continue reading Global Asset Allocation Update

Global Asset Allocation Update

By Joseph Calhoun of Alhambra

Market based expectations for growth and inflation have moderated slightly since the last update. Since mid-December, interest rates – nominal and real – have fallen back, the yield curve has flattened, the dollar index has pulled back from its highs and gold has moved off its lows. In short, the Trump trade is being partially reversed as it dawns on investors that change will not be easy and probably not that quick either. After our minor allocation change last month to eliminate our cash position, there are no changes to the risk budget this month. For the moderate risk investor, the allocation between risk assets and bonds is unchanged at 50/50. There are some other changes to the portfolio that moves the allocation a little more toward a pro-growth stance.

As I said last month, the changes in growth and inflation expectations after the election, as expressed in the bond markets, were fairly small. Stock investors were obviously more optimistic – downright giddy for a while – but the rally has stalled recently as markets reassess, as the reality of change nears. This is all just part of the normal market process of incorporating new information into prices as it becomes available. The process is normally fairly smooth, bonds, stocks and commodities shifting slowly as perceptions of the economy shift. But when big changes are afoot, the market process can get messy as it has since the election. The market tries its best to price in the coming policy changes but has to adjust more frequently as what is proposed and favored by the market butts up against what can actually be accomplished. I would expect to see more “adjustments” – volatility – in the coming months as the new administration tries to implement its agenda.

Indicator Review

  • Credit spreads  –  Spreads were one of the few areas that continued to improve since the last update. The spread between junk bond yields and Treasury yields is rapidly approaching the low for this cycle set in the summer of 2014. The recovery in oil prices has obviously been a boon to energy bond holders. There is no stress in the junk bond market presently but spreads are quite narrow and it wouldn’t take much of a negative surprise to increase spreads. For now, though, in the midst of a mild growth rate upturn, that seems unlikely.

Continue reading Global Asset Allocation Update

Renzi Falls, Markets Rise

By Doug Noland

Credit Bubble Bulletin: Renzi Falls, Markets Rise

Italian bank stocks (FTSE Italia bank index) declined a modest 2.3% Monday on the back of Sunday’s resounding defeat of Italian Prime Minister Renzi’s political reform referendum. The bank index then proceeded to surge 9.0% Tuesday, 4.5% Wednesday and another 3.6% Thursday, for a stunning 27% rally off November 28th trading lows. “Par for the course,” as they say.  Italian 10-year sovereign yields rose eight bps Monday, yet by Wednesday’s close yields were actually lower on the week. Italian sovereign CDS ended the week little changed. Italian stocks gained 7%.

Following Brexit, Trump’s win and Renzi’s defeat, hedging market risk has been relegated to the status “senseless lost cause”. A short squeeze and unwind of hedges fueled this week’s 12.7% Italian bank rally, along with a 9.5% surge in European banks that reverberated in Asia (Japan banks up 5.6%), the U.S. (banks up 5.4%) and globally. Especially in Europe, a reversal of bearish hedges created powerful buying power. It’s a common trading strategy to purchase put options with proceeds from selling out-of-money call options. Increasingly in the U.S. and in Europe, equities trade as if those on the wrong side of derivative (calls) trades are being forced to hedge exposure by aggressively purchasing stocks into a rapidly rising market. It’s a self-reinforcing market dislocation similar to that which not many months back fueled a historic collapse in global bond yields.

One is left to assume that there must be some silver lining to Renzi’s defeat and resignation. From a fundamental perspective, it’s not obvious where to look. Italy’s anti-establishment Five Star Movement and Northern League political parties are salivating at the thought of new elections possibly early in the year (some speculating February). The Continent’s anti-euro and anti-establishment parties are emboldened. Meanwhile, the slow-motion Italian banking train wreck is chugging along.

December 9 – Reuters (Silvia Aloisi and Paola Arosio): “The European Central Bank has rejected a request by Italy’s Monte dei Paschi di Siena for more time to raise capital, a source said…, a decision that piles pressure on the Rome government to bail out the lender. Italy’s third-largest bank, and the world’s oldest, had asked for a three-week extension until January 20 to try to wrap up a privately funded, 5-billion-euro ($5.3 billion) rescue plan… The ECB’s supervisory board turned down the request at a meeting on Friday on the grounds that a delay would be of little use and that it was time for Rome to step in… The Italian government is expected to intervene in the next few days to recapitalize the bank to avert the risk of it being wound down, according to banking sources…”

Continue reading Renzi Falls, Markets Rise

Global Asset Allocation Update

By Joseph Calhoun of Alhambra

The change in our indicators – no matter the cause – does warrant some changes

Markets have moved sharply over the last month, mostly in the post-election period. Stocks are up – small caps exuberantly so – the dollar is up, bonds and gold are down. Surprisingly though, our indicators did not move all that much. The direction of change in the indicators is consistent with the moves in assets but not the magnitude. The yield curve, for instance, did steepen in response to the election but the change in growth and inflation expectations has been fairly minor (33 basis points). Even considering the potential for corporate tax changes, the 11% move in small cap stocks seem a bit, well, irrational. These moves are being attributed to the new administration’s potential policy changes but I think it is important to note that directionally these moves were already in progress. Bond yields were already rising, the yield curve already steepening, gold already correcting. What changed with the election was the rate of change.

I don’t make portfolio changes based on politics but the change in our indicators – no matter the cause – does warrant some changes. For the moderate risk investor, the allocation between bonds and risk assets shifts to 50/50, eliminating our cash position.

50-50-risk-budget

The change in the risk budget is, like the change in our indicators, fairly small. I do not believe it is appropriate to make big changes based on potential changes in economic policy. While we can see a general outline of the Trump administration’s policies – some of which I like quite a lot – we do not yet know the details. And those details are important. Furthermore, some of the proposed policies may not be as positive for stocks as those charging into the market seem to assume. Trade policy – as outlined on the campaign trail – in particular could be very negative for corporate profits and therefore stocks. In addition, threatening tariffs sends a very negative signal about the dollar. Labeling China as a currency manipulator is tantamount to telling the world you’d like a cheaper dollar – and I would note that Presidents generally get the dollar they ask for. That has implications for commodities, gold, interest rates and not least the effectiveness of his other proposed policies. Tax cuts and a weak dollar are not very effective; just ask George W. Bush.

Economic growth, as I’ve said many times, is a function of just two things – population (workforce) growth and productivity growth. The incoming administration is hostile to immigration – or at least that is the perception – so the only option on the first one is to get the economy growing fast enough to raise the participation rate. Demographics would seem to be working against us in that regard but I suppose it is possible. Where the new administration could have a big impact is on the second item – productivity growth. Cutting the corporate tax and the capital gains tax should be a positive for investment and therefore productivity growth. I would caution the bulls though to consider that companies have had ample profits and opportunity to invest the last seven years and have instead chosen to engage in financial engineering – stock buybacks and the like. And don’t count on a tsunami of corporate cash coming back from overseas either. Large companies – where most of the offshore cash lies – can bring that money home now and still avoid the tax. If you doubt that, remember that Apple floated several bond issues the last few years to do exactly that – and used the proceeds to buy back stock. In any case, any impact from changes to tax policy will take time to be reflected in the economic statistics and we don’t even know yet what will eventually emerge from the sausage factory known as the US Congress.

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What a Week

By Doug Noland

Credit Bubble Bulletin: What a Week

The S&P500 jumped 2.3% Monday in what appeared growing confidence that Hillary Clinton was on the verge of becoming the next POTUS (buoyed by Director of the FBI Comey’s statement). It’s worth noting that Monday trading saw both the Financials (XLF) and the Industrials (XLI) jump 2.5%, only to be bettered by the Biotechs’ (BTK) 4.1% surge. EM equities (EEM) rose 3.6% Monday. Election day trading was then relatively quiet, with the S&P500 adding 0.3% Tuesday.

After closing Tuesday’s session at 2,135.50, S&P 500 futures jumped to 2,151 in evening trading on exit polling and early reports from Florida that appeared favorable for Clinton. Futures, however, reversed course as it became increasingly apparent that Donald Trump was performing better than expected, especially in Florida, Pennsylvania, Michigan and Wisconsin. By midnight on the East Coast, S&P futures were “limit down” 5%. DJIA futures had reversed a full thousand points, and Nasdaq futures had fallen almost 6%.

The huge move in U.S. equity futures was outdone by a stunning 14% collapse in the Mexican peso. In a span of a couple hours, the U.S. dollar/Mexican peso moved from 18.205 to a record high 20.78. After trading near 17,400 (futures) in overnight trading, the DJIA closed Wednesday’s session up 257 points (1.4%) to 18,590. Financial, industrial and biotech stocks, in particular, were in melt-up mode. The Banks (BKX) closed Wednesday trading up 4.9% – then added another 3.8% Thursday, before ending the week up 12.7%. The Broker/Dealers (XBD) surged 5.9% and 3.7%, with a gain for the week of 14.8%. Again not to be outdone, the Biotechs (BTK) spiked 9.2% higher Wednesday and 17% on the week. The Industrials (XLI) gained 2.3% both on Wednesday and Thursday, closing out the week 8.1% higher.

As exuberance took over, the broader market dramatically outperformed. The small caps (RTY) traded higher all five sessions this week, with Wednesday’s 3.1% rise the strongest in a noteworthy 10.3% weekly advance. The mid-caps (MID) gained 1.9% Wednesday and 5.7% for the week. The DJIA traded to a record high this week, with the S&P500, small caps and mid-caps just shy of all-time highs.

There are different perspectives through which to interpret this week’s extraordinary market action. The bullish viewpoint will take a casual look at U.S. stock performance and see overwhelming confirmation that the bull trend remains intact. And with news and analysis, as always, following market direction, rather quickly we’re deluged with material professing a bullish outlook courtesy of a Trump Presidency and Republican House and Senate. Apparently the country is now on the verge of a major infrastructure investment program, positive healthcare reform, corporate tax reform, and a dismantling of Dodd-Frank financial regulation (for starters). In particular, a focus on infrastructure and de-regulation implies a Trump Administration lot likely to place confrontation with the Yellen Federal Reserve (or the securities markets) high on their priority list.

From my perspective, it was anything but a so-called “bullish” week. I saw alarming evidence of dysfunctional markets. There was also further confirmation of a bursting bond Bubble. Indeed, there was strong support for the view of a faltering global securities Bubble – even in the face of surging U.S. stock prices.

Let’s return to election late-night. I doubt traders and the more sophisticated market operators will easily forget what almost transpired. It’s worth noting that while S&P500 futures and the Mexican peso were collapsing, the Japanese yen was in melt-up. In just over two hours, the dollar/yen moved from 105.47 to 101.22 – an almost 4% move. Meanwhile, EM and higher-yielding currencies were under intense selling pressure – the Brazilian real, South African rand, Turkish lira, Colombian peso, Australian dollar and New Zealand dollar (to name a few). At the same time, gold surged from $1,270 to $1,338. Crude sank 4%. Global markets were on the brink of a serious speculative de-leveraging episode.

There had been significant hedging across global markets going into the U.S. election. Especially after Monday, the markets viewed a Trump win a low probability. With markets shaky of late, along with an approaching historic political event, enormous derivative positions had accumulated in various markets. In the event of a surprising outcome, those that had written (sold) market “insurance” would be forced to aggressively (“dynamically”) hedge their losses by selling/shorting into already weak markets – perhaps even with major markets highly illiquid (or already halted limit down).

Continue reading What a Week

The Daily Shot 11.9.16

By SoberLook

The United States

Once again we begin with the US where as of midnight on Wednesday, the presidential election resembles the Brexit shock. Donald Trump has pulled ahead in the betting markets as polling results come in.

Source: electionbettingodds.com

The market reaction was quite violent on higher US policy uncertainty.

1. Treasury yields dropped sharply.

Earlier in the day, the US 2016 rate hike probability rose to 86%, and it seems that the markets are now taking the hike off the table.

Also during the day US market-based inflation expectations rose to the highest level in almost a year – a trend that is now likely to reverse.

2. US equity futures dropped 5%, and VIX spiked in response to the elections news.

 

3. The dollar gave up 3.5% against the yen as the results came in.

During the day traders were bidding up US dollar puts, hedging against a Trump victory (a hedge that worked out quite well). The chart below shows USD/JPY risk reversal – the spread between the 1-week call and put implied volatility.

Continue reading at TalkMarkets →

Peak Monetary Stimulus

By Doug Noland

Credit Bubble Bulletin – Peak Monetary Stimulus

October 28 – Bloomberg (Eliza Ronalds-Hannon and Claire Boston): “After all central bankers have done since the financial crisis to prop up bond prices, it didn’t take much for them to send the global debt market reeling. Bonds worldwide have lost 2.9% in October, according to the Bloomberg Barclays Global Aggregate Index, which tracks everything from sovereign obligations to mortgage-backed debt to corporate borrowings. The last time the bond world was dealt such a blow was May 2013, when then-Federal Reserve Chairman Ben S. Bernanke signaled the central bank might slow its unprecedented bond buying.”

German bund yields surged 16 bps this week to 0.16% (high since May), with Bloomberg calling performance the “worst month since 2013.” French yields jumped 18 bps this week (to 0.46%), and UK gilt yields rose 17 bps (to 1.26%). Italian yields surged a notable 21 bps to a multi-month high 1.58%.

A cruel October has seen German 10-year yields surging 31bps, with yields up 58 bps in the UK, 31 bps in France, 40 bps in Italy, 33 bps in Spain and 30 bps in the Netherlands. Ten-year yields have surged 43 bps in Australia, 40 bps in New Zealand and 25 bps in South Korea.

Countering global bond markets, Chinese 10-year yields traded Monday at a record low 2.60%. There seems to be a robust safe haven dynamic at work. It’s worth noting that China’s one-year swap rate ended the week at an 18-month high 2.73%, with China’s version of the “TED” spread (interest-rate swaps versus government yields) also widening to 18-month highs.

Here at home, 10-year Treasury yields this week jumped 12 bps to 1.85%, the high since May. Long-bond yields rose 15 bps to 2.62%, with yields up 30 bps in four weeks.

And while sovereign bond investors are seeing a chunk of their great year disappear into thin air, the jump in yields at this point hasn’t caused significant general angst. During the October sell-off, corporate debt has outperformed sovereign, and there are even U.S. high yield indices that have generated small positive returns for the month. Corporate spreads generally remain narrow – not indicating worries of recession or market illiquidity.

October 27 – Wall Street Journal (Ben Eisen): “By some measures, October is already a record month for mergers and acquisitions. Qualcomm $39 billion deal to buy NXP Semiconductors helped push U.S. announced deal volume this month to $248.9 billion, according to… Dealogic. That tops the previous record of $240.2 billion from last July… It was assisted by last week’s record weekly U.S. volume of $177.4 billion.”

And while bond sales have slowed somewhat in October, global corporate bond issuance has already surpassed $2.0 TN. The Financial Times is calling it “the best year in a decade,” with issuance running 9% ahead of a very strong 2015. According to Bloomberg, this was the third-strongest week of corporate debt issuance this year.

Continue reading Peak Monetary Stimulus

The Daily Shot 10.27.16

By SoberLook

The United States

Let’s start with the US where we apparently had a surprisingly sharp recovery in the service sector this month. Here is the PMI chart from Markit Economics.

It’s worth reading the comment from Markit below. The chart on the bottom shows the composite PMI (including manufacturing).

Source: Markit Economics

Combining the above with rising wage growth, higher inflation expectations, tightening credit spreads, etc. and we got ourselves a rate hike coming up.

The probability that the Fed will move by year-end is now 74%.

Source: CME

1. In other US developments, mortgage applications for house purchase declined to the lowest level since January. Part of the issue is the ongoing tightness in the mortgage market.

Continue reading at TalkMarkets →

The Daily Shot 10.25.16

By SoberLook

The Eurozone

Once again, we start with the Eurozone where economic activity has picked up momentum (based on Markit PMI reports).

German manufacturing sector is expanding at the fastest pace since early 2014.

Source: @MarkitEconomics, @tEconomics

Moreover, German service business activity unexpectedly bounced from a three-year low.

Source: @MarkitEconomics, @tEconomics

At the Eurozone level, the composite PMI (both manufacturing and services) also surprised to the upside.

It’s worth noting that the ECB pays close attention to these reports, which would suggest that the next major policy announcement from Mr. Draghi will be some details of the QE taper.

Even if the ECB wanted to change the securities purchases strategy from the capital key ratio to the amount outstanding by country, the deficit of QE-eligible German bonds would persist. Balance sheet expansion at the current pace can not be sustained for much longer.

Source: Deutsche Bank, @joshdigga

Source: Deutsche Bank, @joshdigga

1. In other Eurozone developments, DBRS’ maintaining of Portugal’s rating not only brought down bond yields but also resulted in a lower sovereign CDS spread.

Source: Bloomberg

Continue reading at TalkMarkets →

The Latest on China’s Mortgage Finance Bubble

By Doug Noland

Credit Bubble Bulletin: The Latest on China’s Mortgage Finance Bubble

It’s been a full seven days since a CBB focused on China… Important – confirmation of the thesis – data again this week.

October 21 – Reuters (Yawen Chen and Nicholas Heath): “China’s new home prices rose in September at the fastest rate on record as buyers rushed to close contracts before new restrictive measures took effect in October. The boom in sales and prices was evident in mortgage lending, with new housing loans to individuals totaling 475.9 billion yuan in September alone, some 76% higher than the same month last year… Prices in China’s 70 major cities rose 11.2% in September from a year earlier, accelerating from a 9.2% increase in August, as 64 of them saw year-on-year price gains…”

Year-on-year prices were up 34.1% in Shenzhen, 32.7% in Shanghai, and 27.8% in Beijing.

Also from Reuters: “The house-prices-to-household-disposable-income ratio in first-tier cities has risen to be around 18 to 20 times in this year’s housing fever, putting housing affordability close to Hong Kong’s and making it less affordable than London, UBS wrote…”

October 19 – Wall Street Journal (Lingling Wei): “Xiong Meifang was about $30,000 short two months ago for a 30% down payment on an $895,000 apartment in the southern part of China’s capital. To make up the difference, the 31-year-old graphic designer took out a line of credit from a national bank. She said the bank told her she could use the loan however she wanted. China bans borrowing for down payments. A surge in such financing offered by nonbank lenders earlier this year led to a regulatory clampdown. But as banks increasingly turn to mortgage lending, there are new signs of risky practices. In some instances, banks offer credit lines to borrowers buying apartments with few questions asked. In others, banks work with independent loan brokers or property agents to funnel money into down-payment financing… Data released Tuesday showed medium- and long-term household loans, almost all of which are mortgages, made up 60% of all new loans created in the third quarter, up from 47% in the second quarter and 23% in the first.”

Continue reading The Latest on China’s Mortgage Finance Bubble