Conclusion: In the report below, we analyze clues embedded in the price action across asset classes and key global markets for hints as to what Global Macro trading could look like over the intermediate-term TREND.
While the consensus outlook for risk (be it “on/off”) hinges on the latest update from the grave situation at Japan’s Fukushima Dai-Ichi nuclear power plant, we thought we’d take the opportunity to: a) reiterate our belief that risk is always “on”; and b) provide some clues as to what the Global Macro trading environment may look like over the intermediate-term TREND with a bevy of ideas on how to play it across asset classes.
This is in no way an attempt to make a “call” the chaos that is Global Macro risk. Rather, it is our best attempt to analyze the market data provided in the near-week since the current series of tragic events began in Japan in an attempt to offer some clues as to what the major moves will be across the asset allocation spectrum. Understanding that prices often lead fundamentals, we attempt to get you ahead of the storytelling that may be coming down the pike over the next 3-6 months.
In the essence of keeping this report tight, we’ll get right to it by addressing each asset class individually. As always, we encourage you reach out to us if you have any follow up questions or would like to discuss a topic(s) further.
Since the close of 3/10, the average and median percentage change in the 65 global equity markets and nine S&P sectors we track has been (-1.7%) and (-1.6%), respectively. Only 13 of them currently register a positive gain.
Excluding Japan’s Nikkei 225, which is down (-14.1%), the leader board is bookended by countries like Germany’s Dax (-5.8%), Hong Kong’s Hang Seng (-5.6%), and Switzerland’s Market Index (-5.2%) on the losing end and Greece’s Athex (+4.9%), Venezuela’s Stock Market Index (+3.3%), and the XLE (+2.9%) sit atop the winning end. Without reading too much into it, it seems that the “bailout trade” (Greece) and “inflation trade” (Venezuela, XLE, Hong Kong) are still intact. Interestingly, we see currency strength is hurting the more export-oriented countries of Germany (Euro +1.6% vs. USD) and Switzerland (Franc +3.7% vs. USD).
Perhaps even more so than before, keeping an eye on FX volatility will be integral to managing exposure to certain equity markets. For example, Brazil’s Bovespa has appreciated modestly (+0.3%) on its positive exposure to the anticipated increase in the prices of basic materials needed for Japan’s recovery and crude oil via Petrobras. We do caution, however, that this story may be a trap, as further weakness in the real (-1% vs. USD) via Japanese repatriation (Japan is the largest source of foreign demand for Brazilian local bonds) may give the Brazilian central bank the headroom it needs to accelerate rate hikes.
Elsewhere, we expect a further yen strength to weigh on Japanese equity prices; the current sell-side recommendations to buy this dip on “valuation” and “rebuilding” are ill-timed at best, reckless at worst. We don’t subscribe to the Keynesian school of investing which largely follows the “broken window economic theory” followed by a fix of Big Government Intervention and we don’t subscribe to the sell-side’s strategy of using the current crisis in Japan as a “catalyst for growth” and a reason to buy Japanese equities right here.
All told, we made the intermediate-term TREND research call on Global Stagflation in early November and, irrespective of the situation in Japan, this major risk to both corporate margins and equity valuation multiples hasn’t gone away. If anything, the tragic events in the world’s third-largest economy support this Macro backdrop. That said, we do expect Asian equity markets to bottom first and have been watching Chinese stocks with a bullish eye for the past several weeks.
With the exception of Natural Gas (+8.6%), Coal (+5%), and Copper (+3.5%) – all of which benefit from current anti-nuclear power sentiment and the Japanese recovery story – commodity prices have been largely soft since last week’s incident. There’s been particular weakness in agricultural commodities; we posit that investors have aggressively “de-risked” their portfolios by slashing their speculative exposure to Oats (-5.9%), Corn (-5.3%), Cotton (-4.4%), Cocoa (-4.7%), and Wheat (-4.1%).
While the situation in Japan is definitely something to pay attention to as it relates to consensus’ risk appetite in the near term, over the intermediate term, we don’t see any change in the fundamentals of the most dominant of the many factors supporting elevated commodity prices – US Dollar weakness (-1.7%). In fact, the our expectation of continued Japanese repatriation and further unwinding of yen carry trades supports further JPYUSD strength, which, in turn, is a bearish factor for the US Dollar Index (yen = 13.6% of the basket).
After a (+5.2%) up move since in the earthquake and ensuring tsunami first hit Japan, it’s obvious that the Japanese yen is “stealing the show” here. As far as the fundamentals are concerned, we see two reasons for continued yen strength over the intermediate-term: 1) repatriation by Japanese households and corporations to help finance the rebuilding effort (Japan’s net foreign assets total roughly 56% of GDP); and unwinding of yen carry trades, as short-end interest rate differentials relative to Japanese sovereigns continue to compress across the board.
Of course, we don’t expect the yen to continue appreciating in a straight line and since touching a post-war high of 76.36 in intraday trading overnight, it’s come in to around 78.98 – still a post-war high, nonetheless. Further, we feel much of the current yen strength is actually being driven by investors getting ahead of the aforementioned fundamentals. Given that the speculative bid may be priced in at current levels, we’d expect the yen to continue a gradual appreciation over the intermediate-term TREND.
As always, the risk of Japanese officials intervening in financial markets looms large and we can all but count on their intervention in the FX market in the near future. As we saw late last year, however, their attempts will likely prove futile in reversing the trend of the global currency market. They will, however, succeed in perpetuating the heightened volatility that accompanies Big Government Intervention. The current two-year high on implied volatility for the dollar-yen lends credence to this stance.
Elsewhere in the FX market, the Aussie dollar (-2% vs. USD) and Brazilian real (-1% vs. USD) are two currencies that look particularly vulnerable given the aforementioned Global Macro backdrop. The Aussie looks vulnerable because the market could increasingly start to bake in interest rate cuts if Australian growth falters in any way from slowing growth in its three largest export markets: China (#1), Japan (#2), and Korea (#3). In fact, the market is increasingly sniffing this out, as analysis of swaps trading suggest investors are betting there is a 27% chance the RBA cuts the cash rate by (-25bps) – up from 22% yesterday.
Even though we’re looking to get ahead of the bottoming in Chinese growth and increasingly like Chinese equities, the fact of the matter is that consensus is still far too bullish on Chinese growth, which we expect to slow. And understanding that Australian (or any) central bank action will lag the reported data, the Aussie dollar may be a victim of consternation for quite some time.
Lastly, we continue to remain bullish on the Canadian dollar, insofar as crude oil continues to trade in a bullish quantitative formation on all three of our core investment durations. We remain bearish on the US dollar’s intermediate-term TREND and long-term TAIL; as Japan’s Keynesian Debt & Deficit Crisis gets exposed to the world via this tragic event, we expect the focus of the global currency market will turn to similarly-positioned countries. Though the EU continues to have its issues, we still like EURUSD understanding the following factors:
- The EU has largely gone through the austerity wringer while the US continues to kick the can down the road, instead opting to fund the federal government for two weeks at a time;
- We’re inching closer to a full-blown debt ceiling debate and a potential stoppage of the federal government; and
- As we saw a few weeks back, the Trichet & co. stand ready and willing to tighten well ahead of the Fed.
With regard to fixed income, there are two things we’re acutely focused on: QE3 and inflation. Our current bullish stance on crude oil and gold and bearish view of the US dollar implies we expect inflation to continue to remain a headwind over the intermediate-term TREND. That’s bad for bonds.
What’s good for bonds is a rotation out of risk assets like equities over the intermediate term, particularly as consensus forecasts start to come in toward our bearish view on the slope of global growth. That doesn’t make us bullish on bonds, but we could foresee a scenario whereby they continue to get bid up like they have in the wake of the incident in Japan.
Looking at the US Treasury curve specifically, we see that 2’s, 10’s, and 30-year yields continue to trade below what used to be their TREND lines of support. Whether or not this bullish bid is forecasting another round of Quantitative Guessing remains to be seen. Both Bernanke and Dudley have recently stated that the Fed has no intentions at the current time to increase the asset purchases beyond June or the $600B target. By removing phrases like “the recovery is disappointingly slow”, “tight credit”, “modest income growth”, and “lower housing wealth” from their latest statement, the Fed sent a signal to market participants that the US economy is indeed in a better place in their eyes and that no further easing would be required. At the bare minimum, however, as long as Treasuries continue to have a bullish TREND-line bid, QE3 remains a possibility in our model.
All told, the events in Japan have created much consternation in global financial markets and the large amount of news coverage dedicated to this crisis has masked some global economic fundamentals – both positive and negative. Given, we continue to urge investors to acutely focus on all risks, not just those surrounding the Japanese reactors.