Bedrock’s Newsletter for Friday 16th of November, 2018

Posted by Carlota Vandekoppel on 16th November 2018

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Friday, 16th of November 2018

From very close we see it is Friday again, step back a little and we realise it is mid-November. Another step back and this perspective shows us we are closing in on year-end and another Christmas. Didn’t we just discuss Q3 earnings? Yes, time flies by all of us…

A century after the end of World War I, the chances of such a nightmare happening again seem remote. Of course, they seemed quite remote 100 years ago, too. Just before the start of the Great War, Europe hadn’t seen continent-wide hostilities in about a century, and experts thought globalization had ended such great-power conflicts for good. Sound familiar? Let’s not forget how poorly handled peace can lead to decades of horror.

The turmoil in equity markets has been relentless since late September. Does volatility make time slow-down? Somehow, when things are not pleasing, the difficulties seem to linger… these thoughts of the varying pace of time flows are clearly from way above our pay-grade and we best refocus on the mundane of our currently uncomfortable ‘comfort zone’ of the economy and the markets.

Just recently our musings brought us to conclude that at the base of all this discomfort and newfound volatility is the reality that a multi-year era of declining interest rates has ended. We hit an inflection point from whence we may no longer expect capital gains’ returns from fixed income instruments, rather, learn to live with yields reduced by capital losses. What a change! The capital preservation part of portfolios, i.e., the bond investments, had been producing fine returns for over 30 years. It is hard to switch away from such long-standing habits of important allocations to this asset class. Worst, when we realize that this class is indeed undergoing fundamental changes, we look elsewhere and find it hard to identify a new comfort zone. Yes, we had been touting equities as the TINA (Maggy Thatcher’s “There Is No Alternative”), but the last month or so of pain has made us wonder… We slapped ourselves as we forgot our own mantra of reading tomorrow’s news in today’s markets. What are the markets telling us? Both the fixed income universe with its flat yield curves and the world of equities which are losing valuation as earnings are rising? Is there another force acting upon us here? Is it like the world of physicists where to make Einstein’s theory of relativity fit observable realities we must introduce dark matter and even dark energy (?) to force the theory to reality? What is our financial ‘dark matter du jour’? Not Black Swans again? We think that it might well be that there is another fundamental realignment happening before our unseeing eyes; Is it the beginning of the end of empire? The decline of the USA as the uncontested leader of the world? Maybe… Most empires crumbled, but their collapse or simple fading was observed post-factum, rarely recognized when started. We are all old enough to have observed in real-time the demise of the Soviet empire. It felt like it was instantaneous when we saw that Wall fall, but our future history books will describe the cracks and faults of that system from many years before that break. We wonder if the World is sensing this? Is the Dollar not flying because it is losing status faster than it is gaining yield differentials?

Yes, the DXY (US Dollar trade weighted index) is up to 96.78 now, some 5% higher for the year but still some 8% below its mid-2017 levels. And this, whilst interest rates have been steadily hiked by the Federal Reserve, and not elsewhere. And don’t blame inflation – It isn’t there (it is in Venezuela where it hit 150’000%). Perhaps the markets are discretely supporting former Treasury Secretary Larry Summers who has put the chances of a U.S. recession at 50% within the next two years. The economist told CNBC’s Joumanna Bercetche on Thursday that a slowdown in growth was a “near certainty” before adding “the recession risk is nearly 50 percent over the next two years, maybe slightly less.” Summers, who served in Bill Clinton’s administration, said while any economy in expansion has a good chance of reversing course, U.S. growth is likely to be checked by unsettled financial markets, geopolitical tension and the Federal Reserve’s tightening cycle. Despite disagreeing with statements from Washington, Summers says the Fed should be careful about raising rates too quickly. “I think the risks if we have a recession are very, very serious so they need to bend over backward to avoid that,” he said. He added that the Fed could probably afford to let inflation run hot, given the sub-target rate experienced over the previous decade. “It is crazy that a country that can borrow for 30 years at 3% in a currency that we print ourselves isn’t repairing its airports, our highways, and isn’t putting in place a modern infrastructure.” Summers said ideas for infrastructure should come from both Republicans and Democrats but his “best guess” was that divisiveness in Washington would stifle the passage of an infrastructure bill.

Possibly the mid-term elections of last week will help this happen? Both sides of the aisle are seeking brownie points with the public and both parties are likely to be seen supportive of investing in fixing things… We may well need a big spending boost in the world- he global economic slowdown is happening and could spread to the United States next year. The economies of Germany and Japan shrank in the third quarter, according to data published Wednesday, providing a sharp contrast to another quarter of strong US growth. In China, there are signs of a deepening economic malaise.

The reasons for the weak performance are varied, and economists believe that both Germany and Japan will dodge recessions by returning to growth soon. But the data underscore the major challenges faced by many of the world’s largest economies. Germany’s economy shrank for the first time since 2015 in the third quarter. It was hit by new auto emissions testing procedures that slowed car sales and a decline in exports, partly due to the US-China trade war. Japan is much more accustomed to economic stagnation, and even recessions, but the outlook there is brighter. Its lacklustre third quarter was caused by natural disasters, and economists expect consumer spending to spike this quarter ahead of a planned sales tax hike next October. In China, the world’s second largest economy, new data Wednesday revealed weaker consumption growth, subdued confidence and disappointing credit growth. Economists expect the government to ramp up stimulus measures to mitigate the effects of a trade war with the United States. “We believe the worse is yet to come, with growth slowing faster into spring 2019,” Ting Lu, chief China economist at investment bank Nomura, wrote in a research note. And despite the prospect of a rebound in Germany and Japan before the end of this year, the global economy is also heading for a weaker 2019. The International Monetary Fund expects global growth to slow to 2.5% in 2019 from 2.9% this year. Is this what the stock markets have been trying to tell us since early October? Or is there something even more sinister than a global slowdown in growth lurking in the shadows?

Oil can be a kind of canary in the mine of the economy- political machinations aside, it is down to $57 for a barrel of WTI… it was $76 in early October and on an upwards trend… Some markets clearly don’t see the monster under the bed- Bitcoin’s moment of relative stability ended abruptly Wednesday. The world’s largest cryptocurrency hit its lowest level of the year, falling as much as 9 percent to a low of $5,390.12, according to data from CoinDesk. Bitcoin had been trading comfortably around the $6,400 range for most of the fall, a stark contrast from the rest of its volatile trading year. Other cryptocurrencies fared even worse on Wednesday. Ether fell as much as 13 percent while XRP, the third largest cryptocurrency by market capitalization, dropped 15 percent, according to CoinMarketCap.com. Remember that these new thingies were supposed to protect us from the vagaries of central banks and give us a stable, solid parking place for our capital… Hmmm… even Gold is faring better… trading steadily at about $1’215 into the crypto rattle.

The extra yield investors demand to own investment-grade corporate bonds instead of U.S. Treasuries expanded on Tuesday by the most since May as legendary Guggenheim Investment Management Chief Investment Officer Scott Minerd tweeted that “the slide and collapse in investment-grade credit has begun.” Minerd, whose Guggenheim Total Return Bond Fund gets a five-star rating from Morningstar, joins other bond-market titans who have also warned about excesses in the credit markets, including Marc Lasry of Avenue Capital and Howard Marks of Oaktree Capital. More so than any other market, credit is all about confidence. Yes, fundamentals such as revenue, cash flow and leverage matter, but as was seen with Lehman Brothers Holdings Inc., Enron Corp. and WorldCom Inc., when a borrower loses the confidence of its lenders, things can go downhill quickly. And right now, some influential people in the credit market are sounding less than confident.

Contemplate the 100th anniversary of the conclusion of World War I. That conflict began with Austria-Hungary’s declaration of war against Serbia in July 1914, following the assassination of Austro-Hungarian archduke Franz Ferdinand. It ultimately led to more than 15 million deaths, the collapse of four empires, the rise of communism and fascism in some of Europe’s leading states, the emergence and subsequent retreat of America as a global power, and other developments that profoundly altered the course of the 20th century. If we assume today that war between the great powers cannot happen — that economic interdependence will automatically hold rising tensions between the U.S. and China in check, that advances in human enlightenment will consign nationalism and aggression to the pages of history — then we, too, risk discovering that our own peace is far more precarious than we think.

But we like to believe that tomorrow the sun will shine, no matter what… “Our society is dependent on some precarious mechanisms, and they are very dicey. They can easily collapse”. Doris Lessing

Market Weekly Highlights

Currencies & Commodities

The USD continued to rally across major currencies mainly driven by the Federal Reserve’s expected rate hike guidance for 2019. The DXY strengthened and is currently trading at 97.00, fuelled by potential productive conversations between US and China.
The EURUSD pair opened the week at the lowest for the year reaching 1.1216 and then recovered somehow, trading 1.1345 currently, remaining volatile and under pressure on the back of the recent concerns expressed by the European Union over the Italian government’s expansionary fiscal plans, as well as latest Draghi’s dovish comments and chaotic Brexit events.
The CHF is almost unchanged this week with the USDCHF pair trading a tad below 1.0100, as is the EURCHF trading at 1.1413 this morning.
The Pound dropped this week, reaching 1.2724 yesterday on the back of Brexit concerns and resignations from the UK cabinet which might transform into a leadership challenge. The Pound is testing the yearly lows set at 1.2660 back in the middle of August, well below the 1.4375 top seen early this year in April.
The USDJPY seems to have hit a resistance at 114, marking a pause in the latest two-week drop against the USD with the pair trading currently at 113.15.
In EM, both the Russian Ruble and Turkish lira are suffering amid US sanctions for the former and economic crisis and political turmoil for the latter. However, since mid-September the Russian Ruble has strengthened against the USD trading from 70 to 65.90, unchanged for the past month, as did the Turkish Lira which reached 7.23 in early August and is now at 5.36.
The Brazilian Real is down for the week, now at 3.75 against the USD. It however enjoyed a 13% pre-election rally but has not fully recovered from the 20% losses since the start of the year, amid lower appetite for emerging market currencies sparked by trade-war fears and rising US interest rates.
Bitcoin fell thought its long-standing support at $6’400. It is now at $5’650, having lost about 15% this week.
Crude oil WTI is down again this week to $57.42 per barrel, amid US dollar strengthening, Trade War escalation and geopolitical posturing. Brent is trading at about $68.09.

Fixed Income

10Y U.S. Treasuries yields, which had traded in a range during the last quarter of 2017 from 2.30% to 2.40%, crossed the 3.25% this month amid inflationary pressures and FED rate hikes to current show 3.11%.
The Japanese 10-year JGB yield has traded in a range from 0.020% to 0.060% for the first 6 months and then hit 0.16% as BOJ tapers to only currently drop back to 0.10%.
In Europe, the German Bund yield nearly doubled at one point this year, jumping from 0.40% to 0.80%, but then came back down as low as 0.20% in may on the back of Italian crisis fears. Now at 0.36%, on the back of the latest election results, lower than where it closed 2017. Same for the French 10Y Yield which had crossed the 1% during February dropped as much as 0.60% in summer to trade back higher at almost 0.90%, currently showing 0.75%.
In Peripheral Europe Italian 10Y yields are now trading just below 3.50%, levels seen in May when their internal political turmoil kicked-off, well above the 1.70% low April levels. The Spanish 10Y yields trade some 140 bps lower than Italy at 1.62% where it started the year at 1.61%.

Equities

Markets in the US are all up since last Friday and remain all positive for the Year 2018 with NASDAQ being the strongest performer and posting 7.69% positive yearly return, despite the 10% drop from the highest levels reached this year. SP500 and DJIA are up, respectively by +2.50% and +2.68% YTD. The SP500 is currently at just above 2’740, the DJIA just a couple of points above 25’380, while Nasdaq is trading some points below 7’335.
In Europe, markets are all up for the week but are showing important negative returns for the year so far. The Eurostoxx50, DAX, Spanish IBEX 35, Italian FTS MIB and Swiss SMI are all down by -7.41%, -9.94%, -10%, -10.76% and -3.71% respectively.
In Asia, the Nikkei was also up for the week but negative for the year marking -2.29%, while HangSeng is down by 11.47%.
BOVESPA turned positive for the year again showing a strong positive performance of +15.17% helped by the election optimism.

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