Blain’s Morning Porridge – April 3rd 2019

Blain’s Morning Porridge  – April 3rd  2019

“Will someone rid me of this troublesome priest.. ”

In the headlines this morning:

This morning breakfast was Avocado on Toast, with a poached egg on top. It was lovely. I pity my poor American chums. Who would have thought their economic dream is about to come crashing down. Within days ravening hordes of angry snowflake millennials will be tearing down the state – all because 100% of America’s Avocados are imported from Mexico at this time of year.

Is closing the border to the South going to prove Trump’s biggest mistake?

4 Things to think about this morning:

1) What is really happening in US Treasuries – good or bad for stocks?

2) The Fed and Trump – should we be concerned

3) The real market threat – liquidity.

4) Italy. Have a strong expresso and wake up.

First, Let start with US Treasuries.

I don’t buy the yield curve inversion means economic disaster scenario. As other’s have noted: curve inversions have predicted 12 of the last 3 recessions. I’m going with the world has fundamentally changed after years of monetary experimentation and distortion. I reckon expectations of a lower for longer Fed will continue to fuel the long-end of market. Treasury bond action has been fascinating: The 10-year has risen from 2.37% back to 2.51% over 5 days on the back of stronger Economic Data signals and rumours a China/US trade deal is “just about done”, only partially reversing the rally from 3.34% since November.

The interesting thing has been 10-year trading in a steady 2.60-2.80% range since Jan/Feb. What caused yields to spike downwards in March – especially after a dovish Fed meeting? It looks to have been technical: a surge in swap activity to support new issues and mortgage convexity hedging, investors short-covering and taking derivatives to boost returns impacted by lower yields, but also a reaction to the Fed in terms of Vol hedges. In short, complex, but not end of the world stuff.

Where does that leave US stocks? Well distorted; fuelled by last year’s Trump tax cuts, a “compliant Fed” keeping rates easy and the market’s rapid recovery from the December min-crash sucking players back in. There are warning signs all around – like the 5% plus slide in US auto-sales, the 9% of US Mall spaces now unlet and the warnings of potential meltdown in over-levered private equity from a former Bain partner – but that’s just noise. Is it distorted enough for another crash? Watch that space…

The IMF’s Christine Lagarde has been publicising her big conference next week with warnings of an unsettled global economy and economic slowdown – downgrading growth for the next two years -while the World Bank is also cutting projections. She said: “ two year ago 75% of the global economy experienced upswing. This year, we expect 70% to experience a slowdown.” Although we hear the trade Sherpas talk up rumours the trade discussions are progressing, it feels like global trade is becoming less more and more subject to dispute. I can’t see any signs of positive sentiment re global trade flows between US/China and US/Europe – that can’t be good news?

Second, that brings us on to Trump and the Fed.

I’ve been told a couple of times I’m an idiot for thinking Trump has any influence over the Fed. If he did, then it would break the key fundamental of the US Economic Fairy Story – that the Central Bank and State are entirely separate. But there is a distinct feel of “murder in the cathedral” as Trump’s “Guess I’m stuck with you” comments and apparent fury with Jerome Powell raise the temperature. The one truism about US politics is: “its all about the economy, stupid”, and Trump is clearly set to blame an unsupportive Fed if the US economy slows into election year.

That’s potentially one of the most dangerous moments I can imagine? The global economy losing trust in a beleaguered Fed. The comments Trump is making, including “Mnuchin gave me this guy,” and others, might sound classic Trump rudeness, but there is a great article in the WSJ detailing how he blasted the central bank and its leader at three meetings in the past week alone. This is something the market should keep a close eye on.

Third, the next issue is the biggest threat to markets.. Liquidity

We’re all aware market making across all asset classes is a complete liquidity illusion. Everything is agency brokerage these days. Anyone buying bonds or stocks on the basis of perceived liquidity is very aware they are simply arbing the rules and meeting their CRO’s risk profile tick-boxes. (If they sincerely believe they are choosing assets on the basis of liquidity, get them off the desk before they do something downright stupid.)

There are a couple of ways to play liquidity – one is to take the illiquidity premium and hope for the best by riding through any liquidity crisis. It’s why Alternative assets work. Or, you can try to manage illiquidity risk.

The numbers all confirm bond inventories held by dealers are a fraction of pre-2007. Yet one of the most successful growth stories in fixed income has been the growth of fixed income ETFs. I’m a supporter – as part of a FI strategy not based on being able to rely on guaranteed liquidity. The issue is what happens in a period of crisis and investors try to exit Fixed Income ETFs at Net Asset Value?

Bond markets, because of their discrete nature, are not fungible like equity, and bond ETF unwinds will depend on the appetite of the appointed deals to accept trades where they effectively unwind a portfolio and sell the component parts – they are not obligated to do so. While everyone knows a single bond can become illiquid, what happens when a portfolio of bonds tries to trade in illiquid markets? Do they become even less liquid (illiquidity squared?). Nope, they get discounted further!

The trick is again being able to ride through illiquidity on a buy-to-hold-basis. I’d actually recommend picking up discounted ETFs in a time of crisis on the basis markets tend to revert, and a portfolio approach works in bonds. The question, however, as always, is timing. What is the right time, following a market crash and fire sale of ETFs, to step in an buy that Hi-yield or EM ETF?

Fourth, let’s talk about Italy.

Yes, I know its been a superb performing asset class on the basis the new government made all sort of promises to the EU and ECB about cutting deficits and reducing bond issuance so that it stuck within EU guidelines. Imagine my shock and surprise  to discover the planned cuts haven’t happened, the deficit financing is rising (partly because the economy continues to contract) and that Italy is once again on a crash course with the EU.

If you are surprised.. then no amount of strong coffee is going to help you…

Out of time and back to the day job.. and I didn’t mention Brexit twice..

Bill Blain

Shard Capital