Wednesday , April 26 2017
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Citi’s Matt King says “sell”

Summary:
And quite bluntly at that. With our emphasis:What’s a manager supposed to do when by early March your asset class has already exceeded your expectation for full-year returns? Take profit and take the rest of the year off, of course! And if it carries on rallying, go outright short! Yet somehow nobody seems to want to.Part of the reason is that the rally owes more to inflows and short covering than to institutional investor exuberance. And part is that the economic data do seem genuinely to be improving. But sell we think you should, not only in € credit (as we advised a couple of weeks ago) but also more broadly.He suggests seven reason not to trust your “inner Trump”, here so bullet pointed and slightly fleshed out:1. The Fed may stop the inflow party — as mentioned up top “the principal

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And quite bluntly at that. With our emphasis:

What’s a manager supposed to do when by early March your asset class has already exceeded your expectation for full-year returns? Take profit and take the rest of the year off, of course! And if it carries on rallying, go outright short! Yet somehow nobody seems to want to.

Part of the reason is that the rally owes more to inflows and short covering than to institutional investor exuberance. And part is that the economic data do seem genuinely to be improving. But sell we think you should, not only in € credit (as we advised a couple of weeks ago) but also more broadly.

He suggests seven reason not to trust your “inner Trump”, here so bullet pointed and slightly fleshed out:

1. The Fed may stop the inflow party — as mentioned up top “the principal driver of investors’ buying seems to have been a response to mutual fund inflows” and he doubts that’s sustainable due to the obvious Fed-hike risk. More so: “Each and every additional bp in risk-free yield is likely to make investors think twice about the risk they are running in order to generate return elsewhere.”

2. A rise in real yields should weigh on risk assets — real yields have remained “surprisingly low” even as nominal yields have risen post-election, with “almost all of the action has been in inflation (and growth) expectations.” But:

We suspect that what has made this move possible is the market’s willingness to focus on all the potential growth positives and yet shrug off the increasing signs of hawkishness from the Fed. Such a position seems increasingly untenable on two counts. First, rates markets have now finally adjusted to the new mood music from the Fed, and seem increasingly likely to be confronted with an actual hike; second, the rally in credit was starting to look out of whack even with today’s real yield levels, never mind following any proper adjustment to follow.

3. Central bank support is set to diminish — exactly as it says on the tin, “the extent of the rally once again seems excessive even for today’s level of CB purchases, never mind relative to its likely future trajectory.”

4. It’s the stimulus, stupid — that “fully 80% of the world’s private sector credit creation at present is occurring in China” is, we would suggest, a reason to pay extra close attention to China’s recent state of the union. The question of how long current credit expansion can be maintained is somewhat of an open one, measured in months and years, but the ultimate answer is not in doubt. So what happens when China, perhaps when political power is concentrated enough to really allow for a rebalancing to take hold, cuts back on credit creation in pursuit of growth… Is there anyone able to take its place? From King:

But while there is in principle room for household savings rates to fall elsewhere and create a new credit boom, perhaps aided by a Trump-inspired wave of global bank deregulation, to us it seems unlikely. Outside the UK, household savings rates have remained surprisingly high across the globe in the post-financial crisis era – even in places like Canada and Australia which did not experience a housing bust. Corporate balance sheets are already highly levered. Besides, the sheer scale of Chinese borrowing – $3tn/year relative to a mere $800bn in US and Europe combined – makes it difficult to see how these could substitute.

5. Just how strong are growth prospects really? Not great, says King. “Economic surprises have a natural tendency towards mean reversion and in the US are already starting to come down” while “the EPS growth everyone is getting excited about owes more to further cost cutting and perhaps currency moves (helping explain why the pick-up is greater in Europe than in the US) than it does to anything that will sustainably buoy the economy.” He also underlines the idea that markets may have gotten ahead of themselves in anticipation of Trump’s light-on-details infrastructure and fiscal reform plans.

6. The beast that refuses to die – European political risk. For more, see Le Pen and the general air of populism. As King says, “most persuasively, almost regardless of what you think the actual probabilities of euro break-up are, we still see too little by way of premia across markets to compensate investors for the potential risks. Central banks appear to have succeeded in squashing the volatility and fear out of markets without removing the underlying risk factors themselves. The more markets rally, the greater is the potential vulnerability.”

7. Valuations. Yeah:

Do you really want to be buying credit at post-crisis tights, or the S&P at a cyclically-adjusted P/E which has been exceeded only in 1998-2000 and 1929? The only metrics on which € credit does not look expensive in our regular Valuations Report are those that are survey-based. In Asia last week, we were asked repeatedly not only whether credit could go back to 2007 levels, but even why it should not rally straight through them!

In sum, King’s argument is basically that “markets seem increasingly to be pricing all of the upside and none of the downside” and that those who forget that current valuations are the product of rare circumstances will get badly burnt.

Related links:
China targets economic growth of around 6.5 per cent – FT
Why the Fed means business this time – FT Gavyn Davies

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David Keohane
(Spending some time as FTAV’s Bombay wallah. Noticeably sweatier but not much else has changed.) David studied economics, politics and journalism before joining the FT in 2011 as a Marjorie Deane fellow. He covered emerging markets, equities and currencies before making the jump over to FT Alphaville in May 2012. In between his degree and masters he wandered into the real world of business where he learnt how to manipulate a spreadsheet and organise meetings where nothing gets decided.

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