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We are probably still in the sweet spot for the emerging market cycle. This doesn’t exempt us from the risk of corrections. It doesn’t eliminate geopolitical flare ups, trade war rhetoric, or the macro scare du jour. And it doesn’t make September/October calendar effects any less scary. But it does mean if you are an investor the wise choice is to stay in, stay the course.

(Pro memoria: the dominant error in professional investing is over-forecasting corrections and then chasing bull markets from a position of weakness.)

I’ve given the reasoning for this view here, here, and here. And my broader views on central banks and currency markets are laid out here. Basically, it all boils down to:

1.       At this point in the global risk cycle the US looks mature and investors go abroad

2.       The Fed is closer to its terminal policy rate than expected; other CBs are at the front end of their normalization processes

3.       Investors desperately need yield, and emerging market currencies have it

4.       Country differentiation is less important than asset allocation  

And demand is strong. I continue to hear of managers wanting to get into the space and/or increase their allocation, while, as PIMCO points out, local markets deepen.

Technically, the picture is strong. USDTRY and USDCLP have already broken down. It is likely that currency pairs like USDMXN, USDBRL and USDINR are to follow. Here are the charts:

Turkish Lira

Chilean Peso

Mexican Peso

Brazilian Real

Indian Rupee

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I have a childhood friend who loves to rant and complain so much that I jokingly preface giving him good news with an apology. The market feels very much like this right now. The overwhelming sentiment is “cautious”, “we are due”, “valuations are unsustainably high”.

But the truth is our collective memory of the GFC has made sentiment a countercyclical stabilizer, stretching out both the financial risk cycle and the economic cycle. Every time we get a little confident or frothy, the scolds come out and remind us of our ‘irresponsibility’ and we all slow our roll for a little while and digest gains.

When you think the rest of the world is now going thru the same, drawn out, semi-deleveraging lower-for-longer recovery we experienced–which keeps a damper on our speed limit as well–begrudging good news could go on for a long, long time

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Credit managers have been suffering for years now. Yeah, I know that sounds strange given the run credit markets have had. But the truth is they’ve been suffering from sticker shock since 2011. “But what can I buy at these levels?” has been their constant refrain. Many have been underperforming their benchmarks and bogeys for years.

How did they fall into this trap? Start with the chart of the BBB spread over the last 15 years. 

Credit managers have anchored on spread levels and yields from the strong phase of the last risk cycle, 2004-2007. Spreads then were 110-130bps. Today they are 138bps. Five-year BBB yields then were 5-6%, whereas today they are 3-3.5%. Credit managers have been forced into chasing yields lower and lower for the last 5 years.

What they’ve been overlooking is the risk free rate. The 5 year risk free rate averaged around 4% from 2004-2007, and now we are at 1.8%. If you look at how much risk-free yield (opportunity cost) you are giving up to collect extra spread, it becomes obvious that a spread of 138bps is far, far cheaper when the risk free rate is at 1.8% than when it is 4%. Spread-to-spread comparisons just don’t make sense. Yet that’s what we keep hearing. It’s kind of shocking, really, how many professional managers–especially those with a lot of experience, paradoxically–have been blinded to this simple but powerful consideration.

The TL;DR: Credit markets aren’t as rich as you might have thought, and in any event, the credit cycle is likely to end around the time the economic cycle in the US turns, irrespective of valuations.

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The forward points on BRL and MXN show, approximately, a 6% breakeven depreciation over the next 12 months. Or, in other word, 6% carry. If you believe emerging markets are in the early phases of the same kind of slow, muddle-through recovery we have seen in the US and increasingly Europe, it is hard to imagine spot underperforming the forwards as a longer-term investment proposition. This is the phase of the global risk cycle where the desire for returns is very high but the forward-looking scope for returns in the US market appears limited.

It also looks to me as though there is still tons of scope for further “normalization” from the unwind of the EM bear market.

NB: This blog is currently unlocked. It will convert to locked, accessible to @BehavioralMacro subscribers through PremoSocial, in the near future.

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Up until recently oil stocks have been about playing/gaming some type of normalization from the 2014-15 crash. Mostly, repeated attempts at knife catching. Over this past month or two it seems investors are finally looking a little beyond this and starting to price in the secular challenges facing global oil supply & demand.

1.       Electric car dominance is no longer a question of “if”.

2.       The fuel intensity of global growth continues to decline, as emerging economies catch up with the well-established trends in the advanced ones.

3.       Extraction technologies have become vastly more productive and less expansive.

From an investment standpoint, this is a headwind—whether the price of oil is rising or not. If the price of oil were to rise, no doubt oil stocks would also, just probably with a lower beta to it. It makes the sector a much less attractive risk-reward proposition, despite how beaten up it has been.

NB: This blog is currently unlocked. It will convert to locked, accessible to @BehavioralMacro subscribers through PremoSocial, in the near future. 

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I’m trying something new.

I’ve been looking for months for a better way to share my core competency: global macro investing and trading. My public twitter account and blog no longer reward my effort the way they did when I started tweeting, disincentivizing thoughtful output. And I’ve got tons to say about patterns, narratives, correlations, investor reaction functions, position sizing tricks, portfolio construction, managing mental capital, fundamentals, etc. I live for this game.

So, I was pretty happy when I stumbled onto Premo, the brainchild of the folks at the Bespoke Investment Group. Through Premo’s new platform, I have set up a private, subscription-based Twitter account, @BehavioralMacro, and expect to add to it a locked blog in the near future. It will be all global macro, all the time. And for those of you who’ve followed me on my public Twitter feed, @mark_dow, you know what I mean when I say all the time. There will be no dog pics, no cat pics, no politics, and no puns, either. The focus will be exclusively on reading market trends, patterns and sharing my macro trading/investing processes.

Becoming a follower is easy. Once you subscribe at my @BehavorialMacro profile page on Premo, it’s done. You’re immediately added as a new follower. You can cancel the subscription at any time on Premo as well. Couldn’t be easier. I’ve already been posting to the new feed for over a week, so you should be able to get a sense of what I want to accomplish right away. Most of it will be about process. Some of it will be actionable, but the focus will not be on specific trade recommendations or a blow-by-blow of what I am doing with my portfolios. It will be about sharing my tricks, techniques and frameworks for reading markets and managing global macro risk.

DMs will be open, and I’m going to use the feed to engage as much as possible.

The subscription will be set at $30 a month—at least at the outset. Targeting institutional investors would allow me to charge considerably more, but it would then not be accessible to motivated individuals who want to piggyback on my experience to get up the learning curve faster. If I were to price it too low, I would be basically giving it away to a market segment that could and should pay more. From preliminary discussions, I suspect the price is more likely to be adjusted up rather than down, and, at some point, I may want to cap the number of followers, but it’s really too early to say for sure. I want to be responsive to how things unfold. I hope you bear with me through the trial and error. 

I’m excited about this new experiment. It should allow me to better share my skill set. The platform looks cool. I hope you’ll give it a try. To join, you can subscribe below:

 https://premosocial.com/BehavioralMacro

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I know everyone likes EM. I know it has had a great run the last 18 months. I know the Fed is reducing its balance sheet.

But consider this:

1.       EM had a prolonged bear market, and large allocators are always slow to get back in after a cyclical bear. Expressing bullishness and acting on it can be very separate things.

2.       The EM cyclical bull is on—albeit much in the same muddle-thru way we saw in the advanced economies. Expect ‘slower for longer’. It was a global credit boom, and we are experiencing a global, asynchronous, muddle-thru recovery.

3.       This is not your father’s Emerging Markets. It’s well past time to give up on the generational blowup he bought his beach house with.

4.       Other major central banks are far earlier in their monetary tightening cycles than the Fed is—and the Fed (and markets) have just penciled in a lower terminal federal funds rate—again.

5.       This is very bearish the dollar—ergo bullish EM. Moreover, the other factor holding back EM bullishness has been the fear of what higher US rates might do to the asset class. This fear too has lessened considerably.

6.       Others have been unwilling to chase and have been ‘waiting for a pullback’. Well, we just had one and it was so shallow and fleeting (common at the beginning of bull cycle) that few got the chance to wet their beaks. And, to quote from the Trader’s Bible: “They’re panicking out there right now, I can feel it”.

7.       EM indices all over the world are breaking out to new highs (pick one).

8.       The dollar (to my eye) seems to have made a blow off top in the wake of the US election (red circle). Lots of scope for depreciation.

9.       Long term EM currency charts suggest massive room for further appreciation. Here are a couple from our backyard (they also have tons of carry):

10.   European rates are now rising faster than US rates. If this really is the moment where markets recognize that Fed normalization is closer to its end and ECB normalization is just starting, this is likely to persist. 

If the above is at all correct, this is a very, very bullish set up for EM—despite the EM bull being 18 months in. And, if you know how this game works, you realize how hard and counter-intuitive that is to say. And it also means that the pain for those who have missed the EM train is only going to increase.

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The Great Financial Crisis shook a lot of trees and made many economists/investors/traders go back and question first principles—at least it should have. Here’s a quick list of Things We Should Have Learned by Now:

1.       Potential growth in developed economies is lower than it was before the GFC. And policy can’t do as much about it—whatever your policy inclinations—as we’d like to think. 

2.       The interest rate sensitivity of economic activity is far less than was believed to be the case.

3.       Printing money can cause inflation, but doesn’t always. Asking what are the conditions under which it is likely to, and if those conditions obtain, is the smart question. 

4.       The economic channel of monetary policy and financial channel of monetary policy have to be thought through jointly and separately, and often have very different requirements and equilibrating dynamics.

5.       Oil matters less. It didn’t help the consumer as much as forecast when it fell, and didn’t hurt GDP as much as others suggested, either. Oil intensity of GDP or share of consumption basket is far lower than the levels most observers—consciously or unconsciously—had anchored on.

6.       The overall commodity intensity of output has declined significantly and will continue to do so. It is in some sense the very definition of technological advancement.

7.       Commodity markets (IDK about softs) are driven in the first instance by speculation, which regularly overwhelms fundamentals.

8.       Inflation/wage impulse per increment of GDP has been systematically lower than thought. And transitory shocks are often, well, transitory.

9.       EM has structurally changed—for the better.

10.   Government intervention is a necessary evil in a financial crisis. What’s desirable isn’t always feasible. Path dependency is dominant. And circuit-breaking the self-reinforcing downward spiral of panic is essential.

11.   The bond market—in both shape and level—has been telling us very little about US economic prospects/activity. However, short-term changes do inform us as to the prevailing narrative.

12.   Economics should be used for diagnostic purposes, not predictive ones.

13.   Very few investors/traders can disentangle their political preferences from their economic analyses. Systematic traders, disciplined risk managers, and passive investors have a big advantage in this regard.

14.   The Mexican peso is not a petro-currency; Mexico imports more petroleum products than it exports.

15.   Brazilian growth is driven primarily by domestic credit, not commodity exports.

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These are my views of where we are in markets right now:

1.       The Fed is more committed to the abstract notion of normalization than the market, still, in the aggregate, gives it credit for.

2.       We now know with very high likelihood that they want to start with the balance sheet reduction ASAP, and will, in the first instance, push hikes out further as need be to see how well it goes.

3.       Grinding global growth (by historical standards, not recent ones) is likely to continue as global demand continues to work its way out from under the Global Credit Boom. This means the ECB, BOJ, and BOE will be talking more, not less, about their own normalizations. And they too would love to normalize.

4.       Central banks normalization, New Normal-style global growth, and EM muddle-through is likely to be the dominant backdrop theme for the foreseeable future.

 The implications of these beliefs:

1.       On balance, a weaker USD. The US shifting to the balance sheet from rates as the front-burner tool, and global CBs ‘catching up’ to the Fed are the major drivers. EUR, AUD, EM all good. The positioning/psychology in the USD doesn’t strike me as too extreme, so USD weakness doesn’t have to be dramatic.

2.       Bond yields should go higher in Europe and be flat-to-marginally higher in the US. The ECB catching up with the US should bring European yields up off the floor, but the Fed pushing out rate hike should take the pressure off fixed income sellers, who have been under a little bit of pressure of late. I don’t think, in the event, the tapering of Fed reinvestment will have a material impact of yield levels over the short-to-medium term.   Only longer-term, when the taper might be faster and the cumulative amounts greater, should we see any discernible impact.

3.       Weakish USD and weakish bonds put precious metals in a box. They tend to respond positively to the former and negatively to the latter. Of the two, they tend to be more responsive to bonds than the big dollar, but both matter.

4.       Central Bank normalization means they have won and the doomsday scenarios lost. Basically. This too drags on precious metals over time.

5.       Grinding global growth means ‘slower for longer’ in the equity market. Up over time with earnings, down with the occasional (and lately infrequent) corrections. Not sexy. But positive —more positive than prevailing market sentiment at least–and certainly not tragic.

Long-term chart of $EURXAU (long euro, short gold):


AUD over the past 5 years:

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This is the last of the 3 parts to the recent Interview on Sirius XM Channel 111, Business Radio Powered by The Wharton School, with Jeremy Schwartz. I welcome the feedback/comments.

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