Thursday, October 15, 2015

In A World Where "Most Indicators Have Lost Their Informational Value", How Should One Trade And Invest?........

In A World Where "Most Indicators Have Lost Their Informational Value", How Should One Trade And Invest?

A market which trades day to day on historic "whiplashes", record short squeezes, broken trendlines, and of course, $13 trillion in excess liquidity, got you shaking your head (and burning old Finance 101 textbooks)? Don't despair: here is a guide of how to trade in world where "most leading indicators have lost their informational value."

In our latest commentary we ask whether equities are appropriately assessing risks or whether higher FICC ('Fixed Income Clearing Corporation) volatilities are more rational. Both cannot be right. Are equities reflecting fundamentals? Most leading and trade indicators seem to be highlighting that despite aggressive monetary easing by 20+ central banks, deflationary pressures remain strong and growth rates in both DMs and EMs are rapidly slowing. In response, most indicators are signalling an elevated level of risk. However, equity investors seem to be assuming maintenance of 'goldilocks': low rates & ample liquidity; slow (but steady) growth and low (but positive) inflation.

Who is right? 

We argue that most leading indicators have lost their informational value as private sector no longer has any LT visibility, and hence  survey-based responses frequently send misleading signals. Given that FICC investors tend to be intensive macro data users, they are highly susceptible to whiplashes of false signals. As long as public sector continues to dominate macro outcomes, investors are at the mercy of unpredictable shifts, driven by CBs rather than fundamental drivers. 

We are concerned on two counts: (a) global economy continues to reside on a de-facto US$ standard and the US is not generating enough US$ to enable continuing global leveraging (absent strong recovery or QE4, supply of US$ is falling at ~5% clip); and (b) efficacy of conventional monetary policies seem to be largely exhausted. 

As global velocity of money declines, incremental QEs required to grow liquidity are on an ever increasing scale (~US$1.5tr+ in '16 and escalating to infinity). Hence, there is a need to re-assess nature of QEs. We doubt that the alternative of CBs abandoning desire to regulate and 'smooth cycles" and letting deflationary business cycle to reset itself is In the cards.

If conventional QEs lost potency and aggravate global deflationary pressures, why do equities assume that lack of tightening and further QEs would guide economies towards 'goldilocks'? We believe that it is a simple 'Pavlovian reflex'. In the past, this relationship worked because QEs were generally successful in temporarily reducing deflationary pressures. However, short of massive rise in monetary stimulus, it seems that incremental changes would no longer be able to achieve such an outcome. Are we ready for more extreme policies? The next stage is likely to be CBs directly funding fiscal spending, investment and consumption. However, to accept such a radical shift requires 'accidents' and a severe slowdown. Over 12-18 months, chances of both are high.

Hence in the ST (3-6 months) we anticipate neither aggressive QEs (with at best limited efficacy) nor extreme unconventional policies. Therefore, as investors progress into '16, supply of US$ is likely to continue contracting, deflating global demand and constraining liquidity. This would lead to regular bouts of volatility rather than goldilocks and could easily reverse current equity euphoria. 

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