Looking for a Return of Global Growth
To state the obvious, there were numerous swings throughout the 3rd Quarter that moved the portfolio a little more than we would like. However, given our positioning, which leaned towards defensives and stability, we were able to benefit from most of these swings.
Along the way we made several adjustments to the portfolio as sentiment moved against us at the beginning of September. As seen by our beta, we’ve already repositioned our pairs to a similar risk level as early August.
Although we focus a large amount of time on relative fundamentals and macro, this quarter is a perfect example of why we spend a significant part of our day analyzing sentiment. While sentiment can be measured in numerous ways, we take a blended view of quite a few items across all asset classes to give us a more complete view of the market.
As we enter the 4th Quarter, we expect to continue to see similar movements in the market as it wrestles between fears of recession and a return to growth. Our view is that recession fears will dissipate in Q4 as the rate of change of trade and manufacturing data begins to stabilize and returns to growth in the months ahead. Based on market positioning and most sell side research, this would be an out of consensus view.
Currently, we see the global economy working its way through comparisons from 2H18 that included a substantial increase in US fiscal spending and a race to beat the January 1st tariff increase. Even though global manufacturing peaked around January 2018, as measured by the JPM/Markit Global Manufacturing PMI, understanding how these factors benefited specific segments within manufacturing and global trade is important when analyzing the data. The combination of slowing growth and comping against the strongest part of 2H18 has led to some absolutely horrible economic data points. This has led some market participants to believe that a recession is the most likely scenario going forward. We would disagree.
While every recovery begins with the year over year change lessening, sustainable recoveries are made possible when the leading indicators are improving. Since we are not seeing significant risk taking in the economy, we tend to believe that the inflection of the leading indicators will allow this economic cycle to extend even further.
The thing to remember with leading indicators is that as the global economy changes, so do the ones that give the strongest signal of future demand. For decades, a change in interest rates would lead a change in demand, as measured by ISM Manufacturing. However, as interest rates continued to decline, this was no longer the case as shown by the correlation weakening the past 15 years. This is not to say that interest rates don’t influence the decisions of consumers and businesses, but it has lost its effectiveness as a potential signal of future demand.
Instead of interest rates, we focus on the money supply. For a while, the growth rate of US M1 served as a strong leading indicator of demand but the strength of this indicator began to decline a few years after the change in interest rates broke down.
As China has continued to grow in importance in the global economy, especially since the financial crisis, this has led to the strongest correlation to future demand changing to a combination of M1 for the US and China.
The strong correlation of the combined M1 that began around 2009 can also be seen strengthening as a leading indicator against commodities like oil and industrial metals…
…major trading partners of China…
…major trading partners of the US…
…US Industrial Production…
… and, finally, US Intermodal Rail Volume.
Also, utilizing M1 as a leading indicator is not just a US and China phenomenon. As noted by Morgan Stanley, Euro Area Manufacturing PMI could soon be improving.
Additionally, JP Morgan’s Global Capex Nowcaster looks to be bottoming, which in turn would benefit global capital goods, exports, and industrial production.
One headwind still impacting the global economy are the tariffs. However, the effect felt by them will peak around the same time that the economic data could potentially inflect. Goldman Sachs has calculated that the negative growth impact from the tariffs should peak in 4Q19. Meanwhile, Cornerstone has estimated that the cumulative inflation of the tariffs will peak in 1Q20.
When thinking about the potential of inflation from commodities, the days of supply held at warehouses are very low compared to the past forty years for most industrial metals.
Furthermore, days of supply for oil is also near the lows of this economic cycle. This is also without knowing if Saudi Arabia will have any production issues as it tries to get Abqaiq back online.
As to how a commodity spike would impact businesses, there were numerous earnings calls of goods producing companies by late 2017 talking at length about how commodity prices were affecting their profitability. At that time, businesses were only able to pass on some of the increase while making no reductions in their workforce. Given that profitability has not recovered to the previous highs, if we do see a similar or greater spike in commodities, we doubt that businesses will be inclined to see their margins decline much further without first trying to increase their pricing.
It is important to note that we don’t use M1 or economic data as a timing mechanism. However, we do use it as a guide for a potential change in positioning that we need to be aware of.
Given our continued preference to be positioned in defensives and stability, missing or fighting a turn like this would be painful, even if it ends up only being a 3 to 6 month counter-trend move. Therefore, our focus will be primarily on our sentiment indicators to lessen the probability of missing the potential transition as it occurs in the market.
Finally, and as stated previously, we continue to invest more than 90% of our liquid net worth in the fund and will continue to do so in the foreseeable future.
As always, we are happy to discuss the portfolio structure and drivers in more detail for serious inquiries.
CEO and Portfolio Manager
Eventurum Capital LLC