Wood for the trees
We have all been obsessed with rates and inflation, but we seem to be in danger of missing what looks like a widespread bull market running broadly from last October. This is widely applicable outside the main US markets, including in gold. There is a similar and at times masking trend of dollar weakness.
What are the implications of this?
We also look at the unending tragedy of the various remnants of the Tory party.
Still Rising?
With markets still fixated on the next crash, we can sometimes overlook the long momentum swings. Although the US banking crisis matters, it is of little relevance to the far more concentrated and tightly controlled Basel III banks in Europe. Many would say to excess, but they are clearly tighter rules. The few assets not marked to market are a footnote in Europe; in the Wild West of US regionals, they can be the whole story.
On a one-year basis, the France CAC 40 is up 14%, the German DAX by 12%, with both the UK large cap and Japanâs Nikkei also positive, so equity markets have been strong, almost regardless of rate rises. The US is the main home of negative twelve month returns, but the gap between the S&P and the NASDAQ declines over that period, is now quite small, after the spring bounce back in the latter.
What does that mean?
For all the media love of the disaffected trashing their own communes, doing the right thing on pensions (they were very out of step) apparently helps France.
While the splitting of power in the US Congress and the meanderings of a senile President, has perhaps hurt the US, with everything from banking regulation to the debt ceiling made into a political game.
Brazil is down too, but India and Russia are up.
Well perhaps I go too far, but maybe there is a pattern? Markets like stability.
Relative values
While comparisons are complex where accounting systems diverge, the UK still looks like the lowest rated with the highest yield, and conversely the NASDAQ still has (by some way) the highest rating and lowest yield. US earnings are it seems still much more valuable.
The savagely anti-business stance of the UK, including a brutal rise in corporation tax maybe part of it, it will create a fall in earnings (and likely dividends) next year.
While the less visible, but still onerous onslaught in the US, including  a minimum tax take, wonât be good.
So, does inflation matter?
The UK perhaps is also seen as the one major European market that looks to have dithered too long on controlling inflation (which could explain sterling strength). However, I see no real appetite for more austerity in the UK, so I find that assumption slightly puzzling. Having the FX market convinced UK rates are going a lot higher (because of policy failures) is hardly comfortable, but feels a little like re-living last year now.
Oddly too, controlling inflation the US way, has hurt equity markets more, it seems, than letting it burn out in the European style. Heresy to many of us, but thatâs what the numbers imply.
All the theory, all the historic data says we now must get a sharp recession, but then grandpa, pray where is your beloved recession? Still looking, since mid February. It seems we must appease the inverted yield curve and believe base rates matter, but a bit more evidence would certainly help.
And rate cuts will be a powerful tonic, when they come. The bears are now reliant on widespread recessions, and soon.
Perhaps the best of this little bull market has gone, but there is a lot of liquidity still about and being out of the market with high inflation, is not great.
A multitude of sins â local elections coming up
And what of the UK Tory âPartyâ, if such a mess can be called that. The assumption for a while has been that the imminent local elections will be bad for them. However, they are a curious mix of voting locations this time, not London, not all of the Home Counties, none of the Celtic fringe, but a good chunk (but again not all) of the Red Wall seats. See map below.
Map from Wikipedia page on 2023 local elections
But really it is heavily biased to the Tory heartland, vast swathes of Labour free wards, where they are not even bothering with candidates, so it will not tell us that much. The Lib Dems will do well, but significant conquests in many areas will now require quite substantial swings.
The assumption is also that Dominic Raab was cut down by Sunak, who has yet to learn that throwing competent colleagues under the bus may feel good, but it thins the ranks of effective ministers, and builds up the malcontents. He has handled these badly, and forgets the real target is not his ministers, but his own position.
Tory strategy
Seemingly the Tory party has run just one electoral strategy for years, based on old victories; just trash the opponent. In a two-party state, voters must then decide who they dislike least. And both Labour (and the SNP) have reliably offered something so vile, that a simple victory follows.
But no longer, Labour (despite their recent rather crude posters) still seem innocuous.
The Lib Dems are sticking to their amateur politics, which can also look strangely alluring, if the other two parties look mysterious or inept. The Tories (like the SNP) are now in danger of being judged by results, not by fear or hatred of the alternative.
The score card on that basis looks pretty bad, and Sunakâs pledges are so far, going the wrong way.
The Sleep of Reason
Big picture risk assessments today, and worries about the prevailing style of regulation - we look at where the next bank blow up maybe. Weâre assuming this will again be caused by regulators and their herding behaviour. On the upside, an improving medium-term market outlook. Also, dollar danger.
But before I beginâŠ
First of all, many thanks to those who replied to our sentiment survey, you are a cautious crowd! Over half (53%) sitting on the fence, alongside us. The largest directional group is bullish on equities (18%), but it is a pretty even bull/bear split with bonds, and quite a few equity bears too.
Regulatory Myopia and Declining Banks
Bank boards (and auditors) are still clearly confusing regulatory approval with sound banking, in the odd belief that excuse will wash, when they implode. In particular we worry about the vast amount of debt that is sitting on bank balance sheets, at below current market levels, and not in this case issued by governments.
We have notable anxiety about two areas, fixed rate mortgages and investment grade debt where, especially for the former, the numbers are vast. Perhaps the tightening steps to date appear so ineffective, just because so much of this old low-cost issuance, is only very slowly rolling off .
Big picture â the effect of long dated low-cost loans, with rising interest rates
This leaves cheap money in the system, funded by banks, that have to pay way more to keep funding these long-term deals. Theyâre doing this typically with short-term sources, like deposits. In sub-prime, asset finance, trade finance, consumer finance, none of it matters much, as they are pretty short duration. Which is where most people worry, because of default rates, we donât.
But in mortgages especially the regulator typically issues the future economic scenarios to banks, who then price (originate) and provide for losses against that projection.
If that projection is absurdly few rate rises, for a decade (as it was till fairly recently), it seems banks just follow obediently along. As a result, they have issued vast amounts of long dated, low cost loans based on false or unrealistic assumptions.
Those regulator driven economic assumptions/scenarios are key, and yet are lost in the detail. Each bank has to publish them if you dig deep enough. (Some are on p155-157 of the HSBC accounts, for example, if you have the stamina.)
Re-mortgages â what they contribute to our big picture
The other part is refresh rates, in a falling interest rate world, borrowers re-mortgage every few years, but in a rising one early redemptions virtually stop. So, the whole system gums up, without fresh liquidity. Regulators have not seen, and have no data, on such a âhigher rates for longerâ world. So, it is assumed that world cannot exist. While the key thing (still) on these scenarios is that interest rates are still assumed to be like rockets, straight up straight down.
Now if you assume that, there is some short term pain, but normal service resumes soon enough with no long-term issue. But is it realistic? It is a vast slow moving market as in this publication of the FCAâs mortgage lending statistics .
Inevitably the scenario dispersion used is small, indicating a regulatory finger remains on the scales. So, most banks take the Central Bank forecast as the middle way, with say 10% either side. All as at the historic balance sheet date. Last year they were nonsense even before publication, two months on.
That is aside from Hong Kong, where real economic models, with real outcome ranges are visible. For most markets you see a skein of twisted rope drifting laconically into the future, but on HK they produce an exploding ammunition graph, smoke trails looping everywhere.
To a lesser extent BP debt (a classic investment grade, big, global borrower) is a similar problem. It has half fixed, half floating issuance, but the fixed is at 3% with a fourteen-year average term and the floating at twice that, at 6%. Now someone holds that fixed debt, and if regulated it will have to now be held below par. Are BP going to prepay it? Despite the roar of cash coming in, why would they? It is stuck, unusable for 14 years, unless inflation (and rates) collapse as fast as predicted.
What else is driving markets?
The big upside drivers to us are, the end of COVID, the end of the energy spike and falling rates. The first two will help through 2023 and 2024. Rising rates are still hurting, but again 2024 and beyond  looks good.
While the biggest current downside driver is the recession, which will impact 2023, but again rebound in 2024. So, the issue is: will the rather timorous monetary tightening and anaemic reductions in the absurd fiscal overdrive, be enough to defuse all that good news coming in the next year?
Markets apparently think not.
We are particularly struck by the NASDAQ up 18% year to date, yet our tech bell weather share, Herald Investment Trust (HIT) is still (marginally) down YTD. So is this a bitcoin-type story (all about liquidity) or is it based on tech fundamentals? If the latter, then why is it seemingly glued to the US, and not translatable? Even failing to reach non-US holders of US companies.
For now, until the price of global tech shifts, I treat the US as a special case; growth is not back yet.
While the currency charts are unclear, it does also feel like the beginning of the end of the great dollar story, with sterling persistently ticking higher of late.
From: this page published by the NY federal reserve.
Thatâs a real danger for portfolios that thrived on dollar power last year.
We close wishing you a happy Easter break. We will be back with St George.
A RIGHT OLD TONKIN
About Influence â American and Russian, mediated by the Chinese
So, to start with what does worry us: That is the slide to a hot war with the powerful Eastern autocracies, fueled by the EU with Napoleonic tendencies, an old man in the White House and a curious sense of âcrusadesâ with no consequences.
For those with long memories of American imperialism, the latest drama even fits neatly as a modern Gulf of Tonkin, a key moment in the slide to war. In that case (south of Hanoi) the clash was naval not aerial but was still notable as one directly between the warring parties and not just their local proxies.
While elsewhere the pieces move, China can not let Russia fail, nor descend into chaos, their long-shared border must stay intact and secure. They no more want the US there than the Russians do. The first step after his confirmation as ruler for life, by Xi, was indeed to go to Moscow.
And the bitter battles in the Middle East of Persian against Arab, Sunni against Shia have cooled abruptly, under Chinese influence. The world once more understands that the US is the threat to peace and stability, not just their fractious neighbours.
For Biden it is an easy fight, the Pentagon so far has played a blinder, what can go wrong? While, for now, France is Europe, no other large state has anything like their stability, Italy is led by the unspeakable, Germany has free market liberals in a bizarre ruling alliance with Greens, Spain is wrapped in its own forthcoming general election, the UK both distinctly detached and under a caretaker government.
The UK budget said nothing, incidentally.
Main influences in France.
While the left in France, as the above photograph shows, are very alive to Macronâs ambitions, to add more territory to the EU, arrange more protectionism for French goods and to suck the labour force out of adjacent states to serve the Inner Empire. Just like Bonaparte tried (and failed) to do, with dire consequences for the French nation.
For all that, the domestic fracas in France (which makes our own strikes look rather tame) was inevitable. Raising (by not a lot) the pension age from 62 to 64, against our own 67 looks small, but it was a clear campaign pledge.
The absence of any minor party wishing to self-destruct, by supporting it in the French legislature, is no great surprise either. So, he has implemented it by decree and Macron has dared the opposition to now either remove his prime ministerial nominee, or shut up.
Banking On Nothing
So, what of markets? Well, the end of SVB is no great loss, it had several policies that had to implode if rates rose, especially on the lending side. It was painfully âwokeâ; I can tell you more about the Board Members sexual orientation, gender and ethnicity than their banking experience, the former just creeps into the end of their latest Annual Report, the latter was invisible to me.
SVBâs long list of ESG triumphs and poses (and it is long) at no point included not going bust. It did commit an extra $5billion to climate change lending, which I guess has all gone up in smoke now. Still apart from all being fired, the bank insolvent, the remnants rescued by the hated Washington mob, under investigation by the DoJ, all the rest of their âGâ was superb, and so, so, cool.
I donât see Credit Suisse as a danger, although it may be in danger. It has had an appalling run of misfortunes, with musical chairs at the top, but it remains a cornerstone of Swiss identity. To let it fold would be highly damaging and cause shockwaves in derivatives markets.
Influence on the markets
So, I do understand the Friday sell off (who wants to be weekend long with regulators on the loose). And we do understand markets needed to go down, after the big October bounce, indeed it was a key reason for our building up over 33% cash or near cash at the previous month end. We knew the winter rally was fake.
But I donât see this as much more. Retest of the S&P 500 October low? It should not be. I take a lot of heart from bitcoin soaring (63% YTD); if liquidity was short, that would not have happened.
But for all that, I donât like March in financial markets, too much is uncertain. So, this is more a time for cautious adding, rather than hard buying, but if we get to Easter (and hoping to be wrong on the Tonkin analogy) it does seem a better prospect.
Nor do I see how the various central banks can justify a pause in rate rises, at this point, but nor will they go in hard, that would be folly.
This Fed has made enough mistakes already.
The Art of the Possible
Image from Wikemedia - by Neide José Paixão
Looking at Absolute Return â Can it be Done?
A wise old hand once told me that all investors want is protection from inflation; do that, earn your fees and your jobâs done. Read more
Bonds and Bullwhips
What are bonds for? Not always what you think. And the whiplash of the economy, (the bullwhip effect on all markets) makes recession both inevitable and meaningless.
Corporate bonds vs government bonds
So, to compare bonds - a corporate bond is issued to fund a project to produce a return greater than the interest and principal, and then pay the lender back. Much of the value lies in the assessment of how reliable that redemption is. Some of it is also whether the bond is cheaper or more expensive than a similar one, some of it is who is allowed to hold that bond.
But value lies in redemption, especially at the shorter end.
So, on that basis, what are government bonds? Well, they are there to achieve other objectives, seldom involving either redemption or a cash positive lifetime. It is largely accepted that they are a funding device to load debt upon future taxpayers, who luckily canât vote. And the price of the bond is just what investors will pay for it.
Market rigging
Governments will therefore try to directly rig the market, to avoid paying too much interest, by for instance, mandating all investors and especially pension funds should hold gilts, their debts, on the gloriously fake grounds that they are âsafeâ. Well, just remember this yearâs disastrous collapse, down by a quarter at the long end, with plenty of volatility too, âsafeâ they are not. But the regulators and professional bodies still peddle versions of the old homily about the percentage of bonds in a portfolio should equal your age.
They can also apparently use the rate of bond interest to control inflation (so they say), so raising it (and devaluing bonds) if inflation rises, albeit the causes of inflation have little to do with the bonds (or bond investors). Then most marvellous of all, they can rig the price by easing and tightening their âquantitativesâ at will. Although no one is quite sure what a quantitative is, or indeed where it lives.
So, the government bond market turns out to be pretty much whatever you want it to be. To be contrasted with the weird and feckless equity, whose value can be, pretty much whatever you want it to be. Or indeed bitcoin, whose valueâŠ.
A difference of degree granted, but less clearly one of substance. Rigged markets in any asset, make us nervous, and all markets are increasingly manipulated, to some degree.
What of bullwhips and earthquakes?
Well, both show a declining sinusoidal wave, that ripples prettily along and disappears. Whether it is the globe scratching its toe itch in Tierra del Fuego, or an irritated ear in Reykjavik, it is very jumpy. Where you stand now can be higher or lower than yesterday; it is erratic, chock full of faults, and crucially, not smooth and cyclical.
So, measuring whether you are higher or lower than last weekâs datum matters little, if your fields have vanished into the sea, or indeed your sea has become a field.
So it is with recessions, after the shock we have had, being up or down two quarters in a row is trivial. Indeed, as that slick whipping wave races by, we will certainly be both.
Do changes in the Government bond markets matter?
And trying to decide whether the gyrations in the government bond market have any relevance to the level of the economy when the whole structure is bucking around, is slightly crazy. Nor are yesterdayâs maps going to be of any use.
That is even assuming that the price of bonds has any relationship to anything except how little governments want to pay for their exorbitant debts. While I have not even mentioned the wealthy autocracies involved in the same game.
And thatâs the market muddle we are in. The US Central Bank is playing old style economics, using the interest rate to control inflation - hang the cost of debt, thatâs a problem for Congress.
But the UK and European Central Banks are playing new style, because they fear that the usual medicine will be disastrous for their rather sickly patients.
And US stock markets are using that funny old, discredited, yield curve to predict a recession that is by their definition (two down quarters in a row) inevitable, but ignoring the COVID earthquake which has upended all our old data and assumptions, simply because we have never had one like that before. The curse of econometrics is that we can only predict the future if it resembles the past.
EU stock markets
Meanwhile European stock markets have understood rates are not going up much more, because the EU would prefer to rig the market, so investors think they must have avoided a recession, which is equally a delusion.
And underneath all that is the great big chunk of molten sludge at the core, the vast irredeemable mass of government debt, where real yields are apparently staying submerged everywhere.
So wise men can select from all of that to predict that markets in debt and equity are going to go up a lot or down a lot, really as you wish. And they may all be right, at least somewhere on the globe.
Our own choices
But we still see no point in holding state debt, nor much in holding cash for too long. Corporate debt and equities, especially equities with a real value that you can figure out, maybe. We look at ones without state interference rigging the price, and with an ability to raise prices to hold margins, and which have a dividend yield. Those, we think, may still be attractive.
And we are not alone, many markets and stock prices bottomed out in October and are steadily inching up. Our own MonograM momentum models (both in the USD and GBP versions, a rarity this year) have triggered a re-entry into equites, and for once in a while, not US ones.
Something is shifting under our feet. So next year at least, is very unlikely to be like this year.
When we next write the calendar will have changed and no doubt many rate rises will have happened. But we doubt if the big themes will change much.
In the meantime, Seasons Greetings and a prosperous New Year, to all our readers.