Tuesday, April 23, 2013

Is there Method in the Market Madness?

Commodities are in a 'normalisation' process that will drive their prices more in line with their marginal cost of production. We expect this to be a 'one-off' process.

Lower commodity prices are in effect a tax cut and will go a long way to offset the US fiscal drag. Expect the world economy to show more strength in the second half of the year

Gold will not see the previous highs, perhaps not in this decade.

Oil has moved very quickly and violently and it is time to reduce short positions.

Though we are not experts in equities we would suspect that lower input costs will assist prices in the long run.

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A lot of has happened in the last few trading sessions and confusion reigns. We thought it wise trying to put forward our ideas and highlight the sectors and asset classes which will likely be winners, losers as well as how to take advantage of them.

We, here at Archbridge Capital (and we suspect our readers), have survived the moves with little impact. Regular readers will know we had short commodity positions (spreads and outright) especially in energy, which overall offset the adverse moves against us (for instance in the JPY) in those troubling days.

Let us analyse the markets one by one.

Energy:

We have already shared our view that the underlying demand-supply balances favour lower energy prices (see 'I have too much energy' Dec 21, 2012 and 'Anchors Away' Mar 21, 2013) and how to play this theme. We argued, for instance, that, China is becoming a more domestic demand-driven economy and that this would result in her not being 'the same benefactor to commodities as she once was' and why the markets are beginning to move to a more sustainable price level, in line with their marginal cost of production.

The gold market collapse has caused or at least assisted in a lot of the other markets showing extreme moves, as investors have reduced unrelated positions in order to satisfy the margin clerks for their unexpectedly large gold losses. So it was also for energy, where the move in gold has added to the speed and voracity of the move we were expecting - enough so that we have substantially reduced our short oil positions in recent days. (We have done so also in light of refineries coming out of their maintenance season and our expectation that Chinese restocking will commence in the month ahead).

Other Commodities:

It seems as if most view this downward move in commodities as a prelude to a much much slower growing world economy or even a world-wide recession. We do not adhere to this view.

We still believe that growth will pick up in the second-half of the year in the USA, China and even in Europe. In fact we believe this will happen partly because of the commodity price adjustment that is in full swing at the moment, as it represents, in essence, a lowering of taxes. Let us explain:

Most commodities have substantially traded above their marginal cost of production (and their supply-demand balances) for some time. They have been able to do so due to the massive amounts of QE that was injected into the system since 2009. This liquidity fuelled rally has kept commodity prices at unsustainable levels and has correlated commodities, that in essence should not be.

Over the last months we have seen these unfounded correlations break-down, we have seen a more predictable future for QE especially in the USA, we have seen the underlying economy in the US pick-up (with increased bank lending, consumption and a more buoyant housing market). Though these economic strengths have been diminished somewhat by the fiscal drag the US economy is experiencing, we believe that the effective tax cut vial lower commodity prices will go a long way to offset this.

In short, we do not believe that commodities will fall for long enough to create a deflationary spiral, instead we see this move (so far) as part of a 'normalisation' process with which commodity prices will begin to trade more in line with their marginal cost of production.

On gold collapse:

According to our analysis the gold market performs well when real interest rates are negative and expected to either get more negative or stay negative. Since QE is probably not going to be increased in the US it is reasonable to assume that real rates will begin to become positive over time and herewith ending the 10-year gold bull market. We, here at Archbridge Capital do believe that this will indeed occur and that rates will begin rising as we have discussed in "There is treasure in them Treasuries" Apr 4, 2013. We also believe that inflation will not pick up in the foreseeable future and hence we do expect that real rates in the forwards will begin to turn positive as the economies gradually strengthen. We would expect that gold does not see the previous highs in a very long time, perhaps even in this decade.

What does this mean?

If QE was expected to continue or increase while inflation rates remain at the current levels, then real rates would remain negative for the foreseeable future and gold prices should have substantial support. The move in gold, however, indicates that markets do not believe that real rates will remain negative for the next 10 years (as is currently priced). This is in line with our thinking and reporting to date.

However, real rates could turn positive in one of two ways and it is important to note the distinction:

a.) deflation could take hold and even with rates at zero % we could have positive real rates - like in Japan

b.) economic growth takes hold, and gradually drives interest rates higher, starting with longer maturity rates, while inflation takes its time to feed into the system only once capacity utilisation rates and output gaps are overcome.

We are squarely in the b.) camp as we do believe that the amount of ongoing QE in the USA will heal the underlying economy over time and to the extent that economic growth will continue to expand (2-2.5% GDP growth), despite the fiscal headwinds thrown at it - especially with lower energy prices which are in effect a tax reduction and increase disposable income.

We also find a little solace in the knowledge that deflation is what the world's central banks are doing their best to avoid and especially the Fed has clearly stated that they will do everything in their power to avoid deflation, i.e. avoid becoming Japan (in fact even Japan is trying to avoid being its former self (see "Big in Japan" Apr 16, 2013). In other words we would see more QE before we would see sustained deflation in the USA.

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We, here at Archbridge Capital, are not equity traders and only comment on equities at our investors request:

US companies especially have become very efficient in the last few years and their main profit growth has come from cost cutting, which they have done to the bone. The second wind for equities could come from lower input costs and slowly by increased revenues from higher consumption due to higher disposable income.

Though we believe the above holds in the longer term there are some worrying aspects in the short-term for equities as John P. Hussman points out (www.hussmanfunds.com/wmc/wmc130422.htm):

1) There is a highly elevated level of margined investment in the equity markets, close to levels at which previous price corrections occurred.

2) Anecdotal evidence suggests that when equity targets are on the front page of major magazines one is closer to a correction than one thinks, especially when market surveys clearly indicate extreme bullishness

Disclaimer: This posting is for information purposes only and is not intended as an offer,recommendation or solicitation to buy or sell, nor is it an official confirmation of terms. No representation or warranty is made that this information is complete or accurate. Any views or opinions expressed do not necessarily represent those of Archbridge Capital AG. This information is not intended, tax or legal advice. You also acknowledge that the information should not be construed as a solicitation or offer by Archbridge Capital AG to buy or sell any securities or any other financial instruments or provide any investment advice or service. Unless otherwise stated, any pricing information given in this posting is indicative only, is subject to changes and does not constitute an offer to deal at any price quoted. You should be aware that returns can be volatile and you may lose all or a portion of your investment. Past performance of any investment or trading tool is not necessarily indicative of future performance or results.

Tuesday, April 16, 2013

It's so easy when you are Big in Japan

Structural demographic and economic changes are supporting yen weakness

'Tail risk' reduction reduces yen as 'safe haven' and will do so going forward

Open-ended massive QE programmes ('money printing programmes') support yen weakness

Buy US$, AUD, NZD against Yen - expect multi-year rally, first target 90 US$-JPY has been met and exceeded. Next target is 105 US$-JPY.

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The yen has fallen substantially in the last few months, moving in our favour (please see recommendations in our report 'I think I'm turning Japanese' November 25, 2012) and given the recent wild moves in the commodity markets we thought it was time to take note of what has happened and what we expect to happen next.

Government/BOJ policy:

Structurally, not very much has changed in the Yen story except to say that the Abe/Kuroda reflation programme is much, much, bigger and faster than anyone had expected. The BOJ has vowed to end deflation and in order to achieve this they have embarked upon a massive QE programme, which is twice as big as the US programme since 2008 (measured as proportion of GDP) and is planned to be done in less than half the time. Additionally, it is an open-ended programme which authorities have made dependent upon the success of the programme itself (2% inflation p.a.) and have even stated that they may not stop there. In concrete terms: the BOJ will double the size of the adjusted monetary base to 270tr Yen, will buy bonds and other assets at a rate of around 75bnUS$ per month (so more than 70% of all the bonds they issue) - this is money printing in central bank speak and will help to diminish the value of the yen substantially even from current levels.

The underlying economic factors for a weaker yen are also still in place:

1.) Japan's trade surplus has shrunk substantially and is even in deficit from time to time and will require a weaker Yen to adjust to this new 'normal'.

2.) Japan's savings rate has fallen to perilously low levels, which combined with its ageing population has little chance of returning to its old highs. Combined with increasing debt (which is already above 200% of GDP) which will struggle to be internally financed (without the BOJ that is), will put pressure on the currency.

3.) Increasingly its 'safe haven' status is being diminished as tail risks are being priced out of the markets as we have proclaimed in previous reports (also demonstrated by the low volatility across asset classes).

There are increasingly less reasons for holding savings in yen, especially if the reflation policies work, as that will result in real rates being negative, rather than the positive real rates that savers in Japan have enjoyed for the past two decades. Structural economic arguments, government/BOJ policy and a change in the population are overwhelming factors why the yen should weaken.

What do investors fear about this trade?

1.) If the G20 begins to brand Japan as a currency manipulator and forces Abe/Kuroda to reduce their policies. But since they have held back from calling China that and since Japan is in fact pursuing the same economic policies as the USA and the world requires more reflationary policies, it is hard to see that Japan will not have the full support of the world economic leaders even if there are some noises made to the contrary from time to time. It is also worth noting that the yen-US$ rate before the 2008 crisis was at 110. If it should get to those levels again, it is hard to see how anyone could seriously claim 'currency manipulation'.

2.) If the Abe-Kuroda programme does not work to create inflation. Well, according to Abe they would keep continuing until inflation is created. The programme could be curtailed if the debt burden was simply becoming too much and money en-masse left the country, while additional debt could simply not be financed any more ie if Japan in short imploded. In this scenario the Yen would in the first instance collapse, completely, to levels unheard of and at unprecedented speeds.

3.) If inflation occurs very quickly and the set target is met within 24 months. The BOJ would be reluctant to raise interest rates since they would need to assure themselves that the inflation pick-up was here to stay and was in fact getting built into the psyche of the population again. Savers would either spend more as their real interest rates had just turned negative and/or would move their savings abroad promptly. This internal move out of the country would be the third wave of yen selling which could lead to yen-$ rates of 125 and above.

Conclusions:

We are not very confident about the longer term economic outcome of this monetary experiment but assume that the policies will be able to push Japan out of deflation, at least temporarily. But whatever the outcome, and however good or bad this ends for Japan it seems clear that a weaker, perhaps a much weaker yen lies ahead.

Thursday, April 4, 2013

Press Snips

We, here at Archbridge Capital are trying to inform our readers about some of the trades that we take ourselves and to demonstrate our views about the markets. In short we put our money where our mouth is and are quiet otherwise. Obviously, we do not publish all our trades and also do not publish our ideas before we have put on the trades ourselves, as we do need to leave some advantage to our investors and ourselves.

We believe that in that spirit we should also update you every once in a while, when we are in the press giving interviews on CNBC, the BBC or Bloomberg. Hence from now on we will share some of our newspaper snippits that are market-orientated.

We have not decided in what shape we will do this. Perhaps we will simply attach a weblink to our usual research reports or like today publish a whole page with the articles attached. We shall be guided by our investors and readers on this.

The below articles published a while ago highlight both our views on volatility at the time (which we tend not to publish in our reports) and our view about the oil price.

----CLICKING ON THE LOGO ABOVE WILL TAKE YOU TO OUR WEBSITE----

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From Bloomberg News:

Brent Spreads Hit 8-Month Low as Supply Recovers

15th of March 2013

By Grant Smith & Rupert Rowling

“Tightness in the Brent market is being alleviated,” said Hakan Kocayusufpasaoglu, chief investment officer at Archbridge Capital AG, a Zug, Switzerland-based hedge fund. “For long- only, commodity-index investors the narrowing of the backwardation is going to make Brent slightly less attractive.”

http://www.bloomberg.com/news/2013-03-15/brent-spreads-hit-8-month-low-as-supply-recovers-energy-markets.html

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From Bloomberg News:

Oil options lure banks on calmest WTI since 1996

31st of January 2013

By Grant Smith & Rupert Rowling

“It’s a very good time to buy options,” said Hakan Kocayusufpasaoglu, chief investment officer at hedge fund Archbridge Capital AG in Zug, Switzerland. “Risks like geopolitical dangers and potential for supply disruptions remain, and have to be priced in again over time.”

Volatility has subsided as the threat to oil demand from economic collapse in Europe recedes and as booming output in the U.S. provides a safeguard against disruptions to Middle East exports.

http://www.bloomberg.com/news/2013-01-31/oil-options-lure-banks-on-calmest-wti-since-1996.html

There is treasure in those Treasuries

US real rates are negative all the way out to 10 years. Without deflation this is not a sustainable situation.

QE will not continue forever and the US economy is turning a corner for the better

Fed policy is transparent and guidelines have been give when QE will be reduced or eliminated - it is the additional purchases that matter not just the stock of money supply

Equities are increasingly a more attractive investment opportunity with higher yields and returns. Expect 10-year rates to be 2.5% by end of year and to rise further afterwards

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Due to massive amounts of QE the yields in the USA have been suppressed to their current levels with 10-year yields trading at 1.82% and 30 year yields trading at 3.06%. This is, in our opinion, unsustainable, as current inflation rates in the USA are around 2% and current GDP growth around 2-2.5%. With these statistics based on historic norms we should be seeing yields trading at around 4.5% in the 10-year region and even higher further out. As a rule of thumb we see 10 year yields in high credit worthy countries at roughly inflation plus the economic growth rate.

Looking at some historical charts of the long term interest rates back to 1790 we only see one period where rates have been this low: the period between 1940 and 1950. For those interested the lows over this entire time was around 2% for long end rates in the USA while the highs have reached above 14%.

There are a number of reasons why over the next 12-18 months we do believe yields in the USA to appreciate noticably.

1.) Tail risks are being priced out of the market as we have mentioned in previous reports and with it investors are increasingly looking at additional sources of income, rather than just capital protection. This is a slow process but is underway

2.) World economic growth is at a turning point for the better especially fuelled by the USA and Asia, while the worst for Europe in our opinion is increasingly priced in (though we do expect a world economic slowdown in Q2 and a pick up in the second half of the year).

3.) Lower commodity prices (see our previous reports) overall will assist in world economic growth to pick-up further over the next 12 months

4.) The Fed has clearly stated what their QE programme depends on i.e. the underlying economic development in the USA and their reflection in the unemployment rate

5.) Real interest rates all the way out for 10 years are negative and outside of the Fed and fearful investors, who will want to own bonds if economies do improve?

6.) More than 60% of equities are yielding more than the 10 year US Treasuries and are becoming more attractive as input prices are diminishing and revenues beginning to pick up in line with economic growth. The normalisation of risk perception is also noticable in the equities market in the USA where the highest performances have been witnessed in high dividend paying stocks. The next step of normalisation will be when growth stocks begin to outperform.

7.) The USA is growing and equity markets are rallying despite the fiscal drag forced upon the economy in 2013. This drag will be reduced in the second half and have less and less impact in 2014. If the US economy and its equity markets can show this performance with the fiscal drag, how good can it get without.

Finally, there is last point to mention that we do not subscribe to in the short-term but it could become an issue in the longer term, and that is the potential for inflation picking up - once the transmission mechanism begins working fully and economies are steaming ahead. Though we may not see much evidence of this but if expectations change the 10-year and 30-year areas of the interest rate curve is where it would get priced into..."There is treasure in them Treasuries". Aye.