wknd notes: Don't Say We Didn't Warn You!

“Don’t say we didn’t warn you!” declared the China People’s Daily. And historians rushed to remind us that Beijing used the phrase in advance of their 1962 border war with India and 1979 war with Vietnam. China assembled an “unreliable entities list” for retaliation against foreign companies, individuals and organizations that “do not follow market rules, violate the spirit of contracts, blockade and stop supplying Chinese companies for noncommercial reasons, and seriously damage the legitimate rights and interests of Chinese companies.” Pence responded by warning Beijing we could double tariffs. “Engaging in activities that run afoul of US sanctions can result in severe consequences, including a loss of access to the US financial system,” warned the US Treasury’s undersecretary for terrorism – you see, the Europeans are building systems to circumvent American sanctions. Today, those sanctions are directed at Iran, Russia, North Korea, Venezuela, but tomorrow they may be directed at China. Naturally, the Europeans threatened only themselves - 1,500-year habits are hard to break. Germany and France fought bitterly over who would become European Commission President. Brussels warned Rome to honor its obligation to contain its growing debt. Italy’s Salvini threatened to launch a parallel currency – step #1 in the process to abandon the euro and default. And out of nowhere, Trump warned Mexico to stop the immigrant flow in 10-days or face tariffs. Global CEOs who were rushing to rearchitect their China supply chains, digested the risk that these investments could be instantly devastated by some future tariff - imposed to achieve Americas geopolitical objectives - and they prepared to warn shareholders they’re putting new investment on hold. As the US treasury yield curve inverted, with 3mth bills at 2.34% and 10yrs at 2.12%. Which of course, is one of the most reliable warnings of looming recession.

Week-in-Review (expressed in YoY terms): Mon: Greek PM calls snap elections after poor Syriza result in EU Parliamentary elections (Greek stocks & bonds surge), Trump “US is not ready to make a trade deal. Tariffs could go up very, very substantially, very easily,” S&P closed (Memorial Day); Tue: Salvini after election victory says “League is the first party in Italy, Marine Le Pen is the biggest party in France, Nigel Farage has the biggest party in Great Britain, it is a sign that Europe has changed,” EU lending growth +0.3 to +3.9% (Germany +6%, Italy/Spain decline), EU consumer confidence improves for 1st time in 12mths (German confidence falls), Swiss Q2 GDP +0.2 to +1.7%, Poland buys 32 Lockheed F-35 fighters, US consumer confidence 6mth high, S&P -0.8%; Wed: Japan’s Softbank names Nokia and Ericsson as 5G providers, German unemployment +0.1 to 5.0% (first rise in 5yrs), Canada rates unch at +1.75% (maintains wait-and-see stance), corn prices hit 3yr high on mid-west flooding, Pelosi accuses Facebook of “lying to US public” over a doctored video that made her look drunk, US equity indexes close below 200-day averages, S&P -0.7%; Thur: Aussie new building approvals extend decline, Brazil Q1 GDP +0.5%, Assange fails to appear in UK court (faces 17 counts from US and 175yrs in prison – an indirect threat to 1st amendment and freedom of the press), Venezuela fails to pay its bill to a UK money-printing firm, US Q1 GDP revised -0.1 to +3.1%, Clarida “Fed would consider rate cut is growth outlook darkens,” S&P +0.2%; Fri: China PMI manufacturing -0.7 to 49.4 (exp 49.9), India Q1 GDP -0.8 to +5.8%, German CPI -0.6 to +1.4%, 10yr bund yields record low -0.19%, one-in-four small European SMEs say skilled labor shortages are biggest business risk, Italian 5yr yields rise above Greece for 1st time since 2008, US PCE inflation +1.5% (core PCE +0.2 to +1.6%), oil prices 12wk lows, Trump threatens Mexico with tariffs if immigration flow does not stop in 10days (5% rising to 25%), Trump ends India’s developing nation status (ending duty-free access for 2,000 products worth $6bln/yr), Trump ends Turkey’s preferential trade treatment (ends duty-free treatment on $2bln/yr of Turkish exports), Fed’s Williams talks about the value of preemptive rate cuts in the face of deflation or severe downturn, S&P -1.3%; Sat/Sun: DOJ opens antitrust investigation on Google, Trump endorses Boris Johnson, China launches FedEx investigation (latest trade war escalation).        

Weekly Close: S&P 500 -2.6% and VIX +2.86 at +18.71. Nikkei -2.4%, Shanghai +1.6%, Euro Stoxx -1.8%, Bovespa +3.6%, MSCI World -1.4%, and MSCI Emerging +0.8%. USD rose +3.0% vs Mexico, +2.2% vs Chile, +1.5% vs Russia, +1.2% vs South Africa, +0.7% vs Sterling, +0.6% vs Canada, +0.3% vs Euro, +0.2% vs India, and +0.1% vs China. USD fell -4.6% vs Bitcoin, -4.0% vs Turkey, -3.0% vs Ethereum, -2.5% vs Brazil, -0.9% vs Yen, -0.9% vs Indonesia, -0.5% vs Sweden, and -0.2% vs Australia. Gold +1.6%, Silver +0.1%, Oil -9.6%, Copper -2.5%, Iron Ore +2.0%, Corn +5.6%. 5y5y inflation swaps (EU -3bps at 1.29%, US -4bps at 2.11%, JP +1bps at 0.12%, and UK +2bps at 3.62%). 2yr Notes -24bps at 1.92% and 10yr Notes -20bps at 2.13%.

May Monthly Close: S&P 500 -6.6% and VIX +5.59 at +18.71. Nikkei -7.4%, Shanghai -5.8%, Euro Stoxx -5.7%, Bovespa +0.7%, MSCI World -5.1%, and MSCI Emerging -7.8%. USD rose +4.9% vs Chile, +3.5% vs Mexico, +3.2% vs Sterling, +2.5% vs China, +2.0% vs South Africa, +1.6% vs Australia, +1.3% vs Russia, +1.0% vs Canada, +0.4% vs Euro, +0.2% vs India, +0.1% vs Brazil, +0.1% vs Indonesia, and +0.1% vs Sweden. USD fell -40.2% vs Ethereum, -38.4% vs Bitcoin, -2.8% vs Yen, and -2.1% vs Turkey. Gold +1.5%, Silver -2.8%, Oil -16.0%, Copper -9.5%, Iron Ore +15.0%, Corn +17.8%. 5y5y inflation swaps (EU -13bps at 1.29%, US -17bps at 2.11%, JP +1bps at 0.12%, and UK +1bps at 3.62%). 2yr Notes -34bps at 1.92% and 10yr Notes -38bps at 2.13%.

YTD Equity Index Returns: Greece +31.9% priced in US dollars (+35.4% in euros), Russia +19.9% in dollars (+12.5% in rubles), China +15.8% (+16.2%), Canada +12.8% (+12%), NASDAQ +12.3%, New Zealand +11.8% (+14.8%), Australia +11.5% (+13.3%), Israel +11% (+7.6%), Switzerland +11% (+13%), India +9.9% (+9.8%), S&P 500 +9.8%, Brazil +9% (+10.4%), Saudi Arabia +8.8% (+8.8%), Russell +8.7%, Portugal +8.4% (+11.2%), Germany +8.4% (+11.1%), Ireland +8.1% (+10.9%), Netherlands +8% (+10.8%), Philippines +7.5% (+6.8%), France +7.3% (+10.1%), Thailand +6.8% (+3.6%), Euro Stoxx 50 +6.5% (+9.3%), Denmark +6% (+8.9%), Norway +5.7% (+6.1%), UK +5.5% (+6.4%), Italy +5.4% (+8.1%), Japan +4.7% (+2.9%), South Africa +4.5% (+6.1%), Taiwan +4.4% (+7.9%), Colombia +4.2% (+8.2%), HK +4% (+4.1%), Belgium +3% (+5.7%), Austria +3% (+5.5%), Czech Republic +2.8% (+5.8%), Mexico +2.8% (+2.7%), Spain +2.8% (+5.4%), Indonesia +1.9% (+0.2%), UAE +1.8% (+1.8%), Sweden +1.2% (+7.2%), Finland +0.9% (+3.4%), Hungary +0.8% (+4.5%), Singapore +0.7% (+1.6%), Poland -1.6% (+0.4%), Malaysia -3.5% (-2.4%), Chile -4.7% (-2.5%), Argentina -6.1% (+12.1%), Korea -6.3% (+0.0%), and Turkey -10.2% (-0.7%).

Frameworks: “Economists generally use tax frameworks to evaluate the trade war,” said my favorite strategist. “They calculate a -0.4% hit to GDP, which is not such a big deal. But they’re using the wrong tool.” Tax frameworks treat tariffs as a tax. They then model how a nation’s currency adjusts to the tax, how corporate profit margins shrink to absorb the tax, and how consumers shoulder the remaining burden. “Tariffs are being used as a proactive, combative tool. The GDP hit will be at least double. Modelling these tariffs require more complex frameworks.”

Frameworks II: “If all of the affected nations simply agreed to adopt new tax regimes, then the tax framework would work fine,” continued my favorite strategist. “But the world has built specialized supply chains. So if Nation A tries to hurt Nation B, and Nation B is part of critical supply chains that impact Nation A, then there are many things B can do to harm A in non-linear ways.” Banning rare earth metal exports is a small example. “Once Apple locks down their product production for Nov 2019 release, China knows exactly how to push that past Feb 2020.”

Frameworks III: “Global trade was already in the process of fracturing,” added the strategist. “Now Huawei can’t use Google’s operating system.” Their phones are as good as paperweights. “But do you really want to bet that Huawei can’t spend the next 6mths building a competing operating system?” We’re entering a world of competing superpowers. “The overall impact will be to operate economies with redundant technologies, fewer efficiencies, lower ROEs, lower ROAs. And ironically, or perhaps by design, it’ll be bad for profits, but okay for labor.”

This Time: “Hate to say this because it’s so obviously wrong,” said the investor. “The dollar always soars in recession. But I think this time will be different.” In the later stages of a typical market cycle, money flows to emerging markets, foreigners amass large US dollar debts, global trade expands and often creates outsized demand in commodities. “You usually end up with this overwhelmingly short dollar position in the market.” A massive carry trade, with investors short dollars and long higher-yielding foreign currencies/assets. “I see no sign of that this time.”

This Time II: “The US fiscal position is usually strong late in the cycle,” continue the same investor. It enters the downturn with lots of room to expand deficits to levels that remain manageable. “But we now have 5% deficits for as far as the eye can see. They’ll jump close to double digits in recession, and much of that will be structural. The Fed will cut to zero while the rest of the world does little other than say - Welcome to the club.” It’s been lousy for a while. “Perhaps the first move in the dollar is up, but this time US policy will overwhelm it.” 

Backroom Dealing: “Only one seat matters,” said the politico. “Investors fixate on who replaces Draghi, but in political circles, no one actually cares,” he said. “The ECB doesn’t have much left to do now that rates are -0.40%. Maybe they could buy some equities, perhaps go a little deeper negative.” The central banking era is ending. Replaced by politics. “So the Germans and French are fighting for what matters – that’s the Presidency of the European Commission. The French know Europe will have a chance to really change, only by diluting German control.”  

Anecdote: “Their methods continue to grow in sophistication,” said the engineer. “They collect data exhaust - your emails, chats, phone records, who you called, how long you spoke, your trades, what time you transacted, how you sized each relative position in your portfolio, and so on,” he said. We were discussing advances in Alpha Capture strategies employed by the industry’s large quantitative firms. “They also pay Wall Street analysts to rank equities each week, and upload these onto their servers.” The Alpha Capture data scientists then start mining. “They discovered most long/short equity managers think they generate alpha through position sizing and portfolio construction, but in many cases, they destroy alpha.” An equally-weighted portfolio of a manager’s stock picks will often outperform the manager’s actual portfolio. So the data scientists take all of these stock picks, equally weight them, and produce a superior diversified portfolio as a starting point. “Then they discover the really interesting things. They scan the portfolio manager’s chats for language that reflects shifting bullish/bearish sentiment. They track phone calls with sell-side analysts. Do a specific manager’s stock picks tend to generate alpha after a short call or a longer call with a specific analyst? Do the picks outperform after he supersizes them? Or underperform? The data scientists triangulate this with everything found in the portfolio manager’s email and chats, together with what’s happening in the overall market, economic data, sentiment data, time of day, week, month, year, everything.” The data scientists then construct their own portfolio, and its size already dwarfs any individual portfolio manager at these firms. “Discretionary portfolio managers and equity analysts have become rich sources of data to analyze.” Each one is inferior to the greater whole. “And someday soon, the discretionary portfolio manager’s highest value will be the behavioral data they generate.”

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.