Keep Rotating

Either weak energy prices, a break down in copper, low iron ore prices etc are a sign of a deflation crunch in the making that will lead to a flush in all things risk related (Albert Edwards style). Or we are in a extermely powerful Goldilocks situation where low headline inflation finally lets the real economy release higher, and the market goes on towards a final mid-to-late cycle tantrum. I think that this is now the key choice that everyone must make before proceeding to call their broker on Monday morning. 

In the Eurozone, margins are getting squeezed and companies are being forced to cut prices to maintain market share. You need to tread carefully on cyclicals here, but on the other hand, many UK/Eurozone retail have already been crushed (and I admit I am donning the kevlar in some of these names). In addition, the market is probably underestimating the impact of private QE and TLTROs at the ECB, which is odd, but a natural consequence of the extreme obsession with when the ECB pushes the button on QE. 

On the US I it seems to me that in a world where you have disinflation and real GDP growth humming at 3% with ZIRP added to the mix, you can probably get some pretty spectacular runs in consumer oriented stocks. I would not discount that even as the run in Spoos seem to defy logic. Basically, low global headline inflation is allowing CBs to double down even as growth is not calamitously negative and this does extend the “Goldilocks” feeling noted above. We need to understand, though, that the UK and US economies are really running the show in terms of growth here … if they fail, I think we are buggered! The question I am really asking myself now in relation to the puke in oil is how long this can go one before we see real debt distress in one or more US energy HY bonds. And when that happens, will this test the much debated “lack of liquidity in the non-fin corporate debt market” story?

My mantra, though, remains, as it has throughout the year … sector rotation, sector rotation, sector rotation … the big story for me this year is not the rally in Spoos but the alpha that you have been able to pick up this year being long/short the right sectors. We are talking risk neutral/adjusted returns of 20-30% on some cross-trades! I would expect the same next year based on what I am seeing now. As for the the perennial debate on the when the crash is coming, why bother. Polemic has done a good job explaining the issues here anyway. A friendly word of advice though, ignore Zero Hedge and similar proselytes to the altar of the Black Swan. It can be a lonely and frustrating experience marrying yourself to such a creature, most of the time it isn’t there at all! When the crash comes, you won’t be short, and don’t be the guy or girl who waits endlessly to be able to say; “I called it!”

A couple of final points on leading indicators and the market in general. Firstly, China’s LEIs are tanking here, with narrow money growth looking very weak. This is worrying me. Low commodity prices may be “benign” in one scenario but when you couple it with near-deflation, low narrow money growth, an no FX reserve accumulation in China you lose one of the big liquidity pumps of the last decade. PBoC easing will help at the margin, but the fact that they have to do it even as they have announced the desire to scale down the credit fuelled growth isn’t exactly encouraging. 

Secondly, flat yield curves are customarily negative inputs into most cyclical models, but I would honestly strip them out now. The market has basically been conducting a huge Operation Twist in the past year, everywhere! I am not sure this is such a negative signal. But if the Fed is bullied into an aggressive move next year and/or the short end in the US goes crazy in some taper tantrum 2.0 I would obviously need to revisit that view. 

Safe trading out there, the week after giving Thanks is usually a sporty one. So, play it cool and keep rotating.