“May you live in interesting times” is supposedly an English translation of a Chinese curse.
Despite what media pundits would like you to believe, we do not always live in interesting times. Not every single data point or trading day is the greatest in the history of earth or the beginning of the end of civilization.
Interesting times come around once every 5-7 years and offer traders with the proper framework the opportunity to earn outsized returns. Now, let me lay out my case for why right now is a very interesting time indeed.
The overarching theme of this interesting time is the Fed’s decision to begin tightening during 2015, while literally every other central bank in the world is adopting easing and accommodative policies.
No economy has ever stayed at 0% interest rates as long as the US. Hence, no economy has ever attempted to come off that particular brand of juice, so there's not historical precedence for what to expect. Add to that equation the fact that the world’s central banks coordinated to enter the 0% interest rate environment together, and now it is every central bank for themselves.
I’ll leave it there because I’ve written extensively about this topic in past issues of TWR, but needless to say, interesting times. The markets are expecting the US to be the locomotive of global economic growth in the year ahead and the capital flow over the last 3-6 months has backed this perspective up. No markets more clearly show this than US Treasuries and the US Dollar.
The US Dollar has only declined one time in the last 9 months, it's sitting at a 12-year high and its strength is beginning to be an issue. A strong US Dollar makes US companies less competitive overseas, so those companies that gain a large share of revenues from abroad get hurt the worst.
There are a number of things that can adversely affect a company’s earnings beyond the strongest US Dollar since 2003. That said, analyst expectations for all 10 S&P 500 sectors' Q1 2015 earnings have been destroyed since the USD’s rally has begun.
All 10 sectors’ earnings expectations have been revised much lower from last April’s consensus. The S&P 500’s Q1 2015 earnings estimates have dropped from 14% last April, to -1.4% today. In addition, in its latest round of minutes released last week, the Fed admitted that the US Dollar’s strength has been a “persistent source of restraint” on US exports. The world now wonders if the Yellen and the Fed have just joined the global currency wars to see who can burn their currency the quickest in an effort to prop up equity markets and “spur economic growth.”
The minutes also led to questions as to whether the Fed is re-considering its 2015 rate hike. Even the Oracle of Omaha has come out questioning whether the Fed can raise rates in such a strong USD environment without wreaking havoc on the US economy.
It should be pointed out here that the LONG USD trade is extremely overbooked.
The “dumb money” or smaller speculators have the largest LONG USD position that they have ever had. The current positioning is twice as large as the last LONG USD positioning peak in May 2013. The USD fell 7% over the ensuing 12 months.
The “smart money” also believes in the Dollar bull. The large speculator LONG USD positioning hit an all time high at the end of January. When positioning is leaning that strongly to one side, it doesn’t take much more than a pin prick to unravel a litany of trades across all asset classes, quick, fast and in a hurry.
But our interesting times are not just about central bank policies, the US divergence or the market’s current love affair with the USD.
Like with most pursuits in life, it's all about the fundamentals. In a phrase, the fundamentals are not so good. I’ve written extensively about the US situation.
Yes, we are the tallest of the pygmies but we are a long way from healthy, sustainable economic growth. At the margin, our growth is slowing and inflation continues to be anemic.
China’s 2014 economic growth was the lowest in 24 years. 12 months ago, the PBOC was talking about financial reform and growing the economy in a healthier way without all the gimmicks. A month ago, they cut the reserve requirements for banks to improve lending and at the same time put policies in place to curb the feverish speculation in the Chinese equity markets.
"People's Bank of China will continue to implement a prudent monetary policy, maintain an appropriate degree, guiding monetary credit and social financing scale steady moderate growth, and promote the smooth operation of economic health." Oh, in that case, I felt much better.
When it comes to fundamentals, rather than look at headline numbers, I focus on what’s happening at the margin. From that vantage point, the Eurozone has turned a corner. However, it’s a long way from hitting the escape velocity needed to have healthy economic growth free from ECB intervention.
A short plane ride from China, Australia just registered the highest unemployment rate in 13 years. The crash in oil prices has hurt Venezuela’s economy so bad that the government there has reduced the amount of dollar disbursements to the point that pharmacies can’t afford to import condoms. A 36-pack on the black market now costs $755.
That’s US dollars and I’m not kidding. But it's not just these countries that are suffering. The fundamentals are bad all over, which is why no fewer than 16 central banks have already announced easing policies so far in 2015.
And Stocks Continue To Rise
We’ve discussed central bank policy, the world’s most crowded trade and global fundamentals. How are equity markets reacting to all of this? Well, they are breaking out to the upside of course.
Domestically, last week saw the S&P 500 breakout of a 4-month trading range and close within spitting distance of its previous all-time high. This breakout was confirmed by a breakout in both US Small Caps and US Mid Caps.
In the Eurozone, German equities, as measured by the DAX index, breakout in mid-January and have been moving up and to the right ever since. The dollar denominated EWG, the German equity ETF, broke out of a 7-month trading range this past Friday. Sweden, Italy, France have all broken out of significant trading ranges last week.
Despite the horrific data that has been spewing out of Japan so far this year, both the Nikkei 225 and EWJ broke out and are now sitting a brand new post-Crisis highs. The one divergence in this sea of glory, and my contrarian perspective loves a good divergence, is emerging markets.
With the exception of the Phillipines, EPHE, not one emerging market is breaking higher right now. The emerging markets I cover are either in trading ranges or still in down trends. Even Chinese equities, FXI, are having difficulty breaking out of its 2-month trading range. This type of divergence is absolutely something to keep an eye on, if for no other reason that no one seems to have noticed.
Notice how many times the word “EVER” was used in this commentary to describe an event? Ever is a long time. Or the number of events that are occurring for the first time in 10, 20, even 30 years? You add the number of things that are occurring the first time ever with the divergence in economics and price action and it definitely equals interesting times.
We may be living in interesting times but it certainly doesn’t mean that it has to be a curse. Managing Interesting times using the right investment framework can turn a Chinese curse into a Chinese fortune.