Marked Up October 18th

Central Bank policy doesn’t work

There is a growing chorus of complaints that the zero interest rate policy (ZIRP) isn’t working.

Paul Singer from Elliot Management described the $USD60 Trillion global bond market as the biggest bubble in the world and the world’s largest hedge fund[i], Bridgewater Associates’ Ray Dalio believes “when you can’t lower interest rates any more, there is a limited ability to produce growth”.

There are many commentators with similar views.

I am sympatric about the challenges for central banks. History will judge the banks, but without context history will be meaningless.

What else are central banks to do?

Lowering of rates was meant to stimulate growth, drive borrowers to access cheap funding and grow their businesses.

Did the corporates live up to expectations? Probably not - it seems that many companies have used the cheaper cash to buy back shares or provide dividends.

Central banks have called for political support. Has that happened? Probably not - governments of many persuasions have declined to use their fiscal powers to stimulate growth.

Why has this triumvirate failed to agree on a strategy to deal with the continued ramifications of the global financial crisis? It doesn’t help that each member answers to a different authority:

• Politicians have to appease dissatisfied voters who are intolerant of government debt and bailouts.
• Corporates have shareholders who live off dividends and are unforgiving of any change in compensation.
• Central banks have mandates based on employment, financial stability and inflation.

In a world of sound bites this disconnection is hard to understand.

It is hard to develop realistic solutions, but it doesn’t mean the ZIRP policy is wrong, the central banks have been doing the majority of the heavy lifting, that is what’s wrong.

Mr Trump has had a tough week

No one likes being disliked but it is almost impossible to be liked by everyone. The lesson could be in consistency, by being yourself you can take comfort in the fact that those who you keep company with do so on the basis of who you are.

Mr Trump was recorded on a bus making disparaging comments and apologised saying the comments do not reflect who he is.

Many friends in the Republican leadership seem to think the comments do reflect who he is and are ending their friendships.

Mr Trump hasn’t taken this well and has threatened to go ballistic on Twitter, pouring scorn on the Republican leadership. Paul Ryan, the House Speaker, has been called a coward amongst other things.

The consensus is growing that Mrs Clinton will be the next American President and if she does it will a first for America on many fronts.

There is also the rarity of an electoral mandate. If the polls are to be believed, the devastating performance by Mr Trump may result in a political landslide for the Democrats.

If the Democrats were to control both houses of the Congress then Ms Clinton’s legislative agenda has to be considered. What does it mean for trade negotiations, interest rates, oil discovery, average working wages, productivity? What does it mean for the American budget and the capacity for the Congress enacting policy?

If Mr Trump was elected, investors would need to consider the ramifications of an isolationist America.

The ramifications for investors in a Clinton administration will be better understood on November 9th, those who control the Congress control the agenda.

So you want to trade the currency?                                                                                          

There has been a huge growth in investors looking to trade currencies. The technological advances makes price discovery very easy to achieve. The spread between the bid and the offer has contracted to the point where it is increasingly difficult to make money as a market maker.

Has transparency made it easy to pick trends? Sterling and Mexican Peso are the flavours of the month.

Anyone who trades currencies will have an opinion on the story of Brexit. Will it be hard or soft, and is it better or worse for either Britain or Europe?

Nothing has been decided. UK Prime Minister Teresa May has advocated a “hard” Brexit and intimated that the UK Parliament will be able to discuss the terms of the disengagement.

If one of the reasons for leaving the EU was to reclaim control of Britain’s sovereign destiny then it makes sense that the parliament debates the most significant legislative change since the end of the war.

But how do clients invest in geo political currencies like the Peso? They don’t.

It isn’t investing, it is trading or in some cases just taking a punt.

This is a momentum trade not a strategy trade; no one knows the outcome of the political change as the long term implications are unknowable at the moment.

What we can safely assume on the basis of previous experience is that each politician or bureaucrat at the negotiating table will act in their best interests.

The risks are high and volatility will be the name of the game.

Looking at what will be a tortuous negotiating period I think there are going to be numerous opportunities to take advantage of momentum trades.

Speaking of momentum

The unloved commodity was coal but now that it is loved, it is wholeheartedly loved.

The following chart shows the spot coking coal price.

 

The price has risen steadily and the analysis is that China is rebalancing its economy and reducing support for heavy polluters and uneconomic industries. The assumption of continuous government support is now being questioned.

The China bears are being challenged by their country’s political narrative. Traditionally, the leadership of the ruling Communist party rotates on two 5 year terms. The first term is reformist and the second is ceremonial. President Xi Jinping is not using his second term to be a ceremonial outpouring of good will.

The President is consolidating and building on the reforms of his first term[ii]. The success or otherwise will be for history to judge but what appears to be happening is an emphasis on economic growth. In order to sustain reform, the government appears to be committed to stimulating the economy.

The Reuters report pointed to political changes that are now evident in China and the possibility of Xi Jinping’s colleagues gaining representation on the politburo and powerful standing committee.

Why does this matter to Australian investors?

The movement in commodities prices has in part been driven by the change in global perception about China.

The following chart shows commodity prices for BHP, Rio and Fortescue.

These are powerful rallies and investors need to consider will there be a supply side response to the change in prices of commodities?

Should investors look at the equity option market to limit downside risk, if taking money off the table isn’t an option?

It is important to recognise the positive equity movement isn’t only in response to commodity prices. The mining companies have executed some incredibly impressive cost saving initiatives which have also been a powerful stimulant for equity prices. 

What does this mean for Australian Investors?

Clinton looks the most likely. Markets would prefer the most likely as that outcome removes anxiety about the political and economic response.

The US Fed will endeavour to lift rates at the end of the year; it was incredibly hard to lift in December 2015. It seems no easier in 2016, so it is difficult to see rates moving dramatically higher.

China’s transition continues to be on track and the positives from the structural rebalances are being felt by our miners.

It looks like modest economic growth and a slightly higher Fed funds rate.

Which means when columnists write about bond bubbles it is hard to come to grips with the singular bond market they are discussing.

Are critics writing about Sovereign bonds or corporate bonds? Which country is in bubble territory? Is it Australia, the US or perhaps Germany or Japan.

If the fear is about corporate bonds, then which corporate and what structure? Corporate bonds can be fixed rate or floating rate, rated or unrated and are we discussing senior or subordinate bonds?

I understand a tightening environment creates concern for all asset classes but I am yet to be convinced we are in a tightening cycle; we seem to be in a singular state modest nudging cycle.

If the US can lift rates in 2016 it will have been a herculean intellectual effort and it isn’t obvious that it will be any easier in 2017.

The world doesn’t appear ready for significantly higher rates.

The case for a balanced portfolio doesn’t diminish when the rhetoric increases.

It can still be said that the equity options market can provide protection, the bond market can provide consistency, the cash market delivers liquidity and the equity market delivers growth and income.

A 25 basis point increase shouldn’t change that dynamic too much.

Please read the NAB disclaimer.

Have a good one.

Please remember this article is not investment advice. No one but you or your advisor knows (or hopes to know) what is best for you. We want you to understand the risks. If you’re unsure then don’t act.

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[i] AFR Sept 14th “The world’s biggest hedge fund warms investors of more pain ahead”

[ii] Reuter’s article Exclusive: Xi set to consolidate power in China by curbing Communist Youth League 30/9/16