2016 was a year of ups and downs and many unexpected events, but they are merely symptoms of the signs of the times.. If any, 2017 would probably be tumultuous as well, and as global macro investors, we are rewarded and protected by being opportunistic, nimble and adaptable. Like the famous Bruce Lee used to say, the way to be triumphant is to be like water, shapeless, formless and flexible.
Since the start of August 2016, I ended 2016 down 3.89%. Due to heavy work commitments and exams to study for, I was unable to commit more time for the portfolio. As such, I kept a high amount of liquidity, lowered the portfolio’s maximum downside risk limit to 10.0%, and kept individual risk positions smaller than the usual size.
It was a frustrating period of time as there clearly were discernible trends to trade. My entry and risk points were not well calibrated. For example, throughout the second quarter of 2016 to July various indicators and data points started to suggest that China’s economic situation had roughly stabilised. Whether or not it was a ‘Soros-type false trend’, the markets liked it and I figured a way to play that situation was to play a rebound in base metals – like iron ore. Iron ore stocks have been beaten down for the past 3-4 years as China entered an economic rebalancing, and many companies had to take painful asset write-downs and implement cost-cutting measures to improve their bottom-line, which naturally sows the seeds for a cyclical rebound. I followed price action of iron miners like Vale and took a long trade in August (blue arrow), but was shaken out only to see prices retrace downwards and then continue surging higher. This serves as a strong reminder to me that trade implementation and management is as important as the idea itself.
I did not re-enter a long position in the subsequent breakout as I started to doubt the rally in iron ore prices due to my belief and bias of a stronger USD trend for 2016. Frustrating as it was, I also did not capitalise on the USD’s rally, especially since real estate tycoon Donald Trump won the US Presidential Election in early November.
The USD has several strong macro drivers that will continue to propel it higher against many currencies, and I pointed out in October about the potential strength the USD has. One currency that the greenback has much weight over is the Singapore Dollar (SGD), and I was bearish on the SGD (bullish bias on the USD/SGD pair) but unable to express my view as it was a tough FX pair to implement a position psychologically due to its wide retracements historically:
I was unable to capitalise on the greenback’s rally against many emerging market currencies as well as developed market currencies. The swift rise of the USD since November hardly had any retracements at all, making bulls that would like to enter on a pullback in a difficult position to join the trend. A look at the historical prices of the USD/JPY pair tells us that the recent rally had hardly any breather (no pullback). Additionally, the yen’s recent movements against the USD may not be an actual ‘super-bull’ move yet as it is still within a range on the higher time frames:
Looking back over the past 9 weeks, I could have given more weight to price action and obeyed it. However, due to the almost-consensus bullish view on the USD, there could be several rounds of greenback weakness soon (January?), and should it materialise, opportunities to build USD long exposure will be presented. In particular, going long on the USD against several emerging market currencies may offer the higher probabilities of being successful. Several currencies of interest would be the Turkish Lira (TRY), Chilean Peso (CLP), Brazilian Real (BRL), Indonesian Rupiah (IDR), Nigerian Naira (NGN), Egyptian Pound (EGP) and the South African Rand (ZAR). These emerging markets are vulnerable to not just the USD’s rise but a shift of capital flows from the periphery to the core as they see a tightening of domestic financial conditions. The Bank of International Settlements has a recently released research paper on this issue.
Due to their relatively high cost of carry, one has to be nimble with such bets. I am currently considering the USD/TRY and the USD/ZAR pairs. The USD/TRY pair looks set to continue its uptrend, as seen from the weekly chart:
For developed market currencies, I’m currently holding a short position in the Euro against the USD, although the level of consensus for the EUR/USD to hit parity makes me cautious on my current position. I’ll use price action movements to guide and manage this trade. Other DM currencies that may present opportunities are the GBP, SEK, CAD, AUD, NZD.
Another area of concern in the FX space is the continued weakening of the Chinese Renminbi against the USD. This could further raise volatility in the FX space and among Asian currencies, and could exacerbate given the rise of populism in the West and as the incoming Trump administration moves into DC. The Yuan requires further monitoring as the Chinese deal with their balance of payments issue and their domestic economic situation, especially when the Lunar New Year beckons since its the time of the year when liquidity normally decreases (the People’s Bank of China depleted 23% of its foreign reserves in 2016!)
Over in the fixed income space, the relatively strong surge in bond yields across the world since Trump’s election victory in the US also caught many off-guard. However, I wasn’t too surprised as the bond markets this year had one of its strongest performance in its history before October! It’s ironic that at the possible end of a long bull market, the change in its trend is marked and preceded by one final upward push (like a blow-off top literally). There could be a rebound in global bond markets, especially in long duration sovereign debt if global equity markets sell-off after December 2016’s ‘Santa-Claus’ rally. That would be a great opportunity to prepare for further shorts in certain bond-proxies like real estate investment trusts (REITs), utilities and dividend-yielding consumer staples stocks. Here’s a chart of the SPDR Select Utilities ETF (XLU), an ETF tracking the S&P 500 Index’s utilities sector. Prices of US utility stocks look like they have finally turned, and in a rising rate environment, look ripe for shorting as debt financing costs increase and a movement out of defensive sectors (into cyclicals) continue to take place:
Over in the equity space, the rally over the past 9 weeks was strongest in cyclical sectors like financials (banking stocks), industrials as well as materials. Financial markets have been pricing in the expansionary fiscal stance of the incoming Trump administration, and moves look extended on a short term basis. In fact, these areas are vulnerable to a sell-off if the Trump administration run into implementation issues and fail to deliver according to expectations. In these areas, we’ll have to play by ear and monitor…
A probable scenario that I could envision is positively-moderate economic improvement in developed markets which feeds into continued performance of banking stocks, which may increase investor optimism on the global economy and many industries and sectors. This is due to the fact that investment sentiment on banks globally was so terrible (remember January/February 2016?), and it has only started to recover slowly recently. Should this scenario develops, banks could allocate less capital for non-performing loans (NPLs) and also increase lending, transmitting more credit into the real economy – perhaps benefiting the small and mid-cap companies. This in turn could lend a hand to stronger earnings growth among smaller-capitalised companies and boosting their stock prices. This is a reflexive scenario that could happen on the European continent.
Due to many clear trends that have developed in the past 9 weeks, I’m increasing the portfolio’s overall maximum downside risk limit, but keeping individual position sizes the same as before to take advantage of more opportunities that I currently see.
To sum up, my thoughts for 2017 are as follows:
- Watch the trend of the rising USD and monitor the Core-Periphery framework to develop coherent theses and views for emerging markets
- Be wary of geo/political risks as populism is on the rise in the West; play defensive if necessary
- Short interest rate sensitive areas like bond-proxies if inflation continues to rise (especially if inflationary pressures rise quicker-than-anticipated, forcing central banks to rein on liquidity in the markets)
- Banks may be in for a strong rally after poor performance in 2016 (dependent on macroeconomic performance and a decrease in political uncertainty risks)
- Be flexible/nimble, opportunistic and adaptable (mental flexibility)
*cover image credits to Forbes*