Sunday, October 04, 2015

Here's A Macro Trend Not Enough Traders Are Focusing Upon

I've long thought that financial markets are master magicians.  They get you looking at the one hand that's waving around, while the real magic is being performed with the other hand.  There have been a lot of waving hands in 2015, including the U.S. dollar and rates, stocks, and assets in China and emerging markets.  All that hand waving has led some investors and traders to lament an absence of clear themes and trends in macro markets.

Meanwhile, real magic can be found in the trends depicted above.  The top chart is a weekly chart of the WIP ETF, which tracks the prices of international inflation protection bonds.  The middle chart is a weekly depiction of the JNK ETF, which tracks the prices of high-yield bonds.  The bottom chart is of the EMB ETF and takes a weekly look at the prices of emerging market bonds.

Since the middle of 2014, these have been in a steady decline.  We are seeing global deflationary forces, with higher quality debt significantly outperforming lower quality debt.  In short, there is too little growth and too much debt globally.  Per the charts above, markets continue to price in continued deflation and continued concerns with the sustainability of debt.  

Now this is the point where the blog writer is supposed to trot out the uber-bearish scenario and headline the piece with a dire warning that will attract the eyeballs in cyberspace.  I strongly suspect, however, that the perma-bear thesis is yet another hand wave of the magician.  Here's what I'm watching in the magician's other hand:

1)  Quality - There are too many baby-boomers still out there needing to protect their capital.  Many have been reaching for yield and seeking returns in stocks.  Stocks have been a mixed blessing: strong if you've been in consumer-related sectors, weak if you've been in commodity-related shares; stronger if you've been in developed market stocks, weaker if you've emphasized emerging markets.  Those of us old enough to recall the "Nifty Fifty" know what it's like when a market reaches for quality:  large, stable companies with decent dividends and growth and little debt.  If the trends depicted in the charts above continue, it's not difficult to imagine a "boring is good" mindset among investors:  own stable, quality stuff that won't interfere with your sleep.

2)  Volatility - Some debt will not be sustainable and continued deflationary forces will weigh on global growth.  That could lead us far from the low volatility markets we've enjoyed under global regimes of quantitative easing.  The smart money managers I know express concern for the liquidity of many assets.  With investment banks no longer as active as counterparties that can warehouse risk, we are increasingly vulnerable to shocks.  That's an environment in which you want to own negative tails and be long volatility.  Predicating trading and investment strategies on the kinds of markets we've had from 2012 to mid-2014 has not worked well of late.  It's not difficult to imagine that the recent discussion of Fed hiking will look quaint in 2016.

If all this is correct, a tipping point might come when central banks continue their easing but no longer can produce the low volatility shift from bonds to stocks that we saw from 2012 to recently.  In other words, deflation dynamics would outweigh QE dynamics across assets.  In such an environment, the reach for yield would be replaced by a reach for stability.  For those not prepared, that could look suspiciously like black magic.

Further Reading:  Why Traders Succeed and Fail in Financial Markets