Equities and expensive and credit spreads are tight. Some investors may be able to eke out further returns, even safely, if they are familiar with certain markets such as the ABS and leveraged finance markets. Eventually, given the weight of capital chasing returns, even these pockets of value get crowded. In the long only world, we are wringing out the last bits of opportunity. What comes next is either a lean period or, hopefully not, a crash.

The hedge fund world has promised for almost half a century, to deliver uncorrelated returns, to make money in rising or falling markets. It has rarely delivered. Most hedge funds will run a long biased strategy. Why would they do this? Because its easy when markets are rising, and markets are more often than not, rising. Also, to be really market neutral and deliver a meaningful returns requires quite a lot of leverage and for some reason investors are leery of that. For a time, so were prime brokers. The result is that most hedge funds are exposed to significant market risk.

Private equity may be immune to downturns by focusing on fundamentals and value creation. However, funding costs are a big part of private equity returns and if the bond markets fall or credit spreads widen, the ability of private equity to leverage itself cheaply will be reduced. Also, by eschewing mark to market, owning private equity in a falling market and recession is like having the blinds down in air turbulence. You can’t see it but you can feel it around you.

Real estate of the physical kind is often a haven asset especially when the tangibility of financial assets is questioned. But real estate is a yield play, a fixed coupon investment, albeit with regular rental revisions. Still it is a very long duration investment a leveraged one and it likes falling or low interest rates.

When markets fall, as they eventually do, almost everything takes a loss. The only way to effectively avoid falling markets is to time them and as anyone who has tried to time them or watched professional investors try to time them will know, this is an exercise in futility. So from a practical perspective, you can’t time markets, your hedge funds will be net long, your niche markets will soon be squeezed dry and the current bull market in everything is getting long in tooth.

What not to do: You don’t go short because a bull market is ageing and valuations are high. Shorting requires a catalyst, a tangible reason. One may soon emerge but for now, the economy is fine and liquidity conditions remain accommodative.

Neither do you switch to cash in scale. USD cash is beginning to yield a fair bit compared to the last decade but it’s still yielding very little. Those little pockets of value in leveraged finance and ABS are still good risks for the yield they generate.

But don’t be greedy. When the mass of investors is greedy, it’s time to go on a diet. Reduce market length, reduce exposure but in a smart way. For example, instead of rotating from IG to HY, it may be more efficient to stay in HY but move up the capital structure. Or to buy assets through structured vehicles which may be cheaper.

Brace yourself. It can seem strange to be bracing for hard times when the general conditions are good but as early signs of market fatigue or economic slowdown appear, it pays to brace oneself. Reducing exposure and buying protection are ways to brace a portfolio. Option protection can get very expensive in the middle of a drawdown but there are ways to construct limited protection without overpaying. Using options adds a dimension of control to a portfolio.

In a rising market, stay long and look for bad things. In a falling market, reduce length, maintain a portion of liquidity, and look for good things.

This article was originally posted Sep 7, 2017. It is updated for new trade data Feb 2018.

The Trade War continues. Since 2011, the Obama administration has been actively pursuing a program of reshoring.

http://agmetalminer.com/2015/01/22/obamas-manufacturing-centric-state-of-the-union-youll-never-hear/

Donald Trump’s agenda only seeks to bolster or exacerbate an existing trend. As global growth slows, every country seeks to become more self-sufficient and insular. Trading nations and those with a small or ageing population do not have the back stop of domestic consumption, and will suffer. Populous regions will seek to tap domestic consumption and investment as sources of growth. The strategic responses of the various regions are already becoming clear. China is a prime example with a stated objective of being more reliant on domestic consumption and less dependent on exports.

In China, total trade, here taken to be imports plus exports, have stalled and as a percentage of nominal GDP (ignoring inflation base effects), peaked in 2007 and has since been declining.

(data source Bloomberg)

The decline in trade has also brought with it a decline in manufacturing, as factories facing a foreign export audience are wound down and new ones facing a domestic audience are established. Such a decline has had a transitive impact on industrial commodities.

2016 was a year of recovery in manufacturing, a recovery that has extended well into 2017. This is likely a rebound due to the differential times in decommissioning old, export facing assets, and building new, domestic facing ones. The rebound has reversed the decline in manufacturing and commodities. A growth rebound also impacts demand for imports and reverses the decline in global trade. However, this is reactionary rather than causal. As the world’s productive assets settle into a new equilibrium, trade will stabilize at a lower level. If countries like the US under Trump accelerate protectionist policies, trade could resume its decline. In any case, lower trade is inflationary, ceteris paribus.

The fact that inflation is weak is all the more concerning in the context of reduced trade. It suggests that median output and income is weaker than mean (average) metrics. This could likely be due to a skew in the population for output and income data. In fact it supports the anecdotal evidence that wealth and to a lesser extent income inequality is acute in the developed nations.

The Trade War hypothesis is part of a more general and pervasive adversarial world. We see examples of this in the failure of the Accord de Paris, Brexit and the perceived Siege of Britain, protectionism in the US, Chinese policy to maximize FDI and minimize ODI (which is the investment analogue to trade war), China’s belligerence in the South China Sea, to name but a few.

In such environments, self-sufficiency is a sound but ultimately costly strategy, provided one has the resources. Countries lacking in land, resources, labour and knowledge, will have the most difficult run of it. Collectively, self sufficiency is costly and results in lower growth at all price levels

Fundamentals give us the courage to place our bets. Gains give us the hubris to up the ante. Greed blinds us when fundamentals deteriorate. Denial paralyzes us when gains are lost. Fear grips us as losses mount. In despair we sell the good with the bad. And turn our backs when the storm passes.

We’ve spent nearly a year in disbelief watching equity markets rise against some pretty lofty valuations asking ourselves when the next correction would be and how far equities could keep rising. They rose beyond our most optimistic expectations.

We are now watching in disbelief as equity markets fall against some pretty strong fundamentals of growth and earnings asking ourselves when the market will find a floor.

S&P 500 PE ratios are at a 25 year average, or just a touch below it. On a yield gap (equity earnings yield less 10Y UST) basis, equities are cheap on a 50 year basis and on a 25 year basis covering the 1960 – 1980 rising rate era and the 1980 to current falling rate era. On a 18 year basis, equities are slightly expensive.