Authored by Peter Tchir via Academy Securities,
What Can We Learn From ‘Surprises’?
This is the time of the year where you get lots of lists detailing potential surprises for 2018. I may yet do one too (my surprise is that inflation has been here for years and just not getting picked up in standard measures).
At their best, the surprise lists generate critical thinking and interesting discussions. At my most cynical (which I’m trying to give up for the New Year), the ‘surprise’ lists are just a great crutch. “I would have done well, but one of my negative surprises occurred. Don’t I deserve credit for recognizing the potential surprise even if I didn’t act on it?”
Regardless of the value of looking forward to this year’s potential surprises, I think it is extremely useful to examine what we can learn from some ‘surprises’ from 2017. One reason I want to examine last year’s surprises, is because one person’s ‘surprise’ is often someone else’s ‘base case’. We are often ‘surprised’ by things that in retrospect we should have been able to figure out. There are times that much of what is passed off as ‘surprising’ is merely the real world failing to live up to ‘groupthink’ expectations.
There were many surprises, but I will focus on three surprises, and the order I present them in is important
1. The first ‘surprise’ is a good example of what made logical sense but was likely hurt by positioning. There were many examples to select from, but I think this one seemed very ‘obvious’ and probably didn’t hurt many investors so it is easy to write about.
2. The second ‘surprise’ is one that ‘surprised’ the market repeatedly but probably shouldn’t have. There is history that indicated this ‘surprise’ wasn’t going to occur. Even more interesting, is that this is the one negative surprise that many people were hoping to occur.
3. The final ‘surprise’ is probably the most annoying to the most number of people. I’m writing about it third because if I started with it, most people wouldn’t bother reading the other two ‘surprises’. This one highlights best that one person’s surprise is someone else’s base case.
The Demise of Mexico
Of all the Trump trades, the most universally accepted was that Trump was bad for Mexico. Border walls. NAFTA. Not only was the rhetoric against Mexico strong during the campaign, nothing changed after the election. Early in the presidency there were some bizarre, if not heated exchanges between the leaders of the two countries.
Mexican Peso Since July 2016
The peso followed the script nicely right after the election. It then went on a tear, defying the bears. It has slipped in recent months, as NAFTA negotiations proceeded and as we focused on tax reform. It wasn’t just the currency that did well despite the overwhelming negativity towards Mexico.
The stock and bond markets also did well.
The Mexican Stock Market Since July 2016
The stock market reversed course quickly (originally benefitting from the weaker peso) and rallied for 9 months straight – which is very impressive given that the currency was appreciating at the same time.
Mexico Credit Spreads Since July 2016
Mexican credit spreads are truly impressive. Not only did they rebound from the post-election highs, they have done nothing but grind tighter since then. This chart shows the difference between US Denominated 10 year Mexico debt and 10 year U.S. treasuries. The Credit Default Swap (CDS) charts look similar. Mexico issued 30-year bonds denominated in dollars, tapping into this demand for their bonds.
While the bond market benefitted from the global chase for yield caused by ongoing easy monetary conditions created by central banks, it is impressive nonetheless.
Could We Have Anticipated this ‘Surprise’?
This one is tricky as the logic seemed flawless. Even with perfect hindsight the logic makes sense. The actions even supported the logic. So, what could we have done to anticipate this?
Identifying consensus trades and positioning. I think the most important thing we could have done is identify just how widespread this view was AND how much money was positioned for it. That was probably the single biggest factor that could have avoided the ‘surprise’ of the first 9 months of this year.
But that isn’t the only thing about this that could have reduced the ‘surprising’ nature.
To some extent, we let a good story get ahead of the facts. The headlines made for great talking points, but the reality was that if the U.S. economy is doing well, there is little reason, despite the rhetoric to expect one of its biggest trading counterparties to do poorly. Not only did we have a domestic economy doing well, but the global economy was doing well – further mitigating the ability of the difficult headlines to impact the economy and the Mexican markets.
Add to that, the well-known chase for yield, and it less obvious why Mexican bond spreads had to widen. The global search for yield dwarfed many other factors last year (that chase for yield could diminish as the ECB is pulling back on its bond purchases and the Fed is finally reducing its balance sheet, but that wasn’t the case in 2017).
Lessons from the Mexico ‘Surprise’?
I think the biggest lesson from this is to be open minded and focus on ‘what is priced in’ or what is consensus and crowded. The cynical part of me (yes, I am trying to reduce that part) looks at the moves in the currency and the stock market starting in September and thinks – ‘so all the shorts got stopped out, momentum longs got put on, the investment theme was altered to fit the move’ and then the market was ripe to follow the original 2017 premise.
I really don’t know whether this one could have been avoided, but is should offer some food for thought as we look not at the surprise lists of 2018 but at the consensus trade lists.
Washington Doesn’t Matter
Washington finally delivered on tax reform at the end of the year. That helped spur the year-end rally that is continuing this year. In that respect Washington clearly mattered, but what I am trying to address is the fact that for most of the year, D.C. was incapable of enacting policy, had a rotating door in terms of staffing, is mired in investigations that take twists and turns at every step of the way, and markets didn’t react.
There was disappoint that markets didn’t react to failed policy initiatives.
Early in the Trump administration there were clear failures on initiatives, but markets didn’t care – much to the chagrin of many (including me) until we fully applied the “Whatever it Takes” methodology.
In July of 2012 Draghi uttered the words ‘Whatever it Takes’ in regards to saving the Euro, or European banks, or European sovereign debt, or however you chose to interpret it.
Markets rallied on his words. Then for months and months Draghi did absolutely nothing, but it didn’t matter.
It wasn’t the action that mattered, it was the hope that action would occur in the future that mattered. So long as their was hope that something would occur in the future it was hard for bears to do much and bulls had something to cling to.
That played a large part in this year’s trading regarding to Washington. It didn’t matter what got done or didn’t get done, so long as tax reform was on the table. Until tax reform was ‘derailed’ there would be support for the market because being on the wrong side of that trade would be too painful. Ultimately tax reform wasn’t derailed. We can, and will argue about how impactful it will be, but it got done and rewarded those who stuck with the trade, despite the noise in and around Washington.
The secondary aspect of this is the ongoing support of central banks for markets.
Brexit, in theory a nasty surprise for markets, was immediately righted by central banks. Markets at the time of the French elections were coddled by central banks too. In an era where immediate political failure will be supported immediately and aggressively by central banks, it is difficult to trade the way one would expect.
Lessons from D.C. Doesn’t Matter ‘Surprise’?
The lesson is that Washington does matter, but the promise of future good results matters more than near-term setbacks, especially when central banks view part of their job as stabilizing every negative headline.
I really could have titled this section [XXXXXX] Doesn’t Matter where XXXXXX could have been chosen from a long list of things that seemed important that failed to impact markets.
Eventually XXXXXX will occur and will impact markets. But it either it needs to be a real surprise, or something that cuts of all possibility of future hope and is such an event that centrals banks can’t smooth things over quickly. The fact that it is getting more difficult to imagine such event is concerning as a contrarian and as it relates to the first surprise.
The Bitcoin ‘Surprise’?
Who would have thought that Bitcoin break, $1,000, then $2,000, then $5,000, then $10,000 and then $15,000? Who would have thought that Ripple and Litecoin and Ethereum would become household words? Who would have guessed that we would have not just one cryptocurrency futures contract, but two? Who would have bet that there would applications to launch at least 20 ETFs linked to cryptocurrencies? Who would have bet that Goldman Sachs would make headlines on their quarterly earnings call because they discussed plans to think about the possibility of trading cryptocurrencies? That on JP Morgan’s earning call, they had to tiptoe around their CEO’s call that Bitcoin was a fraud? Who would have expected that Bitcoin is now a regular ticker on TV screens?
LOTS OF PEOPLE.
Lots of people made those bets to varying degrees. While it is easy to say Bitcoin and cryptocurrency is a bubble, while it is easy to trot out Tulip arguments, many believed in Bitcoin and are right so far.
After the year Bitcoin and cryptocurrencies and ICO’s (Initial Coin Offerings) have had, virtually everyone will accept that ‘blockchain as a technology is valid’ but that view doesn’t necessarily extend to cryptocurrencies.
Bitcoin still largely exists in a world of believers and haters mixed in with some dabblers, but it is hard to continue to ignore.
Whether you believe in current valuations or not (and I don’t) it is impossible to ignore (and has been for some time). There are a lot of issues regarding it, but it is impacting investors and investments and understanding those influences seems important even if the thought appalls you.
The Lesson from the Bitcoin ‘Surprise’?
Listen. Listen and remember that your wildest case may be someone else’s base case.
I don’t want to go any more into bitcoin itself, I just think it is a great example of the need to be open minded. To those who weren’t surprised by Bitcoin’s meteoric rise in 2017 – congratulations! To those who missed it, let’s get beyond the ‘tulip’ analogy as it isn’t working.
What Last Year’s ‘Surprises’ Mean for 2018?
I don’t know what this year’s surprises will be (though I do keep leaning towards something around inflation and that inflation has been understated by official stats – though I might just be bitter with three kids heading to college and what seems like unsustainably high health insurance costs). What I do ‘know’ is that not all ‘surprises’ need to be surprises and we should
- Be diligent in identifying crowded trades
- Accept that hope outweighs disappointment when central banks have the near term covered
- That someone has the other side of most trades and we should always try to understand why, whether we wind up agreeing or not
Hopefully we will be able to work together in 2018 to be on right side of as many ‘surprises’ as possible in 2018.
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