Market Thinking - A View From The Equity Market - Commentary From Mark Tinker

Festive Season Rituals

Mark Tinker

When I worked as a sell side strategist, literally back in the last century, I was once advised by my then head of sales that there was no point in writing anything any later in December than the Varsity Rugby match, on the basis that ’nobody would be in the office to read it'. Unfortunately nobody explained this to the head of research, so we duly toiled on, producing vast tomes of economic and market predictions for the year ahead, working to crazy deadlines, liaising with city printers until the final delivery of hundreds of boxes of hard copy Almanacs on around Christmas eve. The sales desk meanwhile were busy entertaining the very clients these notes were intended for, organising Christmas lunches, quizzes and trips to the Varsity Match. I know who got the better end of that deal.

The Varsity Match was usually around December 12th, meaning an alternative 12 days of Christmas and I have often thought that the Christmas rituals of that song were reminiscent of the attempts by strategists and economists to woo their clients. "On the first day of Christmas, my broker gave to me...a forecast of US GDP" and so on. Now that I suppose I am that client, I find that, while sadly there are no Christmas broker lunches allowed anymore and hard copy publications are all but gone, there is nevertheless the ritual of 'The Forecast', and without being too harsh on my broker friends, much of the forecasting ritual can in my personal view be as irrelevant as the proverbial ‘partridge in a pear tree’.

The process tends to start with the big number, GDP, something I have often described as a lot of interesting small numbers aggregated up into one great big useless number. Certainly as an equity investor I can’t find any good stock or sector thematic from the prediction that US GDP growth will be 2.3% or 3.2, or indeed (from last year's big 'call') that Chinese GDP growth would be 6.4% or 4.6%. Discussing whether Chinese retail sales would be 11% or 12% might add some value, not so much for the accuracy of the prediction as from the acknowledgment that the mechanics of the equation, GDP = Consumption + Investment + Government spending + Exports minus Imports mean that the sub-components can and do move in different directions and that these - and the sub components of these sub components are where we need to look for insight.

The brokers with the highest GDP prediction traditionally were also the most bullish on equity markets and usually favoured cyclical stocks, while the most bearish tended to be bond houses who always saw the safety in bonds and an imminent crash in equity markets, often described in subtle language, like ‘Armageddon’. I used to regard this with some cynicism, but increasingly I realise that this is just what behavioural finance refers to as confirmation bias; the equity bulls selected out the positive news flow and the bond bulls the negative.

On the second day of Christmas, the GDP forecast is then usually linked to an inflation prediction, broadly reflecting the notion of an 'output gap'. If GDP as predicted is above what is regarded as trend, then the assumption is that there will be less spare capacity in the economy (the output gap will close) and that prices will rise and vice versa. This is of course to simplify enormously, but it does expose the key assumptions behind the modelling, that we have an understanding of what the trend growth in an economy actually is, how much spare capacity exists within that economy and how much of our predicted demand increase will affect that. Far more important however, and similar to the first point on the demand prediction is the fact that a Consumer Price Index is an aggregate of lots and lots of useful pieces of information about pricing power, aggregated up into one big largely useless inflation number.

I think that this big figure can be largely useless from an equity perspective, but it is key for a bond investor, because the most important forecast for them is not what the economy will do, but what the monetary authorities, the Federal Reserve (Fed), will do. Thus on the third day of Christmas we tend to get the predictions of what the policy makers will do to interest rates. Back in the late 1980s and early 1990s we had a pretty good notion of the models that the Fed were using to set rates. Essentially a variation on the notion of an 'output gap' outlined above, stronger GDP tends to lead to tighter monetary policy. This is the logic behind the market obsession throughout the year with the US non-farm payrolls. This high frequency data is deemed a proxy for changes in the output gap and thus a need for tighter monetary policy, hence short term market responses to this data release - despite the fact that the data is a) lagging anything we already know from the bottom up and b) frequently heavily revised.

The 'model' was even codified by an economist called John Taylor as the Taylor rule although unfortunately it immediately fell foul of Goodharts law (the recognition by economist Charles Goodhart that as soon as you start to target an economic variable it ceases to work as a reliable indicator). Indeed, despite the intrinsic logic the level of interest rates set by the Fed has consistently failed to match the level predicted by the Taylor Rule. This year, the views on the Fed will have much more of a political dimension as the prospect of a change in fiscal policy will be factored in. As we noted post-election, tax cuts and other fiscal stimulus will allow the Fed to 'normalise' interest rates more quickly, something the dollar is already picking up on. Meanwhile, we should not forget that the markets have arguably already taken over from the Fed, Libor rates continue to rise (partly due to money market fund regulation) and have now hit 1%.

This rate is more important for the cost of borrowing in the 'real world' so that the focus for forecasts really should be here, rather than the Fed. Tighter monetary conditions are the reality for 2017 and are part of the new, ‘New Normal' that we should anticipate.

The fourth day of Christmas therefore tends to bring the market forecasts from the equity brokers. They tend to focus on earnings, linking their nominal GDP forecasts to a view on corporate profitability, often taking GDP as a proxy for sales and adding in some assumptions on margins - some value added on pricing power can sometimes be found here as this often involves liaising with the bottom up analysts at the sector level. The earnings are then valued using a discount rate comprising the bond yield and a second component referred to as the equity risk premium.

Derived from the academic literature, it can also be derived by observing the internal rate of return on the market, in other words what discount rate would you need to use to get current market prices from current market assumptions on earnings? Generally the discount rate assumptions are stable, with any rise in bond yields being absorbed by an assumed fall in the equity risk premium. Other valuation measures (the whole catalogue of acronyms, from P/E and PB to EV/EBITDA and CFROI) are then viewed through a mean reversion lens and assumed to remain within a normal distribution curve related to history.

The fifth day of Christmas is the turn of the bond brokers, and while the equity brokers tend to take the bond market as given, the bond brokers seem to spend a lot of time on talking equities. Rarely positively in my view. Depending on the GDP and inflation forecast, they are either very gloomy about corporate earnings, often taking nominal GDP as an EPS forecast on the basis that profits can't grow faster than GDP forever, or very negative on bond yields which means that equity markets 'will crash'. Heads equities lose, tales they can't win.

Fear trumps greed almost every time and the bond market forecasts of equity markets tend to get the most publicity, not least because they are often presented by sagacious economist types (three wise men) whereas equity strategist tended to be dismissed as over-enthusiastic Pollyannas, or people with a Panglossian view of the world. Of course, if you are gloomy and wrong, then a long only equity investor can smile indulgently, but if you are bullish and wrong then you get kicked out of the playground. Darwinian survival tends to kick in here which means that constructive voices on days four and five tend to be relatively rare, while negative views tend to dominate.

The sixth day of Christmas and the equity brokers try to shift from markets to stocks and sectors. Here they tend to have a little more room to maneuver. As noted earlier, the bottom up analysts tend to have good insights into the sales, pricing power and short term earnings prospects of their companies. Aggregating these insights up into sectors and indeed markets can be much more useful for equity investors than trying to do it from the GDP data, not least because, outside of the US, the quoted equity markets are only loosely representative of the underlying host economies.

Back in the early 1990s my efforts to build a bottom up model of the equity markets took, literally, months, now I can get it from Bloomberg or any number of data providers in seconds. The insights we are now looking for therefore are the more qualitative ones, the sustainability of those earnings, the ability to obtain and maintain super-normal profits. Where these are not in prices is where we can hope to find alpha. Also understanding that active investors are not buying 'the market', but a subset of it means separating alpha from beta. Too much time is spent on the latter rather than the former.

The seventh day and the forecasters are onto swans a swimming, of the black variety. Of course predicting black swan events is to miss the point of the genre - they are, in Rumsfeld speak, ‘unknown unknowns’, but since 2008 it has become a key part of the Christmas forecasting tradition. Several brokers make a virtue out of their alternative predictions - which do at least provide an important focal point for discussion of risk (more on that in a minute), but the usefulness tends to be obscured by post hoc claims of ‘I told you so’. If you forecast both up and down, you ought to be right sometimes!

The 2008 crisis was not entirely an 'unknown unknown'. History (and the Big Short) tell us that a few people were aware of what was happening to the derivative products trading off the US housing market, but the real unknown was the extent of the linkage through the system and the impact it would have on the US economy when policy makers allowed Lehman to go bust. As I have noted many times before in these notes, the financial crisis became an economic one through the workings of financial market liquidity. When Lehman was allowed to go under, all bonds linked to Lehman were market to zero, triggering redemptions in the US money market funds and paralysis in the US commercial paper markets. This in turn froze working capital across the US and triggered cash flow crises globally. Inventories were run down and industrial production stopped.

The GDP measures collapsed (the expression for GDP earlier, C+G+I+X-M also has an adjustment for inventory, which is usually ignored as it is not normally material. In Q4 2008 it was responsible for almost all the measured collapse in GDP). The US housing market sold off a little, but the impact was magnified by a CDS structure few people understood (certainly few of the economists credited with predicting the housing crash) and in turn became an economic event when policy makers allowed Lehman to fail without realising the extent to which it would impact global working capital. To be fair to the US authorities, the Fed acted pretty quickly to fix this (QE1) which is actually what gave the signal in 2009 to buy back in.

Day seven therefore tends to be largely about forecasting 'bubbles'. Since 2000 it was tended to be bond houses predicting an equity crash, usually based on valuation (mean reversion on long term cyclically adjusted PE or Profit as a share of GDP or Tobins Q ratio). Unfortunately even when they 'get it right', in the wake of any sell-off they tend to double down regardless of the true underlying cause, only to find markets going back up again. Hence the Christmas forecasts of bubbles tend to be backward looking and focused on equity markets 2009 US, 2013 Europe, 2016 China etc. which probably explains why the last 7 years have been the most bad tempered bull market in history.

This predates the global financial crisis of course, 1988, 1993, 1995, 2001, 2003, were all years when equity crashes were predicted due to a 'bubble' and the failure of equity markets to listen to what is regarded as good for them tends to be ascribed to ignorance and a failure to understand how markets ‘should work' combined with the blandishment of lots of econometric models, which really will get it right this time as the markets come to their senses.

This of course all has echoes of what I expect to be the big focus of the eighth day of Christmas - politics and policy. 2016 has been literally a shocker of a year, not because of unknown unknowns, but largely because of a refusal to properly consider the implications of known unknowns. We knew there was going to be a vote on the UK leaving the European Union in the same way that we knew there was a Presidential Election in the US. The fact that neither outcome was expected did not mean we should not have hedged it, let alone not even discuss it. In my view the big mistake with discussing unknowns like these is the implicit assumption that we need to first predict the binary outcome and then put on a trade to generate alpha from it. To me this is precisely the wrong way round for an investor.

We should focus on our underlying sources of alpha, be they equities, credits, spreads or a combination of all three and then 'shock' the diversified portfolio with the 'event'. We can then judge how we may need to hedge any undesirable consequences from a cost benefit analysis - so we hedge or 'self insure'? To do so we need to also have an assessment of how markets are already positioned immediately ahead of the event and the cost benefit of going against consensus. This year there will of course be focus on the calendar of European politics - notably elections in France and German, but also the policies of the new President of the US.

The ninth day of Christmas and we turn to currencies and commodities. The currency markets to me are the ultimate 'noise markets'. As my good friends at Gavekal put it, there are three types of trade - spread or carry, mean reversion and momentum and all three apply to foreign exchange. There is a fourth type in my view, which is investment in discounted cash flow, but since neither currencies nor commodities deliver cash flows in this sense I consider them trading vehicles rather than asset classes. A trading vehicle works on 'noise', it finds a direction, usually as a function of carry, and amplifies it with leverage. A narrative develops that gets louder and more compelling as the trade delivers momentum until finally there is no one left to join in, at which point it mean reverts and the whole process switches around.

Currencies have been the quickest to react to the politics, with sterling most obviously in June, but then the Mexican peso and now the euro. This coming year is all about the dollar and the consensus is very bullish - in fact one of the most reliable contrarian indicators, the front cover illustration of the Economist magazine has just pictured a 'mighty dollar'! Perhaps most interesting here is the assumption that a strong dollar is bad for emerging markets (EM), based on 'last time'. The mechanics are that any emerging market borrowing in someone else's currency - essentially dollars - has no control over their monetary policy. The price and availability of their funding is essentially out of their control and a stronger dollar is bad for their balance sheets. While this may be the case in some countries, in many it is not and to the extent that EM has sold off on a strong dollar there looks to be an opportunity. If dollar weakens they rally, if it continues to strengthen then the fundamentals will appear to prove the point that the dollar is not as important as the noise traders believe.

To me, the important thing is not to confuse the trade with the investment; this time last year, a momentum trade in so called China sensitive trades in the foreign exchange (FX) and commodity markets such as iron ore, copper and oil, as well as the Canadian and Australian dollars and other emerging market currencies had created a compelling narrative about China collapsing. Q1 was dominated by the ’Davos consensus trade’ whereby the Chinese economy was going to collapse. I got lots of forecasts of Chinese GDP being much lower than consensus because they had found these great indicators like railway shipments and electricity production (the old economy indicators favoured by Premier Li discovered via WikiLeaks from 2007) while they were simultaneously unaware of the developments in the service sector, online shopping, travel or frankly anything about the Chinese consumer.

I was assured that the peg with the dollar was going to be devalued by 40% as the 'Chinese need to boost exports', when to refer back to the earlier GDP equation, the export sector is not the driver of Chinese growth anymore, nor the focus of policy. As it turned out of course, the China trade was just the start of an Annus Horribilis for Davos man and several of the more high profile members of the tribe (from the political side at least) have joined the international speaker circuit where doubtless, like the bond economists, they will explain how the people didn't understand.

So onto the tenth day of Christmas and the discussion of personalities. Usually this involves some focus on the composition of central banks, the Fed obviously, but also the Bank of England, European Central Bank (ECB) and so on. This year, however, it is much more about politics, and after the eighth day discussion of policy, the tenth day has much more discussion of people. In the US of course, this is not just about President Elect Trump, but also about the people he appoints. The fact that he appears to be appointing practical deal makers like Rex Tillerson as Secretary of State is significant in my view. In the same way as the Ambassador to China is 'known' to China, this appears to be a signal of a willingness to do deals and appears to be supporting the observation that with Mr Trump it is best to watch what he does, rather than what he said in the campaign. As was noted at the time, the mistake with Trump was to take him literally but not seriously, when in fact it is far better to take him seriously, but not literally.

Equally the fact that the various new heads of government agencies like the Environmental Protection Agency (EPA), the Housing and Urban Development department and the Departments of Education and Labour are practical people, often from the other side of the debate is important. As the Wall Street Journal noted, the last decade has seen a massive increase in regulation in the US, for every law passed there have been 35 new regulations and efforts to reduce this pace of regulation, let alone reverse them, may be the most significant supply side reform to look out for. This year the policy discussion will doubtless stretch to Europe and some discussion of French and German politics.

However, I have yet to see any analysis of what the prospective policies might actually be of the various candidates in various parties other than them being variously described as populist or far right, although I am encouraged by my Italian colleagues who assured me that the fear of an Italian referendum on the euro (to me the biggest threat to European markets) will not come to pass.

By the eleventh day the forecasts have become more global, encompassing emerging markets and a bit of geopolitics. The latter of course tends to get bound up in forecasts of oil prices as it belatedly acknowledges the importance of supply as well as demand (most commodity forecasts tend to come earlier in the process and are largely a function of demand assumptions). As we close 2016, the OPEC agreement has caused some excitement (and an attempt at a momentum trade) and the general perception is that a stronger dollar is bad for emerging markets. However, as noted earlier, both of these assumptions look rather suspect. The Middle East meanwhile is caught up in assumptions about the new US administration and their relationship with Russia.

The twelfth day of Christmas and the brokers try and bring it all together, which is what I will attempt to do now as a summary. Apologies for the length of the note so far....

The coming year will not be about GDP forecasts, nor will it be about the Fed, markets have taken over from bureaucrats and deal makers have taken over from lawyers. At the short end, the cost of capital is being set by US Libor, which is already at 1%, while the long end is trading off the US long bond, re-pricing towards a 3% level. Equity markets appear to like this, but if we look into the mechanics a little, we see that much of the Trump rally has been in financial stocks and in this sense is both narrow and over-bought.

The twin prospects of a normal yield curve and less regulation (or at least a peak) have rightly triggered a short covering rally in financials that have largely traded sideways for years, but with the likes of Goldman Sachs up 80% since June, a pause is now due. Similarly with commodities, falling prices in the last 18 months have been about excess supply not failing demand and this has not altered since November 8th, even if prices appear to show this. China has shown good supply discipline in areas such as coal and iron ore which looks sustainable, but the oil markets for example look more like wish than reality. Bond investors are moving to shorten duration, while credit is moving to higher yield but with greater focus on default.

With a rising dollar, corporates in emerging market local currency debt are arguably in a better position than those borrowing in dollars, but investors need to work out if they want to hedge the currency or whether it is better to allow the company to do so. Either way, the assumption that a stronger dollar is bad for emerging markets will likely be challenged next year and this, to me, is where a lot of the opportunity lies.

The first 100 days of a Trump administration are likely to focus on repeals of regulation more than legislation and a further shakeup of the existing political and bureaucratic class. As noted, Mr. Trump has put business people into the big agencies and has promised term limits for Congressmen. He has also put deal makers into foreign policy positions which promises to alter the dynamic here as well. Personally I expect him to approach many of the US geopolitical positions from a "what do you want to trade?’ point of view. If North Korea is best handled by China and Syria/Iran/ISIS by Russia, then what does the US offer in return? Some withdrawal from the South China Sea? An easing of sanctions? In cash strapped Europe, what will he ask in return for continued funding of NATO and defence? Davos should be interesting this year, not least because Mr. Xi will be attending for the first time!

Post Trump's first 100 days we will be into the French Election and the UK triggering article 50. The contrarian investor should see some value in Europe at this point. The currency has already moved toward parity with the dollar and the most likely outcome of all of this is a positive supply side shock. Small and mid-cap companies in particular should do well from a roll back of regulation and more free trade - which, despite the gloom from some is where I see the likely outcome. Europe could easily be the equivalent of the ‘China isn't dead’ trade of Q1 2016. Beyond the summer, we have the German Elections, but I suspect the markets will have moved on by then.

I won't attempt to predict black swans at this point but rather close with a couple of thoughts on the likely Christmas presents (and thus disruptive technology) for 2017. Augmented reality will be even bigger than virtual reality (VR) - the Microsoft holo-lens is truly astonishing - but the new iPhone 7 with VR capability will be the catalyst for VR to go mainstream. For those with a more generous Santa, hybrid and electric cars will become almost universal for new products with every major manufacturer tacitly acknowledging the end of the Internal Combustion Engine.

The Tesla model 3 created the buzz this year, but every manufacturer is now moving into this space, while Tesla's solar roof tiles (that really look like roof tiles) are actually probably a bigger part of the sustainable energy future. I am not sure about asking for roof tiles for Christmas, nor exactly how the blockchain can make me a present, but this may present the biggest disruption to services in 2017.