“The odds are six to five that the light in the end of the tunnel is the headlight of an oncoming train.”
-Paul Dickson
Whether it be hockey (which no doubt many of you are tired of us writing about!), card games, or chess, it's critical to put yourself in the best position possible to win. In effect, you want to play the strong hand. Most games involve some level of probability in which playing the odds can improve your chance of success meaningfully.
For example, in chess there are few basic rules of thumb that even the novice chess player should know and follow, such as:
- Use the center pawns to gain space on the opening
- Control the center of the board
- Secure your king early
- When ahead in material, force exchanges
- And perhaps the most important . . . never fight a land war in Asia.
Obviously, the last rule of thumb is not for chess, but was reputedly advice given by General MacCarthur to President Kennedy and then popularized in the 1987 movie, “The Princess Bride”. As rules of thumb go, given America's lack of success in the four Asian land wars post World War II, Korea, Vietnam, Afghanistan, and Iraq, the last point may be the most accurate rule of thumb.
As it relates to global macro investing and asset allocation, a couple of rules of thumb we have recently been reminded of are: 1) be on the right side of liquidity (It’s all about the flows, bro!) and 2) it’s the fundamental changes on the margin that matter.
Back to the Global Macro Grind...
In the Chart of the Day, we highlight a point that many asset allocators have been focused on over the past few weeks, which is that high yield bonds, even despite the recent rally, have sold off sharply from the highs of the year. As a result, the spread between high yield and comparable duration treasuries is at its widest of the year.
Some strategists have been flagging this as an opportunity to wade back into the high yield market, an entry point if you will. One point that gives us pause on this line of thinking is the risk of illiquidity in the high yield market. In some ways, this time IS different on the liquidity front.
According to Lipper, fund flows in high yield bond funds have experienced outflows of some $13 billion over the past four weeks. Rightfully, you might push back and say that is a smidgen of the size of the entire high yield market, which according to recent data from Barclay’s is north of $1.2 trillion in the U.S. alone. So based on those rough numbers, we are looking at only about 1% of the entire market in outflows, but the kicker, again, is liquidity.
Since April 2013, the New York Fed has started to break out dealer inventories of high yield bonds and they currently stand at about $8.2 billion. So even as the high yield market has ballooned from $660 billion in 2007 to almost double that now, liquidity, as facilitated by the dealers, has been shrinking. This then is the unintended consequence of government regulation and tighter capital rules: dealers have a more limited ability to facilitate an orderly rush for the exit.
The other rule of thumb we noted above is that fundamental changes on the margin matter. Europe is on the sell side in our current macro themes deck and that position is seeing the benefit of more slowing economic data from Europe this morning. A few points to highlight from this morning’s data:
- Eurozone GDP slows to +0.7% year-over-year in Q2 2014;
- German GDP contracted sequentially by -0.2%; and
- France cut their GDP forecast in half again to +0.5% for 2014.
For Germany, this is the first sequential contraction since 2012. Given this, it no surprise then that the German Bund hit a record low of 1.0% this morning and has also been front running this slow down. Clearly, low reported inflation is leaving the door open (some might say wide open!) for incremental easing in Europe (a point the German bund market is front running).
Incidentally for those that have been watching, the U.S. 10-year yield is ticking lower again this morning. The contrarian Hedgeye call that 10-year yields may touch 2.3%/2.2% may happen sooner than even we anticipate!
And conversely in a sign today that this time truly isn’t different, Reuters is reporting that mortgage lenders are again offering stated income mortgages in an attempt to facilitate mortgage activity. When combined with excesses in the auto loan market and a spike in subprime credit card issuances, perhaps there is more than just liquidity that is making the credit markets shake.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.39-2.48%
RUT 1109-1148
DAX 8
VIX 11.84-15.55
WTIC Oil 96.60-98.26
Gold 1
Copper 3.09-3.15
Keep your head up and pawns in the middle,
Daryl G. Jones
Director of Research
