The trade of 2016: do the opposite of consensus

A view I have been advising in 2016, perhaps rather cynically, is doing “the opposite of what feels right”.

Source: Bloomberg

In many cases aligning investment portfolios to do the exact opposite of the consensus view has worked well, especially for those who have traded bonds, which continue to be the most influential asset class.

Take the consensus call from sell-side strategists on the US ten-year treasury by way of an example.

We started the year with the consensus expecting the US ten-year treasury to close out the year at 2.75%. The call was premised on seeing four rate hikes from the Federal Reserve, but as soon as everyone started talking about “deflation” and “recession risks” in July, we saw yields fall to 1.31% and subsequently the consensus estimate was lowered to 1.7%. We look to be closing the year shy of the original estimate of 2.75%, with traders no longer talking about deflation but positioning for inflationary risks.

As things stand, the market is expecting the US ten-year to average 2.57% by Q4 2017, with the Federal Reserve (Fed) expected to hike two times in 2017. Analysts’ estimates range from 3.6% to 1.35% – these diverging calls paint two very different pictures of the US, global growth and inflationary trends. It is now widely thought that monetary policy has reached its limits and that fiscal stimulus has taken over as the new kid on the block, but when US Federal government debt is already close to 100% of GDP, It seems unlikely in my opinion that yields will trade to 3.6% as the servicing costs (with such elevated debt levels) would be 10% of GDP!

Donald Trump can increase the fiscal deficit to boost growth, but doing so when the debt-to-GDP dynamic is at such worrying levels is fraught with dangers if bond yields rise too fast too soon. I see downside risks to bond yields from around Q2 which could have wide-ranging implications for markets, especially the USD and gold.

USD shortage a major issue for 2017

One of the biggest event risks for 2017 and 2018 is the fact that non-US borrowers have to roll over a huge amount of USD-denominated debt, which they accumulated through the Fed’s various quantitative easing (QE) programs. With rising bond yields and the trade-weighted USD at a 14-year high, there is a real risk that getting access to USDs is going to be a major problem, notably for emerging markets and Asia. This puts upside risks to the USD in itself and although being long the USD is a major consensus trade for 2017, it seems hard to bet against at this stage.

Positioning for USD/JPY upside is one of the most recommended “trades of 2017” from brokers, and although the consensus is the pair averages ¥110.00 by Q4, the various estimates range from ¥128.00 to ¥97.00. The fate of the pair once again will be dictated by US bond yields and the yield premium commanded over Japanese government bonds. The greater the yield premium (of US bond yields), the higher USD/JPY will be.

Global political events have schooled so many

I think it’s fair to say that global political events have schooled so many in understanding what to expect, although in most cases the opposite result from consensus has come true. Perhaps more importantly, the actual reaction in financial markets has been widely different from what the consensus had said would happen on this very outcome.

So as markets bounce from event risk to event risk, 2017 will be riddled with political outcomes that traders will have to navigate. Certainly the French (between April and May) and German elections (Q3) will be front of mind and specifically those questioning the sustainability of the European Monetary Union (EMU) in the face of rising populisms. Italian politics and the mountain of non-performing loans is also a key issue for markets to deal with.

Further gains in oil expected in 2017

With inflation expectations rising in many economies, oil continues to be a key focal point in 2017 and again we find an asset where forecasters have been continually wrong. As things stand, the consensus is calling US crude to average $54.64 in 2017, but where oil trades will largely be driven by OPEC’s ability to adhere to its new production quotas of 32.7 million barrels a day. There is natural scepticism that the cartel will meet these targets, but it won’t really be evident on whether they are being compliant until late February to March. The real headwind remains the US shale producers and there is a view that OPEC and non-OPEC may well be underestimating the response from US shale producers if we actually see production quotas respected and oil trades into $55-$60. It seems unlikely we will see a collapse in oil prices in 2017, but it’s hard to envisage a move too far above $60. As mentioned, it seems prudent to prepare to be surprised.

In terms of asset allocation, equities are still preferred over fixed income, as they are every year and the trade which has become consensus is being long stocks that benefit from higher inflation. This includes energy, financials (including insurance) and materials. With this general belief that developed market bond yields should head higher, investors should limit exposure to stocks that have a high dividend yield, are expensive and have been issuing sizeable levels of corporate debt to buy-back equity to support their share price. Of course, in a rising bond environment, stocks that have altered their capital structure to increase their debt allocation (such as tech, utilities and staples) are going to attract sellers.

Japanese and US equities seem to be the preferred geographical preference from strategists, and this seems to be where the big investment flows have been aimed at, but we must remember there are real risks to this view in 2017. As discussed, political shocks could easily cause a deflationary event in 2017 and markets just aren’t prepared for this. Importantly there is a lot of “hope” built into Trump’s plans for fiscal stimulus, not to mention OPEC and certain non-OPEC’s plans to rebalance the oil market, which suggests downside risks to US (and developed market bond yields) and presumably the USD if the execution is not spot on. As we have seen in 2016, if we go into 2017 understanding what is expected but happy to not fall in love with a view and cut our losses (and admit we are wrong), then you’ll greatly increase the chances of profit.

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