While market participants may think they have dodged a bullet after last week’s volatility, whilst also being somewhat unsettled by the dangerous correlation between equities and bonds, analysts argue that there is perhaps no more important question for long-term investors and allocators than getting the inflation question right. As Ben Hunt from Salient Partners (see below) you don’t have to be precisely right, but you sure better be generally right. He says that this is the source of the “rethink” that’s happening right now, and that’s why he for one doesn’t matter believe that what’s happening in markets is a temporary blip or a “technical” adjustment. It’s the first stage of a fundamental shift in the behavior and beliefs of investors, and that’s a really big deal.
Substantive's Top Themes - Best of the Broker Notes
1. The Secong Leg Down?
Cross Border Capital are experts in analysing global liquidity across the public and private sectors. In this note They say that the latest madness in markets centres less on the price of 'risk' assets and more on the valuation of ‘safe’ assets. For a couple of months now, CBC have argued that US safe assets – the US dollar and US Treasuries – have been 10-20% expensive. As they adjust, more traditional risk assets will similarly adjust downwards in price, much like previously occurred in 1987 and 1994, CBC say in this report. The obvious question is: Whether this will be an orderly exit or a Crash? The answer largely depends on capital flows, says CBC. Whereas the market is focussed more on the negative effects of perhaps US$450 billion of prospective ‘reverse QE’ by Central Banks in 2018, CBC’s worry centres on the odds that US$3 trillion of cross- border ‘flight’ capital would exit even quicker. With the US dollar already down sharply in 2018 and US 10-year bonds testing 3% yields, much damage has already been taken, the report says. However, two continuing factors remain of concern: (1) Treasury term premia – the key valuation metric for bonds – still look too low, and (2) major Forex reserve managers are pondering their long-term commitment to the US dollar amidst a growing interest in the Chinese Yuan. This shift is unpredictable, but it does seem inevitable, conclude CBC. They add that investors should watch the success of the planned Shanghai oil futures contract in March as a bellwether. This note can be
2. Risk Parity - Gell-Mann paradox
The newsletter, Epsilon Theory, authored by Ben Hunt, chief risk officer of Houston-based asset manager, Salient Partners, examines the markets through the lenseshttps of game theory, history, and behavioural analysis. Salient also happen to own the index that tracks the risk parity. So they know a thing or too about it, and in this note Hunt seeks to address a lot of market misinformation about risk parity. For him, it’s a classic example of the ‘’Gell-Mann paradox. This relates to how an expert reacts to information they read where they know exactly what the facts are, and where - in their view - it is not just that the facts are wrong but it is also wrong in interpretation, impact, motivation … everything. Yet as soon as the said expert reads an article on something he or she knows nothing about, that person might go go, ‘hmm, that’s interesting.’ It’s as if they’ve been struck by amnesia. This occurred to Hunt last week when he read an array of pieces that suggested risk parity was at the heart of the sell off in risk assets. These stories were completely wrong, and he provides references to a piece from AQR, that he cites an example of something closer to the truth. Also check out WRGuinn on twitter, which is also quite useful. Last weeks Epsilon Theory captures what Hunt does think is responsible for what’s going on in February (and the months ahead), Click here to read the full note.
3. Brexit Risk for UK Fin Services Overstated
Ewen Stewart at Walbrook Economics is an expert on BREXIT analysis and has a much more sanguine than the consensus so his work is worth taking notice of. In this report, published this week, he makes a strong case that even if there is no Single Market access nor passporting for the UK financial services sector, there will be little overall impact on the overall sector, apart from a few pockets of activity. He presents four possible choices the UK faces, but concludes that in the end a deal will be reached, that will effectively enshrine the status quo. It will be made politically acceptable by time dating it post the transition period. The report goes on to say that the UK’s share of the European financial services market is huge and cannot be replicated in any other financial centre. So even if there is no deal and the UK has to trade with Europe under the WTO, it will still dominate. He concurs with the figure of up to 10,000 job losses being likely and points out that this is only 3% of the total employment in high-end UK financial services. Click below to request trial access to read this full report.
4. Testing Signals
Alot was written and said last week about the breakdown in the inverse correlation between bonds and equities, which struck fear into the markets that there was no safe place to park money in the event of an equity market rout, aside from cash that is. Of course it’s all the fault of Risk Parity (Isn’t it?). we thought we’d flag up the work that’s BAML have done in this area the easily pre dates last week. In a piece published on Dec 14 last year ”Moving on from the safe house” BAML analysts predicted that the conventional wisdom about the ‘safe haven’ and diversification attractiveness of USTs will likely be challenged in 2018. While no mention was made of ”short vol unwinds,” BAML argued that the possible increase in deposit betas (given hikes and Fed balance sheet run-off) will make cash a competitor to US Treasuries. Indeed, history also suggested equity corrections that happen in a high growth and high inflation environments are not hedged by Treasuries. This is what seems to be playing out now, BAML writes in last Friday’s Global Rates Weekly. BAML clients can read the full piece on BAML Mercury.
5. Chinese Equities; Marching to a Different Drum
If you thought the sell off in Chinese equities last week was simply a reaction to the global rout in equities after the volatility spike, then think again, writes Gavekal Dragonomics. In fact Chinese equities did worse. But why? To be sure the global sell-off was an aggravating factor in the mainland’s market meltdown, it was not the trigger, Gavekal say in the report. Instead the slide in Chinese stocks owed more to heightened local investor anxiety over Beijing’s new financial regulations, exacerbated by a crackdown on leveraged buying. When the regulatory dust settles, which is likely after the coming week’s Lunar New Year holiday, benign fundamentals and attractive valuations should come to the fore again, with Chinese stocks resuming their upward march, the report concludes. Click below to request trial access to read this report or to request samples.