Master of puppets I’m pulling your strings
Twisting your mind and smashing your dreams
Blinded by me, you can’t see a thing
Just call my name, ’cause I’ll hear you scream
– Master of Puppets, Metallica
- US: Steepening bias while reduced overall long duration positioning after recent rally.
- Europe: Flattening with an overall short bias. Tactically long Italy.
- UK: Remain tactical with heightened political noise.
- FX: Trading tactically RUB, CAD and JPY. Strategically looking to be short USD vs both EM and pro-cyclical DM currencies.
- Credit: Subordinated banks still the pick of the bunch. We have taken profit and rotated away from smaller issuers.
A large part of the Resco team had the pleasure of attending Metallica’s recent London gig at Twickenham stadium, which both metal heads thoroughly enjoyed. There are many songs of the set-list we could have chosen to characterise today’s market. “Ride the Lightning” or “Sad but True” would just as well describe elements of today’s state in financial markets as the one chosen above. With the lyrics describing past experiences with substance dependency, it is analogous to how today’s markets eagerly anticipate a further shot of monetary stimulus by major central banks.
Notwithstanding the fact that, at least from the top down, markets are a slave to those controlling monetary levers, it is at the very least useful to observe and respect this as a contemporary status-quo. It creates—albeit temporarily—a ‘known known’ in respect to market behaviour and allows those managers keeping a close eye on the politics of central banking to remain carefully positioned in risk assets.
Given part of our investment process requires reflection on the likely themes and drivers of global fixed income markets for the coming months, we are adjusting our strategic positioning to respond to the market’s forward pricing for substantial further monetary easing. This has led us to reduce risk in our portfolio while keeping a high degree of flexibility through tactical investment ideas and an increased preference for more liquid instruments in the segments of the market in which we operate. We are wary of how liquidity could fare if we were to see large repositioning swings in the current context.
As such, and with credit spreads dipping back to 2018 tights, we have taken profits on holdings across Credit & EM while reducing overall interest rate risk as the rally ran into resistance for the major government bond markets. We remain defensively, but not yet negatively, positioned to credit spreads overall, with holdings mainly out to the belly of issuer curves, across a selection of higher conviction investment grade & high yield corporates, and selected additional tier 1 banks.
We do not see an obvious catalyst for universal spread weakness over the summer period, as the primary market dries up again however, we assess the risk/reward for most elements of the credit spectrum as currently being unattractive. At the issuer level, it is apparent to us that looking at market-cap weighted indices as a barometer of universe risk/reward misses the ‘small picture.’
Measures such as the number of ‘zombie’ companies paint an uglier picture and, based on this, many companies would struggle to survive if the extremely accommodative market conditions were taken away from them. You can see from the right-hand chart below that zombie firms are surviving for longer as a result of contemporary loose monetary policy. The failure of just a few of the worst students in the class could cause a wider repricing of credit, even if the better companies continue to fare well.
¹ Simple averages of zombies as a share of all listed non-financial firms in the Worldscope database from Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States. ² Firms with an interest coverage ratio less than one for three consecutive years and over 10 years old. ³ Broad zombies with a Tobin’s q below the median firm in the sector in a given year. Sources: Banerjee and Hofmann (2018); Datastream Worldscope; authors’ calculations.
As for other catalysts for the coming months, we see the direction of core government bond markets as important in determining how relaxing a summer it is for investors. In the US and Germany, we are now more actively looking for opportunities to implement negative duration stances. We see a back-up in US government bond yields as a possible catalyst for a re-pricing in broader risk assets in coming months, which would dampen the recent exuberant sentiment.
“Reliance on monetary policy as an effective stabilising device would involve… a high degree of instability… in the capital market…The capital market would become far more speculative… longer run considerations of… profitability would play a subordinate role. As Keynes said, when the capital investment of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done.” — Kaldor, 1958
In considering what could alter our strategic roadmap from here, we cannot help but return to the theme du jour of central bank policy. We are somewhat bemused by the expectation that another round of monetary easing using a combination of conventional rate cuts and QE will yield better economic results than previous iterations.
Former Fed Chairman Bernanke’s famous quote from 2014 “the problem with quantitative easing is that it works in practice, but it doesn’t work in theory” could now become more relevant than ever before. More importantly, we consider the shift to more politicised central banking as potentially opening the door to a new investment paradigm, requiring a new playbook for asset valuations.
A 2013 paper by McCulley/Pozsar reflected on the possibility of fiscal and monetary integration and how it could see a more aggressive stance taken by central banks in order to lift nominal growth and inflation (below, left). The move from unconventional to radical and now potentially “nuclear” monetary policy, which sits towards the top right of the green quadrant (below, left), looks an increasingly likely scenario.
We touched on this area back in our Monthly Issue Three when we opined on MMT (Modern Monetary Theory).
- Central bank easing anticipation is supporting risk markets over the summer months, but we do expect more weakness in the months ahead.
- US data have deteriorated. However, we do not think a US recession is likely in coming quarters. A pro-active Fed and weaker USD would stabilise growth globally. Furthermore, anticipated ECB easing is risk-supportive.
- Government rates offer protection only from a recession scenario from current yield levels.
- Credit spreads, largely driven by external rather than fundamental factors, and the risk/reward favours a more defensive stance coming into summer (for all segments). Fund flows and benchmark government bond performance are key for the rally to remain on course.
Thank you for reading and don’t forget to comment, share and contact us for questions – the Resco Team
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