ALPHA SOURCES

OCTOBER 16, 2017

 ALPHA SOURCES
AS IF I WAS NEVER AWAY
I ts been a while since I had a look
at financial markets. But I am
happy to report that the laws of the
natural world, inhabited by investors,
are undisturbed. Volatility across most
asset classes remains pinned to the
floor, equities have pushed onwith the
annoying exception of the majority of
the portfolios holdingsand short-term
rates in the U.S. also have crept higher.
In this environment, the DXY has re-
gained its footing, although it still looks
vulnerable relative to many of its G7
sisters, and the yield curve in the U.S.
is still not sure whether to steepen or
flatten. It seems to have settled in the
middle; a small rise across the curve.
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Political risks have returned to
Europedid it ever go away?but I am
unimpressed with the bears attempt
to kick up a fuss. In Germany, I am
reasonably certain that a government
is formed, eventually. In Spain, I think
the Catalan separatists are on the road
to nowhere. Their leader Carlos Puidge-
mont is caught between a rock and a
hard place, and I think they will need
to have regional elections to settle what
precisely the mandate is. Finally, we are
supposed to worry about Italy leaving
the Eurozone. Break-up risks in the euro
area, however, is the dog that never
barks. The periphery wants to use the
euro, not jettison it for their own.
 ALPHA SOURCES

ALL CLEAR FROM THE MACRO DATA Elsewhere, the obvious negative
Macroeconomists probably have never outliers are in Poland, Spain and Austra-
predicted a market drawdown, let alone lia. Spain is interesting in light of how
a recession, and theyre not about strong GDP growth has been here since
to start now. Almost all indicators 2013. A slowdown in growth here would
macro-wonks look at suggest that be a big shock for markets. The upshot,
everything is absolutely fine in the though, is that other leading indica-
global economy. torsI use the OECDs amp-adjusted
The first chart below shows that my index hereare still fine. In Australia,
in-house diffusion index of leading the leading index is still well above its
indicators is still rising. Factoring the in- long-run trend, despite slowing. Finally,
herent lagthe latest value is August I have no insight on Poland, but its
it suggests that G4 industrial production OECD leading index looks grim.
growth will be robust in Q4. Hard data Another way to look at these data is
are released with a lag of one-to-two to derive a momentum indicator from
months, which imply that investors them and compare with the global PMI.
should not face any nasty macro sur- The second chart below does just that.
prises in the final stretch of 2017. Anything can happen in a given month
The most significant gains in my with the PMIs. The fact that my lead-
standardised LEIs are in Latin America, ing index is rising on a six-month basis,
where Chile and Colombias indices though, suggest that headline PMI
stand out. Mexico and Brazil, though, readings of about 54 should be doable
also show rising momentum from a low in the next three-to-six months.
base. In the major economies, the LEIs This is no guarantee of smooth sailing
are rising in the U.S., the EZ and China, in markets. Equities and credit look ex-
while it is falling in Japan and the U.K. pensive based on almost all metrics. But
In Japans case, however, it remains I wouldnt put a large bet on something
above its long-run average. in the economy throwing off markets.

fig. 01 / In the pipe, five by five fig. 02 / Steady global PMI data ahead?

Alpha Sources, global LEI diffusion, advanced one month (Left) Alpha Sources, Global LEI diffusion, 6m/6m, advanced four months, (Left)
OECD industrial production, y/y% (Right) Global composite PMI, (Right)
1.5 15 1.0 58
1.0 10 0.8 57
0.5 5 0.6 56
0.0 0.4
0 55
-0.5 0.2
-5 54
-1.0 0.0
-10 53
-1.5 -0.2
-15 52
-2.0 -0.4
-2.5 -20 -0.6 51
* GDP weighted index of the
-3.0 U.S., the EZ, Japan and the U.K. -25 -0.8 50
Latest value is August 2017.
-3.5 -30 -1.0 49
08 09 10 11 12 13 14 15 16 11 12 13 14 15 16 17 18

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 ALPHA SOURCES

ABOUT THAT U.S CURVE Economic bears are hoping that the
Its possible that we will have forgot- Fed will push too hard and invert the
ten about U.S. rates soon, and move curve, while bond bears are looking for
on to debate a big move in curren- Trump to deliver on tax cuts and an
cies, equities or commodities. For now, infrastructure spending plan. Both are
though, I think treasury yields, and the difficult to expect at the moment.
stories that drive them, remain key. The tug-of-war for the movement in
Since Mrs.Yellen sent the message that the U.S. yield curve is given a twist if
the Fed intends to press on, economists we look at COT positioning of non-com-
have been debating whether the dots or mercial traders. The first chart below
FF futures are right. I dont see a clear shows that speculators bets are heavily
winner, so my interpretation is that the tilted towards a flat(ter) yield curve. The
consensus has settled on somewhere second chart shows that market posi-
in between. This would imply a persis- tioning is looking a bit like 2006-07.
tently flat curve and a terminal rate of They suggest that a positioning for a
about 2.5% in 2019. This doesnt point steeper curve clearly is now the con-
to huge gains in long-end yields, but trarian trade, at least in the world of
probably room for a rise all the same. non-commercial bond futures. But how?
Treasury yields have got the mes- If you believe in the late cycle economy,
sage, settling on the parallel shift high- the real contrarian should bet against
er. The curve hasnt gotten any closer U.S. two-year yields moving higher
to inversion, undoubtedly to the chagrin rather than a leap of faith on a growth-
of those with a pessimistic worldview. boosting tax reform with a short on the
Meanwhile, the bond bears have been long bond. After all, 1.5% for lending
left frustrated by only a small rise in to Uncle Same over two years is better
long-term yields. In other words, the than a hole in the head. But the yield
Trumpflation-driven push to GDP growth curve is not inverted yet, which also
above 3% is nowhere to be seen. makes this trade a leap of faith.

fig. 03 / The market is positioned for a flat curve fig. 04 / a bit like in 2006 and 2007

U.S. 10-year yield less two-year yield, %, (Left) COT positioning, Z-score U.S. two-year notes, no. of contracts
COT positioning*, U.S. 10-year less two-year, no. of contracts, (Right) COT positioning, Z-score U.S. 10-year notes, no. of contracts
5
3.5 -6 * In standard deviations above/below median
4 based on data going back to 1999
3.0 -4 3

2.5 2
-2
1
2.0
0 0
1.5 -1
2 -2
1.0
-3
0.5 4
* Non-commercial, inverted. Latest -4 Remind you of anything?
observation is week ending October 6th.
0.0 6 -5
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 ALPHA SOURCES
CAN THE FED GET TRACTION?
Picking up yield on the U.S. front-end
currently requires two narratives to
take over, preferably at the same time.
If something snaps in U.S. equities, it
could be the opening salvo to a pain-
ful back-pedalling exercise for the Fed.
Were not talking about a 5%-to-10%
correction, though. I think we need
something more sinister. But the point
is that even a 20% deep dive in Spoos
wouldnt necessarily spell the end of this
bull market. It would sting, but if the
Fed kicked back from the table, it would
also likely set up a leg higher, propelled
by the lower for longer story.
Betting against the Fed, though,
also will sting if U.S. wages and in-
flation accelerate. As such, investors
likely need help from the BOJ and ECB
too Will they get it? Well, Mr. Kuroda is
in no hurry to change anything, and the
ECB has made a pact with markets. The
pace of QE will be reduced, but rates
will be pinned to their extraordinarily
low level for a while. Both Japan and
the Eurozone run large external sur-
pluses, so in a world of free movement
fig. 05 / Is it going to zero? fig. 06 / Value in waiting for a steeper curve?
EZ high yield corporate bonds* less U.S. 5-year treasury yield, %
6 3.5
5 3.0
4 2.5
3 2.0
2 1.5
1 1.0
* St. Louis Fred, BofA
Data, blended maturities.
0 0.5
13 13 14 14 15 15 16 16 17
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of capital, their interest rate policies
effectively are everyone elses prob-
blem. The first chart below provides
an example. Assuming a continuation
of the trend, investors in EZ high yield
credit will soon be able to get the same
headline yield by giving their money to
the U.S. treasury for five years, assum-
ing full currency hedge. I have been
criticised for this comparison, but I think
it is o.k. with 5-year yields. The point is
that excess savings in Europe and Japan
are more than willing to play whack-a-
mole with other central banks trying to
push short-term rates higher.
Whether the U.S. curve steepens or
not is important for equity investors
too. The final chart shows that return-
starved value investors could do with a
steeper curve. In fact, it likely is one of
the critical factors for them to start flex-
ing their muscles again. The problem is
that if the curve steepens as front-end
rates collapse, it probably will be as-
sociated with weakness in equities. On
a relative basis, however, such an
outcome might not be the worst
thing imaginable for value plays.
U.S. yield curve, 10-year less 2-year, % (Left)
S&P 500, value less growth, level, (Right)
1.00
0.95
0.90
0.85
0.80
0.75
0.70
09 10 11 12 13 15 16 17