Vues d’Iggo : les profits sont là pour s’en servir

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1 décembre 2017

All the volatility in financial markets seems to have been transported into the virtual world of bitcoin trading. It is not proven that the brilliance of the technology necessarily equates to real economic value creation. Indeed, it is fair to conclude that with a market capitalisation bigger than some household name corporations, we are witnessing a digital bubble. Some say robots may be coming to take our jobs but I think bitcoin might take people’s wealth first. In the real world the word bubble is being used more and more in discussions about the US stock market. Maybe President Tweet can keep the market going up. However, recent price action set against extremely low levels of volatility means stock investors have rarely had it so good. Bonds have little upside so there is more focus on equities. Is this late cycle stuff? Who knows, the economy is certainly not slowing down. But with 20% total returns this year, a bout of profit taking would not be a big surprise.              


Volatility is low everywhere apart from in the market for trading bitcoin. Anyone following the price movements of bitcoin can’t have been anything other than amazed at its recent performance. It was quoted at $6,377 at the close of October and closed the month of November at a price of $9,960, having hit a low of $5,660 on November 12th and a high of $11,395 on November 29th. I was looking at the whole block-chain technology / digital currency phenomena earlier this year and even download an “app” to facilitate buying bitcoin. Needless to say, I didn’t but if I had I would have trebled my money. That kind of price action is very alien to a bond guy and the whole story with bitcoin is quite alien to a classically trained economist who sees a currency as being a store of value and a means of exchange. Hard to see that bitcoin satisfies those criteria at the moment. I am more inclined to view it as a commodity – not as an asset as it delivers no income (unlike bonds, equities and real estate). Commodities are notoriously prone to bubbles and speculation and this is what bitcoin is at the moment, a speculative bubble perfectly illustrating the “greater fool theory”. What is the rational investment case? Owning bitcoin gives you access to owning parts of digital businesses through the purchase of “coins” (it’s hard not to think about “Wii” games at this stage) and the growth of the digital market place means that there will be profitable returns to investors in such businesses? The irrational argument is that you should buy bitcoin because somebody else will buy it at ever higher prices. Call me old-fashioned but I’d prefer to hold my wealth and savings in assets and currencies that had some legal covenant. I note from a Google search that the market capitalisation of bitcoin is estimated at $165bn. That’s more than the market cap of GE Corporation, McDonalds, General Motors and BP. That is madness! Where is the economic value creation to justify this enormous increase in “paper/digital” wealth? Having watched foreign exchange (FX) dealers punting on “” in 1999 I can only imagine there will be some kind of crash before most holders of bitcoin have been able to monetise their holdings into a real currency. Is that a risk to the financial system? Probably not, nor do I think it will be the end of the digital market place, but it may mean that the application of block-chain technology is not distracted by “Tulip” fever going forward.

High returns, low volatility

Back in the real world, one may also worry about “irrational exuberance”. The US stock market keeps making new highs while realised volatility has fallen to new lows. The Dow Jones jumped 4.8% in the last three days of trading in November, rising above 24,000 (with a celebratory tweet from the President) and marking a price gain of 23% so far in 2018. That is one heck of a bull market. Since the US high yield bond total return index peaked on 24th October, the Dow is up 3.5% while the high yield index is down 3.5%. This may just be a short term technicality but there comes a point where bond markets offer very little upside (as discussed last week) while investors think stocks can keep going up. At any rate, volatility is so low because markets have shown very little corrective price action recently (it’s been a one way bet). Volatility of returns is very cyclical and tends to be fairly highly correlated across asset markets. Previous bull markets were associated with cross-asset declines in volatility and the most recent observations of 1-year rolling volatility of total returns for the US investment grade credit market and the S&P are below the lows they reached in 2006. The volatility of returns from government bond indices is above previous lows but not by much and is falling. With markets seemingly unfazed by the prospect of another interest rate hike in the US this month and curve flattening momentum being the biggest trend in the fixed income markets, we could see bond return volatility reach cyclical lows in the coming weeks.


What goes down does not necessarily go back up again, but these are unusual times in that stock returns are high and volatility is low. Indeed, the 1-year return from the S&P500 divided by the 1-year volatility of daily returns is at an extreme high. The same measure of bond returns is negative for Treasuries and credit and only just positive for high yield. The point is that bond markets have almost run out of the ability to provide positive risk adjusted returns while equity markets are delivering their best risk-adjusted returns. The divergence between risk-adjusted returns of equities and Treasuries typically reverses at extremes and it seems that if there is going to be a change in the dynamics, it would come from the equity market. Maybe the bitcoin crash will spill over into the stock market.

But the economy is strong, strong, strong

Despite these misgivings over market valuations, the economic news remains good. November’s round of purchasing manager indices (PMIs) points to a strong global manufacturing sector, buoyed reasonable final demand and a strong technology cycle. If there is any relation between the amount of words spoken about artificial intelligence, machine learning and big data and investment in the technology to enhance these concepts, then surely this must be having an impact on global capital spending and manufacturing output. The euro area PMI came out at a reading of 60.1 in November indicating solid expansion in European manufacturing companies. This was barely above 50 (meaning no growth) at the beginning of 2015. It’s a similar picture in the UK. Despite the immediate post-referendum dip in business confidence, the PMI has been rising steadily since and printed at 58.2 in November. The report suggested positive trends in new orders, production and employment. There is a good relationship normally between global PMIs, the economic cycle, corporate earnings expectations and stock prices. Markets might not turn until the economy does and I can’t see at the moment what makes the economy turn down.

Yield will not equal return

So for bonds next year it looks as though it will be more of the same to begin with. But be warned, the level of yield at the beginning of the year is a poor predictor of subsequent total returns. The yield on the UK investment grade credit index, for example, was 2.6% at the end of 2016. To date, total returns have been 3.3%. A typical emerging market bond index had an end-year yield of 5.8% last December and that index has subsequently returned over 9% to investors. Unless volatility falls even further, total returns to bond indices are not going to look like the level of yield at the beginning of 2018. Active management of bond portfolios should also ensure that return does not equal yield as active investors should be able to take advantage of any increase in volatility. For what it is worth, my team’s stance is to be cautious at the moment with limited duration and credit risk exposure relative to typical benchmarks or to more “normal” market conditions. If volatility rises, and in the context of this bond market that will mean higher yields and lower prices, there will be opportunities to add risk in terms of duration and credit, exploiting higher yields and creating the opportunity for higher subsequent total returns. For the moment, I think the short duration strategy is well suited, especially as the flattening of yield curves reduces the compensation for extending the maturity of a portfolio. The yield that is given up by concentrating on the shorter end of the yield curve can be replaced by adding higher yielding short maturity corporate bonds. This allows a portfolio to remain focused on income, to be somewhat protected from higher rates and to have the firepower to add risk when the inevitable market correction takes place.

Losing it

It was quite amusing seeing Pep Guardiola losing it with a Southampton player in mid-week after City had snatched a last minute victory to keep their impressive run going at the top of the league. Apparently he was upset at the tactics employed by The Saints, accusing them of time wasting and being too defensive. What did he expect. City were massive favourites being the super in-form team. I’m not sure I have ever seen Sir Alex or Jose give that kind of verbal abuse to a player from the opposition, but Pep can’t do any wrong can he? Mid-week games are often very entertaining and there were two great goals this week – Jesse Lingard for United and Wayne Rooney’s drive from within his own half for Everton. With Arsenal up next, let’s see if this weekend can match.

All data sourced by AXA IM as at 1 December 2017.

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