Now that we have milked “January Effect” for a nice return, it is time to look forward to the medium term. This idea will take two letters to flesh out. This first part will set up the conditions; the next will describe the catalyst.
Weather and Markets
As the Northeast digs out of its blizzard, it is hard to resist a reference to the weather and its causes.
Growing up in New York, one is introduced to the concept of the Gulf Stream Current in grade school with a few interesting facts:
- New York City is roughly on the same latitude as Madrid and Naples.
- London’s latitude would put it on the southern shore of Hudson Bay in Canada.
- There are palm trees sprouting near the southwest tip of Ireland.
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I cannot vouch for the palm trees but the other checkable datapoints suggest that the Gulf Stream is a critical part of what makes Western and Northern Europe quite a bit warmer than one might expect. With an estimated 100x the total global energy demand contained in this “river through the Atlantic”, the Gulf Stream has energy to spare for generating and feeding hurricanes that we give names like Katrina and Sandy.
Ocean currents are both powerful and not immediately obvious to the observer on or near the water. The first map of the Gulf Stream was published by our ambassador to France, Ben Franklin, who gathered data from American captains. When he tried to clue the British in on his findings, he was rebuffed. As a result, American shippers were able to beat the leading global maritime power by a significant margin on trips from England to the US for a number of years in the early days of the Republic.
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Source: Wikipedia
What do currents have to do with the market?
Moving from weather and shipping to the market, the markets also have a current which is known but largely overlooked by the financial media. The largest and most powerful single part of the global economic engine is the US Trade Deficit, currently running at $40bn a month. When US consumers purchase more oil and widgets from other nations than they export, a stream of US dollars are sent overseas to settle the balance. That’s about an Apple Inc. a year ($450bn market cap).
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Source: Bloomberg
Exported dollars become imported capital
Those US dollars must return to the US to purchase assets. Sometimes the actual recipient will invest directly but mostly the dollars end up with larger government and sovereign wealth sized entities as exporters turn in their excess dollars for local currency to pay running costs. Those US dollars are aggregated and used to purchase a combination of deposits in banks, property, debt instruments or equity. There have been some fads and there have been some constants. US Treasuries and Agencies have always been a popular choice, particularly for the managers of “foreign exchange reserves” (Central Banks or Sovereign Wealth Funds).
Why Treasuries are always popular
The US Treasury market remains the most liquid of the financial markets. Even after S&P’s downgrade, the question of security has never been a serious issue. In addition to the policy demand from the Federal Reserve, Treasuries have remained the most popular choice for the foreign currency reserve manager. Those two sources of demand have pushed Treasury prices up to what some consider bubble levels and interest rates down to generational lows.
Property and Equity (M&A)
But there have been other bouts of enthusiasm. Large Japanese companies went for property and corporate buying sprees in the late 80’s and early 90’s (remember Pebble Beach and Rockefeller Center?). European corporates have not been shy about snapping up large US rivals when the opportunity has arisen (who makes Bud Light?). And more recently, Chinese State Owned Enterprises have been deploying some of the Chinese cash pile into corporate projects.
The Mortgage Boom
Even though US Agencies like Freddy Mac and Fanny Mae have always been on the shopping list, the biggest boom in recent times has to be the Securitized Mortgage Boom from 2000 to 2008. For those few years, the demand for CMOs and their alphabetic siblings was nearly bottomless as Sovereign Wealth Funds called their bankers in New York and London to put money to work. Mortgages were no longer a cottage industry run by Savings and Loan officers in towns across the US whose banks wore the risk on their books. The loan officers were turned into buyers for the mass production lines run out of the money center banks and investment banks to feed the demand for homogenous, commoditized product. We all know how that ended.
Continuation of the Treasury Bull market
Since 2008, the weight of funds has been towards the short and medium portions of the US Treasury market. Foreign Reserve Managers have not been terribly interested in the long end of the market which is why “Operation Twist” was deemed necessary by the Federal Reserve. There was plenty of demand for the bills and notes that the FED swapped out of to buy the longer term bonds. The FED’s goal was to flatten the yield curve but it would have inverted (short rates higher than long rates) if the underlying demand for the securities the FED was swapping out of had not been there.
Where do we go now? Great Rotation?
Now that we have identified the strongest current of capital flow in the ocean of money that forms the Global Financial markets, will there be any asset class shifts this year which might lead to relative outperformance?
One potential change being touted is the “Great Rotation” into equities by some analysts on Wall Street. From the equity side of the equation, it would not take a massive shift of funds to have an outsized impact on equity prices.
In the 80’s and 90’s there was some equity participation by offshore investors but as we can see from the charts, the total amounts ($10bn monthly deficits) were smaller. Now we are talking about a much larger “river” of capital which needs to be invested. Until the maturation of the ETF product, which allow investors to efficiently and anonymously buy entire indices, it would be difficult to argue that Sovereign Wealth Funds could participate meaningfully in equities because of liquidity constraints.
Means and Opportunity
The funds are in the market as a result of the US Trade Deficit and the opportunity to invest in other asset classes exists with the mass adoption of ETFs. But, as any seasoned investor knows, the necessary conditions are only part of the equation. The investors will need a catalyst to shift their asset allocation assumptions.
And now for Motive
Are we on the cusp of that asset allocation shift or has January been a temporary blip of enthusiasm? In our next newsletter, we will explore the one factor that may tilt the balance in favour of equities. If we are right, what has been termed a “melt up” could become a full fledged bull market move.
Stay with the “risk on” trade for now.