Contrarian Bets Pay Off in Q1…

‘Wall Street has projected its wildest fantasies onto the largely blank canvas Trump provided, but this is politics reinvented as performance art. As the lack of policy coherence or even consistency becomes painfully clear, investors risk a degree of buyer’s remorse. Many of the key policy suggestions look contradictory, such as the border adjusted corporate tax system and its impact on boosting the already ‘too strong’ USD or the proposed tax cuts… political gridlock is now a risk if he also splits the Republican Party with what is fast looking more like a Silvio Berlusconi than Reagan style administration.’ Weekly Insight, 23rd Jan 2017

A key theme since December was that the consensus assumption of a rampant USD,  10-yr Treasury yields testing 3% and accelerating US growth looked as misguided as the deflation panic a year ago. The implosion of what we termed a month ago as the ‘incoherent mess’ healthcare proposal occurred during our recent Asian roadshow, further shaking complacency. The overweight bet in EM equities paid off, with a 13% return the best quarter in five years while a resumption of carry trade inflows boosted EM FX to its second-best quarter led by the 11% Mexican Peso rally (18% from its January low), distilling the broader Trump reassessment across markets.

Global growth has outperformed value as expected and our preference for North Asian cyclical exposure (notably tech) has been justified – Korean exports surged almost 14% last month led by semis while Samsung is one of several regional tech names hitting new highs. Chinese and European demand rather than US has been the key upside driver for Asian trade this year. India’s rally has been surprisingly strong and driven further multiple expansion on a surge in domestic mutual fund inflows YTD, but the credit and earnings growth backdrop remains very weak. Reflecting the rapid shift in sentiment, on IIF data net capital flows to EM were positive last month, with China seeing the first  inflow since 2014.

With the yield curve flattening again, US banks have now joined the reversal of crowded post-election consensus trades. The hope that feuding Republicans factions can now regroup and move swiftly on tax and regulatory reform looks optimistic – the CBO projected $839bn in savings on Medicaid spending over a decade as 14m beneficiaries were removed, a key offset for deep corporate tax cuts. The border adjustment tax was meant to be a revenue windfall to cut the headline rate, but is already mired in Congressional wrangling and the conservative Freedom Caucus looks set for a war of attrition ahead of next year’s mid-term elections.

The Washington swamp has drained Trump, whose ignorance of even basic policy details and lack of a core political base in Congress were always obvious weaknesses which will have to be addressed but this is not a man with any experience in building coalitions. Before tax reform can even be discussed seriously, the highly controversial budget has to be passed, with many Senators angry as brutal cuts to key departments and basic scientific research budgets. Our view remains that tax cuts will be both more modest and later than most expect.

With the dollar index testing four month lows, we have taken profits on the tactical short on USDJPY and the FTSE 350 mining sector, which has corrected with the sharp iron ore reversal. In contrast to further upside (particularly for surprises in Europe, recent US data looks soft. That ranges from the slump in gasoline and supermarket food sales (both branded and generic) to a broad downturn in bank credit growth.

With investment banks belatedly noticing the divergence between ‘soft’ survey and hard reported data, consensus inflation and growth expectations look vulnerable for H2. We’ve been highlighting rising stress in the auto loan market since Q4 and the auto market bears close watching in Q2 for deterioration in sales volumes, loan delinquencies and residual values.  New vehicle incentives are reaching new highs at about $3500 per unit while second hand values are now falling at an almost 8% y/y pace, as subprime repossessions spike after a 5% decline in 2016.

These signs of underlying US consumer weakness will be key to Q2 asset allocation, as will be the risk of China tightening policy more broadly to slow a still booming housing market. For the US consumer, while belated IRS tax refunds will help, the shock of absorbing 20% plus hikes in healthcare insurance costs will squeeze discretionary spending across low income households in H2. Growth is more likely to slow to about 1.5% rather than accelerate and we remain underweight US ex tech versus EM and Europe.

There are signs that the recessionary style freefall in gasoline demand is now abating, which drove US inventories to a record in February and has been a bigger factor in the crude selloff than shale output rebounding. If we see an OPEC output cap extension, as seems likely give the Saudi desperation to get the Aramco deal away next year, a bullish stance on energy should pay off and we’re now adding long global oil E&P exposure to the tactical portfolio. Downside on that trade would require  US gasoline sales to sustain the remarkably weak trend seen in Q1, in which case the wider economy is heading for a much deeper slowdown and the 10-year is more likely to test 2 than 3% by mid-year…