Front Row represents the personal opinion of Rodrigo Rodriguez, European Head of developed cash trading for Credit Suisse.
Short week for me as I went back to my home country for a long weekend to do the follow up on little Rods’ helmet and his overall health. It is amazing how much you learn by observing and listening in the doctors waiting room.
I chose one weekend that was quite hot on the press in terms of accusations of possible corruption, misconduct etc…, however the overall conversation from people was not different from previous weeks as people have got to the point at which versions of the truth makes no difference, as they are convinced only the middle class can turn the country around independently of the guys running the show as they are all seen to be similar independent of the colour of their party (currently there are examples of politicians from every single party under investigation in Spain).
I guess the market felt quite Spanish: after some slight over reaction (that either way was due) on Monday , it seems to have stabilized itself, accepting that Spain has put enough reforms in place to start seeing the light at the end of the tunnel at some point.
However Italy and a possible downgrade on US debt by Fitch could be painful…
- What is going wrong.
- What history tells us and what could change
- Dividends a trade of its own
What is going wrong.
So it looks like we can take the “might” from last week out of the equation. European politicians are here to help, corruption is not as easy in Southern Europe, while in Spain we have both parties accusing each other of corruption, in Italy we have Berlusconi (no comments… ) with chances of winning the elections again. No wonder why a serious country in which a Coaltion minister resigns for lying on a traffic fine, is considering leaving the EU.
Regarding Spain, I do not think I would surprise anyone by saying that I am nearer to the Conservative Party than to any other, and that while there is no smoke without fire, people need to be careful about Spanish media as they are quite reactionary, and can effectively just take a clear political side before anything is proved and judged. (Just as an example today ABC said that all papers from the previous Treasurer were fake as they are a copy and it is impossible to prove the origin and a lot of the entries made no sense, El Pais treated them as if there were bullet proof documents ) .
Either way all this noise cannot help the Spanish risk premium or the Spanish recovery itself. Whoever is guilty should resign and then let the justice do the rest, it is the only way that International investors maintain their confidence in Spain.
Regarding Italy, I still think that Monti will be the winning option through an alliance with Centre left, it is not time for populism , and hopefully the Italian people will realize that you get the leaders you deserve (and vote for!).
We know the game, as we have been there seen that, you just need the noise to extend to the US debt ceiling and all of the sudden you have the perfect storm. Still bullish but tactically bearish and on that I would like you to think about the chat I had with my friend Sacha on the back of my latest note.
Sacha dixit: How do you know the monetary easing will last? It coincided with the market rally. If the market falls, would that spread go back up…
We are again close to the precipice I think. Going short S&P with maximum leverage and a stop a few per cent above current levels….” at which my reply was clear :” I prefer buying 5per cent out the money calls hedge delta and buy crash protection, I think inflows could squeeze u out”
Sacha replied: I guess vol is low so I could spend a bit of money on 103 calls… Good idea however you know that talking about “flows” is meaningless right? There is a seller for every buyer of stock. No money is ever “flowing in” (or out) of equities.
This is the piece I continue giving a thought and I honestly do not have the right answer for it, I guess what he means is that on the way up the cake is bigger so everyone can win and that everything is just the result of market cap increases not of inflows into equities.
His point is correct for every buyer there needs to be a seller (ex IPO’s and rights issues) so is all this theory about inflows into equities just wrong? I do not know the answer yet but I guess I leave it as an open question.
If we assume market wealth stays constant , then asset class reallocation might be a better term than inflows…but still the question is there , there is always a seller for every buyer…maybe they just have different mandates?
What history tells us and what could change
But do not worry I am still strategically bullish and history seems to back me fully. Check this step from Andrew G’s team:
A good January = a good year 92% of the time. When equities have risen by 4% (or more) in January, 92%of the time they rise for the rest of the year (by an average of 12.7%). Only once did markets not give a positive return for the rest of the year when then rose by more than 4% in January (1987 and even then they rose 23% between end January and their Aug peak).
Continuing with the history stats what about cheapness of equities? Is this why every placement is getting priced so tight and working so well, liquidity is definitely a problem and the big players are still under weighted , everything points to equities and mainly to value…looks like we are the cheapest bubble in the financial markets!
So in order to get more clarity or where we stand at the moment I decided to meet with Andrew today, here are some of the main bullet points out of our discussion:
Focus areas today, my two preferred and probably most talked topics….Tactical consolidation and Japanese markets.
Fundamentally bullish but tactical indicators are at three years high so he remains cautious short term , however there are 6 factors that invite him to maintain his bullish view:
As mentioned since 1970 if Jan is up more than 4% the market yields on average 12%
State of the cycle in terms of macro surprises is strong.
Liquidity is supportive of equities.
Valuation: Equity Risk Premium is currently at 6.1% while looking at ISM and credit spreads our model will call for 5.4% there are three factors that could point towards a lower one: Corporate balances being healthier than Government ones, dispersion of earnings vs. the mean and implied vol of equities vs. bonds could suggest an ERP of 5.1% i.e. a possible rerating of equities of 20%
oInflation expectations moves in opposite direction to headline inflation and while QE continues, expected inflation will continue going up with Equities being the best hedge for inflation.
Positioning: People think equities will be the best performing class according to Andrew’s survey but none is really positioned but Hedge funds. Retails investors are at 25% of historical investments in equities
The problem that is frequently argued for equities is earnings, as trend of downgrades continue increasing as margins are at quite elevated levels. Andrew’s argument against that is that earnings outside US are not high and that 55% of the margins in the US comes from low interest rates and 20% from Taxes. There is no problem for margins as long as there is no wage inflation , and this will not happen till unemployment is at 6.5%, therefore margins will stay stable.
Tactical indicators however are stretched with macro momentum turning negative in 5 of the main 7 economic areas, however the danger of these indicators is that they have been implicitly back tested in a bearish market (some of them are only 10 years old).
In summary no surprise of a tactical consolidation but bullish on the cycle.
One interesting point was the one regarding the required equilibrium between debt & unemployment, thus Andrew considers that No Fiscal tightening in the Us would be the worst possible scenario as if in the short term it will imply a GDP growth of 4% , this will bring unemployment down to 6.5% and therefore the end of low rates, the immediate wage inflation and the real bond yields increase requiring a massive Fiscal tightening to recover the equilibrium and provoking a massive market deleverage or sell off. This could ruin the beautiful deleveraging thusfar
On the other hand if fiscal tightening is 2.5% and GDP grows at 1.5% , QE will continue and equilibrium will be achieved in an orderly fashion. i.e. we want government to continue doing fiscal tightening, as CB’s will maintain QE
oIt is all about time horizon, on 5 years he is extremely skeptical as Japanese corporates do not care about minority shareholders, Japan is a time bomb and it has terrible demographics.
1 year out of 7 Japan comes good and Andrew thinks this is the one.
Looking at a four factor model( OECD leading indicator, US 1o y yield , Yen/USd and Net foreign purchase) he thinks Japan has a potential 14% upside.
Corporates have not reflected yet the weaker JPY so potential for earnings upgrades is high.
Japan has massive operational leverage.
LDP popularity is at all-time highs, and inflation target stays at 2% while real inflation is at 0.4% what implies BOJ to do all kind on unorthodox QE
While Japan might not look particularly cheap on earnings it does on price to book and on replacement value with 70% of companies market cap below their replacement value.
Household asset allocation in Japan is clearly positioned for deflation : 56% in cash, 6% in bonds, 28% in insurance and pensions and 6% in shares, in an inflationary environment they need to own real estate , Japanese equities or international assets that will devalue the JPY and trend the equity market higher
He thinks clients are still skeptical in Japan and that this time the rally without the JPY effect is only 10% vs. previous ones of 30% , upside is still there !!!
Dividends a trade of its own
Ahead of the dividend season and considering div yield one of the main value measures a lot of PMs look at , I thought it was worthy to ask our specialist Mr. Ghosh to bring some light into all of us of what is the trend , what are the risks. (although you see not much text the guy has been coding the graphs for 4 hours …poor little grasshopper)
The coming months hold the promise of very interesting times in dividend-land with more than 60% of the 2013 dividends on Eurostoxx50 being announced in the month of February. The most exciting announcements to watch out for could be BNP, Societe Generale, France Telecom and ABI. These along with a few other names hold the potential to move the Dec 2013 div future by 3 points which is a big move for a contract expiring in the current year.
Further, by the end of February, Dec 2014 div future should start trading much more on a bottom up basis than a yield basis and should see a significant reduction in beta with respect to Eurostoxx50 index.
Interesting to see below how the yield curve has been reacting to the current market weakness, 2013 has kept strengthening and the far end kept weakening. As we go further into the year, 2014 should also start displaying a similar behaviour
The interesting piece to consider here is that this trade has been overcrowded in the past, has buried those without the patience to do the fundamental analysis, mark to market might kill you , but if you do your homework as Chandan does it will pay off.
Not to mention the inflationary hedge… 😉