To date Huddlestock1 is up +6.37% versus -3.73% for Europe2, +6.94% for the US3, +0.07% for China4 and -6.00% for Emerging and Frontier Markets5. Huddlestock was down -1.99% in June. We temporarily reduced our exposure to emerging markets, including Argentina and Brazil in early May and will seek to re-establish positions in those markets at a superior price point soon.
1Estimated actual performance of all strategies/themes on the Huddlestock platform on an unleveraged basis since November 2017.
2As defined by the iShares MSCI Eurozone ETF (EZU) which seeks to track the investment results of an index composed of large and mid-capitalisation equities from developed market countries that use the Euro.
3As defined by the S&P 500 (SPY) which seeks to track the investment results of the S&P 500 index.
4As defined by the iShares MSCI China Index Fund (MCHI) which seeks to track the performance of the MSCI China Index. The index is a free oat adjusted market cap weighted index designed to measure the performance of equity securities in the top 85% in market cap in the Chinese equity markets.
5As defined by the Global X Next Emerging & frontier ETF (EMFM) which seeks to track the Solactive Next Emerging & Frontier Index.
As we transition into the second half of the year we thought it a good point in time to take stock of the current investment landscape. As you are aware, we have been navigating a turbulent, tweet-driven period where fundamentals have been buffeted by geopolitical side winds. The fact that just 10 stocks accounted for more than 100% of the return of the S&P500 so far this year is elucidatory.
The most important fundamental determinant of the shape of the global financial markets right now is the expected path of interest rate rises in the US (and the concomitant withdrawal of monetary accommodation). We are expecting the Fed to continue along its path of gradually raising rates and as that happens there is a need for us to adjust our investment approach from being top-down and growth-driven to being bottom-up and quality-oriented. The geopolitical buffeting, which typically manifests itself in periodic flights-to-safety, is providing us with short-term tactical trading opportunities around our longer-term view. Consistent with this, we are going to look to take advantage of the short-term mispricing that can arise from these flights-to-safety and will start focussing on specific investment cases, in the context of macroeconomic news flow, in future Investor Briefs. In technical terms, we are shifting away from beta towards alpha.
Our emphasis on top-down, growth-driven investing over value-based, bottom-up stock picking so far this year has been a good call. Numerous highly successful hedge funds, typically with a very disciplined, value-oriented, bottom-up approach to investing, have been suffering large losses while strictly and dogmatically sticking to the investment style that has worked for them in the past. To be fair, we believe that, on average, the investments that they have made will prove to be very good over a longer time frame (if they survive that long). This will likely happen when US interest rates rise above some tipping point, the yield curve inverts and other leading indicators suggest that a recession is imminent6.
While the yield curve has flattened considerably over the past 6 months (an inversion of the curve is seen as a warning sign for a recession), none of the other indicators are flashing red7. Interestingly, we are now in a position where we could possibly outperform these hedge funds and leverage their investment acumen by simply investing in the same stocks as they have, gleaned from regulatory filings, but with superior entry prices8.
Most investors agree that the US is in the latter stages of the current economic expansion. There is considerable debate however as to exactly where we are in the cycle and, relatedly, when a recession is likely to materialise. Since the US economy is leading the way for other markets we thought we would start there.
6 Ignoring exogenous economic shocks like the bursting of the bubbles in the Chinese real estate and banking sectors, or, more likely, an exogenous shock that the markets are not foreseeing.
7 Indeed, there is reason to believe that this may be the first time in 50 years that an inversion does not signal a looming recession. The argument being that market distortions caused by central banks after the great recession may have caused the yield curve to lose its signalling power.
8 This is both an enormous oversimplification and roughly true.
Investment Landscape: The United States
On the positive side, numerous favourable economic factors including a strong labour market, stimulative federal tax and spending policies, accommodative financial conditions, and continued high levels of household and business confidence have led to above-trend GDP growth over the past few years. On the negative side, US-initiated protectionism, unilateralism and de-globalisation have escalated global trade frictions and now pose a major risk to global economic growth.
Despite these risks, the US economy continues to grow and the likelihood that it runs into a binding structural constraint, like a prohibitively tight labour market, rises every day. When an economy approaches the end of an expansion, market observers start focussing their attention on which economic constraints are likely to become binding since they provide insight into how inflation might take hold and, consequently, what the shape and timing of a potential policy response might be. The uncertainty caused by the escalating trade dispute with China is not making this any easier.
Wage inflation has historically been a reliable leading indicator of the end of an economic cycle, since it tends to rise non-linearly once an economy outgrows its supply of labour market resources. The solid growth of the last few years has resulted in an unemployment rate that is currently at its lowest level since 1969. Strangely, wage inflation remains moderate. One explanation is that the labour market is less tight than is being suggested by the unemployment rate (likely because there are new factors in play like the emergence of the gig economy and the scale of the opioid crisis) and consequently the economic cycle in the US has longer to run than most believe. Indeed, if businesses reduce or postpone their investment activities because of uncertainties surrounding the trade dispute, and there is some evidence of this, then this conclusion would be truer still (assuming the dispute moderates and does not ultimately derail growth).
Price inflation, on the other hand, is where we are most likely to see the short-term effects of the trade dispute, the renegotiation of trade treaties and the stimulation of consumer spending via tax cuts. Though there is some uncertainty regarding the last point since it is not clear exactly which groups benefit most from the tax cuts and what their marginal propensities to consume are. Given the nature of the beast that pushed the tax cuts through, we believe it likely that the vast majority of the benefits will go to shareholders in the form of stock buybacks and dividends (meaning that its effect on price inflation may be muted).
Over the past 6 months, financing conditions in consumer credit markets were and continue to be largely supportive of growth in household spending while conditions for consumers with subprime credit scores continue to tighten, which, at this stage, is mostly evident from the decline in auto loan extensions to such borrowers. This is a positive development given the risks posed by rising interest rates.
US inflation has been rising steadily over the past few years and now stands at 2.9% but, as you can deduce from the discussion above, there is a risk that a sudden structural break upwards could catch the market, and policymakers, off guard. The reason why this is important is that central banks typically raise interest rates to prevent inflation from rising above some predefined target, so a sudden rise in inflation could lead to an acceleration in interest rate rises. This exact dynamic9 (i.e. rapidly rising rates in the US) triggered the correction that occurred in emerging and frontier markets over the past few months. Complicating matters, during this cycle central banks will need to balance this against withdrawing the liquidity that has been injected into the markets since 2008.
Raising interest rates before the next downturn is crucial since the Fed will need the ability to lower them again to stimulate the economy during the next recession (especially since fiscally very little can be done after the passing of December’s deficit-funded tax reform bill). Keep in mind our warning of the possibility that we will not see a V-shaped recovery in the US because of the high allocation that 401k retirement savings plans currently have to stock markets in a previous Brief. It would make sense that the Fed raises interest rates, and withdraws accommodation, at a level that keeps investors in the stock markets on their toes. Higher volatility and the occasional 10-15% correction is exactly what is needed to shake out investors that are unable or unwilling to stomach the risk for the returns on offer.
It seems highly unlikely that the Fed will push up rates substantially without being reassured that systemically important institutions, like the largest banks, can handle the kind of crisis that caused several lenders to fail in 2008. The recent stress tests, which were passed by most but not all large banks, had a worst-case scenario where US unemployment spikes by 10%, the stock market plunges by two-thirds, house prices drop by 30% and severe recessions grip the eurozone, UK and Japan. Those with large trading businesses also needed to be able to survive the sudden default of a large counterparty. These tests and the recent shift in language by the Fed, to aim at a symmetric inflation rate target instead of a point target, is setting the stage for a continuation of rate rises while allowing for the possibility of a policy misstep.
One of the reasons why so many of the banks passed the recent stress tests is that there has been a broad shift from bank loan financing to bond market financing since the previous recession. This has resulted in a rebalancing of risk away from systemically important financial institutions onto the balance sheets of corporate borrowers. The value of corporate bonds outstanding has nearly tripled while its share of GDP has doubled since 2008. Unsurprisingly, because money has been very cheap, lower-quality, higher-risk borrowers have also been tapping the bond markets. This has resulted in a situation where we are likely to see defaults on a substantial portion of nonfinancial corporate bonds, especially if the Fed needs to push up rates more rapidly than these companies are expecting. The quality of borrowers has become a concern with 22% regarded as ‘junk’ and a further 40% rated BBB (which is one notch above junk). Disproportionately many of these higher-risk borrowers are in the retail and energy sectors.
9 Combined with idiosyncratic factors.
Investment Landscape: Europe
Over the past 6 months, the exceptionally strong growth we saw in the EU last year has moderated somewhat. This moderation is mostly explained by various manifestations of populism, both in the US and in Europe, including the withdrawal of the UK from the EU, and difficulties in forming governments in Italy and Spain. Italy was particularly hard hit by a bout of populism-induced uncertainty which caused a significant widening of Italian risk spreads and a sharp decline in the prices of bank shares. In some parts of Europe and in some sectors, this moderation could be attributed to capacity constraints becoming increasingly binding, resulting in signs of a pickup in wage inflation. All the jobs that were lost during the great recession have been recovered and the unemployment rate is at its lowest level since 2008, despite a labour force that has grown by over 2% since then.
The ECB’s accommodative monetary stance and the broad-based expansion in global demand, spiked by US fiscal stimulus and poisoned by the trade dispute, should, on balance, see growth in Europe continue to advance, especially given the likely signing of a trade treaty between the EU and Japan. Indeed, we are also expecting an expansionary fiscal reaction to the US tax cuts and rising inflation.
Historically, the slopes of the US and European yield curves moved in tandem because central bank policies tended to be closely linked. That link was broken, and the yield curves diverged after the financial crisis and the euro-zone debt crises. The flattening US yield curve led to a weakening of the dollar and the loosening of financial conditions. We are expecting a similar response when the ECB moves to reduce and then reverse its asset purchase program and raise rates though it will take some time before the yield curve has flattened sufficiently to warrant action. Having said that, it is clear that the EU is not ready for an unanticipated acceleration of US rates since it brings with it the very real possibility of a recession before the ECB can withdraw liquidity and raise rates.
These considerations reaffirm our previous conclusion which is that the Fed will aim to make this expansion last as long as possible, giving European monetary policy a chance to catch up before the next recession materialises. In the meantime, the pressure on the Europeans to get their house in order will be ratcheted up. A European economy unable to countercyclically stimulate its economy during a recession is an undesirable outcome all round.
Investment Landscape: China
The principals of modern American foreign policy were set out in a document written for Harry Truman in 1950 as a response to the (military) threat posed by Soviet communism. At its centre was the belief that international leadership would best serve American interests. Over the past 6 months it has become clear that the Trump administration wholeheartedly disagrees, deciding instead to steer away from global leadership, alliances and international institutions.
The US has come to recognise the threat that China will pose to its hegemony, both economically and militarily, if it continues to grow unabated. As a result, and unsurprisingly, it is seeking to undermine its dual growth engines of manufacturing and technology by pushing for tariffs on its exports and insisting on compliance with the international laws that govern Intellectual Property Rights. Specifically, advances in AI, robotics, energy storage technologies and gene editing (and their military applications) is feeding into American anxiety, while China’s reliance on US semiconductor manufacturers is a sore point.
According to the PBC, China’s GDP grew by 6.8% while CPI-based inflation stands at 2.1%10. A major shift is underway whereby the export-driven, low-margin, rapid-growth industries of the past are being replaced by higher-quality, higher-margin industries that can fuel greater domestic consumption. While this is happening, there is a recognised need to structurally reduce leverage throughout the Chinese economy, especially at state-owned enterprises and within shadow banking, while simultaneously opening it up to foreign entities. The PBC has tightened regulations to curb loan growth, the effects of which are most obvious in a clear deceleration of mortgage loans, while forcing a diversion of loans away from industries suffering from overcapacity, such as iron, steel and coal. Despite this, loan growth still exceeds growth in nominal GDP meaning that the problem is not getting smaller but rather, that it is getting bigger at a slower rate. Part of this is a marked acceleration in corporate debt financing while equity financing is decelerating. Indeed, the Chinese corporate-bond market is now one of the largest in the world. Over the past decade, the value of Chinese nonfinancial corporate bonds outstanding increased from just $69 billion to $2 trillion.
As part of its drive to grow its international influence, the Chinese Yuan was officially recognised as a reserve currency when it was included in the Special Drawing Rights basket of the IMF in 2016. As a result, the international use of the Yuan has risen steadily. To take it a step further, crude oil futures denominated and settled in Yuan were officially listed on the Shanghai International Energy Exchange earlier this year which will further promote it as an account unit and settlement currency for commodities. The One Belt One Road initiative, discussed in detail in the previous Investor Brief, will continue to drive the adoption of the currency regionally. Given its growing role and our expectation that the PBC will devalue the Yuan as a part of its retaliatory response to the threat of US tariffs we believe it highly likely that the US will need to seek a resolution to its legitimate grievances on the IP front without imposing tariffs if it has any real intention of reducing the trade deficit.
10 These numbers should all be taken with a pinch of MSG.
Investment Landscape: Emerging and Frontier Markets
As a collection, emerging market economies (EMEs) have been exhibiting relatively strong growth with broadly supportive economic fundamentals over the past few years, though this has been tempered by the ongoing tariff dispute between the US and China which has been causing sporadic cross-border flights of capital out of these countries and into the relative safety of dollar denominated assets. Indeed, early June saw the highest outflows from EME equity and debt in 18 months. Protectionist rhetoric appears to be having a disproportionate impact on EMEs even before material restrictions have been applied.
The rebound in commodity prices, such as oil, has allowed Russia to stabilize its economy and reduce inflation after it needed to be controlled. The Indian economy has been reasonably stable with inflation rising to 5.1% and a slight weakening of sentiment in the manufacturing and service sectors. Despite South Africa’s struggles with reducing its stubbornly high unemployment rate, credit-ratings agencies recently revised its credit outlook upwards. A series of shocks combined with economic vulnerabilities in Argentina in May resulted in severe pressure on the Peso, a higher sovereign risk premium and short-term liquidity risks. It received a $50 billion stand-by arrangement from the IMF to help it restore market confidence, reduce inflation (which currently stands at 29.5%) and put the country’s debt on a firm downward trajectory. Higher fuel prices caused truckers to go on strike which resulted in a crippling nationwide shutdown in Brazil, which exposed the government as being weak and unpopular. Fighting for political survival the Brazilian government jettisoned fiscal discipline which spooked the markets especially given that there is also a wildly unpredictable election on the docket this year. The Turkish economy grew by 7.4% but has been dogged by a state of emergency and political interference in its economic institutions by Erdogan.
Many EMEs have been issuing debt in their local currencies instead of a hard currency, like the US dollar, which combined with the fact that much of that debt is held by domestic investors, makes them less prone to flights of capital and less sensitive to movements in the dollar than they were in the past. Relatively healthy current account balances should also reduce the likelihood of negative spillover effects between EMEs, though in an extreme stress situation we would expect regional cross-linkages to give rise to contagion.
What does this mean for an investor?
It has become evident over the past few months that the global economy, including the US itself, is not yet in a place where it can handle rapidly rising US interest rates from current levels (corporate default rates would be too high, retirement plans are overly at risk, not all systemically important banks are ready to handle an extreme stress scenario while numerous emerging markets have proven to be fickle in the face of sudden flights-to-safety). As a result, we believe that US policymakers will try to make this expansion last as long as possible and that they are following the most prudent path available to them, which is to clearly telegraph their intentions of gradually raising rates while withdrawing liquidity at a pace that induces broad deleveraging across households and businesses. Given these considerations, it would not surprise us if the Fed eventually moves to push up the target inflation rate to buy more time.
Thankfully, global inflation is contained for now but if it were to rise rapidly and unexpectedly, perhaps because of the current geopolitical tussle, and interest rates are forced to follow suit, we are foreseeing a record number of defaults across high-yield corporate bond markets. As we have highlighted in previous Investor Briefs, a solvency event of this scale will likely lead to a liquidity event in the stock markets where liquid ETF products, promising illusory diversification, will sell indiscriminately into a relatively illiquid stock market. At that time, many of the most popular stocks across the various ETFs (which include the same 10 stocks that have accounted for the return of the S&P 500 so far this year) could see their stock prices get crushed. As you know from previous Briefs we closely monitor high-yield corporate credit markets, especially the US market, and ETF flows for signs of stress.
New Features: User Notifications
No-one wants unwanted e-mails so we’re adding a new feature very soon that will allow you to control what communications we send you and how you receive them.
It’s called the ‘User Notifications’ settings and it can be found in (you guessed it) the Settings page. At the moment whenever certain things happen, e.g. a new investment idea appears in a strategy you are subscribed to, we’ll put it in your activity feed, we may send you an email and, if you use the Huddlestock mobile app, we may send you a push notification as well. These settings will enable you to set how, and in which ways, you want to be informed.
As always, if you have any feedback, please email us at firstname.lastname@example.org.
(Honestly, we read it all!)