Rudi's View | Oct 10 2018
In this week's Weekly Insights (published in two parts):
–Investing Used To Be So Much Easier
–Rudi On TV
-Rudi On Tour
[Non-highlighted parts will appear in Part Two on Thursday]
Investing Used To Be So Much Easier
By Rudi Filapek-Vandyck, Editor FNArena
"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
(Political consultant and US media personality, James Carville)
It is probably way too early to start preparing for worst case scenarios like, ahem, the next bear market for global equities, but one conclusion that should be on every investor's mind is that things are getting tougher, and not necessarily only because of bond price movements and sudden spikes in volatility.
Those among you who follow me on Twitter would have noticed that, well before there was a sudden spike higher in global 10-year bond yields, there had been regular updates on how investment strategists and asset allocators viewed the year ahead. Most updated targets for US equities, and for the ASX200 here in Australia, suggested further gains would be a lot smaller than what has occurred post Trump election in late 2016.
As per always, the exact timing or trajectory of what comes next is the difficult challenge. Nothing really happened in September, but all of a sudden tables have turned quickly in the first week of October.
One of the factors that is easily forgotten by the financial commentariat is that trading robots, algorithmic programming and short positioning is just as prevalent in today's bond markets as it is in equities. This can make for sudden moves higher or lower depending on the context and the direction from which technical levels are being broken.
Last week a combination of the populist government in Italy challenging the European Commission's determination about government budget deficits, stronger than expected US economic data and a candid Fed chair stating US interest rates are still a fair distance away from reaching neutral territory (a statement he might come to regret) combined triggered a sudden sell-off in 10-year US Treasuries. Note that as bond prices fall, the yield on those bonds jumps up.
Along the way technical levels were broken, triggering more selling (yields further upwards). A tight US labour market combined with China tariffs and strong economic momentum are feeding into fears inflation might be about to spike higher too. Meanwhile, every forecaster worth his/her salt sees ever greater US budget deficits on the horizon. The latter most likely means the US will be issuing more long dated bonds at a time when buyers from the past (Fed, China) might remain absent.
I have often made the comparison and it remains as valid today as it was in the past; bond yields are like crude oil prices. The world can cope with a higher oil price, as long as it doesn't happen within a flash. The same principle applies to bond yields. Last week the US 10-year yield sprinted higher; lifting in no time from 3.06% to $3.23%. Such a quick move upwards will always spook investors elsewhere.
The impact of last week's movement in the US bond market was best described by strategists at Morgan Stanley: in one quick two-day move it transformed US equities from reasonably valued into a richly valued asset. (Higher bond yields translate into lower valuation for equities effectively weighing down Price-Earnings ratios in general). Hence investors started selling, simply to adjust for the change. Further selling should follow if bond yields continue to rise.
Back in February, when conditions were partially similar, US equities instantly reversed course, after an exceptionally buoyant January, but Australian equities quickly recovered and outperformed. This was partially explained by money flowing out of Emerging Markets and into Australia; something that might not be repeated this time.
One key difference with February is that the real yield in the US -US Treasuries minus inflation- has now broken out of its five-year trading range between zero and 0.9% to 1%. It doesn't sound like much but financial markets are the place where seemingly small changes can have much larger consequences, in particular in the short term.
Don't forget: a small ripple in the landscape can look like a giant tsunami to the eye with a short term focus. Plus a number of experts has been calling for much higher inflation and bond yields since 2016, while others, even though they still suspect this time will be proven different from the past, realise we are effectively in unchartered territory, en route to discovering where exactly is the new monetary neutral and how long exactly will inflation be kept in check?
Third quarter reporting season for US companies is effectively upon us and investors will be anxiously looking for guidance. While economic data have remained buoyant, tariffs, higher wages, rising bond yields and a stronger US dollar all represent potential headwinds.
Then there are the mid-term elections in the US in November, less than one month away. Will the Trump administration back away from placing an embargo on Iranian oil exports? The People's Bank of China (PBoC) has cut the reserve requirement ratio for most Chinese banks by 100bps, releasing an additional CNY1.2 trn into the banking system. (Some economists already are anticipating another RRR cut early in 2019).
Not getting much attention in Australia, but India effectively avoided a mini-Lehman crisis for the world's second most populous nation. The Indian government and Reserve Bank of India reacted swiftly to multiple defaults by a systemically important non-banking financial company. While a looming disaster appears to have been avoided, economists are expecting local credit markets to be affected as well as the country's growth momentum.
From a technical point of view, the health of the current uptrend is quickly being eroded with trend lines broken to the downside and the Nasdaq trading below the 50 day moving average. And let's not forget; outside the USA, global growth is slowing.
Higher bond yields are usually cited as a valuation constraint for equities, in particular for growth stocks that trade on higher PE multiples than their peers in the "value" basket. In practical terms, this means share prices for CSL ((CSL)), Afterpay Touch ((APT)), Xero ((XRO)) and WiseTech Global ((WTC)) should sell off more than, say, ANZ Bank ((ANZ)), Fortescue Metals ((FMG)), Woodside Petroleum ((WPL)) and Harvey Norman ((HVN)).
Plus your typical bond proxy -Vicinity Centres ((VCX)), Transurban ((TCL)) and the like- should sell off too to reset implied dividend yields at a higher level (to remain attractive yield stocks in the share market need to offer a higher yield because they represent higher risk than government bonds).
Historical data analysis by Morgan Stanley suggests changing dynamics in bond markets effectively set the framework for which stocks and sectors perform. Morgan Stanley strategists believe US Treasuries have now moved into the "Bear Steepening" phase on the far right, or maybe into "Bear Flattening" on the left.
Either way, this suggests miners and energy stocks are but the only places to be for investors seeking outperformance (plus maybe Consumer Discretionary).
In practice, however, things are seldom that straightforward and simple. For starters, few will deny clouds are forming for the Australian economy, in particular if global growth continues to decelerate. Financial markets might price in potential RBA rate hikes next year on the back of a weakening AUD, but surely falling house prices in combination with record high household debt, low wages growth and tightening credit are sufficient reasons for the RBA to sit on its hands for much longer?
Also, AUD/USD traded at 78c at the beginning of the calendar year. It is now threatening to break below 70c. At what point does this become a positive factor for foreign earners who mostly trade on above market PE ratios?
Plus secular changes and tectonic shifts that have dominated the Australian economy and share market over the past five years are still very much alive as witnessed by profit warnings issued on Monday by ANZ Bank and InvoCare ((IVC)), accompanied by a private equity take-over approach for MYOB ((MYO)).
Witness, for example, the fact that share prices of Goodman Group ((GMG)) and Charter Hall ((CHC)) have held up remarkably well, including during the week past. In addition, the last two updates on Woodside Petroleum both were downgrades to Sell while Carsales ((CAR)) has now received three recommendation upgrades in two days (including from Baillieu Holst which is not included in the Australian Broker Call Report).
The most recent survey among institutional investors by Citi suggests share markets can still advance into year-end and in 2019, but a correction to the magnitude of -20% (exact timing unknown) could well be a genuine possibility. The correct interpretation is not that such a large correction is now guaranteed on the horizon, but more that risks seem skewed to the downside. No wonder most institutions are lifting their cash levels.
Cooler heads in the bond market are not anticipating further fast continuation for bonds, but bigger picture comfort doesn't tell us anything about short term possibilities. Investor nerves won't settle until US bonds do and the experience of the past few days has unmistakably damaged the general market psyche.
My personal advice is to raise your cash level (if you haven't already) by getting rid of low quality exposures, irrespective of whether they paid off or not, and irrespective of where the share price is heading.
It is against the background above that investors should digest the Conviction Calls in Part Two of this Weekly Insights.
See also: My Name Is Bond, published in July last year.
Rudi On TV
Lots of changes are taking place at Your Money, the renamed Sky News Business TV channel. As a result, the schedule below might be subject to changes:
This week my appearances on Your Money are scheduled as follows:
-Tuesday, 11.15am, Skype-link to discuss broker calls
-Friday, 11.15am, Skype-link to discuss broker calls
Rudi On Tour
-Presentation to AIA members and guests Chatswood, on October 10
-Presentation to ATAA members and guests Sydney, on 18 October
-AIA Celebrity Lunch, Brisbane, on November 3
(This story was written on Monday 8th October 2018. It was published on the Monday in the form of an email to paying subscribers at FNArena, and again on Wednesday as a story on the website. Part Two shall be published on Thursday).
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.
In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: email@example.com or via the direct messaging system on the website).
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– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
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(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)