I’ve got four snippets from recent research today which echo some of my own observations about global financial markets at the moment. They argue for three relatively simple investment ideas:
- Long emerging markets but especially China. Be more cautious about India ahead of the up and coming general election
- Be short most bonds
- Long many commodity trades (especially energy – see yesterday)
As I keep repeating in this blog, I think we are still mid-way through the late stages of a long business cycle and bull market. I do think it will unwind at some point in the next 18 months to 24 months with currency markets the likely cause of volatility – or possibly geopolitics and the rise of the radical left in Europe (especially the UK).
I also think that the central banks will be very cautious about how they slowly withdraw QE and increase interest rates. In particular, I see President Trump enjoying his economic bounce – it is his only positive bit of news. He wants a good year or so of reflected glory from the economy – as does President Xi in China (for very different reasons). If the Fed does suddenly tighten aggressively, causing a big bond sell-off and then a market crash, I can see Trump leaning aggressively on the Fed to slow down. Trump shows no sign of respecting bureaucratic sensibilities and rather like President Erdogan in Turkey, if he thinks central bankers can help him win re-election, he’ll apply the pressure (to his appointees). So, all we need is for another fit of Taper Tantrums and we’ll see the printing presses restarted again. Obviously, there are two possible “spanners in the works”. The first is geopolitics, where frankly any prediction beyond a surprise Corbyn win is pointless. The second threat comes from inflation. I readily accept that increasing commodity prices and some evidence of firming of wage rates could provide an upward jolt to inflation trends, but I also think that the strong structural factors pushing down prices (technology and globalization) aren’t likely abate. If anything, they might actually intensify. Thus, I think we could find ourselves in a situation where inflation is subdued, interest rates only rise to around 2 to 3% and we have another 12 months of strong growth. We could even see a sell-off in bonds and a final late cycle redeployment into equities in search of an income.
Anyway enough of my prognostications, here are my four research snippets.
UBS on EM fund flows – EM funds looking strong
Asia ex-JP funds renewed their 2½-year high, but still lag Dedicated GEM funds. According to EPFR Global, GEM equity funds reported more very heavy inflows of $7.6bn last week, only a touch lighter than a week earlier.Big inflows continued to roll into EM equities despite a pause for the markets as MSCI EM lost 0.3% w/w. However, this is not an unusual situation – as we have argued, fund flows follow the market, not lead it. Inflows into Asia ex-JP ($3.3bn) funds saw a further acceleration and renewed their weekly high since early-July 2015 again. In contrast, Dedicated GEM ($4.1bn) fund flows slowed down by over $1bn relative to the prior week’s print. Inflows into EMEA ($97m) and LatAm ($89m) funds also declined w/w; their combined contribution to last week’s inflows was only 2.4%. By market, China saw inflows of over $3.5bn, absorbing 46% of the EM weekly total, followed by inflows of over $800m into India and Korea each and a further $474m inflow into Taiwan. No EM saw outflows last week, but 17 out of the 24 countries reported a w/w decline in the inflow pace.
ETF ($5.3bn) flows surge to a 2½-year high; Non-ETFs ($2.3bn) flows still strong
Last week, inflows into EM ETFs ($5.3bn) hit a new post-July 2015 record. Non-ETF ($2.3bn) inflows remained strong, but were 41% below their all-time high in the prior week; their contribution to the weekly total fell to 30%, which is, however, above their 20% share in 2017. The YTD inflows have reached $25.9bn (Figure 1).
Investors add to ETFs and rotate to Value – Why now?
This year’s uptick in the ETFs’ share in EM inflows has coincided with a 2.1% MSCI EM Growth underperformance vs. Value in the past five weeks. The high concentration of EM gains in 2017 showed the merits of active investing; and after the 17% EM Growth beat over Value last year, investors are likely rotating to the latter, which is consistent with our EM equity strategy views. This can potentially be a start of a reversal of the post-2008 winning streak for EM ETFs, as well as for the EM Growth style. Since January 2009, ETFs have enjoyed cumulative inflows of $141bn vs. only $446m for non-ETFs, which is also the first positive print in two years. During the same time period, the EM Growth Index has risen by 153% – more than double the 74% gain in the MSCI EM Value. That said, a cointegrating relationship between the gap in ETF and non-ETF cumulative flows and the Growth/Value relative index has emerged (Figure 2).
Korea and Brazil turn less crowded but remain the most crowded major EMs
According to our investor positioning model, China turned sharply more crowded last week, having gained three ranks. In contrast, Korea and Brazil lost three ranks each, but remained the two most crowded major markets.
Cross Border on Why Bond prices have much further to fall
Global bond markets will suffer a tough 2018, with G4 markets losing an average 5-6%, and with losses concentrated in US Treasuries and JGBs. Neither the pattern of the
US term structure, nor latest data that show fleeing cross-border capital flows from the US
dollar, are bullish for US Treasuries. Nonetheless, many investors are trying to read the latest yield curve flattening as potentially favourable for bonds. They are wrong. We continue to expect 10- year bonds to test 3.5% yields this year
Cross Border also argues that term premia matters. “ ….the term premia has averaged 117bp (standard deviation 78bp) and in 2005-2017 it averages 72bp (st. dev. 49bp). The current minus 29bp reading is more than two standard deviations below. Therefore, assuming G4 policy rates rise by an average 50bp over the next 12 months, this would add around 25-30bp to risk-adjusted 10-year yields. Add in ‘some’ mean reversion in term premia of say one standard deviation, and G4 yields could rise from an ‘average’ 1.35% to 2.1% – an expected capital loss of around 5-6%”
Researrhc firm Lalcap on why the Indian budget is potentially bad news for investors
This is a rural development and infrastructure focused budget with the vast rural vote clearly in mind ahead of general elections by May 2019. Stock markets ripe for profit-taking.
1. Positives include: a) The world’s largest health protection scheme, now dubbed “Modicare”. This is excellent news for the poor and quite sad that it has taken “election” politics to introduce this; b)
Continued record investment in infrastructure, especially rural; c) “Make in India” given a boost.
2. Negatives include: a) Slippage in fiscal deficit targets may lead to higher interest rates; b) Promise to reduce Corporation Tax rates across the board not kept; c) LTCGT will upset investors.
Overall, no major negatives for the average person but capital markets are going to react badly in the short-term. The key, as always in India, lies in implementation and speed of delivery
Goldman Sachs on the 3Rs and why they are optimistic on commodities
The 3R’s – reflation, releveraging and reconvergence – reinforce our bullish overweight commodity outlook. Strong demand growth against limited supply growth due to OPEC and Chinese supply curtailments created significant reflation in commodity prices last year. During 2H17, commodities were the best performing asset class, posting a solid 18% return. Given the high level of debt held by commodity producers, not only do higher commodity prices reduce the number of bad loans and free up capacity on bank balance sheets, higher commodity prices also help strengthen EM currencies and weaken the dollar via the accumulation and recycling of rising excess savings. On net, this in turn lowers EM funding costs and leads to EM releveraging. More EM leverage leads to more EM growth reconvergence, reinforcing even more synchronized global growth and, ultimately, reflation pressures – creating a feedback loop. Our global Current Activity Indicator (CAI) is tracking 5.1% annualized real GDP growth, and as of last Friday (January 26) financial conditions in the US were the best ever recorded in the history of our Financial Conditions Index.
Based on this increasingly supportive growth backdrop we have upgraded our commodity forecasts across oil, copper, iron ore and coal. Given we have raised our 6-month Brent crude oil target the most, to $82.50/bbl from $62/bbl previously, we have front-loaded outperformance of the S&P GSCI and now expect returns of +15% and +10% over the next 6 and 12 months, respectively. In addition, with low and declining inventories in key commodity markets, we expect commodity price volatility will rise from the current historically low levels.