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The Pass-Zone
| Rodrigo C. Serrano, CFA | SIPA | Columbia University Master of International Affairs 14 Candidate | New York City, NY | 01-305-510-0181 | rcs2164@columbia.edu !
he Winter Games ended this past weekend in Sochi. Ironically though, the global economy is in the midst of a crucial proceeding, more representative of the Summer Olympics. In addition to super-natural physical talent, relay races require pivotal collaboration. Within a 20-meter pass-zone, team runners exchange batons. This exchange more often makes the difference between winning Gold or returning home empty-handed. Since 2010, major emerging markets (EMs) such as: Brazil, China, Russia, and Turkey, have underpinned the global recovery. They have provided time for advanced economies; such as the U.S., Europe, Japan, and the UK, to recover from their nagging recessions. However, in June 2013 Ben Bernanke began to discuss tapering. In December the policy began. In my outlook, I noted increased uncertainty on Fed policy direction as a key macro theme for the year; however, it seems that Central Bank uncoordinated policy has emerged as a formidable contender. Brazilian and Russian economic growth has withered; their currencies have tumbled. Russia is set to follow Brazils lead in raising interest rates. Turkey, rocked by political scandal, was forced to raise interest rates as well to avoid volatile outflows. These policy responses will likely punish economic growth. Meanwhile, China wrestles with curtailing credit expansion. Tapering has marked entry of these EMs, which together account for 18% of global GDP, into the pass-zone. Despite turmoil in these countries, the Fed remains on track to continue its policy. The U.S. and Eurozone are expected to lead the recovery in 2014, according to the IMFs World Economic Outlook update, which was released late January. In effect the baton is being passed on to these advanced economies.
Highlights
Fed policy means major emerging markets will hand the baton to developed economies. !Uncoordinated" Central Bank policy has turned into a key macro trend. Regardless of Beijing#s ability, a policy response for the banking sector may be required. Europe#s ongoing recovery remains asymmetric. OMT
ruling by Karlsruhe could At the turn of the year, I noted that China would be increasingly dependent on the U.S. and EU to provide it with external demand as it carries out its plenum be the seeds of a political reforms. Economic turbulence has increased, placing the countrys banking system crisis if recovery flounders. under strain. Bad debts are at their highest level since 2008. Meanwhile, wealth The U.S. seemed poised to management products (WMP) have become increasingly risky. Local investors grab the baton, but winter claim that they invested their capital in these products assured that they were secure. has created a Fog of War. Two bailouts, one from an unknown source and another from a policy-bank, have already occurred, fanning moral hazard. Roughly 48% of the $1.78 trillion invested Other trends: in these vehicles will come due this year; to what point do the bailouts continue? o Abenomics floundering. Meanwhile, online money market companies, such as Yuebao and Alibaba, have Additional QQE on the accelerated interest rate liberalization by offering annualized rates of 4-6% on shorthorizon. term deposits vs. 0.35% provided at banks. Official financial institutions are in a dogfight with these competitors, creating competing products for deposits. In addo Tensions firming but are ition to a tightening bias by the PBoC, this rivalry will raise funding costs. Regardnot critical. less of Beijings bailout-ability, a policy response looks to be required at some point. To be sure, there are batches of good news. Indications of firming global trade exports surprised to the upside by 5 times the consensus in January and are confirmed by Australian, German, and U.S. seaport data may allow time for Hukou registration system, land, and free trade reforms to be implemented. 7-day repo rates recently fell to a 9-month low. A crisis is not imminent, but officials need to move with a purpose. The nation is handing the baton to the U.S. and Europe. Those developed economies will need to provide external demand as it reforms and sheds overcapacity.
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Baton Recipients:
Italy has exited recession. At +0.5% in Q4, Portugals economy outperformed. The Eurozone as a whole grew 0.3% in the final 3 months of 2013, the 3rd consecutive quarter of expansion. As a result, optimism is on the rise. Investors are returning to the Eurozone. Hope has intensified due to a new vigorous Renzi administration in Italy as well. Paradoxical, serendipitous turmoil in EMs has resulted in additional money flows seeking stability away from volatile EMs. European citizens and officials have become reenergized in pressing on with reforms. Dutch Finance Minister Jeroen Dijsselbloem said that the will to cooperate is stronger than ever and that the North-South divide is fading away. Investors are practicing patience, allowing officials to administer less draconian austerity policy. By no means is Europe out of the woods though. In fact, the ingredients still remain in place for a political crisis. The recovery remains asymmetric and is a toxin for political will, despite officials reassurances. France has shown signs of renewed downturn, music to anti-euro National Fronts Marine Le Pen. Greece remains a basket case despite news of improved manufacturing numbers. Youth unemployment is now a head-spinning 60%+. Another bailout after the summer is in the cards. Perhaps the biggest piece of news was the largely underreported German Constitutional Courts referral of the OMT examination to the European Court of Justice, in order to seek clarification on the programs terms. As the scheme stands, Karlsruhe would likely deem it an illegal extension of the ECBs mandate, setting the stage for a legal crisis between Germany and the Eurozone. If the recovery begins to falter, look for this ruling to resurface. Meanwhile, creeping deflation will require a policy response from the ECB. Look for another LRTO, a rate cut, or an official ending of SMP bond purchase sterilizations. Europes recovery continues. Investors are counting on a fluid baton exchange for the next leg of the race. A smooth exchange remains in question; an alarming prospect given the near-term nature of the pivotal transition. Until recently, the U.S. seemed poised to take the baton seamlessly from EMs and lead the global recovery. However, Mother Nature has descended a fog of war on the Fed and investors. Two weeks ago I had noted a red flag from the consumer. Weak wage growth left little room for consumption to expand. On cue, the latest retail sales report was lackluster. Although many attributed the miss vs. expectations on the weather, online sales also decreased. While leading indicators still point to growth for the U.S. economy, a weaker consumer is becoming a notable risk to the global outlook. News on the economic front will be particularly important over the coming weeks.
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| Rodrigo C. Serrano, CFA | SIPA | Columbia University Master of International Affairs 14 Candidate | New York City, NY | 01-305-510-0181 | rcs2164@columbia.edu !
Over the near term, the overall positioning of the portfolio will remain tilted towards the bullish scenario of an ongoing recovery in Europe and weather-related economic weakness in the U.S. proving transitory. However, I remain concerned with the overall macro backdrop, particularly in China and the U.S. consumer. Thus I remain conservatively positioned, knowingly at risk of trailing my benchmarks should markets rally strongly from here.
Investment backdrop:
Notwithstanding macro developments, the S&P 500 remains trading in a constructive manner. After falling roughly 6%, the SPX bounced off its upward trend line in place since Jan 2013 (at 1740), sliced through its 100 and 50-day MAs to the upside with relative ease, and has now made an all-time high. It must be disheartening for the bears to continually fail at even notably taking control of price action, especially with weak US and Chinese economic data and continued political risk in Europe. Whether bulls have solid reasons to keep bidding the market higher remains in question; however, there is little doubt that the trend remains higher. Price action must be respected. Furthermore, given healthy breadth metrics, there is lacking evidence of alarming internal weakness in equity indices. NYSE stocks above their 200-day MA have increased in number. Meanwhile, the Advance/Decline line has made a new high. The fly in the bullish ointment remains the sentiment picture. Sentiment is at an important juncture. US economic data has significantly underperformed analysts' expectations as of late. Markets' resilience in the face of these data points suggests that most investors believe that the soft patch of data is transitory due to inclement weather. This brings up a notable potential dynamic. If underperforming data improves (i.e. weather did play a distorting role; business activity strengthens) further gains are probable, as investors become ever more confident that the U.S. is on a sustainable recovery. However, there is the risk that the spell of weather has blinded investors at precisely the wrong time. A soft (hard?) patch led by floundering consumer spending may be at hand. Risk assets could be riding on an air pocket, particularly if the latter bearish scenario plays out. In general, buying on the dip has been a winning multi-year strategy. It has been increasingly embraced. There lacks a significant wall of worry that characterizes bull markets with plenty of upside. This means that a significant downturn in economic activity or a negative surprise from Europe or China could damage market sentiment and technicals. Looking ahead, we may see a retest of the 1850 level to confirm the recent breakout. Overall, investors are voting that Europe remains on the rebound and that the Chinese economy will not adversely affect the U.S. economy. Given the recent upside break, the next technical stop would take us near 1,885, a point that is at the top of the index's upward channel.
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Asset Allocation:
RCS Investments portfolios top holding was the short in Chinese financials. Since the positions inception at the turn of the year, it has appreciated almost 10%. Given continued pressure on the Chinese banking system, it will remain a current position until there begin rumors of a Beijing bailout. Additionally my core and tactical position in the 10-yr U.S. Treasury were beneficial. The worst positions for the portfolio were the long emerging markets (EEM) and short Japanese government bond (JGBS) positions. Given continued tapering, the former may see further downside. I will consider conducting a little tapering of my own should underperformance continue. Under the bullish macro scenario, ongoing recovery in Europe would lead to further financial inflows, making EZU (Eurozone stocks) a candidate for the proceeds from the EEM position. However with France showing relative underperformance (and constituting 30% of the ETFs holdings), I would consider individual European country ETFs as well. Meanwhile; should the U.S. recovery strengthen, as the adverse effects of inclement weather pass; Europes recovery shift into 2nd gear; and China remain stabilized, Ill begin considering a more cautious view of U.S. Treasuries (10/30 yr). While wintery mix has hit most of the U.S. eastern seaboard, drought conditions have plagued California, home to 1/3rd of U.S. agricultural output. For the first time ever, farmers will not receive their full allotment of irrigation water from the State Water Project. Meanwhile Brazil, the worlds leading exporter of coffee, soybeans, orange juice, and beef has been reduced to rationing water for over 6 million people. The confluence of these factors together with faint signs of wage inflation in the U.S. make David Rosenbergs contrarian postulation of an inflation scare a scenario to seriously consider. On the other hand, a strengthening bearish macro scenario may call for a few tactical plays. The housing market has come under duress from falling demand as per the Mortgage Bankers Associations purchase index. Other leading indicators, such as building permits and housing starts, signal reduced vigor. If economic activity decreases, housing may be adversely affected. What makes the bearish thesis on housing even more intriguing is that should economic growth accelerate, higher interest rates = higher mortgage rates would act as a headwind for the sector as well. A fly in the ointment for this idea lies in lumber prices, which have not indicated significant weakness. Ill be keeping an eye on 33.26-33.39 on XHB. A shooting-star pattern may be developing, making this play a near-term possibility. Finally, remaining under the bearish umbrella, weakening wage growth and lackluster coincident indicators of consumer strength make XLY an interesting candidate. Despite highs in the S&P 500, this sector remains short of its high. Although this could quickly change, especially if economic activity reaccelerates, Ill keep an eye on a potential shooting-star pattern here as well. A break under 64.61 would make me consider entering into a short position. From a global perspective, faltering economic data would lead to a reversal of Fed policy and further easing from the ECB and BoJ. Gold miners look interesting at this juncture. A break of 27.19 on GDX makes this investment a near-term possibility. Stay tuned
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