Risk-Adjusted Return Monitor Summary & Views

a global macro investment newsletter by Neil Azous

Morning Edition | August 30, 2019

Risk-Adjusted Return Monitor

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Summary & Views Contents

Collection Of Thoughts To Prepare For Post-Holiday Trading Summary & Views Top Observations . Global Fixed Income – German Buxl Remains Key Driver Tracking Portfolio . Can You Spot the Outlier Asset? Economic Data . The 2015 Analogy

. US Small Caps – Russell 2000 Index . Trump Owns the Machines…They Just Don’t Realize It Tracking Portfolio

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Today’s edition is a collection of thoughts. They are in no order of importance. It has served us well over the years to write down our thoughts or conversations we had this week with risk takers we respect. The views laid out in Wednesday’s edition of Sight Beyond Sight have not changed.

Global Fixed Income – German Buxl Remains Key Driver

In the August 19th edition of Sight Beyond Sight, we described how the German Buxl had been the primary driver of global fixed income for the past several months.

Although German growth, either realized or expected, is at recessionary levels, we believe that the stronger driver of lower yields is supply/demand related, not fundamental.

As a reminder, the ECB can only purchase bonds above its deposit rate, which is currently -0.40%. Therefore, unless there is a rule change, the German Buxl is currently the only German bond that the ECB will be able to mechanically purchase in its upcoming QE program. Every other part of the curve is trading below the deposit rate.

There is €117bn outstanding of German bonds longer than 20 years. The ECB already owns at least 33% of them and will likely own many more – rivaling the amount that the BOJ owns of the Japanese bond market – after conducting another QE program.

Conclusion: The bid-tone in the very long-end of the German curve should remain firm until the ECB releases details of its easing package on September 13th. Also, shorting the long end of US fixed income outright or via a steepener position is ill-advised until then as well.

NY Fed President, John Williams, is one of the top three most important voices at the Fed. Williams has made it clear that he has a strong concern regarding US interest rates diverging too far from international ones. Said differently, Williams is afraid of a stronger US dollar. This thought process is labeled the “convergence” trade in global fixed income, and is why the US long bond has followed the Buxl lower in yield.

A key example of this “convergence” is the US fixed income market. Despite constructive data on aggregate this summer, the US has experienced its second “bull flattening” in history during an easing cycle.

The leaders of this bull flattening were the 10yr and 30yr US Treasury bonds. The only other time this occurred was in 2008 when Lehman Brothers went under. While things are certainly difficult globally, we do not think it is as bad as when the financial system came to a halt in 2008. Regardless, the US bond market feels like a financial crisis because of ECB mechanics.

Can You Spot the Outlier Asset?

Last Friday, the trade war was escalated by both China and the US. Nothing formally has been walked back, and tariff increases are expected to go into effect this weekend.

Last Friday, Dollar-Yuan (USD/CNH) closed at 7.1315. Currently, it is trading at 7.1485.

Last Friday, gold (XAU) closed at 1526. Currently, it is trading at 1526.

Last Friday, December 2020 Eurodollars (EDZ0) closed at 98.725. Currently, it is trading at 98.715.

Last Friday, the 2-10-year US nominal yield curve closed positive. Currently, it is trading at -2.5 bps.

Last Friday, SPX closed at 2847. Currently, it is trading at 2945.

One of these assets is an outlier. We will give you two guesses which one and the first guess does not count.

The 2015 Analogy

China devalued the yuan in August 2015. The US dollar relative to the yuan (USD/CNH) appreciated 3.56% that month.

After a delayed reaction, SPX fell 11% over six days. However, from August 26-28th, SPX bounced 6.39%. On the last day of the month, August 31st, SPX dropped 0.84%. On September 1st, SPX fell 2.96%.

This month, USD/CNH appreciated 3.47%, or similar in magnitude to the August 2015 devaluation.

This week, SPX has bounced 3.07% (using current pre-market bid in futures).

The parallel would be a sell-off today and a larger sell-off on Tuesday.

US Small Caps – Russell 2000 Index

There is an old saying that the market is most volatile at the top. We attempted to determine if that is true now.

The average true daily range (ATR) in the Russell 2000 Index (RTY) this month is 1.39%. RTY has moved more than 1% in either direction on 15 of 21 days, or 71% of the time.

The ATR over a rolling 21-day period (i.e., one calendar month) in August has been the fourth-highest this century. The others were in 2000, 2008 and 2011.

Currently, the ATR is slightly higher than the periods during the fourth quarter of last year, and the second half of 2015, but approximately the same.

Two of these periods – 2000 and 2008 – were during bear markets. The other three – 2011, 2015, and 2018 – coincided with a bear market, but further losses once this condition was reached tended to be about 20% on a peak-to-trough basis, not the more than 40% seen in the other periods.

The average peak-trough drawdown for these five periods was 37.84% with a minimum decline of 26.4%.

We remain mindful that small caps continue to be the weakest market on an absolute and relative basis despite the benefit lower yields provide to many walking zombies.

Trump Owns the Machines…They Just Don’t Realize It

For the last several years, many founders of firms or CIO’s have complained to us that it is too difficult to beat the machines. The argument is that machines have the input of information already released, and markets are no longer a discounting mechanism, only reactive.

We believe it is more acute than that pedestrian view. President Trump has mastered taking advantage of algorithmic trading and key members of his Administration – Navarro and Mnuchin – are learning how it works too.

During the Presidential Election, Trump used social media to his advantage better than any opponent. It did not matter what the issue was or what side of the issue Trump came down on.

What mattered is that Trump controlled the headlines and took both sides of the issue. The media outlets syndicated him talking out both sides of his mouth continuously, in the process drowning out the truth or anything Hillary Clinton had to say.

The same thing is happening now. Here is a good example.

“WHITE HOUSE MULLS RICK SCOTT IDEA TO CUT TAXES BY AMOUNT RAISED IN TARIFFS THROUGH U.S.-CHINA TRADE WAR”

Investors respond two ways to this headline. We have put those responses in two columns below. The column on the left is for winners. The column on the left is for losers.

No Rationalization Rationalization Required

There is no rationalization. Traders trade price. If the Rationalization is required. This thought process keeps S&P 500 goes up driven by machines that are reactive, investors underweight or is reasoning to remain short it is prudent to follow their lead. and fight the machines. If the US is going to do a deal, how can the US cut a tax if there are no tariffs or if the tariffs are ratcheted down? Is it because the US now has a balanced budget, and the Federal Government has extra cash lying around? No, the 12-month rolling average of US federal budget deficits is currently running at $80 billion per month. If there is any truth to tax cut? If the answer is yes, is that not further evidence that the Administration is not going to reverse their stance on China soon? Or, is this another acknowledgment by the Administration that Americans will be hurt by tariffs?

Here are two other examples this week from President Trump:

1. The President said Chinese officials had called "twice" over the weekend to discuss trade talks with his Administration. He would not say whether he personally spoke with his counterpart Xi Jinping recently, and the Chinese Minister of Commerce twice denied any knowledge of phone calls over the weekend.

2. Trump said US-China trade talks scheduled for Thursday 'at a different level.'

Aides denied the weekend comment. Yesterday, the media did not bother to follow through regarding whether “talks” occurred “at a different level.”

Regardless, Trump controlled the headlines, and that is all that matters in short-term trading where machines are reactive

Conclusion: You must accept this environment will remain heightened at least until November 2020. Longer-term views will be challenged with senseless price swings over days and hours, but in the end the fundamentals will always be realized.

[Back to top] Top Observations

Tidbits

. Hong Kong Protests: China refused to let Hong Kong scrap the controversial extradition bill which caused mass protests as a way to end the tension, Reuters reported. Reuters, citing evidence from Chinese and Hong Kong officials, said Hong Kong chief executive Carrie Lam told Beijing that scrapping the controversial extradition bill which sparked the protests could stop them. In response, the Chinese government rejected Lam's proposal, submitted before August 7, and outright forbade her from cancelling the bill

. German State Elections: Two populist parties are poised to gain a significant number of seats in this weekend’s German state elections in Brandenburg and Saxony, where the ruling coalition hold the majority. The AfD party could be poised to become the largest party in Brandenburg, the region that surrounds Berlin.

o It is believed that a strong showing by non-coalition parties could cause the final blow to push Chancellor Merkel’s party out of power.

Trade War

. Further Conciliatory Measures: China will exempt 16 Tesla electric vehicle (EV) models from purchase tax, according to a statement from the Ministry of Industry and Information Technology.

. New accounting term for judging a company's quarter: Earnings excluding Tariffs and Tariffs Related Costs

. Markets & trade war wheels passed around yesterday

Global Growth/Inflation

. No-deal Brexit would cost 2.5% of GDP over 2-3 years and cut domestic banks’ earnings by as much as 25%. (Source: Citigroup)

. China August Weakness: UBS big data indicators for China are showing growth softening in August for industrial production, auto sales, property investment and property sales. In spite of consumption growth (ex- autos) holding firm, UBS overall activity index has softened in August, and now suggests slowing Q3 growth.

. Inversions & ISM: Historically, once the US yield curve inverts (10Y-3M), the ISM enters contraction (<50) 7M later on avg. Furthermore, using the last 8 inversions as my sample, the ISM tends to trough 19M later at 43. The yield curve inverted in May, so this puts us at Dec ‘20 for a bottom. (Source: Pictet, Multi-Asset Fund Manager, Julien Bittel)

Central Banks

. ECB Hawkishness This Week: Knot, Weidmann and Lautenschlaeger all out this week saying it is way too early for a big ECB easing package in September.

o See Dove/Hawk chart from Citigroup. All three are traditionally hawkish and do not set trend.

. BoJ: The BoJ made the biggest cut to its purchases of 5-to-10 year bonds since starting yield-curve control in 2016. It is the third cut to its purchases in the 5-to-10- year range this month.

o "Sources": possibility of the BOJ putting a limit on the yield investors can offer at its buying operations next September policy meeting.

. Bank of Korea – Easing Footing: “There is some room in monetary policy to respond to economic situations if necessary. Future policy will depend on external risks, and how they affect the domestic economy and financial markets.” (Source: Bank of Korea governor Lee Ju-yeol, press conference)

o Two out of seven BOK board members dissented from Friday’s decision and called instead for an immediate rate cut, an indication of growing concern at the BOK that more must be done to prop up growth.

Money Flow

. Fixed-income assets attracted $325 billion of inflows this year, including a record $160 billion in the past three months alone, a clear sign of global recession fears and capitulation to the “Japanification” theme. (Source: BAML, Strategist, Michael Harnett)

o As for gold, the precious metal’s haven status is underscored by $12 billion of 2019 inflows.

. Lipper Fund Flows for the week ended 08/28/2019

o ExETFs - All Equity funds report net outflows totaling -$4.981 billion o ExETFs - Domestic Equity funds reporting net outflows of -$3.061 billion o ExETFs - Non-Domestic Equity funds reporting net outflows of -$1.920 billion o ExETFs - Emerging Markets Equity funds report net outflows of -$0.487 billion o Net inflows are reported for All Taxable Bond funds of $5.020 billion, bringing the rate of inflows for the $3.052 trillion sector to $2.625 billion/week o International & Global Debt funds posted net inflows of $0.179 billion o Net inflows of $3.475 billion were reported for Corp-Investment Grade funds o High Yield funds reported net inflows of $0.689 billion o Money Market funds reported net outflows of -$16.235 billion o ExETFs - Municipal Bond funds report net inflows of $1.245 billion.

. EPFR Fund Flows for the week ended 08/28/2019

o Overall, bonds took in ~$12b; equities saw ~$6.9b in redemptions o Money-market funds saw ~$12b in withdrawals as investors deployed funds elsewhere after three weeks of inflows o Government-related bonds drew $1.7b, as investors shifted flows into intermediate and long-duration funds, while withdrawing from short-term bonds for the first time in eight weeks, with outflows of $728m o Allocations to emerging market bonds rose by $788m, the entirety of the inflows going to U.S. dollar- denominated notes, alongside HY bonds, with ~$1.1b of inflows o Within commodities, gold drew inflows of $1.9b during the week o U.S. equities saw withdrawals of ~$3.3b, as the U.K. led outflows from European stocks with ~$675m of redemptions o Emerging market stocks saw $2.4b of liquidations, extending their streak of outflows to a record 19 consecutive weeks o U.S. muni bonds inflows totalled ~$1.3b o IG bonds drew ~$529m, while inflation-protected bonds received ~$637m in flows

. Emerging Markets fund flows through August 28th: EM debt-dedicated funds saw inflows of US$801 million after three week of outflows totalling US$5.3 billion. Overall flows were in the 79th percentile, substantially higher than the 2nd the prior week. Hard currency was the main driver with US$828 million of inflows (84th percentile), up from the 7th previous week and with 78% coming from non-ETFs. Local currency on the other hand saw net outflows of US$39 million, making it the fourth consecutive week of outflows but substantially more moderate than the prior week’s US$1.5 billion of outflows. Blended currency saw small inflows of US$11 million (38th percentile), however still a quick turn from outflows of US$232 million the week prior. Hard currency and local currency flows followed performance this week as weekly returns stand at 0.5% and -1.1% for hard currency and local currency, respectively, with local currency returns driven entirely by FX returns as duration returns ended flat this week. Year-to-date performance currently stands at 13.3% and 6.5% for hard and local currency, respectively. Year-to-date flows stand at US$30.7 billion, -US$1.4 billion and US$2.3 billion in hard, local and blended, respectively, leaving overall year-to-date inflows at US$31.6 billion. (Source: Morgan Stanley)

Cross Asset

. Consensus Trades Keep Working (Source: Goldman Sachs)

o Long Equity Momentum o Long Gold/Short Copper o Long Cyclicals/Short Defensives o Long Treasuries/Short SPX o Long USD-Asia FX

. Stock-bond correlation has now returned to ‘normal’ negative relationship, with higher yields being better for stocks (the correlation peaked in July 16th when central bank euphoria was at its peak). (Source: Morgan Stanley)

. Correlations are Rising Everywhere: SPX, Gold, Treasuries, BTPs, JPY, China A-Shares, Oil, DAX (Source: Goldman Sachs)

Equities

. BAML Bull & Bear Indicator: Our flagship positioning tumbles from 2.4 to 1.3 triggering a contrarian “buy signal” for risk assets, the first buy signal since Jan 3rd 2019.

o “The decline in the Bull & Bear Indicator was driven by emerging-market debt and equity outflows, a rapid rally in Treasuries against corporate bonds, and oversold MSCI equity country indexes,” (Source: BAML, Strategist, Michael Harnett) o Since 2000, the BofAML Bull & Bear Indicator has sent 16 “buy” signals, providing a median three-month return for global stocks of 6.3%, and a hit ratio of 10 out of 16.

. Positioning – Global hedge funds moving nets away from US to Germany and China (Source: Goldman Sachs, Prime Brokerage)

. Corporate Insiders have sold an average of $600m/day in August $70bn YTD. Last occurred in ’06 and ’07 (2x market-cap today vs ’06 though). (Source: TrimTabs)

. Buybacks: August is the busiest month (Source: Goldman Sachs)

Foreign Exchange

. Revising EM Lower, JPY Higher: A softer global growth and risk outlook, driven by an uptick in trade tensions, impacts EMFX from two angles. First, growth concerns are likely to weigh on commodity prices, in turn reducing EM's terms of trade (given that EMs tend to be larger producers of primary products). Second, many EM economies are closely linked to China via the globalisation of supply chains. For EM prospects to improve, we would need to see the Fed turning more proactively dovish and/or trade tensions abating. Neither of these outcomes seem likely for now. In our view, the Fed will need to see supply-side weakness spilling over into the labour market and more conclusive consumer data to be convinced that proactive dovishness is necessary. We think the volatility in recent weeks suggests that it may take time to rebuild the trade relationship, which could keep investment uncertainties high. We expect 2% depreciation in EMFX versus USD in the next month before rebounding by year-end. We like short CNHJPY, long THBKRW, short SGD NEER and long PLNHUF (Source: Morgan Stanley)

. Long USD/JPY Vol For the Weekend: 1-week implied volatility surges 0.92 vol to 8.70 while 1-month gains 0.11 vol to 7.96; 3-month gauge up 0.06 vol to 7.86.

. AUD/USD: Overwhelming driver for weakness in AUD/USD is broad USD strength, which is having a bigger impact on the currency pair than worsening global risk appetite or falling commodity prices. Rate spreads to the U.S. have actually turned sharply in Aussie’s favor but AUD/USD keeps making new lows. (Source: RBC)

o Lower iron-ore and equity prices as well as greater China risk all help explain AUD/USD losses, but it is broad USD strength that has stopped AUD/USD forming a base o This echoes a wider theme of USD not falling with U.S. rate expectations o AUD/USD is set to keep drifting lower going forward

. CNY Forecast Cut: Lower end-2019 yuan forecast to 7.23/USD from 6.86/USD on expectations Chinese authorities will permit further depreciation to counter higher tariffs and shore up exports. Forecast for onshore and offshore yuan cut to 7.28 for end-1Q, 7.33 for end-2Q and 7.32 for end-4Q respectively. (Source: Standard Chartered)

o Sees no new hard line of defense and expects officials to continue to avoid "heavy handed" intervention o Yuan’s fundamentals are decent, supported by current account surplus, inflows into bonds and equities and the rate gap between China and the U.S.

. Take Profit on CNH Short: We tactically take profit on short 3-month offshore yuan position as China’s softer trade war stance suggests tensions may have peaked for the time being. See offshore yuan at stronger than 7.1/USD in near term given latest developments. (Source: Citigroup)

o Stays bearish on yuan as prospects of a trade deal seem limited and the Chinese economy continues to face downward pressure o Offshore yuan could drop to 7.5 per greenback if U.S. imposes 30% tariffs on all Chinese imports o CNH weakens 0.1% to 7.151 per dollar as of 10:05am local time o Recent stronger-than-expected fixes suggest the central bank wants to stabilize the onshore yuan to reduce outflow pressure, especially ahead of the nation’s 70th anniversary on Oct. 1

Fixed Income

. The 2/30 USD swap curve is currently at 2 bps – on the verge of inverting. It has inverted for a total of 8 days in history (26 years).

. US 30-year Treasury: The 30-year US Treasury bond is on track to have its third best month this century. The other two months that had larger gains were November and December 2008.

. JGB CTA Length Added: Foreign buying flows in JGB futures show five consecutive weeks of net inflows. In the week ended Aug 16th, foreign accounts purchased 8,000 10-year futures. (Source: Japan Exchange Group)

. Survey Finds 20Y Treasury Still Favored Over Ultra-Long (Source: JPMorgan, Strategist, Hay Barry, survey distributed the week of Aug. 26 received close to 130 responses, with asset managers accounting for more than 40% of total responses, followed by hedge funds, banks and insurance companies

o The share of investors who would choose an ultra- long has doubled since the last time we took this survey.However, the conclusion remains the same: if Treasury wants to create more borrowing capacity, a 20-year would be a more prudent addition to the curve, and would benefit from more sustainable demand than either an ultra-long bond or a zero coupon bond. o Compared to a 2017 survey, the share of investors who would choose to buy an ultra-long has doubled within the LDI community, the share of respondents stating a preference for either either an ultra-long or zero coupon bond rose to 65% from 45%, with all of the gain coming from insurance companies o The pension-fund community has reduced its pace of buying of long-duration debt as yields have declined, and over time, the duration of its liability will shorten o “The conclusion remains the same” as it did in 2017: If Treasury wants to create more borrowing capacity, a 20Y would be a “more prudent addition to the curve,” and benefit from “more sustainable demand” than an ultra-long bond o Adding a new long-duration point on the curve would likely “negatively impact demand for Treasury’s existing suite of long-duration securities,” such as the 30Y and STRIPS o Prospective 50Y bond would likely price around 10-20bp higher in yield relative to the current 30Y, strategists say, based on empirical evidence from Treasury and other developed-market issuers o Introducing an ultra-long maturity wouldn’t fit with Treasury’s current debt management objectives o “Treasury is also mandated to be regular and predictable in its financing, and we fear that an ultra-long may ultimately be orphaned along the curve”

Emerging Markets

. Local Currency Debt: EM local currency debt experienced its worth month of returns since November 2016 when President Trump was elected.

. Currency Returns: Emerging-market currencies have experienced their worst drop since 2012 in August of 3.4%. All 24 currencies declined except the Thai baht.

. Argentina: We are keeping our exposure to Argentina’s external debt until there is more information about what the government is calling a “voluntary reprofiling.” Market-friendly voluntary reprofiling of the debt is certainly a positive for Argentina, but the uncertainty is extremely high. (Source: Amundi, co-head of EM fixed income Sergei Strigo, Bloomberg interview)

China

. Tax Cut in Shanghai Free Trade Zone: China said it would cut taxes and ease restrictions on cross-border money flows in the new free-trade area in Shanghai, a move that will likely attract more foreign investment and help counteract some of the effects of the trade war. The Lingang Special Area, part of the existing Shanghai free trade zone, will lower the tax some companies have to pay on income to 15% from 25% for five years and offer some income tax subsidies to foreign workers with skills that are in high demand. The 50 measures announced also include easing restrictions on property purchases, cross-border capital flows and currency exchange. (Source: Shanghai government statement)

. Food Prices (Source: JPMorgan)

. China's tax revenue is expected to fall this year for the first time since 1968 (Source: Nikkei, LINK)

. Strong Fixings: The PBOC has set its yuan central parity against the US dollar stronger than expected for 8 consecutive days. The last 4 days have been the strongest on record.

. State-Backed Late Debt Payments: Qinghai Provincial Investment Group Co. is set to pay its bondholders late for the second time this year, indicating persistent financial strains at the company that’s considered by some as a local government financing vehicle.

o The Chinese state-backed aluminum producer’s 2020 dollar bond trustee, Bank of New York Mellon Corp., has received an overdue coupon payment on the note, according to investors briefed on the matter. Qinghai Provincial had failed to transfer the funds last Friday, a day after the due date, making it the second delay this year on its offshore note payment. There’s no grace period for missed coupon on its $300 million 2020 note, according to the bond prospectus.

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Economic Data

SOUTH KOREA Event Period Surv(M) Actual Prior Revised Industrial Production SA MoM Jul 0.5% 2.6% 0.2% 0.1% Industrial Production YoY Jul -3.2% 0.6% -2.9% -2.6%

. Goldman Sachs: Headline IP accelerated to 2.6% mom sa in July, up from 0.1% in the previous month. The headline figure was significantly stronger than our above-consensus expectations

HONG KONG Event Period Surv(M) Actual Prior Retail Sales Value YoY Jul -12.5% -11.4% -6.7% Retail Sales Volume YoY Jul -12.5% -13.0% -7.6%

GERMANY Event Period Surv(M) Actual Prior Revised Retail Sales MoM Jul -1.3% -2.2% 3.5% 3.0% Retail Sales NSA YoY Jul 3.3% 4.4% -1.6% --

ITALY Event Period Surv(M) Actual Prior GDP WDA YoY 2Q F 0.0% -0.1% 0.0% GDP WDA QoQ 2Q F 0.0% 0.0% 0.0%

. YoY figure negative two quarters in a row based off the final revision of Q2 GDP

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POSITION NOTICE: It should be assumed that, from time, or as of the publication date of this newsletter referencing any instrument or security in Equities, Foreign Exchange, Interest Rates, Commodities, or Credit, RVM (possibly along with or through our partners, affiliates, employees, clients, investors, industry contacts and/or consultants) may have a position in the instrument or security covered herein, and therefore stands to realize gains if the forecasts and judgments about the future presented in this communication prove to be accurate. Following publication of this newsletter, it should also be assumed that we intend to continue transacting in the instruments and securities highlighted therein, and RVM may be long, short or neutral at any time thereafter regardless of the initial position or communication.

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