Thinking what others are not thinking

In the uncertain world of investing, evolutionary instincts sometimes lead us to see patterns when there are none. While humans are susceptible to biological weaknesses when it comes to investing, computers and machines suffer from a lack of perspective. Most of the research in machine learning and artificial intelligence is on reverse engineering how the human brain processes information. Computers can process a vast amount of information, but that still doesn’t solve the problem of finding patterns that may not exist.

Our approach is to be objective and we want to be bold, but we don’t let our conviction bend toward obsession, and so “when the facts change, we change our mind”. However, “facts” under our approach are not others’ interpretation of information (which allows us to see things form a different viewpoint). While we are open and flexible to changing our mind when the facts change, our investment philosophy is fixed. Avoiding to buy expensive and crowded assets may cost us short-term potential performance, but we prefer the pain of discipline (adhering to our process) over the pain of regret (chasing pure momentum or what’s working).

Going into 2017

Investors were convinced that a higher US dollar was a sure bet because the US Federal Reserve was the only central bank which was on a tightening cycle. Monetary policy divergence was a valid theme over the past few years which had already led to a significant US dollar appreciation. But it was an old theme which was being overplayed through extrapolation (and imagination) and not evidence. The evidence at the time was pointing to monetary policy convergence. We saw the same data that others could see, but thought differently. At the end, it was the global growth contagion and the resulting monetary policy convergence that derailed the one-way traffic in US dollar buying. The sharp sell-off in USD in recent months shows how unprepared the market was for this scenario.

But there is still another missing piece to the global reflation theme: The collapse in bond yields, and a fall in inflation expectations are inconsistent with the global reflation theme. The resulting market leadership in the same old defensive growth sectors, the underperformance of value over growth sectors (e.g. underperformance of financials and energy sectors) and the underperformance of European and Japanese equities against US equities all have their roots in inflation disappointment and falling bond yields of recent months (this has led to the flat lining of the Fund’s performance in recent months). But what if, bond traders are doing what USD dollar traders were doing at the start of the year? That is, doubling down on the old game of quantitative easing and easy money and disinflation forever? We think they are. If so, bonds are likely to be the next shoe to drop (although unlikely to be the same pace as the sharp USD sell-off. Why?

Markets have spent most of 2017 pricing out the frantic and unrealistic expectations of a huge growth and inflation uplift following Trump’s election. But the sentiment pendulum seems to have once again moved to the opposite end of the spectrum where there is little prospect of inflation being priced in. Underneath the daily noise we see two key facts:

1. Major economies are growing in sync for the first time in a decade;

2. Central banks have made it clear that Quantitative Easing (QE) is ending and Quantitative Tightening (QT) is coming.

With global growth gaining traction, loan demand on the mend and bank balance sheets in a much better shape, a perverse positive correlation between Quantitative Tightening (QT) and rising inflation might soon develop. The most likely outcome here is a slowdown in asset price inflation and a recovery in consumer price inflation. Any signs of inflation and a more hawkish (or less dovish) central bank will catch the markets (the bond market in particular) off guard.

Risks and opportunities over the months ahead

Risks:

• A sharp bond sell-off spills into bond proxies and QE winners and drags down the broader market with it. Given US share market’s uninterrupted gains over the past 12 months a correction is overdue. A bond market sell-off can provide the trigger.
• An inflation surprise in the US (against the low expectations), pushes up USD and bond yields higher at the same time, leading to a tightening of financial conditions. EM equities, and high yield corporate bonds will likely to be the key casualties (bearing in mind that US dollar sentiment is now at pessimistic extremes in a sharp contrast to the bullish extreme at the start of the year).

Opportunities:

• Signs of an inflation trough will put a floor under inflation expectations and nominal bond yields. Central banks remain on track for gentle tightening and balance sheet unwind.
• The gentle transition from QE to QT sees a leadership change to value over growth (bearing in mind that value-to-growth ratio has tracked bond yields down for 10 years from 2007).

Fund positioning in response

• High cash exposure - cash gives us the optionality to buy the market at lower price).
• Put options on EM equities and US high yield corporate bonds - EM equities and US HY bonds have been the biggest beneficiaries of the recent fall in market expectations for further rate hikes in the US. Bearing in mind that with financial conditions in the US easier now than before the first rate hike, it’s unlikely that the Fed is done with rate hikes in contrast with the current market expectations.
• Long USD against EM FX - Any US inflation surprise (against very low expectations) and a less dovish stance by the US Fed will likely trigger a rebound USD against EM FX (given that sentiment toward USD is at pessimistic extremes and for EM FX at optimist extremes).
• Concentration in equity exposure to sectors leveraged to global growth (materials, transportations, energy)
• Allocation to sectors benefiting from the transition from QE to QT and most notably allocation to European, Japanese and US banks.
• Allocation to commodities (total allocation of 14% in commodities): Multiple years of commodity weakness following post GFC’s “new normal” in the macro backdrop leaves plenty of catch up room as we move back to the “old normal” of synchronised global growth. The Bloomberg Commodity Index demand vs supply indicates early recovery similar to what was seen after the GFC but with a foundation of prolonged price declines. Furthermore, Agricultural commodities may be heading into a perfect storm for higher prices supported by record US exports, massive drop in plantation acreage, tight inventories, and the increasing likelihood of adverse weather impact (e.g. multiple hurricane in the US, flooding etc).

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