In November of last year I attended a meeting with some independent consultants employed by my firm to analyse US politics. It’s no exaggeration to say that they were ecstatic with joy at the prospect of a trump presidency. These were intelligent, accomplished, educated people with a strong grasp of the facts of world affairs and US domestic politics. Whilst they undoubtedly leaned to the right politically, their arguments were one of the principal reasons I was moved to examine my own thinking and write my grounds for optimism piece in early January. Since then, Equities have rallied, gold ( a traditional measure of risk appetite) has failed to perform, and an atmosphere of feverish expectation has gripped financial markets. Over the Christmas period, I thought long and hard about European fixed income markets – and came to the conclusion that for logistical (running out of bonds) and macroeconomic reasons (inflation normalising), the market would soon price the end of European QE.
Having banged the long equities and short European fixed income drums since the start of the year, I now find myself with the right kind of problem – how do I ride my winners? The principal justification for both trades has now come to pass. I had two ideas that seemed at variance with the rest of the market as of December – the first being that whilst any right thinking person might baulk at a reality TV narcissist running the worlds biggest country like a tinpot dictator, the fact of a businessmen in charge presiding over a cabinet of fellow billionaires, Goldman Sachs creatures and former corporate raiders would probably be really good for earnings. The market has now fully embraced that narrative, to the extent that even pouring money down the drain to build a wall with the US’ third largest trading partner is grounds for optimism. The market has indeed begun to look past the end of European QE, helped along by a generous slug of supply from every issuer under the sun in Europe as governments and agencies use the remaining support provided by the ECB to jam as much long term debt down the markets throat as it can handle.
Normally when one’s perception as at odds with the market – there is opportunity. Now that my ideas are more in line I am taking stock and considering what to do next. Broadly, I have decided to stick to my guns. I still believe that being short European fixed income is set to pay off handsomely this year. The main danger to this idea is the market getting a little ahead of itself, curves are already steep and I have from the horses mouth that this is not a deliberate or desired outcome of the recent changes they made to their buying program. They may seek to talk long end rates lower – especially as political uncertainty in France and Italy widens spreads between the bonds of different countries, which typically the ECB does not like. A resurrection of language about the possibility of re-increasing purchases would certainly hurt shorts – but such talk is largely empty considering the constraints the ECB faces buying more paper and should be faded. To that end, I am shifting my small PA short on long end European government bonds into the 5y paper, and recommending similar to my clients. I believe that most of the move in bonds so far has been about the large amount of supply- not the market looking toward the end of QE and normalising of rates.
In US Equities, I think the only sensible course is to stick with the trend. Despite an almost doubling of US equity indices over the past 5 years, pension funds allocation to stocks have barely increased. This to me says that large investors who ultimately drive the returns available in different asset classes have not been participating in the move – and will be acutely sensitive to further moves higher. People often talk about positioning in financial markets in terms of who is long and who is short- but for me that’s an incomplete view. To me – short means “someone who might have to buy” and long means “someone who might need to sell”. By that metric, no one is long. The speculative community who I am intimately involved with professionally – ie big hedge funds- are long via options and not in big size- so their sensitivity to moves lower is low, they’ll likely add. Pension funds and asset managers don’t own anywhere like enough equities. Retail investors are not buying on margin yet – which is the only time those guys are really long. Positioning therefore supports a continuation of the trend.
However, with some gains in hand, it makes sense to look for a hedge to lock in a bit of profit and, well, justify all this smart stuff I’m supposed to have learnt about financial markets by overcomplicating things a bit! I had a go at hedging my views by buying 30y tips – but fluffed the timing badly and got stopped out. Now I think I’d rather just pay some premium. Whilst I’m bullish on stocks because of earnings and positioning – I see no good reason why the various lunacies of the current administration should be any good for the US economy, neither do I believe that the Fed’s undoubted obsession with financial markets cuts both ways. Stocks down is definitely a reason to baulk at hiking rates – but stocks up is certainly no reason to raise them. Stocks up is just a good gosh darn thing. Why spoil the party. I don’t believe that the FOMC with all their collective wisdom actually think that, but the smart things they do think probably cancel out, so one is left with the cognitive biases – few of which are as powerful as the “good begets good” heuristic. Hey, our easy policies are generating good outcomes economically -and given that boor in the white house, we ought to be careful, right? I think so. The US curve is steep enough here to justify paying up for some call spreads on Eurodollars – or some wide 1×2 receiver spreads in swaptions if you’re feeling fancy, as a hedge for a slightly more bearish scenario.