There's a storm coming

In “The Second Machine Age”, Eric Brynjolfsson and Andrew McAfee from MIT, chronologise how quickly technology is changing the world, and posit what the world might look like in the future. "Most fear that technology will replace most jobs. But the analogue and prediction I found most interesting was that man and machine will do better than machine alone".

The alarm bell for machines replacing man was arguably first sounded in 1997, when Garry Kasparov, world chess master, was defeated by IBM’s Deep Blue computer. But subsequently Kasparov could beat Deep Blue, or indeed any follower, with the assistance of a computer and even the most rudimentary chess game.

I acknowledge that there is an awful lot of systematic work in my own process. There has to be in today’s world, where information is so plentiful and absorbed so quickly. And so daily our programs systematically review:

1. Trend and momentum in markets
2. Over 80 indicators of global risk
3. Whether volatility is cheap or expensive across the globe, and the largest volatility “skews” to take advantage of.
4. What factors are the key drivers of all currencies, via historical correlation and regression analysis
5. Whether global economic data is beating or missing consensus forecasts, via our surprise indices
6. Whether the global economy is mapping our forecasts via our nowcasting indices
7. And how our financial condition indices are evolving

I could go on! But the point is we systematise a lot of our inputs to give us an instant read on how economies are tracking and are projected to track, value in markets, timing of execution from market signals, and the best way to express themes in option markets.

And then we use discretion.

Because that is where the creativity comes in.

There are so many macro events that can’t be modelled. Trump, any day of the week. Brexit. A left and right wing party joining in Italy. A central bank suddenly swinging hawkish or dovish. One needs to brainstorm, probability weight and identify catalysts. The systematic analysis takes the pulse of the globe and identifies the best way to structure the portfolio. But then we use discretion to tick the box, or indeed think outside the box.

And so one question is “Are we about to repeat 1994?” The largest annual negative return in bonds in modern time.

The short answer is possibly. But it is more complicated than 1994. For an analogue, I think one has to look to 1994, 1998, and 1968!

Let me explain.

I have talked about 1994 before. Let’s first understand what happened. The backdrop:

1. The Fed funds rate was 3%, and had been there for about 18 months, following a 3 year decline from 9.75%. Rates were never going to rise, and the way to make money for the prior 3 years was simple. Long interest rates (buying bonds) anywhere. The higher the rate, the better. Sound familiar?
2. When the Fed started hiking in 1994, carry/long rates was obliterated. Nowhere was the reversal more ferocious than European peripheral bonds – the carry of choice back then. It was nothing to do with fundamentals – the central bank there never hiked. Simply the bursting of a “carry” bubble.

After a tech bubble and a housing bubble, it astounds me that many don’t recognise we are in the midst of the next central bank engineered bubble, the global bond (carry) bubble.

So, when this bubble bursts, what will it look like? Well first, where is it? After 10 years of quantitative easing and zero to negative interest rates, where have investors gone to find yield? Well it has been out of money market funds and into bond funds to start.

Overwhelmingly the money has flowed into “investment grade” credit (IG) in the US. Corporate debt. But not “high yield”. Money has been flowing out of that sector since the energy crisis in 2015.

Nonetheless, for a true bubble to burst, we need two factors:

1. A fundamental change
2. A lack of liquidity

The two are not unrelated. As the fundamental picture reverses, liquidity dries up. But poor liquidity will dramatically exacerbate a minor fundamental tweak. Whereas good liquidity won’t prevent a bubble bursting when the fundamentals change.

So which bubbles are most vulnerable from a liquidity perspective? To answer that, we calculated how much money has gone into each sector relative to its size in 2009. This gives us an idea of how much money has been driven into these markets by QE/zero rates, and hence the potential for a reversal of those flows. The EM markets are very vulnerable…

How has so much money made its way into this space? ETFs, or exchange traded funds. A decade ago, it wasn’t very easy for an investor to own a collection of emerging market bonds. They would have to buy them in each country, and manage the FX risk. Wouldn’t it be great if someone could package this up and do that for you? With all investors in search of yield, enter the ETF. Voila! You want yield? Get the best in the world via our ETF! Boom!

But what happens if everyone wants to sell? Then the manager actually has to go into the market and sell 1,003 bonds. The liquid bonds turn over about 0.25% of their issue size each day. Heaven forbid if you wanted to sell 5% of an issue. HY ETFs argue they are only 14.2% of the retail market. But if everyone is selling their ETF, won’t the other holders be selling too?

The bottom line is the ETFs allow easy access to an illiquid market. This is fine until it isn’t. God forbid someone yells fire. Or Fed. Because as the Fed continues to hike, the reason for being in these EM ETFs is crumbling. Investors are eyeing the exit…

So how does it play out? A bubble bursting is notoriously difficult to predict.