Fly Fishing and the Market

by | July 13, 2020

As any experienced fisherman knows, a river does not flow directly from its source to the sea. Eddies and backflows are common. In them reside both opportunity and risk for the angler.

The same is true in financial markets. Cross currents abound. Some are sources of return, while others are pools of deception. All contain vital information for those willing to look closely, seeking opportunity while minimizing risk.

Since the end of March, equity markets have risen strongly, with indices regaining most of their first quarter losses and in some cases even reaching new highs. Many stocks, sectors and styles have benefitted, but some investible assets and sub-asset classes have become trapped in side-channels or have even flowed back against the main current. Those exceptions reveal a lot about what’s driving markets and, perhaps, how long the rally can last.

Consider US credit fixed income. Over the past three months, all sub-sectors have made gains. Putting aside equity-linked instruments (e.g., convertible bonds or preferred stock), the best performers since mid-April have been high-grade fixed and floating corporate bonds, municipal bonds and Treasury inflation-protected notes (TIPS). The laggards have been high yield, agency debt, mortgage-backed securities (MBS) and senior loans. Over the past month the market has become even more bifurcated, with high grade, conventional Treasury notes and TIPS advancing, while high yield, senior loans, and MBS have lost value. Three-month returns on 7-to-10-year US high grade corporate bonds have been identical to those on triple-C rated high yield or emerging market crossover debt.

In short, despite the tremendous three-month rally in global equities, US fixed income investors have expressed a preference for quality and duration, not credit risk. Fixed income investors have remained prudent, with few signs of a ‘dash for trash’, which so often depicts the early stages of a cyclical recovery.

Cyclical preference is also difficult to discern in currency markets. Over the past three months, the US dollar has lost ground against all developed currencies, nearly without exception. The top currency performers include some that are traditionally cyclically sensitive, such as the Australian dollar or Norwegian kroner. But other winners include the less cyclical Swedish krona or New Zealand dollar. The US dollar has also dipped in recent months against the Japanese yen and the Swiss franc, traditional ‘safe haven’ currencies. Meanwhile, emerging currencies—typically bellwethers for cyclical recovery—have struggled to regain their sharp Q1 losses, with many weakening again since early June.

As we have noted before, similar patterns can be discerned within equity markets. During most of the rally, large capitalization technology stocks, growth and momentum styles have led the charge, while riskier cyclicals, value and small capitalization stocks have lagged, often considerably. By sector, the best performers over the past one and three months remain technology, consumer discretionary and communications, with financials, utilities and real estate pulling up the rear.

This is neither a pattern of ‘pure defensive’ nor ‘cyclical’, but rather of persistence. Put differently, rotation remains stunted. Growth and momentum have not relinquished their grip on market leadership.

For an index investor, these oddities may seem a distraction. After all, sticking with the market capitalization index has produced strong performance. But even the index holder ought not to overlook its key features—narrowing leadership and increasing concentration. For instance, as of July 8, only one stock in the fifty smallest companies within the S&P500 was in positive territory for the year. An equal-weight ETF version of the S&P500 is down 12% year-to-date, versus the market capitalization weighted index, which is down just 3%. Those figures convey the reality of an index dominated by a few winners and lacking much breadth.

It is clear that without rotation, equities cannot maintain their recovery momentum. Rotation, in turn, should logically require confidence that economic re-opening can be sustained, enabling broader spending and economic activity to durably resume. This is unlikely as long as the Covid-19 virus continues to spread.  In the United States, the outbreak is growing in 37 states, with 60,000 new cases announced last Saturday alone and Florida accounting for over 15,000 of them. Further, eight states set single day infection records last week, with a number of them either slowing re-opening or moving towards a lockdown again. In Brazil, approximately 70,000 people have died, and total cases have surpassed 1.75 million. These dynamics are playing out in numerous countries around the world, from India to Russia to Peru. In short, the pandemic is not under control and there is a strong likelihood of a further delay in the resumption of international commerce and finance.

Yet, at the same time, monetary and fiscal policies worldwide remain supportive to those part of the economy which are functioning, with the beneficiaries largely identified by investors. The upshot is that what has worked for investors continues to work, explaining why market momentum and leadership remain intact. In turn, the prevailing market view seems to be that only exogenous factors – the development of a vaccine on the positive side, a serious viral mutation or geopolitical shock on the negative – will change the current course of markets. For now, the growing rate of infections continues to be met with a shrug from investors. Perhaps they are banking on a miracle vaccine in the near-term, perhaps they believe there is no alternative to equities thanks to the actions of the Federal Reserve, perhaps it is the fear of missing out on the rally. Whatever the rationale, the durability should be viewed critically – the U.S. stock market’s PE today is 50% higher than its long term average.

Investors, it seems, are resigned to following the main current of the river. That may be a good strategy for a boater looking to drift along effortlessly, but an angler knows that fishing in the same pool as everyone else rarely leads to anything except disappointment.

Be wary of the prevailing view – it rests on a precariously slim foundation and requires groupthink, which doesn’t last forever.

Filed Under: Economics

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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