Odd Lots - 57: Was November the Start of a Huge Turning Point In Markets?

Episode Date: December 2, 2016

Something huge happened in November. No, we're not talking about the U.S. presidential election. We mean the worst month in history for the the Bloomberg Barclays Global Aggregate Total Return Index, a bond market index that's more than two decades old. So is this the start of something big, or was it just a blip? In this week's episode, we speak with Bloomberg Strategist Mark Cudmore, a former FX trader, about what's happening in markets around the world. We talk about currencies, inflation, growth, China, the election, the eurozone and more... a full global tour!See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But on Vanguard, at Vanguard, institutional quality isn't a tagline. It's a big line. It's a very big. It's a few. commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com

slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing Corporation Distributor. Hello and welcome to another edition of the Oddlots podcast. I'm Joe Wisenthal. And I'm Tracy Alleyway. So Tracy, markets have been pretty wild since the election. All kinds of stuff happening that people hadn't predicted U.S. stocks rallying, interest rates way up.

It's a pretty exciting time to sort of be covering what's going on in financial markets. Yeah. Do you remember just a few weeks ago people were still talking about Donald Trump as the ultimate tail risk and how the market? was going to collapse if he won. And then it turned itself around almost immediately. The night of the election was crazy because we saw futures plunge like 5%. Right. And then by the time markets opened, most of those future losses had been erased. And U.S. stocks have just been off to the races. And of course, the real big market story has been the rise in U.S. interest rates

because it seemed like interest rates were just going to grind lower perpetually. And now, on say U.S. 10-year yields were at our highest since the middle of last year. Yeah, it seems like, well, I think we've had a couple stories about how the investment outlook has essentially been turned on its head, right? We had years of low interest rates, low inflation expectations, lots of correlation, everything moving together, and that has totally flipped just in the past two weeks or so. And so obviously the huge question now is, was there's two weeks just a blip? is it maybe a longer blip? Or are we seeing some sort of big regime change where market correlations and the trends of growth and inflation correlations are going to be different going forward?

The end of the big bull run in bonds, which people have been worrying about for decades. So this is the huge question. So today we're going to talk about what's going on right now in financial markets. It's sort of a break from our usual fare because usually we talk about something sort of off the news and something. Like one specific thing. Yeah, that's not as timely per se. But today we're going to go super timely and talk about some of the interesting stuff that's happening right now. And we have a great guest in the studio is Mark Cudmore.

He is a FX analyst, Bloomberg FX strategist for – he works for Bloomberg. He's usually based in Singapore, but we have him here in New York, which is a real treat. Mark, thanks for joining us. Hi. Yeah, thank you. Mark, before we start talking about it, what do you do? because you used to be an FX trader. Tell us who you are.

Yeah, I mainly just have great fun, actually, commenting on markets, but my job's a macro strategist for Bloomberg. Okay, macro strategist for Bloomberg. So I tend to try to tie in the various different areas and look in things in a slightly different way. And, you know, a mixture of that world between a trader who's very practical

and an economist who's very kind of model-based, I like my spreadsheets, but it's trying to provide some practicality with those spreadsheets and kind of suit what people in the market are looking at. That does sound pretty fun. It is great fun. So let's get right into it. November turned out to be the worst month.

We have this at the Bloomberg Barclays aggregate bond index, also known as the ag. It's sort of the most famous bond index. There is the worst month in the history of the index was November. It's been on this three-decade bull market. Everyone's wondering, is it coming to an end? Is this regime change? How do you see the world right now? Well, I think that the important thing to remember is we might be coming to the end of the massive bull market and bonds.

As you said, it's been a three-decade bull market. That doesn't necessarily mean it has to turn into a massive bear market now. We could be in this, the consolidation phase. It's not like bonds could continue to go much further. We already had negative yields around a lot of the world, negative real yields. So, you know, the big issue now is, are we really reversing in a significant way or will we just stopped appreciating bonds? Well, we've touched on this in a previous episode, but the thing that amazed me, the most is how Trump's win has pushed up inflation expectations. And it's kind of like, well,

that was all we needed to do for the past six years since the financial crisis was promised some fiscal stimulus. That amazes me. Like, why is it turned around so quickly? There's so much wrong with this when the market reaction, the market perception. In fact, the market narratives got a bit confused, I think. So first of all, inflation was already picking up before the election. There was clear signs of it in wages, input prices. We saw it in China. We saw it globally around input prices. And commodities were going up.

So commodities rose 22% up until November 10th. That's the day after the election. 22% in three weeks. Copper is only up 3% since then. So, you know, really the election's been only a marginal part of this. Fiscal spending, you know, whether Trump does $500 billion or $1 trillion in the next decade, it's irrelevant. China has done over a trillion this year alone.

So, I mean, it's just such a like a small amount of like, input in terms of infrastructure spending and commodities. This is not the real driver. Yes, it's the gloss. It provides another little kind of momentum, another boost for sentiment, which is great. But there's really a real background kind of structural story that's happening in the global economy, and that's caused the pickup, I think. So this is sort of a classic moment then in markets, where you have this trend that's been going on for a while, higher prices, higher commodity prices, rebound in China, wages in the US have been picking up for a while. Then you get this event and suddenly people tell a story about it.

Yeah, I think the main thing is it's a risk event out of the way. It's behind us now. And, you know, before the election, we had fund managers had the highest level of cash they've had, joint highest in percentage terms, highest in nominal terms. They've got to put that money to work. Especially before the end of the year, right?

Absolutely. You know, they can't have a balance sheet where, you know, markets are roaring and they've got it all in cash, and, you know, investors don't get very happy with that. So they've got to allocate it. What's important here is that, you know, markets tend to be dominated by narratives. I love this, like, kind of idea,

that we react to a GDP figure, which is about a quarter that is in the past. And we suddenly go, oh my God, GDP, you know, a couple of months ago was higher or lower. Let's trade everything based on that. That's history. But that's because you can spin a narrative around GDP. And in reality, you know, markets are driven by narratives. There's no point you knowing about an item of data if no one else knows about it because no one else is going to trade it. It's no point going, the world's brilliant and everyone else thinks it's rubbish.

They're going to trade like it's rubbish. What's happened here is Trump's let the markets provide a narrative to what's really already happening, which is a pick up cyclically in the country. global economy. Let's go through. What are some of the signs of the cyclical pickup in the global economy? You mentioned China. Commodity prices are rising. We talked about wage growth in the U.S. What else do you see out there? I mean, I think one of the most important things is we're actually seeing manufacturing data substantially pick up. So manufacturing data in October was the highest more than two years. November, it's ticked up again slightly. So we're at a really high level.

And the important thing is it's broad-based. Sometimes you kind of see pick-ups in one place, but not in the other. The seven largest economies in the world, all about of $2 trillion are all seeing a major pickup in manufacturing. So we're seeing it in all the most prominent economies. We're also seeing banks are starting to do better. Third quarter results were good after like a really, really long slump. It's been a terrible period for banks for a long period of time. Suddenly trading revenues are picking up. M&A, deal making is picking up. So, you know, we've got the financial sector doing well, manufacturing sector doing well, and there's been a level of pessimism out there for a long period of time. And you know what, if we can just change that

narrative. That means people will start investing again. They'll stop being so scared and we can get an extra boost to the economy. So I'm still stuck in the pessimistic narrative, I guess, but tell us. Why are you scared? That's a good question. I don't know. What is your worry? I think because I'm a sort of cynical person by nature that I just tend to buy into the downside more easily than the upside. So like for instance, like a worry for me, I guess, I guess if inflation comes back too strongly. And then it really starts to knock the bond market and what impact that would have on the rest of the market. And then China, like, yes, China has had a very, very large stimulus, but what if it actually doesn't pay off for that much longer? Those would be two major tail risks that I would think about.

I think they're probably the best two ones to address, and they're the most important ones. You know, like, inflation, if it really takes off, will be a big issue, okay? You know, because suddenly we're going to have to hike rates very aggressively and because the massive debt piles and the massive of leverage out there, that's going to cause problems. I'm in the camp, and I'm not in the majority camp, that you know what, we might see a tick tick up inflate, we're going to see a clear tick up inflation. We're seeing it already, but it's inflation rising from way below target. So this is the good kind of inflation pick up at the moment.

Now, if it overshoots, that's not too bad if it overshoots a little bit, does it overshoot massively. I personally think the structural things happening in terms of technology, and you've seen that in terms of commodity prices. We're extracting oil much more efficient all the time, metals more efficiently, producing food much more efficiently. These are important things for inflation, but we're also seeing demographics.

In the wealthy part of the world, you know, a lot less of the world are earning and more of them are retirees. They're older, they're spending down their savings. And that has a different impact on inflation as well. So these things mean that I don't see inflation running away to the top side. But it is a risk.

It's something to watch out. However, even if that ends up being a big problem, we're far away from it yet because we're rising from such low levels. You've got some time to react. You've got some time to play the positive story first. Now, the other one is China. Now, I have to say, as someone who's based on Asia,

I do feel the China perspective on this side of the world is completely misguided. There seems to be some bias against it. I think... Bias against China recently? I know. It does seem shocking, doesn't it? I think one of the things that... I'm not sure how best to approach this first. I guess one of the most important things is

people try to apply an economic model that works for the US and it doesn't apply to the Chinese economy. And what I mean by that is they can instantly allocate resources. I saw a great story earlier this year saying that China might have as much of $1 trillion in bad debt. Well, you know what? If they know that they have $1 trillion of bad debt, tomorrow, China has over $3 trillion reserves. One trillion in bad debt, set up a bad bank, take all the debt. They can do it instantly overnight.

They don't need to seek approval from Congress or Parliament or anything like that. They control the major companies. Right, we've just bought all the bad debt in the country. We now don't have a single bad loan. Oh, and we've still got the largest pile of cash reserves left over. So, you know, their problem at the moment is they actually don't know how big the bad debt problem is. It might be way bigger than $1 trillion. But what I'm saying is the analysis is all wrong.

In the U.S., we'd have to take time to approve that. Also, the government in the U.S. It probably wouldn't get approved these days. It wouldn't get approved. And the U.S. government is also bankrupt. I mean, everyone focuses on the problem in China, right? So what I mean by that is that the corporates. You know, we have our own currency here.

We could print up our own money as well. Yeah, this is the same argument that you could make for, like, the argument you're making for China applies to some. extent to the US. Like, yes, you'd have to approve it, but we could do it. So US could do it by a reserve currency. Well, US could do it by printing money and hoping the rest of the world will keep on letting them print money at an infinite item. But they already are in massive deficit. It doesn't apply on China doesn't even need to print money. It owns, well, it owns all the US debt. I mean, it can basically go, okay, actually know it, we're going to sell three trillion dollars of US debt tomorrow, right? I mean, China has three trillion dollars in reserves, right? It completely dwarves

anything else in the world. So the Chinese government is the wealthiest government in the world. savings rates from consumers in China are very high. The highest end of a wealthy part of the world, like you can completely dwarf anything we've got in the US, UK, Europe, etc. So you've got the consumer is wealthy. Then you got the banks. So the reserve ratio requirement for banks in China is 18%. Now, just to put that in context, for the US banks going into the crisis, we don't actually have an official reserve ratio requirement, but effectively it was 0% going into the crisis. And yet everyone's like, it's going to be like 2008 in China, but way worse. No, no. The banks there have large amount of savings by law

and also it's backed by massive amounts of actually real currency deposits from Chinese consumers. So they've got real cash there behind that. Now, they do have a really, really big debt problem and it may be even worse than we think. The shadow banking thing's massive. But I think that the whole world's focusing

on this corporate debt problem without kind of going, oh, but consumers are actually, the individuals are actually very well off, the government's really well off, and the banking sector's got a lot of assets to go against its very large liabilities. So one part of the problem was we focus on, you know, just one part of the balance sheet rather than the full balance sheet.

And the other thing is I think, you know, where we're underestimating how quickly they can react and do stuff. So finally, I should say, everyone's focusing on the problem that's getting bigger and bigger. And it is. You know, they boosted stimulus this year. So earlier this year they basically said, you know what? We're actually going to reprioritize growth over reform. You know, leave reform a bit later. And everyone's going, oh, my God, the shadow banking problem is going to get even worse.

It's going to be like, you know, it's already the biggest thing in the world. It's going to, you know, blow up. it probably will, but it could blow up in five years time. It's not the story right now. The fact is the story right now is they've gone, we're focusing on growth. So that means growth is re-accelerating in China and that is quite clear from all the data. As a trader, I'm curious on that note, how do you balance the long-term outlook with the short-term outlook? Like, do you literally just say, well, it's a problem years down the road for the next month, I'm just trading over a short-term horizon? And so what's the important timeline or time frame for you, I guess? I mean, that's a great question. It really depends on your mandate and what your product area is and what your mandate is from, you know, the money you're managing. And, you know, there's the full gamut of like ranges there. Some people, you know, might be investing in very short term. And none of these issues even matter because they're not doing economic analysis. They're trading short term momentum. And then there's, you know, people who've got lockup periods and do, you know, set up China funds because they believe that's the story of the next few years. Generally, though, none of these major issues are going to probably come to a head. I would say they're more likely a five-year horizon rather than, you know, even a two-year horizon. So no one should be worrying too much about them right now. You're here at Bloomberg, but you talk to traders all the time. What are the narratives, you know, you have a very sort of distinct take on the global economic cycle right now.

Things are good. China, you say, obviously people are way too pessimistic. You have a very much more optimistic take. Where do you see the biggest gaps between sort of what you see in the world and what traders see in the world? What are the narratives that they're like most clinging to? I think probably the one I think's the largest gap is definitely China. And I think that's the said where I think our analysis is very poor, especially over here in the US. I find a lot of people do very high-level analysis, but they've never been to China and they don't understand the mentality how it works. People there, they're very, you know, it's very capitalist country by nature. People are keen to make money.

They work hard to make money and that helps the system tick and survive. Probably another narrative, actually again, is I think it's changing now. But the last few years, there's been a little bit of a story that US is the one pillar of growth in a slow-growing G-10 world. The powerhouse US consumers specifically. Which is actually rough. Well, the US consumer is still very important. But the US economy has been on the slower than average, even in the developed market world. I'm not even talking about emerging markets, right?

You know, UK grew faster than the US this year, you know, quite clearly. Despite Brexit, UK, 2016 growth will be higher. Oh, we were talking about that the other day. I really, I want to know why the supposed Brexit impact hasn't. shown up in the economic data yet. And you had some really good thoughts on that. Yeah. I mean, okay. Well, I will admit that while I've got a few ideas, it's even surprised me. And I've been optimistic about the Brexit reaction, but it's been, you know, incredibly strong. So I think what's important to notice, the UK economy was doing very well going to the Brexit

vote. But then there was some money held back in kind of nervousness, uncertainty and lack of investment. After we got the Brexit vote, some of that money kind of came in and people started, you know, getting back to life again after it wasn't the end of the world in the first week or two. Now, it's really stepped up. Now, one of the explanations that we were discussing the other day is the point that, you know, companies are going, you know what, I don't know how long my window is of operating normally and therefore they're really accelerating production. You know, they're stepping up investment to get as much done now. You know, they might have trade barriers in some of their imports or exports in a couple years' time. So let's get as much profit in now.

So they're really stepping up activity. You are skeptical that, you know, we've been talking about this post-Trump market. And as you said earlier on the show, you think people are overstating the significance of the election and Trump on markets. And that's fine. That being said, there's clearly just on a global scale a lot of interest in political developments this year, obviously. Votes in Japan, the Brexit vote. We have votes coming up in Europe later this year and then all through the rest of next year. How do you think about political risk, especially if you're used to sort of analyzing things and sort of more of an economic.

framework. Should we just ignore it? Is it all noise? Like, how do you think about it in general? It's a really hard one. I mean, I think it is valid that politics are becoming a bigger input in your whole decision process. The problem is, is that it's a very hard one to pin down and quantify. And when you've got like a data nerd like myself, I want to have a number on it. And I find it hard to put that number in. The other thing that's hard is it tends to be a slow-moving situation. And then you get sudden shocks, like the Brexit vote. Italy's situation is going to take a long time to play out. I mean, it's clearly going to remain a focal point for risk in the Eurozone.

And like, unlike Greece, you can't just, like, silo it or isolated. It's debt market's one of the biggest in the world. It's like the fourth biggest sovereign bond market in the world, I think. There's like U.S., Japan, Germany and Italy. I think those are the four biggest. Or U.S., Japan, UK, Italy. I mean, it's really big. It is.

I think fourth biggest in the world. That makes sense. And, you know, its banks are clearly in a complete mess. And, you know, its political situation will not be resolved one way and the other in the coming months, okay? You know, the whole process takes a long time to play it. And I think people start getting worried about these events and they factor them in, and they go, oh, why did I factor that in?

You know what? We don't have a resolution yet. And it plays on. And then suddenly one day, when you weren't expecting it, you actually suddenly realized the real impact. So I think there's political factors into your investment decision are very hard. Yeah, but this gets back to your earlier point. Like, to some extent you can't fight against the narrative, right? If the entire market is focused on this is going to be bad for Italy or for Austria or

for the Eurozone or whatever. It's difficult to fight that. You're 100% right. And actually, it's funny, you know, before I joined Bloomberg a couple of years ago, I actually gave some talks at a few conferences about the idea that narrative really, really dominates market so much, that your job is to work out when a narrative is invalid

and not fight it as a trader, but to be ready when it turns. So it's not like, this narrative's wrong, this narrative's wrong, I'm going to play it at the other side. It's like, as soon as you start seeing a glimmer of hope that it's changing, you can get on the new trend very quickly, rather than trying to cling to the old trend that's now invalid. So what I think is in this case is that you're right,

you can't fight the worry about Italy. But you know what? It's most likely by middle of this week that people will start going, you know what, we don't have resolution on this yet. We don't know what's going to happen. And this is going to take time to play out. Why am I keeping all my money in my cash, you know? It's almost like gauging the zeitgeist

is kind of more important than actually figuring out what the data or what this specific event means. Isn't this the Keynesian Beauty Contest is all about, right? It's not about identifying who the most. beautiful person is, but trying to guess who other people is going to guess is who the most beautiful are and all that. But of course, everyone's aware of the game. But what you're speaking to sort of shows why, like, smart people can be very bad traders, right? Like, people who are, like, it's easy to overthink it or think that everybody is wrong, but it's really not about

being wrong or right. Absolutely. I mean, you're spot on in that. I think, you know, trading success doesn't come down to necessarily being the best analyst of data. However, I do think it's very important to analyze the data because you can be ahead of when the trend changes. Because what happens is the really bad traders, the people who cling to a trend way beyond when it's valid, because they've just been hearing their friends say things and they keep on writing this trend. Well, a good example goes back to what we were talking about earlier with sort of inflation. And I can't say how many times this summer or in even recent months, you just heard people say, oh, there's no wage growth and no inflation.

And you're just like, look, look at the data. It's there. You could see these numbers that are going up and to the right. But this meme got so entrenched that there's no inflation anymore that then people got totally taken by surprise. It's actually hilarious. You've mentioned that exact example because I was out with a trader only earlier this week. And he was like, we're never going to get wage inflation in the US.

And I'm like, you just bring up the Bloomberg app on your phone and say, look at this number. Exactly. I was like, that's the one bit we've already had. You know, it's the input prices and commodity prices that are new, but we had some wage inflation already. Not tear away wage inflation, but solid numbers. All right, so what are the next big themes? You've got the China thing. We know about political risk.

We know that inflation seems to be building, though not sort of like hyperinflation or anything like that. What are some sort of medium-term stories that you're interested in? Well, I think the dollar is a real hot topic at the moment. Because, you know, in the Bloomberg dollar indexes at the highest level since we've been recording. it and it's incredibly strong and you know people are getting very excited about that again it's the narrative of like Trump's going to make the dollar strong it's going to make it

great again you know everyone's looking at that as one of the top trades for next year and you know at that time of year banks start sending out their recommendations for the greatest time of the year 10 trades for 2017 season exactly and what's great is they keep on publishing them earlier and earlier which means none of them are nearly valid by the time we get to 2017

it's normally like a little pool how many of them will be stopped out by January 1st Right. But I think a lot of people seem to very much believe. It's actually funny, you know, you're talking to a lot of people in the market this week, and I guess probably my main takeaway, and, you know, something I've been thinking about writing about, is that everyone believes the dollar is going to have an amazing year next year. You know what?

I'm not sure how much farther it can go. Like, I understand being optimistic on the dollar at the moment, because some of the current narrative has more time to play out. But ultimately, it's going to be self-correcting, right? A strong dollar is a disinflationary impulse. And if it rises too fast, then we don't get the inflation that everyone's betting on for these rate highs, and there's also several other issues coming into it in terms that Trump's policies, if he is really going to boost investment inflation, then that means all the domestic sectors

of the economy, whether it's businesses, banks, consumers, government, etc., will be spending more, which is going to actually increase the current account deficit for the US, which is a longer term dollar negative. So basically what I'm saying is all the themes we're playing now for dollar strength all are ultimately self-correcting. It's at what level of the self-correcting, right? I personally think that, you know, the dollar uptrend might have another couple of months to go, but I think it's maybe the big trade of next year is at some point in the first quarter going, you fight the dollar. That'd be fun to watch. Except not against the yen. That'll never change, right? I mean, talk about a meme that's entrenched. Maybe just some facts that entrenched.

Let's end there. What do you see in the future of Japan? Well, is this, is that like the one sort of like grinding bond bull market that's just never going to end? There's just sort of no growth, no inflation, no yields, anything? Well, you know, they're coming to an end game. When I say that, they're coming to an end game, I don't think we're going to see it in the next year. In the same way that I say that China's got problems, but, you know, they're building it.

It could be five years away. This coming to the end game could take five, ten years to play out. But what they've done now in recent policy is very interesting. It's very innovative, and it may actually help get inflation, etc. But how do they extricate themselves from this problem? I mean, putting a yield target in when they've got the world's largest bond market. Highest debt to GDP. debt to GDP, exactly. You know, they can't afford for rates to rise and they, you know, they're

going to have real problems if the yen starts running away, getting out of control. Because if they are genuinely going to cap yields at 0% in the 10 year, when the rest of the world's yields are picking up, then that's going to kill the yen. And they might love that at first, but at one point do they start panicking and do they control that? They can't suddenly, let's say the yen starts falling 20, 30%. If they suddenly try to hike rates to control it, then they're screwed. Mark Kudmore, fantastic talking to you, is great not just to get your take, but also some of your insights, like how traders see the world, because I think people often miss that. I really appreciate you coming on. Thank you very much.

Thanks. Tracy, I liked how we sort of talked about something very current and relevant in this one and sort of took a break from our normal... As opposed to our normal odd topics. Exactly. As opposed to the whole premise of the entire podcast, that was not an odd lot. Yeah, I think I had like a self-realization, which is that, because I was asked why do I always see the downside? And I think just journalism by its nature is looking at things over a long-term horizon, especially financial journalism, which people maybe don't seem to realize. Like you never want to be the person who said everything's fine in the U.S. housing market in 2006, right?

Well, you know, I think that's exactly right. And I also think that I have this theory that real life, I don't know if I want to go this far, but like most things are kind of good. We wake up in the morning. Usually the world hasn't ended. Usually the world works. We get to work without getting hit by a car most times. We go to our jobs. We leave.

And so it's like news is fundamentally like we only talk about something. Right. When it's a break from the ordinary. Right. And so there's an inherent negative bias to news because the ordinary is for things to just sort of work out and go as planned. And so I think that, like, you know, it's not really news if it's working. Right. So what should we do if we're trying to provide news for traders?

Well, I think, like, this idea that, like, still we can, whether they're good or bad, identify the memes and figure out where there's a gap between some new emerging story or some new emerging theme. and what people think and continue to try to exploit and arbitrage that gap as to use traitor logo. That was good usage. Yeah, thank you. All right. Shall we call it for today? Let's do it. Okay.

This was another edition of the Oddlots podcast. You can follow me on Twitter at Tracy Allaway. And you can follow me on Twitter at the stalwart. And Tracy, where can people follow Mark? You can follow Mark on the Bloomberg terminal where he writes an almost daily column called Macro View. And it is very, very good. It's really great. You should check it out.

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