Sunday, July 6, 2014

How much cash is too much...?

On May 22nd 2013, the then Chairman of the Fed, Ben Bernanke, announced plans to steadily reduce the monthly asset purchase programme known as QE. At that stage, the Fed was purchasing around $70bn a month of various asset back securities. That day, US Treasury yields spiked from 1.94% to 2.03%, whilst Japanese JGB's also shot up.

The effect on non-US markets was instantaneous: European markets dropped 2%, the Yen strengthened by 4%, the Nikkei dropped by 7%, and Asian and Emerging Markets also fell sharply. The EM debt indices declined 3.5%. Whilst the US, European and Japanese markets all recovered those short term setbacks, the Asian & EM markets remained in the doldrums for the remainder of the year, as did fixed income with EM debt down 14%.

Given the seriousness of the demonstrated reaction to the gradual reduction in the QE programme in mid 2013, what's the likelihood of this type of  "taper tantrum" being repeated this year, or in 2015, as we move closer to the moment at which the Fed actually starts raising interest rates?

Ironically, of course, rates will start rising in a belated reaction to the strength of the economy (specifically the US economy). Normally, a stronger economy is supposed to be good news for stockmarkets since it means better earnings and cheaper market valuations, right?

Although the current Fed Chair, Janet Yellen, is often at pains to emphasize that her Fed prefers to err on the side of "lower for longer", to avoid the risk of de-railing renewed economic momentum, there is little doubt that the continuing US recovery will result in rates being raised at some point next year (even if the initial moves will be very minor given the current "zero to 0.25%" current range).

Although the economy will be deemed robust enough to bear the increased burden of higher rates, it will be the mere change of direction - from flat to rising rates - that will represent a seminal shift for markets and sentiment.

When it does happen, it is also likely that market will over-react. It always does.

A good piece in today's FTfm section highlights the way in which "unconstrained" bond funds are viewing this scenario. Unlike their traditional bond fund brethren, such funds are, by definition, "unconstrained" by such niceties as being fully invested, and "have been given licence to stray from traditional market benchmarks, and focus instead on making the best positive return they can from investing across the fixed income markets".

Such funds are keeping 60% of their portfolios in cash at present, "fearful that too many areas of the bond market [have] become overheated and too many trades [have] become crowded".

This is where the difficulty arises: is it fair to charge investors a fee for sitting on cash?

The fund manager would suggest that it is (although we'd obviously expect them to say that), on the basis that you are paying the manager to generate returns and/or protect your capital. As the FT notes: "inevitably it is a question of timing", as the manager uses the cash he has carefully hoarded to jump in when the imminence of monetary tightening starts to cause panic amongst bondholders, thereby causing a big sell-off in fixed income markets.

As we saw in 2013, when that happens, the knock-on effect to stock markets is potentially significant: typically the higher beta markets (Asia & EM) get hit hardest as investors run for the exits and head for safety (probably cash). We have seen many times before that buying at such moments can lead to substantial gains in subsequent months if one is brave enough to jump. The key thing is having enough cash in reserve at the time to take advantage of such dislocations.

But - how long are investors prepared to wait...? The JP Morgan unconstrained fund, which holds 60% of its assets in cash, is sitting in the bottom 20% of its peer group for returns so far this year.

Waiting for the feared crash is starting to get expensive.

Our experience has also shown that clients don't like sitting on cash for periods of longer than a few months - understandably.But when does the need to preserve capital offset the shorter term drive to maximise returns?

Our answer to that is that - like everyone else - we don't know. But at some point, it will make sense to take a view and lock in gains and raise cash in preparation for a short-term market sell-off. Just not yet....



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Monday, June 23, 2014

Steady as she goes...?

A good piece from John Authers in the FT on Saturday (June 21st) highlighted 8 reasons to remain comfortable about US (and therefore Global) equities:

(1) No signs of Greenspan-ish "irrational exuberance" in a market which looks "controlled and methodical". There are no signs at present that prices are unsustainable.

(2) Continuing low levels of volatility. The VIX, which is frequently described as the "gear gauge" is near its lows for the year of 10.85 and has fallen by 21% so far in 2014 (by contrast, it stood at just under 90 during the Lehman crisis of October 2008).

(3) Relative valuations between stocks in the market are broadly under control, notwithstanding that fact that some areas of the market: biotech, internet and small caps look expensive.

(4) Sentiment remains suspicious - we're not yet at the "taxi driver" moment when everyone, including your local cabbie, is diving into the stockmarket. This is borne out by that fact that surveys of clients in Asia still point toward high cash weightings. Only after this stuff has moved off the sidelines should one really start to worry.

(5) M&A activity is still fairly muted. We're not yet at the same point where AOL used clearly overvalued shares to buy TimeWarner at the peak of the dotcom craze in 2000.

(6) High Yield Corporate bonds are not yet showing any signs of stress, with yields remaining stuck at historic lows.

(7) Gold, although rallying a bit of late, has still some ways to go before it highlights significant nervousness about other assets. We're less convinced by its validity as a real measure of fear and uncertainty but it bears close watching.

(8) Bond yields overall remain low, suggesting a still fairly relaxed global view on inflation and interest rates.

The FT's summary is" Barring a hawkish surprise from the Fed (certainly not forthcoming from last week's meeting) or some external [shock] such as escalation [of the conflict in] Iraq, it looks as though we must wait for a correction".

Last week Merrill Lynch was highlighting the possibility of a "melt-up" during the summer months. We think this looks possible, so hang in there....



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Javelin Wealth Management supports the global microfinance philanthropy initiative, the education charity,, and the Singapore Children's Cancer Foundation, New clients to the firm can nominate any or all of these charities for a donation we make on their behalf.