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Revival of Reflation Ahead of Q4’s Liquidity Drought
Aug 29, 2021
In Q2 2020, we laid out our reflationary thesis with a menu of investment options to capitalize on it – “the pandemic passes, the stimulus stays” as we called it. Since the beginning of the year, even though our view had become consensus and our trades crowded, we have stayed steadfast with our stance. We prescribed the following formula: Reflationary Growth + FMC (Fiscal Monetary Coordination) = Rational Exuberance.
Since May/June, have discussed our thesis of peaking growth momentum and peaking liquidity. Accordingly, we have recommended investors book some gains, correct pro-cyclical overweight by reducing risk selectively while deploying some hedging strategies.
We laid out that: Peaking growth momentum + Peaking Liquidity + Hawkish Fed + Crowded Positions = Perfect Storm. We concluded, “Based on our study, we think conditions are mature for a perfect storm of reflationary trades. Perhaps it has been quietly starting already.” For details, please refer to “The Peaking Process of Reflation” dated June 4th.
Indeed, the reflationary trade has experienced serious setbacks, with sharp underperformance for the small cap and cyclical sectors, while the broad equity market supported by a few large tech names continued to grind higher in the past few months. Where do we go from here?
A Look at the Oil Market
July 25, 2021
The global petroleum market is currently at one of its most uncertain points in recent memory. In theory, given that it is a globally consumed commodity, forecasting oil prices should be simple, or at least easier than forecasting financial asset prices. Simply estimate likely physical demand and physical supply, and then estimate the likely clearing price. However, both the demand and supply situations, both over the short and long term, are among the most uncertain since 2 decades ago.
On the demand side, the short term uncertainties mainly revolve around the impact of COVID, particularly on EM ex-China demand. But in the longer term, significant uncertainties exist regarding the sustainability of Chinese demand growth, as well as the speed of the displacement of Internal Combustion Engine vehicles by Electric Vehicles.
On the supply side, the short term uncertainty of Iranian supply remains, even as OPEC+ has recently come to a temporary agreement. In the longer run, there are significant questions regarding the willingness of Western E&P’s to develop new supply given the strength of the ESG movement.
In this note, we will touch upon all those topics, and try to draw some implications for the longer run for the most important of commodities.
A Discussion on the India Rupee
July 16, 2021
Last week we discussed the economic backdrop, policy responses in China and market implications.
This week, we will take a look at India. We will review the pre-pandemic backdrop, covid-shock and outlook for the remainder of the year and next year. The fundamental backdrop argues for a weaker India Rupee going forward.
Thoughts on China
July 9, 2021
Global equity markets have had a mostly banner first half. However, China has been a glaring exception. Among major global equity indices, China and Hong Kong’s benchmarks are the only one to be down YTD in local currency terms. (See table below) While we have discussed for some time that the reflation in China had peaked last year, followed by US in mid-year and Europe soon, the deep underperformance still surprised us and many others.
We think Chinese policy makers are facing a dilemma similar to what they have been facing since GFC – the balance between controlling the risks of overleverage and debts bubbles, while at the same time preventing growth from decelerating to levels that raise unemployment or even worse, trigger a banking crisis. This was all made more complicated given the geopolitical tensions between US and China, as the Biden administration takes both a strong stance against China like Trump, but also in conjunction with other Major OECD countries.
In today’s note, we will walk through the pre-covid backdrop, post-pandemic policy responses and look beyond the near future. We think that the policy makers are facing a crossroad: whether to embark on easing path to revive the growth or to maintain a relatively tight or neutral policy to control the risks of leverage. The resolution of this crossroad will have implications not only on Chinese assets, but global assets. At the current juncture, we think Chinese assets present exciting opportunities for skilled long short managers, while presenting a little bit more difficult environment for beta investors. We do have higher conviction on being long Chinese government bonds (receiving local rates).
Summer Lulls of Duration
June 25, 2021
In the past few weeks, we have been writing about the conditions of peak growth momentum and peak liquidity in 2nd half of the year. We argued that the peak reflation argues for a change of the balance of the risk reward between equity and long-dated treasuries.
Where will the yields go from here? In this note, we laid out why we would be willing to be the receiving end of long dates
Imminent Perfect Storm
June 18, 2021
Peak growth momentum + Peak Liquidity + Hawkish Fed + Crowded Positions = Perfect Storm
And yes, the storm could be imminent.
Since Q2 2020, we have laid out our reflationary thesis with a menu of investment options to capitalize on it – “the pandemic passes, the stimulus stays” as we called it. Since the beginning of the year, even though our view had become consensus and our trades crowded, we have stayed steadfast with our stance. We prescribed the following formula: Reflationary Growth + FMC (Fiscal Monetary Coordination) = Rational Exuberance.
In the past few weeks, we have discussed our thesis of peaking growth momentum and peaking liquidity. Accordingly, we have recommended investors book some gains, reduce risk selectively and be prepared to deploy some hedging strategies. We think it is time to get more aggressive on these actions. Indeed, this is what we have been recommending to our clients this week.
In this note, we are putting all the pieces of the “Peak Reflation” thesis together and making significant changes for our recommendations. In short, we see:
Peak growth momentum + Peak Liquidity + Hawkish Fed + Crowded Positions = Perfect Storm
Reading Labor Market Tea Leaves
June 11, 2021
In the past few weeks, we have discussed the peak growth momentum and peak liquidity towards late summer and early fall. Generally speaking, these two factors alone serve as headwinds for risk assets and are conducive for lower treasury yields.
Today we will focus on Fed’s reaction function with a focus on labor market. We argue that Fed will likely error towards being more dovish than market is currently expecting, based on their reaction function. This factor alone serves as a tailwind for risk assets and supports lower yields in the near future.
We know the Fed’s dual mandate is maximum unemployment and price stability. We have discussed the Fed’s reaction function to inflation per our note “Capitalizing on Rising Inflation Risks” dated on May 19th, where we laid out the thesis that in the longer term, Fed may stay behind the inflation curve, causing inflation expectations to de-anchor. However, in the near-term, we agree with the Fed that inflation pressures may start to ease. Indeed, we see the actual CPI print peaking in the next few months and easing towards the end of year, before rising early next year. We will provide an update on inflation soon. The takeaway is: a). We disagree with inflationists since we see inflation pressure to start to ease in the 2nd half of the year. b). We disagree with deflationists that we see inflation may be poised to rise again after a temporary pause in the 2nd half of the year. If we are right about this, we think the Fed is unlikely to be concerned with inflation and risk of monetary tightening risks remains low this year.
More importantly, we think it will take a much longer time for labor market to recover than most market participants are expecting. As a result, Fed may prove to be more dovish than what is priced by the market.
The Peaking Process of Reflation
June 6, 2021
Market bottoms are events, but peaks are a process.
Since Q2 2020, we have laid out our reflationary thesis with a menu of investmrny options to capitalize on it – “the pandemic passes, the stimulus stays” as we called it.
Since the beginning of the year, despite the fact that our view had become consensus and our trades crowded, we have stayed steadfast with our stance. We prescribed the following formula: Reflationary Growth + FMC (Fiscal Monetary Coordination) = Rational Exuberance.
In late April, we anticipated that growth momentum could peak in mid-year, and in Q3/Q4 in Europe. We entertained the “possibility” of a potential temporary local top of stocks in May/June. However, we made it clear that we were not ready to call the timing yet, as economic growth momentum is only one piece of the puzzle. The fiscal and monetary reaction function, liquidity, market positioning and other quantitative factors are other important parts of the puzzle to assess asset prices behavior. We wrote “To be sure, our short-term indicators show that probability continues to favor a continuous rally of risk assets in the very near future…..The probability distribution of the exact timing can only be assessed a few weeks/days ahead, based on the assessment of liquidity and positioning – we will communicate as we see it...”
As new data has come in, we are gaining more confidence about our thesis: growth momentum (the growth of growth - i.e. the second derivative) is in the process of peaking in the US. We mentioned that asset price behavior will also depend on liquidity and central banks’ reaction functions, which we have discussed extensively before. We think there will significant volatility and changes to asset prices both on a relative and absolute basis as we head into the second half of the year.
Hot Summer, Cold Liquidity
May 29, 2021
We laid out our investment framework last week. Today we will focus on one the most important components of our framework: Liquidity.
We will discuss the current liquidity backdrop and conclude that we are probably in a period of peak liquidity right now and the liquidity situation is likely to worsen and can potentially cause significant asset volatility this Summer and Fall by examining the M2 growth, the UST funding gap and dealer’s financing capacity. We pointed out that there are many ways the Fed can mitigate these risks. The question is always whether the measures are taken preemptively or in reaction to the asset volatility.
Understanding the liquidity backdrop is critical in our view, as we believe that liquidity is the primary driver for the overall levels of asset prices.
-In an environment of rising liquidity, most assets will rally. Valuation, positioning and forward growth expectations between different sectors/regions determine who will benefit more from the rising liquidity.
- In an environment of stable liquidity, general asset price levels may be range bound, while there will be significant rotations between asset classes, sectors, and regions driven by valuation and positioning vs. forward growth expectations
- In an environment of falling liquidity, general asset prices will fall. The overvaluation vs. forward growth expectations and heavily positioned asset classes will suffer more than others.
Different people have different interpretations of liquidity. For our purposes, liquidity is defined as the “dry powder” available to purchase asset prices. While there are numerous ways to measure liquidity, we have not seen anyone who has put all different liquidity puzzles together to form an overall forward-looking picture.
The amount of “dry powder” not only depends on the size of the capital, but also on leverage: Liquidity = capital x leverage
In the section below we will discuss each section of our liquidity model: M2 Model, UST funding gap and Dealers’ financing capacity.
A Primer for Dao Capital Systematic Investment Framework
May 23, 2021
Dao Capital is about to complete our two-year anniversary in the months ahead. Over the past two years, our research has been read by many CIOs of asset allocators who manage tens billions of assets, CIOs/PMs of major hedge funds and trading oriented family offices, collectively managing hundreds of billions of assets, in addition to some folks from investment banks’ trading desks. We have helped some institutional investors navigate the capital market via active asset allocation and macro-overlay with success in one of the most volatile periods in financial history.
We started with a small group of friends, and we are humbled how much our readership has grown. We have not engaged in active marketing efforts. Our enjoyment lies in the analysis of capital markets. Our audience grows via our old contacts, word of mouths and referrals. True to the Dao philosophy, we never pushed for any business, and many of our currently clients reach out to us because of referrals. For faithful readers over the past two years (some of whom go back 8 years), we would appreciate your continued referrals. If you like what we offer, feel free to reach out to us and we will customize a solution for you.
We believe that we have developed a unique investment process that will capitalize on the structural weaknesses of the industry. This is not because we are smarter and more intelligent than others, but rather it has a lot to do with our combined experience as asset allocators, hedge fund managers and investment bank trader, which has helped us develop a more complete picture how different market participants interact with each other and also enabled us to learn from some of the best practitioners in the industry.
Most investors are educated by a specific school. Value investors focus on valuation. Growth investors focus on EPS growth and market share. Traditional Wall Street macro investors focus on central banks and economic development. Others purely focus on technical analysis, both from price (momentum or reversal), market positioning (both implied and explicit) and sentiment in addition to many other quantitative methods. They constantly argue with each other which method is better than others.
We have learned that all of them matter, but none of them are useful on a stand-alone basis. Capital market asset prices are driven by many different forces, and it is the balance of these forces that drive the ultimate movement of asset prices with different time frameworks. The key is to put all the different puzzles together and make a holistic assessment on where capital markets are heading.
In a series of reports, we will share our systematic framework of how we put each puzzle together and develop a holistic view on the market. Today we will give an overview of our framework. We will delve into some of the details in the future.
Is this a Major Top for Bitcoin?
May 16, 2021
Cryptocurrencies have been in financial news headlines for much of this year. It is both an interesting as well as polarizing topic. The polarization of views has made it more difficult to have open minded discussions between investors. In this week’s note, we would like to share some of our thoughts on the space. We assume our readers have some basic understandings of cryptocurrencies; therefore, we will only focus on some of the areas where our views may be differentiated.
We have refrained from discussing this topic in the past. This is because we believe the intrinsic value of crypto currencies is debatable at best (though we are bullish on blockchain technology and the applications), and that might not be suitable for buy and hold strategies employed by many long-term real money investors.
However, we do enjoy the tremendous volatility that cryptocurrencies offer. If investors have a framework to manage the risks, we think the volatility should be used to investors’ advantage.
We do not have a deterministic view of the ultimate “terminal” prices of cryptocurrencies (nor do we for any asset class), nor do we have firm views on whether cryptocurrencies are “ultimately” bubbles or not. For all practical matters, we think they are not critical factors for what to do today. One should buy tulips during the early stages of Tulip Mania when it was worth a bike for re-example and sell it when its value appreciated to the equivalent of the house. The key was to manage the risks, and if one does not have framework to manage those risks, buying Tulips would be a dangerous idea no matter the price level. If crypto currencies prove to one of the biggest bubbles in history as many skeptics expect, one will likely kick themselves for not being able to capitalize on it. If one wants to wait until the crypto currencies to prove themselves first before they invest, it would probably be too late as most of the price appreciation would be in the past. The sad reality has always been that most early skeptics are converted to believers because of price appreciation exactly at the top of bubbles and become the bag holders for the lucky few.
What happened in the past is not important. What is going to happen in the future is an uncertainty. What is most important is determine what to do now without a conviction of the “terminal value”. To put it simply, the question is not whether you are bullish or bearish, but rather when to be bullish and when to be bearish.
Rising Inflation Risks
May 8, 2021
In September when the consensus was firmly deflationary, we laid out the thesis for the potential secular shift from the past decades of disinflationary environment into a higher inflationary environment in the long-term (please refer to “The Two Rising Tails of Inflation” Part I, Part II, Part III). In addition, we forecasted that inflation was set to rise in 2021 and 2022. Correspondingly, we have recommended a set of investment strategies to capitalize on rising inflation.
Fast forward to today, inflation discussions dominate the headlines of the financial media and most inflationary assets have had significant rallies. Where do we go from here? Unfortunately, we are with consensus this time around with a significant caveat that Fed’s view on inflation might be temporarily right for a short period of time in second half of the year. While we continue stay with our inflationary outlook and assessment, it is far more important to manage the ebbs and flows of the process rather than having a deterministic view.
In this note, we point out that inflationary pressures continue to build in the near term. While we are sympathetic to the Fed’s view that inflation pressures may start to ease somewhat in the 2nd half of the year, we think it is likely to be transient. In other words, disinflationary pressure, if it materializes, is likely to be transitory.
We also examine the Fed’s reaction functions and see signs that inflation expectations are starting to de-anchor. Our current assessment is that the risk is high that the Fed stays behind the inflationary curve in the near term and will be forced to tighten the monetary stance aggressively sometime in the distant future, causing a significant decline of asset prices.
We continue to recommend investors be positioned for our reflationary thesis with the investment menu that we have laid out in Q2 2020. We are providing important updates to our recommendation since the beginning of the year to capture the potential second leg of the reflationary trade.
A Black Swan Price for White Swan Outcome
May 1, 2021
During the GFC, the pension fund that Jim oversaw benefited from positive returns from a few hedge funds that bought some CDS on subprime. However, both the gains and allocations were too small. If those CDS positions were directly overlaid on the overall portfolio, the outcome could’ve been much better!
More than a decade later, we set up Dao Capital to help Institutional Investors to put on asymmetric position exactly like that: direct macro overlays to either hedge portfolio risks or capitalize on highly asymmetrical risk/reward opportunities. A good hedging strategy should not only protect the portfolio, but also deliver positive returns. For this reason, we call our strategies Tail Alpha rather than Tail Hedging.
Before the breakout of Covid-19, we recommended the following strategies to our institutional clients with significant gains during the Covid-19 shock:
1. Conditional Bull Steepener ( > 2500%)
2. Receiver on US rates (results vary depend on instruments)
3. Buy call spread on gold (>1000%)
4. Short Emerging Market currencies such as Brazilian Real, South Africa Rand and Korean Won at the beginning of the year (results vary depending on instruments)
5. Direct hedging using put spreads at the beginning of the year (>1000%)
Post the Covid-19 shock, our focus moved onto capitalizing on inflation risks. Most of our readers are well aware of the capital allocation strategies we recommended to capitalize on the reflationary thesis such as pivoting to commodities, value, small caps, EM etc. However only a few of our advisory clients benefited from the Tail Alpha overlay to short long-dated US rates, recommended as early as April 2020.
The best time to hedge inflation is when market is priced for deflation.
In our note “Cross the Rubicon” dated on April 19th 2020, when the world was in a state of a deflationary despair, we wrote “…more specifically, we recommend investors buy 10y expiry payer options on the 20y swap rate ATMF +300 with a premium of 1.5%. This has never been so cheap in the past 10 years…” At the time, US 10y30y forward rate was around 80 bps. So as a result, a strike price of 3.8% seemed to be outlandish. Fast forward to today, The US 9y30y is at 2.20%. Suddenly, the 20y rate going to 3.8% within 9 years does not seem to be too remote anymore.
Depending on when clients put on the trade recommendation in 2020, the returns would have ranged from 100% to 400%. To be sure, we still like the trade in the long-term, however, it is obvious that risk/reward asymmetry is no longer as compelling as before.
What is the next “un-discovered” strategy that will offer similar or even greater risk/reward asymmetry if global inflation risks accelerate?
A Potential Local Top in May/June
Apr 24, 2021
At the very beginning of the year, we reiterated that within our framework of the four-phase reflationary cycle, world capital markets are in phase three, categorized by rising growth and rising inflation. We prescribed the following formula for the risk asset rally: Reflationary Growth + FMC (Fiscal Monetary Coordination) = Rational Exuberance.
We continue to recommend investors to be positioned for reflationary growth. However, our analysis shows that a potential local top of US stocks could be developed sometime in May or June.
To be sure, our short-term indicators show that a continued rally of risk assets in the very near future is probable. However, we think investors should now make plans for potential risk reduction and prepare for potential hedges sometime in May or June. The probability distribution of the exact timing can only be assessed a few weeks/days ahead, based on the assessment of liquidity and positioning. We will communicate as we see it.
Why do we call it a “potential local top”? First, though our fundamental analysis shows high probability of occurrence, this is a hypothesis that may or may not materialize. Second, while we think it potentially could be one of the tops of the year, we are not sure if it will be “the” top of year. Based our current reading of the Fed’s reaction function, we think the correction, if it materializes, should be temporary.
Our readers know that we are fundamentally driven and technically informed when we advise long-term investors. We are technically driven, but fundamentally informed when we advise fast money investors (hedge funds and trading oriented family offices). Our investment and risk management philosophy focuses on the three-way reaction function between capital markets (asset valuations, explicit and implied prices), economic fundamentals (growth and inflation) and fiscal monetary authorities, examined from the lens of cycles (everything is a cycle in the Dao Philosophy).
Why do we see a potential local top of US stocks in May/June?
Apr 17, 2021
Last week, we scanned volatility across major asset classes. We noted that that despite the elevated volatility in rates, and episodes of risk events in some parts of equity markets, global implied volatility have been in steady decline, which is conducive to global asset appreciation as both explicit and implicit vol target funds will mechanically increase gross exposure to deliver their target vols.
We concluded that “our cross-asset volatility scan shows that the implied vols of various assets continue to be consistent with our reflationary growth thesis.” However, we anticipate that things may start to change when rates rise further from here, possibly when growth/inflation momentum starts to peak sometime in Q2/Q3. We will discuss this in our future writings. Stay tuned.
Given the importance of rising rates and the implications on broad global asset classes, we will examine the rates complex from the volatility lens today.
Cross-Asset Volatility Scan
Apr 10, 2021
As part of our process, we systematically scan economic indicators, asset prices and volatilities globally and across all asset classes. This week, we will focus on cross asset volatility to provide context for understanding the volatility space in the current environment.
The chart below is the DCA global cross-asset volatility index, which is the weighted average of the z-scores of implied volatilities of various asset classes, including currencies (including gold), rates, equity (vol and vol of vol) and commodities (oil and copper).
Despite the elevated volatility in rates, and episodes of the risk events in some parts of equity markets, global implied volatilities have been in steady decline. Generally speaking, falling volatility is conducive to global asset appreciation as both explicit and implicit vol target funds will mechanically increase gross exposure to deliver the target vols.
As long as the treasury funding and the constraints of banks’ balance sheets do not disrupt repo financing, we think re-leveraging will support global asset prices, all else equal.
Bank on European Banks
Mar 27, 2021
We are bullish on European Stocks, both on an absolute basis and on a relative basis vs US Stocks. Within European stocks, we are particularly bullish on European banks.
We have recommended that institutional investors overweight European stocks and particularly European banks the past few quarters. While it has worked out well, it may appear counterintuitive to continue holding such view when Europe is facing another wave of rising coronavirus cases while their vaccination rollout is lagging far behind the US.
But note that vaccines will be distributed and economic activity will pick up. It is but a matter of time. We think China was a few months ahead of the US, and the US is a few months ahead of Europe. We now expect US composite PMI to continue to rise due to rising Services PMI, and we expect European PMI to pick up materially in months and quarters ahead.
Bullish on the Polar Bear
Mar 19, 2021
In the past few days, the Russian Ruble and Russian equities fell sharply following President Biden’s comments that that Putin is a “killer,” and that he will “pay a price” for their interference in the 2020 US election. In response, Russia recalled its ambassador to the US. This follows coordinated US and EU sanctions on senior members of the Russian government in early March in response to the poisoning of Russian opposition leader Navalny.
We view this is a buying opportunity for those who missed the rally of Russia assets. We like the Russia Ruble and Russia stocks. We are bullish on the polar bear.
We wrote a piece on Russia late last year, noting that it was poised to outperform. Since then, it has performed well, especially vs its peer group.
What is the best performing currency YTD? Until the breakout of political tensions, the Russian Ruble was the best performing major EM currency vs the USD YTD, and Russia stocks have been outperforming MSCI EM Index and S&P 500 Index.
Let’s take a look from multiple perspectives. We will start with possible US policy actions given that is the biggest source of uncertainty, followed by fundamental factors.
Yield to Yields
Mar 13, 2021
Global yields have gone up sharply over the past several weeks, with new highs in many cases seen this week. How high will the yields go?
While we have discussed this topic in our recent notes, we want to dig deeper into it given the important and broad implications of rising yields. We think the central banks’ reaction function, economic forces and supply/demand dynamics continue to favor higher yields.
There are three angles to yields that we will cover in this note: Central Bank Guidance, Market Pricing, and Duration Supply. We will take each in turn.
A Precondition for the Roaring 20s
Mar 6, 2021
At the deep of the pandemic panic one year ago, we laid out our case of “pandemic passes, but stimulus stays”. Fast forward today, people are discussing the possibilities of roaring 20s of the 21st century, in comparison to the period from last century i.e.1920-1929.
We see 1920s capital market behavior a distinct possibility - hence our right tail risks as discussed before, though we are not sure if it can last a decade.
We think the pass of pandemic and the increasing fiscal stimulus lays the necessary conditions for the roading 20s, however, they are not sufficient conditions. We need a pre-condition to be met: Fed needs to step up to monetize the fiscal stimulus just like what they did in year 2020. The probability of a repeat of Roaring 20s will increase exponentially once that occurs.
Our base case is that Fed may not pre-emptively monetize future fiscal stimulus – it is too much to ask at this point, however, Fed may be forced to do so in a reactive manner when the passive monetary tightening leads to significant decline of stock prices. In other words, we need a major risk event to force Fed to monetize the debts. That moment may arrive sometimes this year, perhaps in Summer/Autumn – we will communicate as we see it.
Our last report compares our current situation to 1987 and found remarkable resemblance of the market conditions. While the market may not follow the exact roadmap, our current reading shows a distinct possibility for a major top of stock market in Summer/Autumn. Perhaps, that will be the catalyst to force Fed to monetize the fiscal stimulus, laying the foundation of Roaring 20s.
Parallels to 1987
Feb 27, 2021
At the very beginning of the year, we reiterated that within our framework of the four-phase reflationary cycle, world capital markets are in phase three, categorized by rising growth and rising inflation. We pointed out that “In this phase, virtually all financial assets will rally with the exception of bonds. The long duration assets will underperform.” We also pointed out that precious metals would typically underperform during this phase of the cycle.
Typically, the reflationary cycle will enter its final stage when the fiscal impulse and monetary stimulus begins to fade or tighten. This is not the case from the surface: it is clear that more fiscal stimuli are coming, and the Fed appears to be committed to FAIT (Flexible Average Inflation Target) with on-going QE. What could derail the reflationary story?
Perhaps, the fiscal stimulus itself. We wrote that “…the increase in fiscal measures, if not monetized by Fed, will exert negative forces on financial asset prices…” In our framework, the impact of fiscal policy and monetary policy on the financial markets are different.
To illustrate our point, please refer to the chart below, which highlights the four regimes of our framework:
The Twists and Turns of Rising Yields
Feb 20, 2021
In March 2020, when the world was deep in the Covid-19 deflationary shock, we laid out the thesis that US long-dated rates would probably bottom out in the following weeks/months per note “The Mirror Image of Volcker Shock” dated on March 21, 2020. One month later, in our note “Cross the Rubicon” dated on April 19, 2020, we specifically recommended investors to buy long-dated payers to capitalize on this theme. Since then, we have been positioned for higher yields and steepened yield curves strategically.
Today, the recent rise in yields is top of mind for many macro investors and asset allocators. The Bloomberg screenshot below highlights how the upward moves in the long dated yields are a global phenomenon. As the yellow box below shows, for almost every country with bonds denominated in a currency they control, current levels are at the top end of their 6 month range. It's interesting to note that only exceptions are China and the countries whose bonds are seen as credit instruments. (USD Denominated EM debt and Italy)
It is good time for us to revisit this topic.
The key question is how high can yields go and what are the asset pricing implications?
The Sunset in Far East
Feb 13, 2021
There is currently a lot of hand wringing in the US and Europe over central government policies. The size of Quantitative Easing programs by the Fed and ECB, the huge fiscal deficits and fiscal support programs being enacted by the US government and EU Commission, are all causing quite a bit of consternation. In the US, the former Treasury Secretary Larry Summers and former chief economist of the IMF Olivier Blanchard and come out against the size of the new Democratic fiscal stimulus program. With the budget deficit already hitting 15% of GDP in 4Q2020, they have both argued that the sizes of the new programs are too large and likely to result in undesired inflationary shocks that will ultimately be destabilizing.
Regardless, our base continued to be that at least US$ 1.5 trillion stimulus will likely be passed and capital market probably underestimate the possibility of US$1.9 trillion package. In addition, as we enter Q2, Q3 we think more longer-term fiscal stimulus such as “Green New Deal” will be discussed and eventually be passed. We also pointed out that when the Fed has to monetize most of the debt issuance to prevent the rise of UST yield (despite rising inflation expectations) – the question is to be reactive or to be pre-emptive. We have discussed extensively since late Spring 2020 that the roadmap of the FMC (Fiscal and Monetary Coordination) would be rising nominal financial asset prices, rising inflation, and falling currency.
The whole world is taking a page from “Takahashi Economic Policy” in Japan in early 1930s: 1). Exit from gold standard, depreciate the currency 60% vs. USD and more than 40% again Pound sterling. 2). Increase fiscal expending through direct monetization of BOJ 3). Keep interest rate low despite of rising inflation.
Winter is Here, Is Spring Far Away?
Feb 7, 2021
Since mid-2020, we have been discussing the reflationary growth thesis and recommending that investors position accordingly. At the beginning of the year, we pointed out that we are in a reflationary cycle with rising inflation and growth expectations, while fiscal and monetary policy remains accommodative. We laid the following formula as our intermediate term outlook:
Reflationary Growth + FMC (Fiscal Monetary Coordination) = Rational Exuberance.
Last Week, we discussed that investors should be prepared for rising right tail risks in the stock market. We argued that global equity markets are unlikely to reach a long-term peak when fiscal and monetary stimulus are on the offensive, with the economy having just emerged from a recession and growth poised to pick up. We further pointed out that while valuation is an important metric, it cannot be evaluated on an isolated basis. Sentiment is only one part of the puzzle around market positioning, which may serve as a catalyst for short-term volatility, however it will only be a key catalyst for a bursting bubble when the fundamental drivers turn south - mainly monetary and fiscal policy and a change in economic growth expectations. Additionally, our technical reading of the market does not indicate an imminent long-term top.
This week we will discuss why economic growth momentum is poised to pick up and inflationary pressure will continue to build. Before we start, we would like to provide an update the UST funding and related liquidity discussion.
A Liquidity Tsunami of $1.7 Trillion within 5 Months
Two weeks ago, in our note “To be Pre-emptive or to be Reactive - How to Monetize Tsunami Blue Waves”, we discussed “that despite the current large pace of QE purchases, they are not enough to fully fund the US fiscal spending this year, and that may cause a funding squeeze this year. This is important because the increase in fiscal measures, if not monetized by the Fed, will exert negative forces on financial asset prices. The funding squeeze is usually positive for the US dollar and negative for risk assets, all else equal.”
More specifically, we pointed out that “given that the fiscal stimulus is front loaded, we foresee that large treasury issuance will be front-loaded as well. Based on our assessment, a UST funding squeeze in the near future is quite possible.” We estimated that the net UST funding gap for Q1 would amount to $785 billion. (The UST funding gap is defined as treasury issuance minus QE minus foreign demand). We thought this size would be big enough to cause a potential funding squeeze and could potentially cause market volatility.
This short-term picture has completely changed. Instead of a headwind, UST funding is now a tailwind. This is because at the beginning of the week, the Treasury department announced its updated projections of debt issuance, which included dramatic changes compared to the last announcement in November. Treasury now expects to borrow only $274 billion, instead of $1,127 billion projected in the November’s statement, a dramatic decline of $850 billion, or 76%!
The Winding Paths of Two Fat Tails
Jan 31, 2021
Rising Right Tail Risks
Since mid-2020, we have been discussing the reflationary growth thesis. At the beginning of the year, we pointed out that we are in a reflationary cycle with rising inflation and growth expectations, while fiscal and monetary policy remains accommodative. We laid the following formula as our intermediate term outlook: Reflationary Growth + FMC (Fiscal Monetary Coordination) = Rational Exuberance.
At the same time, we recognized the stretched market technical and euphoric sentiments. More specifically, we were concerned with UST funding liquidity as the current pace of QE is not rough enough to absorb the increased treasury issuance. We saw a rising risk of a short-term correction.
Against this backdrop, we recommended aggressively positioned long-term investors to book partial profits, while continuing to be positioned for the reflationary thesis and to be ready to deploy more capital amid market volatilities if materialize. For fast money absolute return investors, we suggested a short-term counter-trend trade to go long the US Dollar and be positioned for a potential temporary unwind of the reflationary trade.
Where do we go from here?
We continue to hold the assessment above and would encourage investors to buy into the reflationary trades we laid out to take advantage of further market volatility. Beyond the short-term, we saw rising risks to right tail risks in the stock market.
Talking about right tail risk at these valuations after such a strong run amidst evident signs of speculative behavior may sound pollyannaish, especially when old hands like Jeremy Grantham (who successfully called the Japanese equity, dot com, and housing bubbles) are calling this another speculative bubble that would burst “within months.”
While we do have tremendous respect for Jeremy Grantham, an imminent reversal of the stock market towards a sustained bear market is not our base case. After a pull-back that may well continue into the next 1-2 weeks, Hedge Funds’ de-leveraging process may run its course, Robin Hood may fail, and some of the most crowded positions will get unwound, laying the foundation for reflationary stocks to move higher (and perhaps substantially higher).
As a matter of fact, we think the bigger the near-term pull back and the faster the speed of the decline, the higher the probability will be for a strong rebound, and the higher chance of right tail risks. Ironically, for bulls, the best- case scenario is for the S&P 500 drop by more than 10% within a week. Why? Let us explain.
How to Monetize Tsunami Blue Waves
Jan 23, 2021
At the beginning of the year, we laid the following formula as our intermediate term outlook: Reflationary Growth + FMC (Fiscal Monetary Coordination) = Rational Exuberance. We highlighted that the economic and fundamental backdrop, along with further coordinated fiscal stimulus, continues to support our reflationary thesis.
Last week, we discussed interest rate policy, and concluded that it is unlikely for the Fed to hike policy rates in the next 2-3 years. Rather, it was more likely that Fed will engage in de-facto yield curve control if rising longer-dated rates start to hurt asset prices.
This week, we will discuss fiscal measures and the corresponding QE programs.
The increase in fiscal measures, if not monetized by Fed, will exert negative forces on financial asset prices. Despite the current large pace of QE purchases, they are not enough to fully fund the US fiscal spending this year, which may cause a funding squeeze. Given that the fiscal stimulus is front loaded, we foresee that large treasury issuance will be front-loaded as well. Based on our assessment, a UST funding squeeze in the near future is quite possible.
What are asset implications? The funding squeeze is usually positive for the US dollar and negative for risk assets all else equal. If Fed does not act pre-emptively (i.e. increase QE programs immediately), this could potentially drive a short-term correction of the reflationary trade. However, we do expect the Fed to increase QE programs aggressively in reaction to any volatility caused by the funding squeeze, creating strong impetus for asset acceleration afterword. To be pre-emptive or to be reactive, that is the question.
Lower for Longer
Jan 17, 2021
Last week, we laid the following formula as our intermediary term outlook: Reflationary Growth + FMC (Fiscal Monetary Coordination) = Rational Exuberance. We highlighted that the economic and fundamental backdrop, combined with further coordinated fiscal stimulus continues to support our reflationary thesis, while short-term market sentiment is going euphoric.
We have pointed out that one of the most critical risks for our reflationary thesis and for risk assets in general is the premature tightening of fiscal and monetary policy. In our judgement, the risks are very low and remote. If anything, we think policy makers may risk overstimulating the economy and asset prices as:
a). The Fed is unlikely to hike policy rate in the next 2-3 years
b). The Fed is likely to engage in yield curve control if long-dated rates start to hurt asset prices
c). The Fed is unlikely to taper QE within 1-2 years. Instead, the Fed may have to increase balance sheet expansion.
d). The Tsunami waves of fiscal measures have yet to come, and they will be monetized.
This week we will focus on rate policy (items a and b).
DCA Global Liquidity Index
Dec 13, 2020
We have discussed our framework for navigating the capital markets, focusing on the three-way reaction function between economic fundamentals, fiscal/monetary policies and asset prices. Within this framework, global liquidity is a key component. Over time, we have introduced some of our models on growth, inflation, and technical indicators (such as the DCA Bull Intensity Index). Today, we will introduce our liquidity indicator.
Before we discuss liquidity, we would like to address a frequently asked question: How long will the current reflationary cycle persist? Our base case has been that the virus will pass, and stimulus will stay. As such we have been positioned for reflation. Like everyone else, we do not have a crystal ball into the future. However, according to our current probabilistic assessment, we think the current reflationary cycle may last at least 2-3 years. There will be inevitable volatility along the way. Rather than being fearful of these volatilities, investors should take advantage of them to add using the reflationary menus that we have shared with investors. How did we come up with the assessment of the time horizon? Let us review the big picture.
A Discussion on Chinese Local Currency Rates
Dec 6, 2020
In today’s new rate environment, we have discussed extensively the importance of finding the truly uncorrelated asset classes.
One of the solutions we offer is the Tail Alpha Overlay program, which aims to generate significant portable alpha while providing protection/diversification to investors’ portfolios. The strategies are: a) Opportunistic b) Infrequent c) Driven by market opportunities d) driven by the convergence of fundamental and quantitative factors e) highly skewed risk/reward asymmetry f) flexible to customize our strategies for your portfolio.
Despite benefiting from tail hedge funds during the Covid-19 shock, many investors shared with us that the size was too small to matter and that they had been severely under water for an extended period of time – a similar experience we had during the GFC. As former institutional investors managing billions of assets, we were frustrated that tail hedge funds would typically bleed capital every year, and when you need them, their size is too small to matter.
It does not have to be this way. We think that the industry structure is the biggest impediment to the success of such programs. Tail hedge funds must deploy capital regardless of market conditions and will have hedges on stocks because of their explicit mandate. We believe that like any other investment opportunity, attractive tail hedging opportunities do not appear often, and therefore requires patience to wait for the opportunities to emerge. By default, our approach is to do nothing in the absence of compelling hedging opportunities, and only deploy the budgeted capital when extreme risk/reward asymmetry present themselves.
Rather than investing in tail hedge funds, a better way is to buy extremely cheap instruments to directly overlay on top of institutional portfolios. (like CDS on subprime during the Financial Crisis) We have recommended some of the instruments used by successful hedge funds during the Covid-10 shock to our clients; one of our recommendations would have returned 25x (and was wildly profitable even before Covid-19). We think our program will empower institutional investors to take advantage of the patient and long-term nature of their capital to capitalize on long-dated options, especially since those are typically neglected by the fast money hedge funds community.
Please feel free to reach out if you would like to hear more about this program.
We have highlighted many portfolio diversification opportunities in the past such FX and precious metals. Today, we will look at Chinese long-dated rates.
This Time Can be Different
Nov 22, 2020
The danger of believing “this time is different” is widely cited and recognized.
We think that the failure to recognize that “this time can indeed be different” is perhaps more perilous for investors today.
We believe that we could potentially be in the transition process from the past four decades of disinflationary trend into the high inflationary regime. We think the monetary inflation will be the single most important driving force for capital markets in the future. Please refer to the “Racing Two Tails of Inflation part one, two, three” for further details.
Our long-time readers know that According to our framework, embedded within the economic expansion cycle that started since GFC, there have been a series of mini-reflation cycles, which started with easing measures from global central banks and ended as the effects of stimuli faded.
While each cycle is a bit different, the typical 4 phases are:
Phase one: Risk assets selloff in reaction to tightening monetary conditions and peak growth expectations.
Phase two: All financial assets rally in reaction to central banks’ easing measures (realized and expected) i.e. rising stock markets, falling bond yields and falling credit spreads.
Phase three: Monetary stimuli and easing financial conditions lead to a new period of reflationary growth, resulting in higher stock prices and higher inflationary expectations, while bond yields start to rise, reflecting central banks’ reaction function.
Phase four: Central banks start to phase out monetary stimuli and tighten monetary conditions, leading to the peak of the mini-growth cycle.
This framework has been instrumental in guiding us to navigate the capital market since GFC.
According to this framework, the pivot of Jay Powell at the beginning of 2019, and the consequent launch of “not-QE” permanent QE (aka large-scale asset purchase program) in Q3 2019 had the full potential to engineer another mini-reflation cycle to extend the longest yet aging business cycle. Covid-19 truncated the mini-reflation cycle. Please refer to the chart below about the mini-reflation cycles.
We had anticipated and advised investors that the end the mini-reflation cycle would lead to the end of the post-GFC economic cycle and lead to a seismic regime shift of policy responses i.e. fiscal and monetary coordination (commonly know as Modern Monetary Theory, MMT), laying the foundation for potentially highly inflationary environment in years and perhaps decades to come. Never would we have predicted that FMC would come so fast and so dramatic!
The end of economic cycle is indeed very unusual in a sense that it was not caused by the tightening monetary policies and the collapse of asset prices, but by an external shock of pandemic. At the same time, monetary and fiscal responses were so strong and fast, they did not allow the de-leveraging process typically associated with a normal recession to run its due course.
The Great Rotation
Nov 15, 2020
Most of our readers know that we have laid out “the virus will pass, but stimulus will stay” as our base case since mid-year.
We have encouraged investors to take advantage of the market volatility to buy into investments long-term monetary inflation, favoring reflationary assets such as EM, cyclicals (industrials and materials), small caps and precious metal and miners.
We have turned bullish on copper, mining and agricultural sectors, however, we have maintained a very cautious stance towards the energy sector, until November 2nd when we published the note “Embrace Volatility.” “…For the first time, we are turning more constructive towards the energy sector. We think that the prospect of a slowing economic recovery due to rising Covid-19 cases and the risk of a blue sweep may lead to the final leg of the selloff of the energy sector, putting a firm bottom for the entire sector….” Today, we are officially adding energy sector to our reflationary basket. By adding the energy sector, we are now turning bullish on the entire commodity asset class.
We entered the week with the news of a Pfizer vaccine. Though we followed the vaccine development closely, we do not think that we have differentiated views. While it is certainly encouraging to see the 90% efficacy of the vaccine, many market commentators have quickly pointed out that the distribution of the vaccine will be very challenging due to the fact that the they need to be stored with very low temperatures of -70 degrees Celsius (-94 F) or below. That the CEO of Pfizer sold more than 60% of his Pfizer shares on the day when the stocks popped certain did not add confidence, even though it was planned.
From our perspective, what is more important is the market reaction rather than the vaccine news itself. On the day of the Pfizer vaccine news on Monday, November 9th, US growth stocks underperformed value stocks by 6% - the worse daily underperformance in the past three decades. At the same time, the Nasdaq 100 index underperformed the Russell 2000 index by 5.9%, also the worst daily underperformance in three decades. See the charts below.
One day does not make a trend. However, it is indicative of the extreme market positioning towards the big tech companies. If history is any guide, such a violent short-term movement against the long-term trend has the potential to mark the onset of the decisive turn of the long-term trend. Though the price action was violent, it was due to levered and fast money players. The real rotation into the value and cyclicals may have barely started.
Two Paths, One Common Destination
Nov 8, 2020
While elections continue to dominate the headlines this week, we want to remind readers that in the long run, capital markets are largely driven by the underlying macro trend, rather than the result of the presidential election.
One Common Destination:
Regardless of who will be elected president and which party controls congress, the predominant market driving force will be FMC (Fiscal and Monetary Coordination) or MMT going forward. In response to economic growth, large fiscal packages will be launched, and they will be directly or indirectly underwritten by central banks. We think this is a tectonic change of capital markets with implications for years or even decades to come. Please refer to reports “The Mirror Image of Volcker Shock” and “The Two Racing Tails of Inflation, part 1, 2, 3)
This is our common destination. And this is occurring not just here in the US, but in the entire world.
Two Divided Paths:
Because the fiscal authorities are politicians, the elections do matter on the size, timing of the fiscal measures. In addition, politicians will decide who will benefit from these measures and who will get hurt by them. From this perspective, the impact of the elections on capital market will be more impactful than in the past.
As we discussed in our last note, “fiscal measures are more likely to be preemptive and larger in a Democratic sweep rather than a Republican sweep. A split Congress will lead to more reactive fiscal measures i.e. large fiscal measures will only be launched in reaction to declining prospects for economic growth and significant asset price declines. …The election results will also determine the types of fiscal responses. The Democrats will likely introduce large scale fiscal spending with a focus on health care and infrastructure, while increasing corporate tax, income tax and dividend/capital gains taxes…”
Our base case is that Biden wins the election while Republicans retain control of the senate. This means fiscal measures will be smaller. However, this also significantly reduces the chance of tax hikes at both the corporate and personal levels, including taxes on capital gains and dividends etc. The more balanced power means one thing: Both sides will get what they want by making concessions to each other.
Nov 1, 2020
We have discussed extensively that that we believe the ultimate driving force of the economy and capital markets in the years and decades ahead will be Fiscal and Monetary Coordination (FMC) aka MMT.
We have discussed the implications for asset prices and how to position portfolios for the long-run:
- We think investors should diversify their currency exposure from major fiat currencies into gold and silver. (we also like gold/silver miners)
- We favor real assets: commodities (energy, metals, and agriculture), farmland, and selected real estate sectors
- Between stocks and bonds, we favor stocks against nominal bonds
- Within rates, investors should be transitioning from nominal treasuries into inflation linked bonds. In addition, investors can overlay the portfolio with long positions in inflation swaps and conditional bear steepeners (for example 5s/30s or 10s/30s).
- Within stocks, we favor Value against Growth, EM, non-US and potentially small caps.
- We think the US dollar cycle may potentially have turned to the downside.
- We think investors should keep their powder dry in their credit portfolios to capitalize on the inevitable default cycle.
- Finally, contrary to the consensus love for private investments (private equity and private debt), we think investors should stay liquid to be able to deploy capital as opportunities emerge.
In addition, we think MMT will have far reaching impacts on the institutional investment management framework. Specifically:
- Institutional investors will be forced to transition their frameworks from static asset allocation into dynamic asset allocation
- Institutional investors will need to seek idiosyncratic long-vol strategies across all asset classes when risk free sovereign bonds cease to be a risk diversifier and valuations are rich across all financial asset classes.
Our job is to manage the timing, sizing and uncertainty related to this long-term thesis.
From a short-term perspective, we see two risks that might lead to a better buying environment for these investment opportunities: election risks and risks of a delayed economic recovery due to new waves of Covid-19. In short, embrace the volatility!
A Note on the Indian Rupee
Oct 25, 2020
Our readers know that we have hypothesized that the US dollar could have turned towards the downside since midyear. One of the implications we’ve highlighted is the opportunity to go long Emerging Market Assets: Equity, currency and local bonds. Currently, we consider it our base case for the long run, though we recognize the potential risk of another short-term USD rally. The US election will probably be the catalyst for short-term movements ahead depending on the outcome. Nevertheless, the fundamental underpinning behind our US dollar thesis remain.
We recommended going long CNH (short USD) a few months ago, which has worked out well and remains one of our favorite expressions in the currency space.
Today we will discuss the Indian Rupee.
COVID-19 has had a terrible impact globally, but it has affected India particularly badly. With a low GDP per capita, limited medical resources, and crowded living conditions in many parts of the country, India’s COVID cases rose sharply, and by September represented almost a third of growth in new cases globally. (Though cases have been falling steadily since)
The Indian government’s attempt to lock down the country in the early stages of the pandemic resulted in an almost unbelievable -23.9% YoY decline in Real GDP in Q2 and a -57% YoY decline in industrial production – one of the worst figures globally. Even now, Industrial production has only recovered … to the worst levels of the financial crisis over a decade ago
Oct 19, 2020
Fiscal and Monetary Coordination (FMC)
Before we proceed to discussing some of the short-term known unknowns, we would like to remind investors to focus on one known known, the likely ultimate driving force of the economy and capital markets in the years and perhaps decades to come –Fiscal and Monetary Coordination (FMC) aka MMT.
Our readers may recall that back in 2019 we anticipated a seismic shift to occur: the end of the current 5-10 year business cycle would coincide with the end of the 40-year disinflationary cycle with FMC as the key catalyst. (see our original note “Navigating the End of Market Cycle”). We think we are in this transition process. Faced with the highest leverage, lowest interest rates and richest valuation of asset prices, traditional monetary policy can no longer function to re-lever economies by lowering borrowing costs. Fiscal spending has to come to the forefront in reaction to economic weakness which has to be monetized since the debt cannot be serviced.
We are not here to debate whether this policy response is appropriate or not, but rather, we think this is inevitable and will be the path of least resistance going forward. Any other measures to allow deflationary deleveraging (via bankruptcy and restructuring) to occur would be too painful in the short term and will result in the politicians allowing it to be voted out. Measures of short-term gain with long-term pain are more likely to be carried out than those with short-term pain and long-term gain.
This tectonic shift in the policy regime will be the driving force of all major asset classes in the years and perhaps decades ahead. It will also have far reaching impacts on the asset management industry in general. As a matter of fact, the vision of this coming seismic shift is one of our key considerations in launching Dao Capital Advisors as we had anticipated the following:
Waiting for the Next Big Fat Pitch - What is Happening in Japanese Yen?
Oct 4, 2020
One of the instruments that we actively monitor is Japanese Yen, given the currency’ past price reactions in risk-off environments and the fundamental underpinning according to our analysis. However, in a highly eventful 2020, the USDJPY cross has been unusually rangebound.
To be sure, Yen has been strengthening since the beginning of the year and has continued to be strong despite of the strong rebound of global risks assets since March this year. What surprised us was the small magnitude of movement, and especially, the rather muted response during the risk-off period.
In a sharp break with these prior episodes, this year’s COVID shock barely registers. Why, and what has changed? We ask ourselves. Our experience taught us that we often gained significant insights when asset prices movement was not in-lined with our base case assessment.
The Two Racing Tails of Inflation (Part Three) – The Near-Term Outlook
Oct 4, 2020
We have shared with our readers that within our long-term framework, we think we are potentially in a transition phase from disinflationary to inflationary for the long run. This can be a lengthy, volatile and uncertain process.
We organized the “Two Racing Tails of Inflation” into three parts.
In part one, we examined the driving forces behind the disinflationary trend over the past 4 decades: declining labor force growth rate, globalization and over indebtedness of the economy. We examined the components of the CPI basket and found out that shelter inflation is one of the most important components that drive the overall CPI reading. We highlighted the key factors that contribute to the shelter inflation.
In part two, we examined how these deflationary forces such as labor force growth and de-globalization may potentially revert the disinflationary trend. We studied how the new policy regime of FMC (Fiscal and Monetary Coordination) may lay the foundation for a highly inflationary environment in the future. Having established the base case that conditions could be set up for higher inflation in the very long run, we also anticipate the process to the lengthy, volatile and uncertain. We illustrate why there may be heightened risks of serve deflation in some periods of time.
In part three, we will discuss some of the near-term inflationary forces.
The Known Unknowns
Sep 27, 2020
“….there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult one…”,
-Donald Rumsfeld, defense secretary, George. W. Bush administration.
In our view, what Donald Rumsfeld missed is that an assessment is need in relation to a time horizon. In the short-term, market (and geopolitics) is squarely focused on the known unknowns: 1. The medical development of the coronavirus and economic recovery. 2. The new round of fiscal stimulus. 3. The presidential election. In the longer-term, they become known knowns: 1. It is inevitable that a vaccine and medical solution to the coronavirus is eventually made available, however the timing is highly uncertain. 2. The fiscal package will eventually pass especially if there is an acceleration of the asset price decline. 3. In the long-run, capital markets are largely driven by the underlying macro trend, rather than the result of the presidential election.
Two Racing Tails of Inflation- Part Two
Sep 20, 2020
A few weeks ago Stanley Druckenmiller, said that the Fed had “hit the jackpot” in terms of fulfilling its price stability mandate the past few decades. He now envisions a potential high inflation period in the future (5-10% of inflation). Paradoxically, he also sees increasing risks of deflation. He did not elaborate further during the interview.
Like minded investors think the same. We agree with Druckenmiller’s assessment in the long run, whom we highly respect.
We have shared that that within our long-term framework, we think we are potentially in a transition phase from disinflation to inflation for the long run. This can be a lengthy, volatile and uncertain process.
It is important to point out that we mainly focus on the longer-term inflationary forces, rather than the cyclical inflationary forces that coincide with the 5-10 year economic cycles. In other words, while inflation may fall and rise based on the stages of the economy cycle, it may be poised to make higher highs in each cycle going forward, contrary to what has happened in the past 40 years. Through this process, there may be sporadic heightened deflationary risks, especially when asset bubble eventually burst.
To put it differently, the sweet zone of 1-3% moderate inflation that we have pleasantly enjoyed in the past in the past decades may not continue. The two tails of inflation are set to race ahead.
Two Racing Tails of Inflation- Part One
Sep 13, 2020
Most of our readers know that within our long term framework, we think that we are potentially in a transition phase from disinflation to inflation for the long run. This can be a lengthy, volatile and uncertain process.
We are organizing our inflation pieces in three parts:
In part one, we examine the deflationary forces that have been driving secular disinflationary trend since early 1980s.
In part two, we will analyze how these forces may be poised to change for the future.
In part three, we will share our short-term outlook on inflation and illustrate how the transition period can be a lengthy process, factors that may accelerate or decelerate the transition, and the risks to our views.
The Fall Season of a Bubble
Sep 7, 2020
On February 15th this year, we wrote the “The Four Seasons of a Bubble”.
We described the four stages of a bubble as the four seasons - spring, summer, autumn and winter. “Bubbles die in the Winter, but Winter is the precursor to Spring. Bull markets are born in the Spring with solid fundamentals, invested in by contrarians and visionaries. They grow strong and mature in summer, beating most other investment options. They peak in Autumn, when smart investors are harvesting the gains, while the general public goes euphoric.”
In our view, financial bubbles are inevitable based on our cause & effects analysis of the investment management industry. Investment managers are constantly evaluated based on if they can beat their respective benchmarks “consistently.” As a result, it is inevitable that investment managers will be forced to chase the winning sectors, styles and/or names, even though they themselves believe that market prices are detached from the fundamental value of the securities. The refusal to join the herd will lead to the redemption of capital and even the closure of their business. Do not blame the investors. The institutional investors are at in the same seat – they are forced to allocate capital to trendy and winning sectors in order to beat their benchmarks. In the bull market cycle from 2003 to 2007, investors could not get enough of EM and commodities. In this market cycle, investors can not get enough of big tech. History always repeats, like the four seasons of the year.
Unlike the common perception that bubbles result from euphoria of investors, our observation is that bubbles result from the aggregate rational behavior of investors based on their deliberate economic calculation of their career risk and business risks. At the final stage of the bubble, euphoric retail sentiment is just the icing on the cake. To put it simply, the performance benchmarking and horse racing will always lead to bubbles - it is inevitable result of the current structural setup of the entire investment management industry.
Financial bubbles have occurred in the past, are occurring right now and will recur in the future. Thus, investors need a process to capitalize on them while managing the risks. In order to do this, we believe the key is to have a long-term perspective and be driven by fundamental value while managing the risks according to ones’ institutional setup.
A Changing Perspective on the Chinese Yuan
Aug 21, 2020
There have been a lot of negative headlines around US-China relations recently. Over the past month, we’ve gotten headlines on the US forcing the divestiture of TikTok, Trade Deals, cancelled meetings between US and Chinese trade officials, the US revocation of Hong Kong’s special status, US sanctions on Hong Kong and Chinese officials and military chess games in South China sea and Taiwan. This week, the US State Department asked US Colleges to divest from Chinese companies. The list goes on. It is fair to say that the US-China relations have hardly been worse in decades.
All of it has been pretty bad. So would you be surprised to know that CNY has actually appreciated versus the USD over the past 3 months? ..and the Chinese stock market is among the best performers YTD globally?
The New Dawn of Value Investing
Aug 16, 2020
“Successful investing is having everyone agree with you……later.” -Jim Grant
We think that “successful investing is having everyone agree with you……tomorrow”. Being early is almost always a euphemistic expression for being wrong, as you may not be able to see your thesis transpire, depending on how early you are and how much you have lost because of your foresight. We always say that getting the thesis right is only half of the puzzle, while getting the timing roughly right is the other half of the puzzle.
If you are “early” in pivoting to value investing, you are not alone. It does not come as a surprise for us that so many investors have been hurt by “value investing” and “being early”. The chart below shows the cumulative excess return of value vs. growth since 1926. The magnitude of the drawdown is the biggest and the duration is the longest.
For decades, the Fama-French value and size factors have been held as textbook principles for CFAs, MBAs and market practitioners. After all, it seems that so many things we learned in finance and economics has turned upside down in the past decade: value has underperformed growth, small caps underperformed large caps, negative or zero interest rates and debt monetization does not matter. If you have followed our notes long enough, you know that we do not think this is a coincidence.
Dao Capital Advisors
Aug 9, 2020
Daoism, the ancient Chinese philosophy with thousands of years of history, argues that effortless actions lead to order and harmony and any intentional or deliberate actions against the laws of nature will lead to unintended consequences. Applying this to governing countries, it argues for small government and self-management of the people. (democracy) Applying this to economics, it argues for minimal intervention and letting natural economic forces play out. (i.e. the invisible hand) Daoism emphasizes natural cycles in life, in the universe and in economic and social affairs.
We named our firm Dao Capital Advisors for a simple reason - we are firm believers in free market capitalism. By trying to manage economic affairs and cycles, governments can extend and twist them, but will suffer from unintended and often severe negative consequences, which require even more active management. Central banks and Keynesian policies can lower interest rates and apply fiscal measures to artificially extend economic expansion cycles, but by doing so, they plant seeds for the next economic crisis, which demand more drastic actions. The Federal Reserve has not been able to raise rates above previous cycle highs since Volcker, which eventually led to the ZIRP (zero-interest rate policy) today and likely NIRP (negative-interest rate policy) down the road. Once normal interest rate policies were ineffective, QE was launched to purchase financial assets: first government bonds, then corporate bonds (like in Europe) and likely eventually stocks (like in Japan). Through these economic cycles, global debts levels have been making higher highs and currently sit at the highest level in human history. What are policy responses for the next economic downturn? ZIRP/NIRP, QEs of everything, plus fiscal measures with outright monetization, aka. MMT – Modern Monetary Theory.
A Rising Black Swan in the Barbaric Relic
Aug 2, 2020
In 1924, John Maynard Keynes called gold a “barbaric relic.” 96 years later, the financial media is squarely focused on the rise of the barbaric relic. In 5000 years of human history, gold has been the currency of choice across different cultures and regions. In comparison, our current fiat system only has 49 years of history (since the Nixon Shock in 1971). We have previously extensively discussed the challenges facing our current fiat currency system. In May, we called precious metals and miner stocks the “new FANG.” Please refer to our past writings “Mirror Image of Volcker Shock”, “Cross the Rubicon” and “The New FANG”.
We are not gold bugs. As a matter of fact, we think precious metals will be the next bubble eventually, and we hope to capitalize on it on the downside when the time comes. However, we think that it is probably years or a decade away, and we are still in the early stages of the bull run from a long-term perspective. For now, our focus is squarely focused on the upside, and how to manage the risks.
Fundamentally, we turned bullish towards gold at the end of 2018. The reason is simple: we thought that the real interest rates might have peaked, and the Fed had to ease. Paper currency can compete with gold if savers can earn positive interest rates above inflation - i.e. positive real rates. Therefore, the rise and fall of real interest rates hold the key to gold prices.
How did we know that real interest rates were peaking then?
July 26th, 2020
Following the Federal Reserve’s rate cuts to near zero, longer term investors have been increasingly concerned about the lack of portfolio insurance choices. High quality global sovereign debt has historically been the preeminent portfolio hedge for risk assets over the past 3 decades, but with yields already close to or below zero, how much more protection can they provide?
In our note “Mirror Image of the Volcker Shock” dated March 21, we pointed out that the inability of long rates to serve as portfolio insurance to risk portfolio will have profound implications on the capital market and that the “elimination of the ultimate cheap portfolio protection for risk assets will force a rethink of portfolio theory.” We discussed that risk parity is a levered version of the 60/40 portfolio, and many seemingly diversified institutional investors’ portfolios have nearly identical risk and return profile compared to the 60/40 portfolio.
What are the implications for institutional investors?
An EM Bull in a China Shop
July 19th, 2020
Most of our readers know that here at Dao, we don’t impose our views on the market. Rather we have probabilistic assessments of various scenarios and capital market development paths. We don’t try to handicap markets all the time. However, at certain defining moments, we foresee potential regime shifts with far-reaching impacts on every corner of the financial markets in the years and perhaps decades ahead.
We think we have arrived at such a defining moment.
First, we have discussed extensively that this is a highly unusual time as we had anticipated a year ago: the end of the 5-10 year business cycle converged with 1-3 year mini cycle and the end of the 40-year disinflationary cycle (see our original note “Navigating the End of Market Cycle”, “Mirror Image of Volcker Shock”). We have identified MMT as the predominant theme in the next 3-10 years, with major implications (“Decades happen in Weeks” and “Cross Rubicon”).
We laid out a long-term strategic plan for investors in our note “Decades Happen in Weeks,” dated April 5th. Our job is now to navigate: 1) uncertainty of this thesis 2) Timing 3) Sizing.
July 12th, 2020
One month ago, we warned on the rising COVID-19 cases due to the reopening of the economy and widespread protests. This is now a reality. Since mid-June, confirmed coronavirus cases re-accelerated after the curve was flattened.
Largely driven by increasing cases in sunbelt states such as Florida, Texas and California, daily confirmed cases in the US has reached more than 60,000, while cumulative confirmed cases have reached 3.2 million, roughly 1% of the US population.
With 4.2% of the global population, the US now represents 25% of global cumulative confirmed cases. While it is true that the US is doing more testing, the statistics are nonetheless alarming. The recent reacceleration of confirmed cases is not a US phenomenon, but global. Internationally, cumulative confirmed cases have reached 12.7 million as of Saturday, July 11th and confirmed cases are increasingly at a daily rate of more than 200,000 – a new high.
Will we experience another round of full or complete lockdowns? Will schools be reopened in fall and forced to shut down again? Your guess is as good as ours. However, we do know that in many parts of the world, the reopening has been rolled back as cases have resurged. Regardless of whether we will have a new round of lockdowns, the 2nd wave of the pandemic has curtailed expectations of a rapid economic recovery as consumers’ propensity to spend will diminish.
June 27th, 2020
This week, we systematically scan economic indicators, asset prices and volatilities globally and across all asset classes.
Our “Volatility Scan” dated January 24th picked up various warning signs in the stock market and risk assets in general, which contributed to our recommendation to put on direct hedges for equity portfolios. This week we will repeat the same process, which will provide context for understanding the volatility space in the current environment.
The chart below is the DCA cross-asset volatility index, which is the weighted average of the z-scores of implied volatilities of various asset classes, including currencies (including gold), rates, equity (vol and vol of vol) and commodities (oil and copper). We have observed a rising volatility trend since 2017. Despite the nearly complete recovery of equity indexes and low volatility in the rates markets, our cross-asset volatility index still remains elevated relative to history, despite a large pull back.
US Dollar Cycle Part 2 – Implications
June 20th, 2020
Last week, we elaborated on our hypothesis for a potential turn of the US Dollar Cycle.
While the implications in the currency space may be relatively clear, the impact on various asset classes may not be well understood or underestimated by investors. In our framework, the direction of the US Dollar is one of the most important drivers for global capital markets, impacting virtually all asset classes with profound implications for capital allocation.
We have successfully utilized the US Dollar cycle to benefit our investment decisions while managing billions of capital in the past, and we hope to share some of those experiences with our readers and clients.
While most investors accept the under performance of Emerging Market and non-US risk assets as fact and history, we decisively underweight EM (short EM currencies), commodities and Non-US assets in 2013, capitalizing on the rising US Dollar cycle. At the time, the consensus was that EM would significantly outperform the US due to “high growth”, “better valuations”, and “attractive demographics.” Our decisions at the time were very contrarian, to say the least.
Fast forward seven years, and investors are giving up EM, citing “low growth”, “de-globalization”, “death of commodities” as “fundamental” rationale. Quite the opposite, we are developing a thesis that a potential regime shift for relative outperformance of EM vs. DM and Non-US vs US might occur in the near future. While we could copy and paste the same consensus arguments 7 years ago (“high growth”, “better valuation”, and “attractive demographics.” ) to support our potential bullish thesis on EM, the truth is that we are singularly focused on the US Dollar.
Implications of the US Dollar Cycle on Asset Prices
Decision Time for US Dollar Cycle
June 13th, 2020
In the past three weeks, a particularly interesting development that caught our attention was the breakdown of US Dollar Index from its consolidated range.
Could this potentially mark the end of the rising US Dollar cycle? Our interest is piqued.
Before we jump further into the rationale, it would be helpful to go through past USD dollar cycles to see how we got here.
The chart below is the USD dollar index since 1970, which clearly illustrates 3 distinct US dollar cycles – 3 weakening periods and 3 strengthening periods.
June 6th, 2020
Recently, we have been asked quite often on the direction of stocks and risk assets in general.
We have shared with our readers since the end of April that we have turned more cautious about the overall broad equity market. Instead of recommending outright de-risking, we have been recommending that investors continue to seek attractive hedging opportunities, while at the same time, investors should opportunistically deploy capital to attractive lagging assets poised to recover if the economic recovers.
Our short-term indicator now shows that that market is highly vulnerable for a downward move in the short term; however we are not ready to call for prolonged downside. Please refer to our recommendation section for our thoughts on potential actions for the time being.
Since the equity rebound from March low, the rally was primarily led by large tech names, and the Nasdaq 100 has fully recovered its losses and the S&P 500 index is only 5% below all time highs. However, the Value line Geometric Index, a broader measurement of US stocks, continues to demonstrate a downward trend. The index is at the same level as 6 years ago and interestingly, the current resistance area of 480 to 500 was the top of the range before the GFC in 2007 – see the chart below.
Thoughts on European Equities
May 30, 2020
YTD, the S&P 500 has outperformed the Euro Stoxx index by 12%. This is a fairly large gap, though almost the entire move occurred in the first half of March.
What’s driving this? How should we think about the relationship going forward?
Before examine the recent period, it’s worth remembering that the S&P has been outperforming Eurostoxx for over a decade now.
The main driver for this is fundamental, not valuation based. From Dec 2009 to Dec 2019, earnings’ estimates for the S&P grew more than twice as much as that for the Eurostoxx...
There is a litany of reasons for this, but the difference in institutional setup is critical...
All Pegs Broken Loose - Saudi Riyal
May 22, 2020
Two weeks ago, we wrote that “the risk reward asymmetry has increased significantly enough to warrant a bet on the potential de-pegging of the Hong Kong Dollar to US dollar. This can be considered a cheap tail hedge.”
Today the Hong Kong Dollar forward price has moved significant beyond its mid-point towards the weak side of the band and the price of HKD put options have jumped in the past two days as the national security law is slated for passage in the National People’s Congress in Beijing next week, which would further endanger Hong Kong’s judicial independence.
Today, we think investors should consider another tail hedging opportunity – a potential de-peg of the Saudi Riyal.
The New FANG
May 17, 2020
Let’s review a simple set of statistics since mid– March to put into context what has happened over the past couple months - when social distancing started, economy was “shut down” and large-scale testing on covid-19 began.
We note a number of divergences and potential mispricings that we think are important to monitor.
All Pegs Broken Lose
May 9, 2020
We think the risk reward asymmetry has increased significantly enough to warrant a bet on the potential de-pegging of the Hong Kong Dollar to US dollar. This can be considered cheap tail hedge.
Hong Kong is one of the few countries that has kept its currency peg. The Hong Kong Dollar has been pegged to the USD dollar at 7.8 HKD to USD since 1983, and has been maintained within a tight band between 7.75 to 7.85 over the past 15 years.
May 3, 2020
Back in March when we urged investors to buy stocks, we said that we could visualize a scenario that “stocks rally against exponentially growing confirmed cases”. Today, we visualize a potential scenario that the rally could stall or even revert to the downside while the economy is being re-opened.
To be sure, we are not saying that a stock sell off is a certainty. As a matter of fact, due to the rapid decline of asset classes, divergences between different assets have emerged and investors should continue to deploy capital selectively and opportunistically. However, on a broad asset class level, we think that the risk/reward on equities have significantly tilted towards downside, contrary to mid/late March.
We are ultimately open-minded to the scenarios that we have laid out. The question is whether we will skip stage 3 or not. Investors have gotten used to the 1-3 year mini-reflation cycle post GFC when central banks actively intervened upon any sign of economic weakness and drawdown of financial assets. As a result, economic recessions did not materialize, and the stage 3 selloffs never transpired. While this is certainly possible given the magnitude and speed of fiscal and monetary responses, equities avoiding the fundamentally driven sell off is not our base case.
Let’s take a longer term look.
What if US Rates are too High?
Apr 26, 2020
In the past reports, we have discussed that the end of current market cycle would mark the beginning of the end of the four decade long disinflationary cycle with falling interest rates. Note the word “beginning of the end”. The reversal of these multi-decades trends is not an inflection point, but rather a bottoming process that can take years.
We recommended receiving US rates at the beginning of the year, and suggested taking profits in mid-early March when US 10y hit the level around 40 bps. Since then, we thought that rates would range bound for a while. Indeed, in the past 2 months, the US 10y rate has been between 50 bps to 140 bps. According to our reading, the 10Y rate is now poised to make large movement in the weeks ahead. Will the rate revert back to the box and continue to be range bound? It is possible. However, we now think that risks have increased for the 10y rate to make a decisive break down below 50 bps, heading towards zero or even negative.
Is it possible that 60bps on 10y treasuries is too high? Let’s take a look at this from some different angles.
Cross the Rubicon
Apr 19, 2020
As our readers know that we believe that the end of the current market cycle could mark the beginning of the end of the four decade long disinflationary cycle since the early 1980s with profound implications for decades to come. We have laid out some key implications in our prior notes and laid out how investors should position the portfolio for the long term – please review “The Mirror Image of Volcker Shock” and “Decades Happen in Weeks”. We will elaborate on those and other long-term themes in the future.
But first, we think it is far more important to understand the impact on the traditional asset allocation framework. We think this could potentially mark the end of the static asset allocation framework, and kick start a new era of active asset allocation based on the risk/reward assessment of various asset classes. We have written about this when we started Dao Capital, anticipating that the seismic change will occur once interest rates hit nadir. Never did we think that it would take a pandemic for this to happen.
We have always said that the institutional setup determines the investment results – give us the name of an institutional investor, and we can roughly estimate their performance without even the need to meet and talk to them. Why? Chances are that their performance will not deviate from their strategic asset allocation, which is static, predetermined, regardless of the market conditions.
The discussions of on market cycles, valuations and fundamentals have little to do with asset allocation decisions for most institutions. In the end, the asset allocations is determined by the risk and return profiles of the investors, and have little to do with fundamental assessments. Most institutional asset allocation frameworks are built on extended versions of Modern Portfolio Theory (MPT). While the theory may sound sophisticated, the end result has always been very simple: if you want to have higher returns, you need to take more equity risk. (both private and public) In exchange you will have higher portfolio volatility. The discussions typically focus on the required returns that investors “need” in order to satisfy liabilities or what kind of risk tolerance they have. The classical example is life-cycle funds, which design a glide path of asset mixes depending on the age of the investor – i.e. the older they are, the less equities in their allocation. To be sure, we do believe that risk aversion (age is important factor of risk aversion) is a significant input to the asset allocation decision. However market conditions play an equal if not more important role in the asset allocation decision.
The End of the Beginning
Apr 13, 2020
“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” -Winston Churchill
In mid and late March, we strongly proposed taking equity risk, and encouraged investors to scale in long positions via risk reversals. We did not think it would be “the” bottom for the market, but we were confident that that it would be “one of the bottoms of the market.”
We anticipated that several specific factors could contribute to this rebound, predicated mainly upon extremely oversold market conditions, visible catalysts for a pause in forced de-leveraging, quarter-end pension rebalancing, and the massive and fiscal stimulus. While others were panicking, recall that we specifically visualized a picture that stocks could rally against exponential growth of COV-19 cases.
Here is the picture on how that visualization transpired consequently in the weeks following. From March 23 to April 10th, SP 500 rallied almost 30% (from intra-day lows) while at the same time, US Coronavirus cases increased more than 10 fold from roughly 50 K to more than 500 K. Obviously it would be silly to state that equities are positively correlated to COV-19!
Decades Happen in Weeks
Apr 6, 2020
“There are decades where nothing happens, and there are weeks where decades happen.”
— Vladimir Lenin
We have quoted this sentence several times in the past year as we have been expecting that tectonic shifts are likely to occur. It is happening.
We have highlighted the unusual confluence of 1-3 year mini cycle, 5-10 year business cycle and the four-decade falling interest rate and disinflation cycle. Simply put, the failure to reflate from the 2018-2019 growth slow down would lead to the end of the current business cycle, which would lead to the end of the four-decade cycle of falling interest rates. Please review our writing from last year – “Navigating the End of the Market Cycle”.
We did not predict coronavirus pandemic. However, in our view, it simply served as a catalyst that led to the downturn of the aging market cycle with record leverage and valuations. We have highlighted that our market cycle indicator has shown that our current market cycle was in a peaking process. It has now decisively rolled over to the downside.
Be Ready to Fade the Rally
Mar 29, 2020
Be Ready to Fade the Rally
We have sided with the rebound in risk assets and it is occurring. But we do not think it’s sustainable, and we urge investors to be ready to fade the rally.
Before we lay out the reasons for this change of stance, it is helpful to review why we believed in the rebound in the first place.
First, unlimited QE seemed to be working to unclog the plumbing of the funding markets for now. Fra-OIS is falling and the SOFR overnight rate (secured lending) has dropped below the IOER (interest rate on the excess reserve). US Treasury liquidity is starting to return to normalcy. Credit spreads have started to tighten as the Fed began buying investment grade corporate bonds. We have been expecting the Fed to purchase corporate bonds. Some of the fast money community and dealers have started to re-lever again to front run’s fed purchases, the first time in the past three weeks.
The Mirror Image of the Volker Shock
Mar 21, 2020
Paul Volker passed away in December 2019. His passing closely coincides with the end of four decades of declining interest rates.
Most of our readers know that we believe that we are at an unusual period with a confluence of the tail end of the 5-10-year business cycle and the 4-decade disinflationary cycle. Most investors are familiar with the 5-10-year business cycle and may be well prepared for the potential end of the current market cycle by following the playbooks of the past four decades. While some of dynamics of past business cycles may repeat, we think investors may be surprised that the same playbooks that has worked well in the past 4 decades may not work well in the future.
The key is interest rates. Volker’s interest rate hikes ended the inflationary era, and laid the foundation for interest rate policy as a monetary policy lever for central bankers in decades to come. However, after every business cycle, the Fed could not hike the interest rates higher than the high of previous cycle, and they had to cut interest rates lower than the low of previous cycle before they could effectively stimulate economy. This trend is now an end with interest rates falling back to zero.
Interest rate are used as discount rates to future cash flows. Therefore falling interest rates have led to higher net present value of all financial assets. For the real economy, central banks are also able to manage the economic cycle by lowering borrowing costs to support credit expansion or increasing borrowing costs to slow down credit expansion. Once interest rates hits zero with the record high leverage as we face today, interest rates are no longer effective tools to manage economic cycle. We are truly standing at an unusual time – interest rates have never been this low in the 5000 years of human history.
Mar 13, 2020
Since the market is changing quickly, our weekly note may not be adequate for some readers. So please do not hesitate to reach us via email if you have further questions.
While we had been cautious about the risky assets and made numerous recommendations to hedge the risk assets (long receivers, put spreads on Nasdaq 100 ETF, and short selected EM countries) in January and February, the speed of the decline and vol shock shocked even us.
Recent capital market developments are concerning. Here are some of things we monitor closely:
First, we are very concerned that liquidity in the treasury market continues to be bad, despite the resumption of QE, and expected Fed cuts next week. Liquidity in treasury markets are on par with the financial crisis. This is key because if there isn’t enough liquidity in treasuries, we cannot hope for rational pricing for riskier assets. Fed may take additional action on this next week.
Levered treasury investors have been key supports to elevated UST debt issuance. They typically invest in UST treasury and hedge the positions using treasury futures. The sustained illiquidity of the UST and the cheapening of cash security vs futures can cause investors to liquidate the treasury positions. Investors also use levered treasury positions to hedge risky assets, and they may chose to liquidate the positions if they prove to be ineffective.
Second, we note that Investment Grade credit yields have unwound much of their decline YTD this week. The chart below shows the US 5y swap rate + 5y Investment Grade CDX as a proxy for 5y borrowing rates for USD corporate borrowers. The combination of spread widening and backup in risk free rates has resulted in an almost 50bp jump in corporate borrowing costs from the lows this month
Fear the Fear Itself
Mar 8, 2020
Our empirical experience taught us that when people regularly congratulate us for getting recent major asset prices right, it is time to think about the opposite. Indeed, we are making some major adjustments of our recommendation this week, mainly in US rates.
Like everyone else, we don’t have a crystal ball, but we focus on risk vs reward, and probability assessments of the future vs the market’s assessment of the future. When a large discrepancy emerges, that’s the time to act. Our views and opinions don’t matter unless: a) they are not reflected by the market pricing, b) there are fundamental reasons why our views may prove to be right, c) roughly accurate timing of the occurrence. As a matter of fact, we are not afraid to put on trades against our views and beliefs if the risk vs rewards of the trade are highly asymmetric.
We said before that we did not have advanced knowledge of the coronavirus at the beginning of the year when we turned cautious, but rather we noted that assets had been priced for a successful period of reflation while the fundamental data failed to pick up as we had expected. The most direct and consistent way to express the view on the growth slowdown is through central banks’ reaction function – they will cut rates and ease. We recommended receiving rates (long treasuries) either through delta one positions or via options when implied vol was still very cheap. Our recommendation on gold was also predicated upon the expected easing measures of central banks.
The implications for stocks are not as straightforward as on rates, because stocks are influenced not only by the economic growth and corporate earnings, but also by the measures of central banks and fiscal authorities. We wish there were instruments like GDP swaps, so that market participants could either be receivers or payers of GDP growth rate to express bearish or bullish view on economic growth. In the absence of such instruments, economic growth is only one of the key factors that influence the stock prices.
Where do we go from here?
Mar 1, 2020
Since the day we penciled “Run FOMO.exe” on October 12, 2019, US stocks had been on fire, rising more than 15% within 4 months. The gains were then wiped out within a week.
Let us review our thought process since the beginning of the year.
First, at the very beginning of the year, we turned cautious, though we were generally bullish on the broad market within the context of liquidity support from the Fed. “Though we continue to side with the reflationary scenario, we are starting to turn more cautious mainly because many leading economic indicators have failed to pick up much, while many major assets classes are already priced for the reflationary scenario”. We showed the YOY change of stocks to long-dated treasuries total return ratio had completely deviated from the ISM index. By now it has converged.
Second, we recommended receiving US rates either through delta-one positions or via options on January 18th per our note Raven of Zurich (Econ Scan). “Given our assessments on the economic situation above, we think that investors can establish long US rates as a hedge to risk exposure.” US 10y yield has fallen by 70 bps since then. We also recommended receivers via options because of the low implied volatility at the time.
Third, on January 27th’s Volatility Scan, we said “Per our discussions above, we think direct hedges to equity indices may not be a bad idea. We like put spreads on the Nasdaq 100 ETF, QQQ – on which we like the April expiry 199-210 put spread for $1.5. We think it is attractive to use USD(put) JPY(call) options given the record low implied vol. For example, we like the USDJPY 100 strike, 1 year option for 85 cents.” The Put Spread has now tripled to $4.5, with very minor losses on USDJPY option.
Fourth, on February 1st, we recommended transitioning a portion of the gains of rate receivers to conditional bull steepeners per our note “Magic Pill”, by noting “We now recommend rotating some of those positions (rate receivers) into conditional bull steepeners so that hedging costs can be lowered. Why? We think that the probability has increased significantly for Fed to embark on a cutting cycle again”
Fifth, On February 7th, we wrote the note “Ag Shame, South Africa”, recommending shorting the South Africa Rand and or CDS. We also recommended shorting the Brazilian Real as a hedge to emerging markets or broad risk exposure.
Finally, last week we alerted our readers about the heightened risks of a reversal per the note “Imminent Reversal – Introducing Bull Intensity Index”, encouraging investors to hold on to the hedges illustrated above.
That was the past, now what? We think it is time to start shifting tactics from defense to offense...
Introducing the DCA Bull Intensity Index
Feb 24, 2020
Readers who know us well often hear us say that our main task is to build puzzles. Our first step is to understand and process the relevant information and data available to us. Like pieces of the puzzle, each data point can only offer partial information. Our job is to put all the pieces together to form a picture on where capital markets stand. To build the puzzle, we have three key components: 1. Fundamentals 2. Asset prices 3. Monetary and fiscal policies. We then focus on the reaction function between them to fit the different puzzle pieces together to form a holistic assessment of the markets...
The Four Seasons of a Bubble
Feb 17, 2020
In our investment careers, we have been fortunate to be able to sit down and discuss global investment matters with the CIOs and PMs of some of the world’s most famous and respected asset management firms. One of the most common topics in our conversations with them is that central bank intervention has distorted price discovery and more importantly has created financial excesses - aka bubbles. Agreed, but instead of complaining about it, one should accept it as a fact and seek ways to monetize it. Here at Dao, we accept that nothing in the financial world is “abnormal”. We believe that the cause and effect functions between economic growth, monetary/fiscal authorities and asset prices will always repeat.
In this note, we recognize that financial bubbles have occurred in the past, are occurring right in front our eyes and will recur in the future. As a matter of fact, one should be excited about “bubbles” because it means exhilarating opportunities. What investors need is a process to risk manage and capitalize on it...
Ag Shame South Africa
Feb 10, 2020
Ag shame (pronounced ach shame) is a South African slang term used to express sympathy or pity. We have been students of South Africa for many years now, and are indeed very sympathetic to the plight that the policy makers there now face.
Despite being blessed with rich natural resources and advanced capital markets relative to the rest of Africa, South African economic development has been very slow. Dutch disease is a likely culprit, along with the structural water and power challenges...
Feb 3, 2020
Fear the fear itself. Don’t you worry? But there are magic financial pills for the coronavirus – easier monetary policy. Since the GFC, monetary policy has been the omnipotent prescription to cure all economic and geopolitical ills – QE1, QE2, operation twist, QE3, global QE, and most recently, “Not QE” balance sheet expansion. European sovereign crisis? Brexit? Trade war with China? Falling stock prices? Repo disruption? Global pandemic concerns? No problem. Easing monetary policies cure them all. No wonder, BOJ’s Kuroda once declared that central bankers are magic people.
Since October 2019, the Fed has put interest rate policy on hold and assured investors that it was a “mid-cycle” insurance cut with a goal to extend the current business cycle. Since the beginning of the year, we have been biased towards lower rates. Two weeks ago, we specifically recommended long US rates either through delta one or option strategies to hedge risk exposure. We still like these positions, though we now suggest booking some partial profits for those who have benefited from the positions. We now recommend rotating some of those positions...
Jan 27, 2020
Over the past week, the outbreak of the CoronaVirus has become the focus of markets. While we continue to believe that the Fed’s liquidity provisions and economic fundamentals remain the key drivers of capital markets, we think we may start to experience some market volatility out of pandemic fears, albeit for a brief period of time. During the Ebola outbreak in the fall of 2014, the S&P 500 dropped around 10%. .
The macro backdrop of the Ebola episode in fall 2014 was quite different from today. At the time, economic developments were generally positive and the Fed was about to end QE. The S&P 500 Index was plateauing in anticipation of the withdrawal of Fed liquidity. The market was vulnerable and Ebola fears provided a perfect catalyst...
The Raven of Zurich
Jan 20, 2020
...In 1996, former Fed Chair Alan Greenspan delivered a famous speech on “Irrational Exuberance”, warning against stock speculation. Afterwards, the S&P 500 more than doubled and NASDAQ composite roughly tripled before the peak in year 2000. In 1926, seventy years before Greenspan’s famous speech, Felix Somary, Austrian-Swiss political economist and banker, warned that a stock crash would come because of the “gap of appearance and reality,” while internationally renowned economist John Maynard Keynes disagreed, believing that a “crash will never come in our time” because of the efficacy of cheap money. Somary was wrong and Keynes was right… for two years. From the beginning of 1927 to the peak of the US stock market in 1929, the Dow Jones Industrial Index went up more than 150%. Somary’s dire prediction was later vindicated as the Dow Jones index would peak in the fall of 1929, dropping 90% in the following three years, earning him the name “Raven of Zurich”....
Riding the Liauidity Wave
Jan 13, 2020
...we think stocks will continue to be supported very possibly through April 15th because of continued liquidity provisions from the Fed and other global central banks. However, the ascending slope will not be as steep as we saw in Q4 last year because the liquidity growth rate is decreasing. We don’t have clear visibility beyond Q2, as we need to see the economic data pick up and catch up with financial assets for a more sustainable reflation cycle. In the absence of a pickup of the data, and if there is a withdrawal of liquidity this spring, it is highly likely that we will recommend derisking strategies and hedging strategies. Please reach out to us for a discussion.
However, in the very short-term (next 1-2 weeks), we think the likelihood to a short-term pullback is very high given the following reasons: 1. Overly optimistic investor sentiments and positioning. 2. Reduced liquidity provisions. 3. Corporate entering buyback blackout. We would advise investors to scale out of overweights to risk assets to be more neutral until the spring to be better positioned for the bifurcated risks....."
Dec 20, 2019
We take a look at long term petroleum projections, and the evolving electric vehicle market. And we find some very interesting marks for Private Equity valuations.
No Falling Angels Allowed
Dec 8, 2019
Since the GFC, US corporations have emerged as the largest buyers of their own shares, driving equity outperformance. Therefore, it is critical to have a forward-looking view on corporate buybacks. Back in fall 2018, we predicted that corporate buybacks could be peaking, and it seems that we may be proved right.
Why this is important? According to Federal Reserve Board Flow of Funds data, US buyback activity is the dominant driving force of this bull market, followed distantly by small foreign demand – refer to the chart below. Household and other domestic entities are net sellers of stocks rather than buyers. If corporate buyback activities have indeed peaked, the longer-term implications for stock market are negative. Note the last peak in corporate buybacks was in 2007, one year before the GFC.
Our peak corporate buybacks thesis last year remains intact due to the following reasons...
Reminiscences of year 1999-2000
Nov 17, 2019
Readers are probably familiar with various comparisons of our current market status vs. history. Many compared our current period of asset valuation, leverage and income inequality to that of 1929, while Ray Dalio at Bridgewater thinks that our current period is most analogous to that of 1937. Others find similarities between the extended period of low inflation today with the 1960s as precursors to the roaring inflation in 1970s. We agree with some of those observations. We also find some remarkable resemblances to the market cycle of the late 1990s.
To be sure, we are not saying that capital market behavior will repeat exactly. As the cliché goes, “The past does not repeat itself, but it rhymes.” However, we think it is the symptoms that rhyme, while the reaction functions between the market, economy and fiscal/monetary authorities always repeat themselves.
Our current economic cycle is now the longest in US history, followed by the one in 1990s, which lasted 120 months. Between the two cycles, we find that the macro backdrops are very similar.
Taxes and Capital Markets
Nov 10, 2019
As the Democratic candidates begin stumping in Iowa, this is a good time to begin considering the different fiscal issues that are likely to impact the investment landscape. This is the first of several articles we have planned discussing taxes and fiscal policy and the impact on capital markets.
But before we discuss fiscal impacts, let’s take a moment to acknowledge the historical nature of the polarization in the political landscape, especially across age. The Boomer generation, with their high voter participation rate but declining numbers, is increasingly facing off versus the Millennials and Gen-Xers, whose participation rates have spiked. In fact, the 2018 midterms was the first election whereby the younger generation outvoted the Boomers and older generations, according to the Pew Research Center.
The anti-ageism sentiment by the younger cohorts is now pervasive enough that it has its own meme...
Nov 2, 2019
As stocks and risky assets continue to rally despite decelerating economic growth and falling earnings, we acknowledge the frustrations of many market participants. We can trade rates, stocks, currencies and commodities, but cannot trade GDP. Our readers and clients know that our framework is built upon the three-way interaction between capital market, economic development and monetary/fiscal activism. From our perspective, asset price action has been broadly in line with our expectations, with equity risk premiums reflecting falling growth expectations.
.Our readers and clients know that we have tilted towards a reflationary scenario for a while, as our report noted that “We think there is a decent chance for risk asset prices to break to the upside next week….” Sure enough, S&P 500 broke out on the first day of the week.
This week, we will examine whether various asset prices confirm the reflationary hypothesis.
Oct 27, 2019
Our clients have often asked how we were able to predict the peak in US growth rates in the summer of 2018 and the subsequent sell off in the equity markets. Like everyone else, we don’t have a crystal ball. However, we do have a systematic framework utilizing an array of leading economic indicators and asset price patterns that paints a mosaic on where we stand. Most of our readers know that our framework is based on the three-way relationship between economic development, asset prices and fiscal/monetary authorities. We start by understanding the messages conveyed by the asset prices. Today, we will share some of our charts in volatility space.
The chart below calculates the daily z-score (3y rolling window) for the VIX (SP 500 implied vol), CVIX ((currency implied vol) and Move Index ( interest rate implied vol). What stands out is the upward trend and still elevated level of Move Index (+ 0.7 sigma above mean), reflecting uncertainty around growth expectations, while stock implied vol ( -0.4 sigma below mean), indicating the easing monetary expectations have stabilized stock markets. The currency implied vol is 1.35 sigma below mean), consistent with the global synchronized slowdown and central bank reactions thus far.
A Note on Hong Kong
Oct 21, 2019
We can understand why investors may be worried about the situation in Hong Kong given that the current protests, which started on March 31st this year, is the longest since Hong Kong’s return to China and shows no signs of ending. It appears to be getting more violent. More importantly, this is occurring alongside an acrimonious trade war between the two largest economies in the world, with the weakest economic growth in China in 3 decades, and the worst economic and political relationship between Washington and Beijing in past two decades. No wonder that two months ago, Steve Eisman, the investor of “Big Short” fame, said on CNBC that this could be a black swan event. Many China bears are getting very excited with the catalysts, especially those wagering on the de-pegging of Hong Kong Dollar.
But before we dive into this topic, we would like to share a story. Back in 2012, I interviewed several well-known hedge fund managers who had successfully bet on the US subprime crisis. I asked them about their views on the depreciation of the Chinese RMB as a result of the credit binge post Great Recession..
Oct 14th, 2019
FOMO – aka fear of missing out, is not a feeling that is unique to retail investors. It is also a predictable institutional behavior based on the institutional setups common in our investment industry – fund managers have a strong need to generate alpha vs. relative benchmarks or absolute returns by year-end. At stake are not only the year-end bonuses, but job security or even the firms’ survival.
It is not surprising that investors are bearishly positioned for seemingly the right reasons: 1. Weak global economic growth outlook with real risks of recession. 2. Trade wars. 3. Brexit risks 4. Presidential impeachment and socialist democratic presidential candidates. The list goes on.
The chart below shows SP 500 index (blue line) and the differential between AAII US investors’ bullish sentiment readings vs bearish readings (green line). The gap shows that investors are as pessimistic as we saw in late December 2018 when stocks bottomed out...
Not Decision Time Yet
Oct 6th, 2019
Most of our friends and clients know that while we recognize the importance of talent, investment process and risk management, we believe that the starting point of a successful investment is the institutional setup... Why is this relevant now? We currently see great opportunities that can only be capitalized by long-term patient investors. While others complain about the market distortions created by central bank policy, we are thankful because the central banks have created these opportunities with great risk/reward asymmetry.
We have discussed previously that we are in the classical stage one period of an economic growth slowdown: financial assets rally, supported by central banks’ easing measures (announced and expected) in reaction to the economic growth slowdown. We have shared with our readers and clients before, while our numerous leading indicators continue point to the downside of economic growth momentum, we nonetheless see some emerging signs of reflation, which is yet to be confirmed. We are open-minded to either scenario. In the past few reports, we have shared many of the indicators that we watch. We think we will get better clarity in weeks ahead. Did the poor ISM data release this week US tilt our view one way or another?
A Crossroad for Inflation
Sept 29th, 2019
Since we published our report on emerging signs of reflation two weeks ago, we have received many questions regarding our outlook on inflation. This topic is very timely. Following the highly inflationary period in the 1970s, central banks learned to get ahead of inflation once economic growth is at full capacity – as the cliché goes “ ..to take away the punch bowl just as the party gets going..”. After a decade of quantitative easing with NIRP and ZIRP (negative and zero interest rates), inflation continues to be muted. As a result, central banks’ reaction functions have been quietly changing – they are increasingly willing to tolerate higher inflation for a longer period of time. More importantly, it is has become consensus that fiscal measures need to take the front seat as monetary ammunition has been exhausted. We have said that we have no doubt that upon next downturn, fiscal measures will be launched and will be monetized by central banks – MP3 (monetary policy 3.0) per Bridgewater, MMT (modern monetary theory) per Stephanie Kelton or fiscal monetary policy coordination per central bank verbiage, planting the seeds for an inflationary period to come.
A risk to this view is that we don’t need an economic downturn to launch MMT. We are already starting to take the incremental steps. If indeed there is a long-term inflationary regime shift, we believe that there will be far-reaching implications for portfolio construction and probably for the entire asset management framework based on static asset allocation...
The Status of the Market
Sept 21st, 2019
Unlike those with developed narratives who fit the data to their outlook, we look at all relevant economic and financial data and try to put the puzzle together to get an evolving picture of the market status. The message from the market prices of various asset classes and economic indicators may or may not agree with each other. When they don’t, they provoke our thinking and often lead to differentiated insights. We are neither bulls nor bears, we simply want to be in sync with the market. We don’t argue that the market is right or wrong. Rather, we accept it as is. We simply want to be one step ahead of the next stage of market development and be in sync. Unlike those who have deterministic views on the “outcome” and “eventuality” of asset prices, we have probability assessments on potential direction and magnitude of the movement of asset prices. They are path dependent based on the three-way reaction function between capital markets, economic development and government policies. Where do we stand now?
We shared with our clients and readers recently that we have identified some emerging signs of reflation (please refer to our last weekly report for further details). However, we highlighted in same report that these reflation signs are not confirmed yet and we are not ready to make the call for another reflation period at the current juncture. On the contrary, most of our leading economic indicators continue to point to the downside.
Emerging Signs of Reflation
Sept 15th, 2019
When facts change, it is too late to change. What do you do sir?
Many quote “when facts change, I change, what do you do sir?” when they adjust their positions after facing losses. We believe that change is the only constant thing in capital markets, where the so-called “equilibrium” is a constant moving target. It is no surprise for most investors that when you see facts change, your PnL (or relative performance vs. benchmark) is already in the red. As Jesse Livermore used to say, narratives follow market prices, not the other way around.
James Grant once said that “successful investing is having everyone agree with you….later.” Our hard-learned lessons taught us that “successful investing is having everyone agree with you….tomorrow.” We believe that to be successful, investors need to be one step ahead of others, but not two steps. If we can help our clients be one step ahead of others, we will have accomplished our mission. To do this, we have built an investment process by systemizing our past lessons. While we recognize some validity of the claim that “financial assets are forward discounting mechanism”, what drives our framework is the three-way reinforcing feedback loop of asset prices, economic/fundamental and fiscal/monetary policies. Late summer of last year, we saw the peak of growth and stock markets, while the mainstream narrative was still on “global synchronized growth” Today, recession talk is the consensus narrative, while we see emerging signs of potential reflation.
Diminishing Policy Choices: a Case Study of Japan
Sept 7th, 2019
In this Weekly report, we wanted to highlight our thematic report, “Diminishing Policy Choices and the Implications, A Case Study of Japan”.
As the monetary policy ammunition is running out across the globe, we think global central banks will eventually cut interest rates further into negative territory and after that start purchases of risky assets such as equities and REITs. Ultimately, fiscal measures will have to be launched upon the next downturn, and since global leverage is at all time highs, fiscal stimuli have to be underwritten by central banks - i.e. fiscal and monetary policy coordination.
Our case study in Japan indicates that further large scale asset purchases, including stocks, may not be enough to compress the risk premium of equities unless done in a global fashion. We acknowledge that Japan has chronical demographic headwinds, which is also true in Europe and many Asian countries such as South Korea and China. We recognize that in a world of free capital flows, the effects of any country’s monetary stimulus are global rather than local and local assets will benefit more from such stimulus, which explains why Japanese REITs have been more responsive to BoJ’s asset purchases than Japanese equities. It is no surprise that in countries with closed capital accounts like China, the stimulus will have a large response from domestic asset markets. Therefore we argue that to support global equity markets, a synchronized and coordinated large scale asset purchase program of shares may be needed upon next downturn...
Art of Deal – Win the War Without a Fight
Sept 2nd, 2019
“It is nice to win 100% of the battles, but the ideal is to win the war without a single fight.” Sun Tzu, the ancient Chinese military strategist believed that wars are suboptimal ways to defeat opponents, because your strength will be weakened even if you win all the battles and you’ll be more vulnerable to other threats. President Trump, the author of “the Art of Deal”, seems to strongly disagree. He famously declared that a “trade war is easy to win”.
In this report, we offered our thoughts on the trade war - both long term and short-term. we pointed out that "in the short-run, unlike the consensus view that the trade war will escalate immediately to a new level, we think that both Trump and China have an incentive to ease the tensions"
We highlighted key risk events in September and why this month is critical. We recommended fast money traders to buy calls on equities to position for a breakout to the upside and to take gains or short safe haven assets such as long-dated treasuries, gold and Yen.
From J-Hole to B-Hole
August 26th, 2019
Today, President Trump asked the same question, “… who is our bigger enemy, Jay Powell or Chairman Xi?” This basically lays bare the intention to escalate the trade war – to create enough trade headwinds so that Fed can cut rates aggressively and start QE as he demanded. On the one hand, he can show how strong he is to take on China and on the other hand, he gets significant monetary stimulus ahead of the election – indeed one stone kills two birds. It is no coincidence that Trump announced recent trade escalation measures on July 31st - one day after last FOMC meeting, which Trump lambasted for not delivering enough stimulus. We wrote last week that the 80 point drop of the S&P 500 tested the pain threshold of Trump as he started to walk back from the escalation and showed a willingness to re-engage in negotiations with “personal friend, Xi”. This Friday morning, he was watching carefully whether this is the pain threshold for Jay Powell – “Now the Fed can show their stuff!” he tweeted right before the speech of Chairman Powell at Jackson Hole, eagerly expecting some big announcement. Right after Powell’s speech, he released a series of angry tweets, promising further trade escalation measures.
Fight the Fed
August 19th, 2019
Before we dive into current market discussions, it is helpful to have a big picture and review our framework on cycles. In our thematic report “Navigating the End of Market Cycle," we pointed out that “we are in a rare period when some major cycles are near inflection points: the 1-3 year mini-reflation cycle, 5-10 economic (market) cycle, 50-100 years inflation cycle.”
Will central banks be able to re-engineer another 1-3 year reflation cycle? We have argued that it is more difficult this time around given the following reasons:
Navigating the End of the Cycle
“History doesn't repeat itself, but it often rhymes,” says Mark Twain. In our framework, the mechanism of cause and effects of the law of economics always repeats itself, what rhymes are the symptoms. We believe that we are in a rare period of time when some major cycles are converging for inflections: 1-3 year mini-reflation cycle, 5-10 economic (market) cycle, 50-100 years of inflation cycle. While driving on the highway, we never realize that the earth is a sphere – similarly, as we monitor capital markets and economic development day-to-day and month-to-month, we may forget where we are in the cycle. The transition of different stages of cycles are a process, rather than an exact moment or point and the evolution process is path dependent. History always happens in a non-linear fashion (whether in capital markets or in geopolitics), as Vladimir Lenin points out that “There are decades where nothing happens; and there are weeks where decades happen.”