Odd Lots - This is What Traders Will Be Watching In 2019

Episode Date: December 31, 2018

After a volatile 2018, few people in the market expect calm to return anytime soon. Politics, the Fed, and trade will continue to be major sources of uncertainty. And of course there will be numerous events that nobody is thinking about right now. On this week's episode, host Joe Weisenthal speaks with Bloomberg macro strategist Cameron Crise and cross-asset reporter Luke Kawa about the key things to watch in 2019 if you're in the market.See omnystudio.com/listener for privacy information.

Thanks for listening to OddLots. Follow the show on Amazon Music for more future episodes or just ask Alexa, play the podcast, OddLLots on Amazon Music. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthall. And unfortunately, my colleague, Tracy Elway, is still out. But you can think of this week as sort of a part two to last week's episode. So last week we talked about the biggest stories. for traders in markets in 2018. And this week, we start the new year looking ahead to try to figure out what the biggest stories in markets will be for 2019. And so we've brought back the same guests. This time they're going to look ahead with me now in the studio. We have Bloomberg Cross Assets reporter Luke Kawa and Bloomberg's macro strategist Cameron

Christ. So Luke and Cameron, thank you very much for joining us. looking forward to hearing your crystal balls for the year ahead. Cameron, I'll start with you. So going into the new year, what are like the big, I guess, events or things you'll be thinking about that you'll want to see develop? Well, it strikes me that there's a few important issues here. One is what happens with the Federal Reserve.

Right. Right now, markets are pricing basically a 50-50 shot, whether they hike at all in 2019. And just to be clear for those listening at home, we are recording this December 18th right before they're going to hike. Come on. They're going to.

No, we're not going to hike in December. It's just important for when people listen to this to realize when this was recorded. Well, this is truly, we're truly looking ahead. We're truly looking ahead. Not with the benefit of perfect information. And, you know, the trade story is, as much as we'd like to think it's going to just go away,

with the turn of the calendar. That's not realistic. We need to get some sort of resolution here. And I think a third, at least domestic issue for the United States, which is a new entry, will be a more targeted attack on the president. Yeah. And the sort of the tapestry that's formed a backdrop in terms of political intrigue will become part of the foreground rather than the background next year, I suspect. Yeah, I'm interested in this topic because for the first, like I would say a year and a half, of the Trump presidency. I recall one of the constant discussions being,

there's so much chaos in the White House, why does it not seem to matter for the markets? And the response is typically like, well, things are going fine and earnings are going up and all that. So whatever is background noise. Do you both get the impression that that's changing a little bit and that people really are for the first time kind of trading on political risk at the White House?

Well, I think to a certain extent we're using this to rationalize how we feel now. I think the market is in a much more vulnerable place. So the potential of adding another headwind from the White House does mean more than it did in the past. But I'll also remember back in August, August 2017, I guess it was when we were getting rumors that Gary Cohn was leaving the White House because of his, he was upset about the Charlottesville protests and the president's response. That intraday move was one of the bigger retreats. saw in the S&P 500 that year. It's just the fact that, you know, it was a nothing burger and the market was able to wash that away so quickly. But right now, I think that it's just something that adds to market vulnerability. But I think it's a cause and a headache, but it's not, you know,

ever a proximate cause of weakness for the markets. Cameron? Well, there's so much going on. It's hard to say that people are selling stocks because Nancy Pelosi is going to be the speaker of the House. But I think moving forward, does it represent a reason to have a risk premium in the markets generally? Probably, probably that's the case. Is there an area of the market that you would look at to try to isolate political risk? Like with trade or trade proxies, Fed, rate sensitive ones? Like, could you even begin to try constructing some basket of politically sensitive assets? Multiple's relative to other developed markets, change in multiples. Because, like, yeah, I wouldn't know how to do it on the non-index level because you'd think if it was, you know, something that was

affecting U.S. stocks in general that would have to, it would have to not be a sector specific thing and have to be an index level thing or that. I mean, maybe the builders of walls. Yeah. I mean, it's kind of the joke that keeps on giving, right? But I think on your themes, there's a couple that, you know, worth developing and they take us into more of a marketplace, both on trade and the Fed. I think in a lot of sense from all the 2019 outlook reports I read. They're Wall Street essentially averaging down into their 2018 outlooks. And two areas where I think where trade and the Fed come into play is 2019, I would expect to see any more, any negative trade headlines manifest more to the downside in U.S. equities than they

do to emerging market equities. I think emerging markets have priced in a ton of pain. And we have already seen a turn in this year in the E.M. versus S&P 500 ratio. So even on, you know, not material improvement in trade. So I think there's more of a potential for U.S. stocks to start to price on the downside risk to trade at the index level than emerging market stocks and another on the U.S. dollar in the Fed. I'm wondering if this is finally the time we do truly get that U.S. dollar top if

2019 is a year of U.S. dollar weakness. And it has to do with just, you know, your second derivative, the fact that the Fed isn't going to speed up the pace of. rate hikes and the fact that the U.S. is probably going to decelerate more than other economies on a like year over year basis. Well, I would say this vis-a-vis the U.S. market versus emerging markets. If you look at this year, actually the multiple has contracted by roughly the same amount in the S&P and the MSCI Emerging Market Index.

What has separated the performance between the two has been earnings, where the U.S. has obviously delivered great earnings growth and EM earnings have been basically flat on an earnings per share basis. So one of the issues I'm wrestling with is right now the consensus top-down forecast looks for something like 8% earnings growth for the U.S. over the next 12 months. That looks way too high. Right. Right. Everyone expects that to come down. Yeah, everyone expects that to come down. That being said, even if we assume zero earnings growth for the U.S., I think you could argue that the multiples is contracted enough that the market actually offers... Where are we right now with your preferred way to look at the multiple?

Well, I like to look at the multiple relative to the rolling 12-month forward earnings estimate, which I have to construct in the spreadsheet because for the S&P, unfortunately, there's no easy way to do it on the terminal. You can get it on the MSCI U.S. Index. a 12-month rolling EPS or price earnings ratio. But that allows for sort of constant apples-to-apples comparisons over time. And I think we're at about 15 in a bit in terms of the PE relative to the spot earnings. So if we assume no earnings growth, that would be 15 relative to 12-month-forward earnings,

which is an earnings yield of about 6.5, 6.7%. You compare that to inflation. As you know, Joe, the real earnings yield is one of my favorite metrics. So we compare that to where inflation is likely to go. That could present a real earnings yield of sort of four, four and a half percent by the middle of next year, which is a level that's consistent historically with fantastic returns for U.S. stocks. You compare it with bond yields, you know, the quote unquote Fed model, not perfect, but that's still a pretty tasty, tasty premium. So I do wonder how much further multiples can actually contract from here, barring a proper economic downturn. And that's really going to be the story for the end of next year is, does recession 2020 become the self-fulfilling prophecy? And a part of that story that I'm starting to see in markets. And I'm wondering if this will be a developing theme in 2019 is the return of rates volatility.

Like we talked about right before the February volatility explosion and, you know, the demolition. and the demise of my friend, XIV. And then again, the sell-off we got in October after Jerome Powell talked about long way from neutral. Those are both rate-sensitive and rate-related moves, but they weren't really accompanied by a lot of implied rate volatility, a huge move higher there. And one thing I'm looking about as something to spur rate volatility is a lot more uncertainty and confusion about the Federal Reserve's path. I think that's a pretty easy catalyst.

And I think that's something that we've been working through in Q4. And one of the places I already see that coming up is looking at the ratio of one year, two-year swapsion volatility. So the implied volatility of two-year rates over the next year versus one-year 10-year swapsion volatility, implied volatility of 10-year rates over the next year. And that ratio is very elevated right now, you know, and it's moved upwards at a speed not seen since the taper tantrum. Taper tantrum to me was like a clear indication of the market pricing and an inflection point

for Federal Reserve policy, even though it took a while to arrive. I think we're getting the same here and where we're starting to sniff out what does the end of the Fed cycle look like what does the turn look like and that as a catalyst for rate volatility that starts at the short end and perhaps move further up at the curve

and has an effect on cross-asset volatility on spreads on equities more so that's something I'm looking forward to to seeing because it has been the dog that hasn't really barked in 2018 I think I'd probably take the under on rates vol for the simple for two reasons One is we have much more explicit forward guidance than we've ever had in the past.

And it's almost irrelevant whether the Fed actually is right or accurate in their forecast. There's a well-known behavioral finance concept called anchoring. And it provides, the dot plot provides an anchor for market expectations. And you can observe that in many ways, that realize, volatility throughout this entire cycle has been much, much, much lower than it has been historically because of this anchoring process. The news doesn't stop on the weekends. Context changes constantly.

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the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. One change that's going to be different in 2019 is that every Fed decision now will be accompanied by a press conference. Previously it just been four a year. It used to be none a year. There was a belief, and it was never officially stated, but there was a belief that I guess kind of got confirmed, though, that only the press conference meetings were locked.

Well, they did claim that all meetings were live. They claimed it. But they've simply admitted basically they were live. They never hiked on a non-press conference meeting and no one ever believed it. Does the theoretical liveliness of all the meetings introduce any sort of volatility into a short rate? A little bit. I think, though, that markets will still anchor on the quarterly meetings simply because that's when the new round of forecasts are unveiled. And we've sort of seen that.

So there are still special meetings. Yeah, well, we've seen that with the ECB, right, where every meeting is theoretically live, but half of them are just mail-ins because there's not the backdrop of the new staff forecast from the ECB. Do you think like, you know, they talk about quote-unquote normalization, and I still don't think I understand what that word means, even though I've heard it a bunch of times. But do you think that we're better off for all of these communication innovations, or should we just go back to where they have a little statement and hike and move on? I think they should go back to the way it was before. But on the other hand, you know, you talk about how volatility has been suppressed the cycle, in part because of those communications. If lower, I don't know which way the feedback loop runs or the mechanism, chicken egg here, but if lower financial market volatility and lower macroeconomic volatility, if those two aren't all related and the feds forward guidance is helping to promote one and the other, that seems to me to be somewhat. of a free lunch. However, I think we could get into the Minskian view of that this is breeding

some level in the uncertainty and instability. Well, you've just gone, yeah, you just referred to your friend, your late lamented friend, XIV. And I think that's a manifestation of artificial sense of certainty that's afforded by Ford guidance. It's an interesting phenomenon. If we go back over the last quarter century, Ford guidance by the the Fed has gotten more and more explicit, starting in 1994, when they started releasing statements sort of explaining what they were doing to now when, obviously, we get the dot plot and all this stuff. And what we've observed is that realized volatility of fixed income markets has gone down, broadly speaking. The lead time, which money market curves invert until the Fed cuts

rates has broadened. And to date, each subsequent economic downturn has become more and more severe. The two rate cuts in the 1990s after 94, which was, there was one in 95, and then the 98 cycle, there was no recession that followed. But yet, as they got more explicit in the 99 tightening cycle, that ended with a recession, obviously with a dot-com bust, and then they got even more explicit. You remember measured pace, yada, yada, yada. 25 basis points every meeting. Exactly. And then we followed that with a period of extraordinarily low volatility,

which bred excessive risk-taking, and we ended up with the great recession. You can argue that this is why the nature of recessions has been more balance sheet oriented and kind of providing certainty to balance sheets that doesn't exist. And then you get more abrupt tipping points. When you look forward to 2019, though, and right now, I think one thing that people have been really, banging the table about is they're worried about the credit market. They're worried about a very severe downturn

and credit. A lot of talk about triple Bs. Then on the other hand, you have a lot of corporates taking steps to improve their balance sheets. What do you think about in terms of a credit versus equity outlook in 2019? I would say from a relative value perspective, I would prefer, at current valuation, I think I would prefer equity to credit.

It seems to me that we've sort of, the credit cycle I view is sort of like a cruise ship. You know, you can't just turn it, turn it like water skis or a powerboat. It's a very long and gradual cycle. And it seems to me that we have now bottomed in terms of spreads and that fundamentally speaking over for the remainder of this cycle, spreads should on aggregate be wider. Now, if equity market valuations were elevated, then you would say sell everything. But given that we've had this come down in terms of valuation, as we just discussed, I don't I think we're kind of at the point where I'd prefer equity to credit.

Let's trade. Let's talk a little bit more about that because the interesting thing is, so 2018, we obviously got the, I guess, the so-called trade truce, that that's at a 90 or 120-day clock, depending on when it started, on getting a deal. Since then, the truce hasn't fallen apart. Some people might have expected it to. I don't know that there's a ton of progress being made. on it, but it's not like there's been a ton of backtracking or undermining of it, right?

But this is the trade truce and the trade war, excuse me, in the trade policy in a nutshell. You know, everyone sings Kuwaita on the campfire and toast marshmallows and Buenos Aires. And then two days later, we get news, A, that Trump is still a tariff man and the Walway arrest. Now, if that's a truce, I really don't want to know what a war looks like. And this is why it's so problematic. Are we going to find out in 2019 what a war? the world looks like?

I tend to think not. I've basically taking the view that Trump would push the envelope on trade until financial markets told him it was time to pull back. And it seems to me pretty clear that financial markets in the fourth quarter of 2018, i.e. immediately after he imposed the $200 billion, the tariffs on $200 billion of goods, financial markets are saying, all right, that's probably enough for now. And it also seems like an issue in which it is positive for the president to keep it a live issue without real negative repercussions on financial markets or the economy.

So if you can go and you can have these mini wins or these symbolic wins over and over and over, while at the same time you don't have the legislative control that you once have, it's a winning issue that you can keep for yourself and no one else can really touch. and as long as you don't push it a little too far overboard, it does not become a negative for you. Do you think other foreign leaders are willing to play that game for them, which is basically like, you know, don't let anything too bad happen and just keep giving it, giving Trump marginal wins that don't mean a lot and let the sort of persistent din of risks just sort of sit out there? Completely. You think so completely. I'm not sure. I'm not sure.

I mean, it's a tough question, to be honest with you. I think if Trump is under political pressure domestically, then surely that, which he will be next year, I think, given that the House will have subpoena power that they might actually use on the White House, that surely gives foreign governments more of a leverage against Trump than they've had heretofore. Speaking of event risk in 2019,

something that hardly anyone is talking about, but which I had a recent conversation with, David Wu over at B of AML, the debt ceiling has to be lifted in 2019. The last time we had a really, or Congress flipped in the midterm was 2010, and the 2011 dead ceiling fight was pretty brutal, went to the end. The politics, I guess, are a little bit different because Democrats maybe are a little less motivated by, that's less of a talking point for them, the debt. But nonetheless, they have leverage and presumably they're going to want something.

Do either of you think this is going to be a big. story or is your guess that the Democratic leaders are going to say like let's just come up with a deal? It'll be a big story but not something that ultimately matters, right? Like it'll be something we worry about and talk about. It was a huge thing in 2011 like that story dominated

the summer. But there was also another back to remember the sovereign downgrade, the Euro's down crisis. There was a lot of stuff going on back then. But that was a huge, I mean, I remember that summer going out to the beach on weekends and just like they glued to Twitter.

or watching every utterance from who is it, Eric Cantor and all of them about that dead sealing fight. Is that going to be what this year's like? I think like it's something that's lost its power to hurt the markets as much as it wants did because of how big and crazy and how much it dominated attention in 2011. And based on all these kind of mini government squabbles we've been able to get over in the past. Fiscal cliffs and so forth. Yeah, I'm going to I'm going to hedge my bets a little bit.

I generally don't care about this sort of stuff because I think it's, It's noise rather than signal because ultimately it gets resolved. But it seems to me that if 2018 has taught us anything, it's that these things that end up impacting markets are things that in hindsight, you can say, well, obviously, that had an impact. But you didn't forecast it in advance because you thought that, yes, it's an issue, but it's not going to matter because it didn't matter in the past. Right. So, I mean, the rules of engagement between the White House and Congress and the White House and the Fed and the White House and the market have totally changed. Yeah. So we're all in sort of uncharted territory here.

So while I don't think that this sort of thing will have any sort of meaningful lasting impact on the market, if we're sitting here next year and it turns out that it did, I'm not going to have been terribly surprised. All right, we got to wrap it up here. Any sort of quick last parting thoughts from the two of you? I expect a hard Brexit. Oh, good one. I like that. We didn't even get in there, but maybe we'll do a Brexit episode soon. That's a really good one. I expect that the rotation to value that we've been waiting for forever does not happen.

Okay, great stuff. Really enjoyed having you both on for both our look back and our look ahead. Luke Kawa and Cameron Christ, thanks for joining us. And this has been another episode of the Odd Lodds podcast. Thanks for listening. And of course, please stick with us for 2019 as we watch these stories unfold. I'm Joe Wisenthal. You can follow me on Twitter at the stalwart.

Tracy wasn't here this week, but you should still follow her on Twitter at Tracy Alloway. You should definitely follow our guests. Luke is on Twitter at LJ Kawa. Cameron is on Twitter at Fifth Rule. You should follow our producer on Twitter, Tofor Forges. He's at Forrest T as well as our substitute producer. this week, Liz Smith at Liz the Smith. And don't forget to follow the Bloomberg head of podcasts, Francesca Levy at Francesca today. Thanks for listening. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories. episodes are published throughout the day with a

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