“A remarkable consensus has developed among modern central bankers … that there’s a new ‘red line’ for policy: a 2% rate of increase in some carefully designed consumer price index is acceptable, even desirable, and at the same time provides a limit. I puzzle at the rationale. A 2% target, or limit, was not in my textbooks years ago. I know of no theoretical justification.”
– Paul Volcker, Keeping at It: The Quest for Sound Money and Good Government
- US: US curve steepening bias while remaining tactical on duration
- Europe: Looking to enter steepening trades, remain tactical in Italy & peripherals at current levels
- UK: Post-Brexit environment favours yield curve steepening positioning
- FX: Open longs in BRL tactically while targeting USD negative positioning vs. both DM and EM
- Credit: Maintain a low spread duration overall; focus on single names having rotated away from smaller issuers
The Big Lebowski is a cult ‘90s Cohen brothers film about a case of mistaken identity turned bad for the protagonist character ‘The Dude’ and his bowling buddies. There are many quotes and legendary scenes which, two decades after the film’s first release, very much live on, certainly in the Resco office.
“Mark it zero!” booms the voice of John Goodman, holding a gun to the head of a competitor attempting to submit a bowling score, having been accused of putting his foot over the line. Analogous to today’s economic reality, money managers are also at the mercy of “zero,” whether it be in the form of interest rates, inflation or perceived risk of buying risky assets. If you consider the position of many developed governments and their corresponding monetary agents, “zero” is a comfortable place to be, given record public debt and lacklustre nominal growth. Similarly, many company Treasurers and CFOs love “zero plus” borrowing conditions in order to re-finance attractively or fund share buybacks. The circuit-breaker to the current state, of course, is a pick-up in inflation – a theme we like to keep a close eye on, especially as no meaningful market narrative currently exists.
Unsurprisingly, the consensus for the start of the new decade seems uneventful on many fronts. Not only do policy-makers such as the Fed anticipate rates on hold for the entirety of the year, strategist outlooks seem equally muted. This might make sense given this year’s global easing impulse and liquidity injection seems to have provided a bottom on global growth for now, with implied one-year volatilities equally painting an ordinary year ahead (Chart One). Interestingly, history shows that in years since 1950 when the S&P 500 gained 20% or more, the subsequent year’s US GDP was never negative, while there were three years when the following year’s equity returns were negative, two of which came after 1980 (Chart Two).
However, inflation seems to be quietly gaining traction, at least in the US, where headline CPI is slowly closing its gap to the core measure. Base effects of last year’s energy slump will slowly turn inflation readings higher while overall momentum seems to have firmed. While the Fed is officially tolerating higher inflation readings to make up for prior misses, it will be an interesting test for markets when inflation indeed realises mid-2% levels by the end of Q1 next year (Chart Three).
As such, we see a healthy backdrop for risk assets for the first quarter and continue to be positioned for higher yields and, specifically, steeper curves across developed market bond markets. The increase in primary market issuance has presented opportunities to increase our tactical exposure to the credit asset class, via corporates, financials and select EM issues, alongside a strategically-low duration and liquid core portfolio of holdings. A weakening USD would help propel global growth back to a 4% GDP trajectory, with EM the clear benefactor of such a move.
In time, the realisation of higher core country government yields, given their role as the benchmark for broader markets, can ultimately force a reassessment of credit and equity market valuations, eventually driving credit spreads wider across the quality spectrum. A tightening of refinancing conditions (as coupons rise) and dampening of overall risk market sentiment (as equity fundamentals respond to a higher cost of capital) would precipitate spread widening from what are now two-year spread lows.
We may soon see the market move to a risk off sequence, as consequence of the melt-up in risk throughout 2019. But as discussed last month, nobody can deny the short-term safety provided by “zero” narratives, which create a slow-moving undercurrent of confidence. The trick is to not position portfolios to become deeply reliant upon the complacency that contemporary narratives create, and Resco starts the new year with a renewed focus on inflationary scenarios.
We congratulate you all for getting through another year and wish our readers a healthy and prosperous 2020.
If you haven’t seen The Big Lebowski or you’re keen to relive it over the break, here’s a neat site to help you find it: https://www.justwatch.com/
- US data have deteriorated but are not recessionary, while inflation readings are rebounding
- Global growth has stabilised following aggressive global central bank easing and overall liquidity injection in the US and Europe
- Government rates offer protection only from a recession scenario and/or aggressive cuts into a new negative rate paradigm
- Credit spreads still driven by external, rather than fundamental, factors, while fund flows are important for spreads to remain stable – we remain defensive and prepared to take advantage of wider spreads to come
Thank you for reading and don’t forget to comment, share and contact us for questions – the Resco Team
A Word on Resco: Resco Asset Management Limited is a 30+ year project that aims to join other like-minded firms in lifting the perception of the investment management industry, while maintaining a laser-sharp focus on net returns by charging sensible fees and limiting fund expenses. Keen for their friends and family to see the virtues in solving investors’ problems and to be looked upon just as favourably as any other corporate innovator, its three co-founders focus on aspects and values that can drive healthier relationships between them and their community of investors and observers.
Resco’s first product, the Resco Macro Credit Fund, is a global absolute return unconstrained fixed income product that aims to capture performance from global macro themes and corporate bonds to deliver positive total returns to investors throughout market cycles, leveraging its portfolio managers’ existing 10-year+ track records.
The three co-founders own 100% of the business and mandate a majority future executive ownership, thus remain focused on the long-term goal of building a trusted reputation upon a culture of investment excellence, without applying conventional short-term incentive structures that can tempt individuals to overrepresent their particular field of expertise during various cycles. This promotes a meritocracy while allowing senior managers to assume accountability, by focusing on process before individuals.
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