This note was originally published
at 8am on August 13, 2013 for Hedgeye subscribers.
“To achieve an extraordinary result you must choose what matters most and give it all the time it demands. This requires getting extremely out of balance in relation to all other work issues, with only infrequent counterbalancing to address them.”
-Gary Keller, “The One Thing”
Yesterday, I presented to the global finance team of a Fortune 100 company. Don’t worry, they weren’t paying us and we don’t do research on the company. In fact, the presentation came at the request of a friend who is the number two person in their finance department. He wanted to provide his direct reports some insights into how Wall Street research works.
The presenter that went before me was a former bulge bracket analyst covering their company. He was a thoughtful guy and talked about the importance of setting guidance that could consistently be beat. His view was that that investors don’t like to be surprised, and in part of course he is right. The perception of predictable returns gives comfort to investors that don’t really do the work (think LINN energy).
He went on to talk about the fact that sell side analysts compete for commissions to get paid and try to make a lot of noise so as to garner “II votes”. This description of traditional sell side analysts obviously gave me the opening to discuss how our model is different. As I explained to the group, we get paid for two reasons: a) two have investment ideas that work and b) to make our clients think.
If we are not succeeding at those two objectives, then our business likely would not be sustainable as we have no asset management, trading, investment banking, or prop desk to cover the overhead. In his recent book, Gary Keller calls this pursuing the One Thing and explains that the pursuit of this One Thing will ultimately determine your personal or professional success. Hedgeye’s One Thing is research, what is yours?
Back to the global macro grind . . .
Every quarter we try to boil down the global macro markets to three key themes. But in the spirit of this note, I’m going to distill this down to One key theme: #RatesRising. Especially in light of the Wall Street Journal headline that emerging market growth is trailing the developed world, and thus indicative of our view of slowing emerging market growth being reflected in consensus, it seems likely that the direction of interest rates are likely to be the One Thing (as always subject to change as the facts change). But consider the following:
1. The Queen Mary of macro trends has inflected– We often use the analogy of the Queen Mary turning to describe the long term trend in interest rates. The Queen Mary, of course, is the massive ocean super liner that dominated transatlantic voyage before the jet age. Like any vehicle that is more than 300 meters in length, turning the Queen Mary was no easy task and not without its implications.
This analogy is appropriate for interest rates as they have literally been in decline for the last 30 years since peaking in the early 1980s. This long term decline has enabled any business that depends on borrowing money to fund its business to have a steadily declining cost of capital. In addition, this has made bonds a compelling asset class with a long term underlying bid to price.
In our models in Q2, yields inflected notably and broke out above our TRADE, TREND and TAIL levels. In fact, as shown in the Chart of the Day, 10-year yields had their largest percentage increase quarter-over-quarter in more than a decade. Even though 10-year yields have broken out, they remain well below the mean yield since 1989 of 5.21%.
2. The market is chalk full of debt – Given the generational trend in interest rates going lower and thus providing a tail wind for bonds, it should be no surprise that investors’ portfolios are chalk full of fixed income. According to the most recent data, there is $38 trillion of bonds outstanding across all subsectors of the bond market. Further, bonds outstanding have increased every single year since 1990.
The more critical data point from an asset flow perspective is that the notional value of bonds outstanding is currently at 68/32 versus the market capitalization of equities. This, too, is an extreme ratio based on history and is literally the highest we’ve seen. For comparative purposes, this ratio was at 50/50 as recently as 1999.
3. Volatility and duration across the bond market are in a set up that could lead to meaningful losses – As volatility in an asset class increases, so too does the expected loss and/or return. According to Merrill Lynch’s MOVE index, bond volatility has almost doubled in the last quarter and is at two year highs. Meanwhile duration is at close to all-time highs. My colleague Jonathan Casteleyn of our financials team highlighted this in his recent presentation on asset managers (ping firstname.lastname@example.org if you haven’t seen it yet), but based on current duration a roughly 100 basis point move in yields equates to a 8.9% loss on the 10-year treasury.
In part we are already starting to see the sort of generational losses in bonds that we should expect from the dynamics outlined above. Specifically, the Barclay’s Aggregate Bond Index is set for its first loss in 14-years and only third loss since 1990. While gentleman may prefer bonds, they don’t prefer losses.
The reality in markets is that there is rarely One Thing that dominates, but the seismic shift in interest rates will certainly be one of the most critical factors over the coming quarters and years. As money flows from the bond market to avoid losses, equities will be awaiting with open arms.
Our immediate-term Risk Ranges are now as follows:
UST 10yr 2.57-2.74%
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research