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As The Tri Polar World Turns - November 2018

MACRO THEMES

The main macro theme of the past month was the return of global market volatility which facilitated a start to the Convergence of US, tech led equity markets (Nasdaq posted worst Oct since 08) with the rest of the world. The US gave back much of the outperformance we have written about over the past several quarters in the space of one pretty ugly month. What comes next remains to be seen but we are unlikely to go back to the status quo ante.

From an ECONOMICS perspective not much seems to have changed. Global growth remains relatively robust though decelerating gently. So, what are we watching for?

US economic weakness in 1H 2019 could surprise given the overstated nature of 3.5% US Q3 GDP growth due to a pre tariff inventory build (See Chart 1). Rate related housing and autos have rolled over while the consumer has been busy reducing savings to fund lifestyle. Notwithstanding a strong recent Average Hourly Earnings (AHE) data point (also flattered by the base affect) the consumer is unlikely to lead a surge of economic activity. The capex boom, expected in a late cycle economy and forecast to be juiced by the massive corporate tax cut, has largely failed to materialize. Trade related uncertainty will likely continue to hamper such activity leaving the US short of growth drivers as we enter 2019. At the same time, Chinese growth concerns could begin to fade as pro-growth measures introduced in 2H 2018 start to bear fruit. This could flip the current script leading to ebbing growth concerns in China and rising growth concerns in the US.

Chart 1: Q3 Inventory Build Up Flatters US Growth

2018.11.09 Inventory.png

Source: WSJ

On the POLITICAL front the US midterm elections have come and gone & for a change occurred pretty much as expected with the House going Democratic and the Senate staying Republican. We expect gridlock in DC to have limited financial market impact. Next up the Mueller investigation which should return to the front pages in the coming weeks & shed light on what the US political future holds. Bolsanaro’s election in Brazil could lead to the very unexpected scenario whereby the US and Brazil begin to focus on regional integration in The Americas, an important topic from the Tri Polar World perspective. European politics (ex Brexit) continues to focus on Italy as the Italian Govt tries to build an anti-austerity coalition for next year’s European Parliamentary elections. In Asia the big news is the rapprochement between China and Japan which bears close watching for Asian integration in general and Japanese corporates in particular as China’s marketplace opens up for non US firms.

One would be remiss to not note the upcoming meeting between Pres. Trump & Xi. The tea leaf reading here rivals the good old days of Kremlinology. It seems likely both leaders may want to start a dialogue which the rest of the world would welcome, but it is probably unwise to expect much more than that.

On the POLICY front the important news is the inclusion of fiscal policy together with monetary policy in all three regions. Fiscal Policy is almost a case of the good, the bad and the ugly. The good would be China’s use of targeted tax cuts and fiscal measures to offset trade related concerns. This is particularly the case given exchange rate concerns which limits the use of monetary policy. The bad is Italy’s fiscal situation which seems likely to remain headline risk for some time to come as Rome and Brussels engage in what would seem to be an unnecessary tussle. There is a case to be made for fiscal stimulus in Italy and in Europe more broadly. As Angela Merkel prepares to step down could the worm turn and Germany begin to embrace some fiscal stimulus as is occurring in Spain and France? The ugly would seem to be the US where the fiscal red ink threatens to exceed a trillion dollars in the years ahead. How this deficit is financed is an open and increasingly urgent question. Foreign investors hold roughly 40% of outstanding UST and hedged returns are not appealing (See Chart 2). This suggests that either a weaker dollar or higher rates will be needed to generate demand.

Chart 2: The share of foreign ownership of UST debt has been shrinking

2018.11.07 Treasury forien ownership.png

Source: WSJ, US Treasury Department

Monetary policy remains front and center, especially in the US where one can be forgiven for thinking that October’s equity market weakness might have been partially meant to test the Powell Put level. While that level remains unknown, at least one hike was priced out of 2019 forecasts. A Fed pause remains quite possible in early 2019. The dollar continues to slowly grind higher against the Euro and Yen; EMFX, which set off the global turmoil, now looks to have bottomed. Tightening financial conditions, weak stock markets, ebbing growth, Trump/Trade uncertainty could all lead to a Fed pause & a weaker USD which would facilitate UST demand while also supporting non US risk assets.

Thus to MARKETS. From divergence to convergence leading to First In to First Out performance as EMFX and ACWX try to bottom vs the US (See Chart 3). From Tech led momentum to high dividend and low volatility factor outperformance. From buy the dip to sell the rally. Much technical damage has been done and many markets and sectors look weak. Early November’s bounce reinforces the importance of stock buybacks in the US. The good news would be that the selloff has priced in a fair bit of the trade, tech and end of QE worries that have been in place for some time. The questions then become twofold:  what brings back the blue skies & who leads? A Fed pause could do the trick, especially for non US markets. An adjustment of 2019 EPS estimates to reflect continued concerns over tech splintering and trade/tariff related margin pressures would also be beneficial for the US. Lastly, confirmation of a bottoming in the non US markets could signal a leadership change in global equity markets.

Chart 3: US Outperformance vs ROW at an End?

2018.10.26 FTSE ex US RELATIVE 2.png

Source: WSJ

PORTFOLIO STRATEGY AND ASSET ALLOCATION

Given our constructive outlook for global growth we continue to favor global equities over bonds and maintain positions in alternatives. We have raised cash across our portfolios in order to dampen volatility. Plenty of uncertainty remains around leadership within the equity space, both geographical and sectoral, while supply - demand risks are rising in the UST market. Within Alts, energy has been extremely volatile. It's too early to conclude equity markets have made a definitive bottom and the all clear  has sounded; as noted above a Fed pause, further earnings adjustments or clear bottoming in the non US markets would be solid signals to work off of. Given market volatility we have reduced our European equity overweight, shortened our UST duration and added to cash.

On a regional equity allocation basis we have reduced our European overweight by eliminating our small cap position while adding to our Japan equity position. Japan offers political stability, growing domestic demand in a full employment economy and upside to the rebalancing of China trade flows. We continue to favor the non US developed markets vs either the US (where we favor high dividend and low volatility exposure) or EM.

Within fixed income our bias has shifted to cash and short duration USTs. We remain constructive on US credit, particularly US HY which remains supported by favorable supply – demand characteristics, declining default rates and the lack of repayment mountains. We continue to favor USD EM debt with its favorable yield pickup vs EM LC debt. Our expectation for better EU growth leaves us with minimal exposure to non-US sovereign debt positions.

Within our Alternative sleeve we remain focused on broad commodity exposure with a tilt to energy via our MLP position.

GLOBAL MACRO SUITE PORTFOLIO CHANGES

Global Macro Multi Asset (GMMA)

  • We exited our EU Small Cap position reducing our EU overweight while adding to our Japan Small Cap position in anticipation of continued domestic expansion.

  • On the sovereign side we exited our long duration UST position after having steadily reduced it in the prior months & replaced it with a shorter duration UST position.

  • In order to dampen volatility, we boosted our cash position.

Global Macro Income (GMI)

  • As in the GMMA portfolio, we eliminated our long duration UST position and replaced it with a shorter term UST instrument. We also added to USD cash and now have a double digit cash position as a volatility dampener while we await better opportunities.

  • Within the multi asset component we eliminated our MLP position due to excessive volatility.

Global Macro Equity (GME)

  • We exited our EU Small Cap position reducing our EU overweight while adding a Latin America position to benefit from Mexico’s oversold condition and Brazil’s cyclical economic recovery.

  • We added to cash as a volatility dampener.

We hope you find this new piece of value and look forward to engaging with you on a monthly and quarterly basis.

Jay Pelosky, CIO & Co-Founder
TPW Investment Management

 

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James Gardiner