“Singleton ran a notoriously decentralized operation; avoided interacting with Wall Street analysts; didn’t split his stock; and repurchased his shares as no one else ever has, before or since.”
-William Thorndike in his book “The Outsiders” 

In addition to Teledyne’s operational practices mentioned above, it was the one conglomerate in the 1960s that elected not to pay a dividend. Henry Singleton labeled them as tax inefficient with the double taxation at the corporate and individual level. 

As Thorndike goes on to write:

“For most of the twentieth century, public companies were expected to pay out a portion of their annual profits as dividends. Many investors, particularly senior citizens, relied on these dividends for income and looked closely at dividend levels and policies in making investment decisions.” 

Singleton’s refusal to buy into conventional practices and his near unresponsiveness to Wall Street analysts made him an unpopular conglomerate CEO to say the least. 

Back to the Global Macro Grind… 

“Trade Wars” and “Trump Tariffs” are newsy headlines this week. We’ve been struck by the range of opinions from analysts and pundits assigning broader market implications to the comments of various state leaders. Everyone seems to have an opinion. 

No Thoughts on Trade Wars? - 03.05.2018 tariff cartoon

We’re here to tell you that we have no thoughts on trade wars. Or I should say, we have no “edge” over others and so far are stumped about how to merge Trade War conclusions into our data-driven process for modeling economies and mapping key risk management pressure points. 

This morning we are repurposing a derivatives-market note that I write to institutional subs daily. An argument could be made that the current set-up in consensus land is effected by trade wars, but we’re more concerned with seeing the forest from a risk management perspective and comparing observed consensus views with our own process for drawing conclusions from the direction of growth and inflation. 

Here are three important call-outs we discussed this morning: 

  1. SPDR Sector Dispersion (Industrials)
  2. Russell Style Performance (Small-Cap)
  3. Rate Volatility Expectations 

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1) SPDR Sector Dispersion (Industrials) 

Trade War Angst? Hedgeye Trade War “Edge” wasn’t a catalyst for our having the Industrials Sector as a TRADE and TREND duration SHORT idea in our Q3 Macro Themes Presentation. The view was GIP-Model driven which was confirmed by the market: 

MM Relative Total Return: -392bps
YTD Relative Total Return: -718bps 

The underperformance gap has widened more recently and whether it’s trade war driven, performance chasing, etc., consensus is unquestionably worried about the sector prospectively. It’s important to note that recent underperformance and worry as seen in derivatives markets fits a QUAD 4 environment which is where we’re tracking in the U.S. for the next 3 quarters.   

We observe this “worry” by viewing sector “dispersion” through then lens of implied volatility embedded in the cost of hedging downside. 

“Implied dispersion” compares put implied volatility At-the-money for a sector (XLI in this case) relative to the benchmark (SPY). The Chart of the Day shows this dynamic for the 1Mth duration (Puts that expire in one month) across S&P 500 sectors. The Industrials Sector is the clear stand-out from a “cost of hedging” standpoint. 

Takeaway: Industrials remains a core short idea at the sector level, but we’re cognizant of the fact that we’re not alone in assigning risk to the sector as of today. 

2) Russell Style Performance (Small-Cap) 

Domestic small-cap has given a little back m/m. Because the underperformance has been minimal (R2K is -130bps m/m vs. R1K), the cost of hedging has stepped up very little and remains not far off the all-time lows… 

In our global macro universe of liquid derivatives markets, we often assign historical percentile readings to hedging costs to normalize across markets.

This global macro universe has well over 100 tickers across global equities and FICC. 

A screen of the most divergent long-term hedging costs in global macro (12-Mth contract expiry) reveals the Russell 2000 Index (RTY) and ETF (IWM) in the bottom 10. Each of those two tickers has implied volatility on a 12-mth expiry that trades 1st percentile of historical observations. 

If we unpack the interest rate component of the Russell 2000 because it’s heavily weighted to financials, we know that some of this is due to the complete suppression of interest rate volatility, particularly at the long-end. 

However, even in the Russell 2000 “growth” index (ETF: IWO), 12-Mth implied volatility trades in just the 9th percentile of historical observations.   

Takeaway: Although a piece of the volatility pricing we see fits our interest rates call, a full-blown QUAD 4 environment would be a surprise to the current consensus view on domestic small-caps.   

3) Fixed Income Volatility Expectations 

The volatility indices that are constructed from options on long-term treasury vehicles have compressed in a big way m/m to trade with low single digit percentile readings. 

10Yr Percentile Readings:

TYVIX (Options on 10Yr Futures): 3%
VXTLT (Options on TLT ETF): 2% 

Scanning the percentile views of the Fixed Income asset class exemplifies the suppression of rate volatility expectations, particularly as it relates to other asset classes. 

Much of this has driven recent market moves as evidenced by realized volatility (TLT RVOL over the last month has traded 1st percentile of historical observation periods). As is often the case, recent performance is extrapolated in last price. 

Clearly this market move and rate compression has created ripple effects from an expectations standpoint: we just discussed one of those above with regard to the Russell 2000. 

Takeaway: As of now the market seems to have come around to our view that rates have possibly peaked. “Rate Breakout Scare” is unsurprisingly viewed as much less probable than it was at the peak in nominal rates Mid-May.

Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND signals in brackets) are now:  

UST 10yr Yield 2.80-2.89% (bearish)
SPX 2 (bullish)
RUT 1 (bullish)
NASDAQ 7 (bullish)
Energy (XLE) 74.25-77.52 (bullish)
REITS (VNQ) 80.20-83.41 (bullish)
Industrials (XLI) 70.99-73.88 (bearish)
VIX 12.11-18.69 (neutral)
USD 93.45-95.33 (bullish)
Gold 1 (bearish)
Copper 2.74-2.96 (bearish)

Good Luck Out There Today, 

Ben Ryan
Macro Analyst

No Thoughts on Trade Wars? - 07.11.18 EL Chart