Hav­ing your cake, and eat­ing it

Financial Mirror (Cyprus) - - FRONT PAGE -

But what if the end of days is not im­mi­nent? In that case, in­vestors face a trick­ier call. With trea­suries now priced for some­thing close to eco­nomic catas­tro­phe, the vi­o­lence of the year-to-date moves would sug­gest that the time is ap­proach­ing to re­bal­ance their port­fo­lios. But while a par­tial re­bal­anc­ing out of trea­suries is a rel­a­tively straight­for­ward choice — if we are not fac­ing a 2008 im­plo­sion, then it makes sense to po­si­tion for sta­bil­i­sa­tion and a po­ten­tial re­bound — de­cid­ing ex­actly what to re­bal­ance into is an al­to­gether tougher propo­si­tion.

The ob­vi­ous choice would be the broad US equity mar­ket. How­ever, since the be­gin­ning of the year, the S&P 500 has gained con­sid­er­able down­side mo­men­tum. Nor, de­spite the re­cent sell-off, are US eq­ui­ties ex­actly cheap. In­deed, the S&P 500 re­mains among the most richly val­ued of all ma­jor mar­ket in­dexes. More­over, with fears over neg­a­tive in­ter­est rates hurt­ing bank shares, the strong US dol­lar ham­mer­ing man­u­fac­tur­ing earn­ings, and the en­ergy com­plex yet to work through the im­pact of cheaper oil, there are solid rea­sons to avoid a broad mar­ket ex­po­sure, even for in­vestors who are in­clined to play a near term re­ver­sion to the mean.

In that light, a more promis­ing op­tion may be not to re­bal­ance into as­sets, like the broad US equity mar­ket, that have taken a beat­ing over the last six weeks. In­stead, in­vestors might want to ask whether it is time to look again at mar­kets that have been beaten down over a longer time span — since the US Fed­eral Re­serve sig­nalled the end of its quan­ti­ta­tive eas­ing pro­gram in mid 2013 and halted as­set pur­chases in late 2014.

The stand-out as­sets here are com­modi­ties, com­mod­i­typro­duc­ers, and com­mod­ity-de­pen­dent emerg­ing mar­kets. Clearly in­vestors should hes­i­tate to in­clude oil and oil com­pa­nies among th­ese re­bal­anc­ing plays. Yes, the cor­re­la­tion of oil and eq­ui­ties over re­cent weeks im­plies that if risk as­sets sta­bi­lize and re­bound, the oil price could out­strip eq­ui­ties on the up­side. But the cur­rent cor­re­la­tion looks anoma­lous — and tem­po­rary. Cheap oil may be a near term neg­a­tive for mar­kets as en­ergy com­pany earn­ings suf­fer and fewer petrodol­lars get re­cy­cled into fi­nan­cial as­sets. But the re­sult­ing longer term wealth trans­fer from pro­duc­ers to con­sumers is a clear pos­i­tive for global growth. What’s more, there are few signs that this trans­fer is go­ing to re­verse any time soon, at least not as long as Saudi Ara­bia has a clear geostrate­gic in­cen­tive to con­tinue pump­ing as much oil as it can.

But away from oil, there are signs that low com­mod­ity prices may now be prompt­ing the looked-for sup­ply-side re­sponse as pro­duc­ers shut down marginal ca­pac­ity and can­cel cap­i­tal in­vest­ments. This dy­namic has been clearly vis­i­ble for some time in the iron ore mar­ket, where prices have col­lapsed -77% since Fe­bru­ary 2011, squeez­ing all but the most com­pet­i­tive pro­duc­ers. In re­cent months, how­ever, the ca­pac­ity clo­sures have also spread to the non-fer­rous me­tals sec­tor, im­ply­ing that the long slide in prices may be near­ing a bot­tom. Sup­port­ing this view is the sta­bil­i­sa­tion since De­cem­ber of a range of com­mod­ity-linked cur­ren­cies, in­clud­ing the ru­piah, rand, real and Chilean peso. This sta­bil­i­sa­tion, cou­pled with the broader weak­ness of the US dol­lar over the last two weeks and the YTD out­per­for­mance of emerg­ing mar­ket eq­ui­ties, at a time of pre­vail­ing risk-off sen­ti­ment, is highly un­usual, and sug­gests that sell­ing by “weak hands” may now be ex­hausted and pos­si­bly that EMs may be poised for a pe­riod of out­per­for­mance af­ter years in which they have deeply un­der­per­formed.

Thus, for in­vestors who are not con­vinced that a mas­sive cri­sis looms around the cor­ner, and who want to po­si­tion for a sta­bil­i­sa­tion in as­set mar­kets and a ten­ta­tive re­turn to riskon in­vest­ment sen­ti­ment, it may well be that re­bal­anc­ing into the com­mod­ity com­plex is a more com­pelling riskre­ward propo­si­tion than re­bal­anc­ing into broad US eq­ui­ties.

Such in­vestors should re­tain siz­able po­si­tions in long­dated US trea­suries and gold as a hedge against the worst case, se­lec­tively look to pick up over­sold com­mod­ity-re­lated as­sets as a mean re­ver­sion play, and hold long po­si­tions in US high yield, Cana­dian Reits, MLPs and In­done­sian govern­ment bonds for their favourable carry. Of course, such a port­fo­lio is a bla­tant at­tempt both to have one’s cake and to eat it.

But as Lon­don mayor Boris John­son likes to say: “My pol­icy on cake is pro-hav­ing it and pro-eat­ing it.” In the cur­rent mar­ket en­vi­ron­ment, that’s a sen­si­ble ap­proach.

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