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Global Connections
January 21, 2015
Objects in Motion Stay in Motion – Or Do They?
2015 has started off right where 2014 ended – with a tricky state of affairs for those in the investing
business. Trends have extended – good for trend followers, worrisome for most of the rest. Questions
abound and answers are few; I have some thoughts, how ‘bout you?
It’s almost been enough to drive one batty, as evident from the ditty above. Nonetheless, I do have
some (hopefully coherent) thoughts on the current state of play.
Objects in Motion
Year V
Issue #169
Itaú Global Connections presents
independent perspectives on economic
issues and market forces that affect your
current investments and strategies for
the future.
Newton’s First Law of Physics states that objects in motion stay in motion in the same direction unless
acted upon by an unbalanced force. Objects in motion include oil, rates, inflation and the USD, among
others. Each has the ability to influence portfolios and is worth consideration, given that unbalanced
forces are hard to identify.
Oil’s price collapse has been the object of much attention. The plunge has been relentless and has left
many analysts and investors far behind – those printing amidst the deluge now see USD 40 oil as a
likely resting spot (i.e., roughly 15%-20% from current prices).
The bigger question is what happens then? Does oil enjoy a V-shaped recovery, as history suggests, or
will it bounce along those levels for some time? Expect the latter, given the weak demand, with even
China (2014 oil imports up 10%) likely to be less robust in 2015. The supply side seems unlikely to help,
as all of the major producers, ex Saudi Arabia, have to pump – be it Russia, with record production in
December; Nigeria, facing elections amidst a falling currency; Venezuela, post President Maduro’s tin
cup tour; and even the U.S., where forecasts suggest a 6%-8% production increase as cash-flow needs
drive continued production.
Another object in motion has been declining sovereign interest rates. Will they continue to fall? How low
can they go? Collapsing inflation prints, another object in motion, are likely to continue falling for at least
the next few quarters given oil’s pass-through effect. Negative CPI prints are likely throughout Europe
and the U.S. in the first half of the year, suggesting that sovereign rates, assisted by reduced supply (Q1
EU net sovereign issuance likely to be at a 5-year low), could also continue to rally.
The rising USD has been another object in motion – will it continue? Anticipated ECB QE and the Swiss
National Bank’s (SNB) recent decision to lift the Swiss franc cap has certainly given the dollar a boost; longterm charts suggest the dollar could be just getting started. Yet, falling oil prices may make it harder for the
USD to continue strengthening against the yen and the euro mainly because, as big energy importers, both
currencies will now be buttressed by much improved trade and current account balances.
The USD has also been bolstered by expectations that the Fed will begin to raise rates. I disagree: falling
oil and a strong USD = falling inflation = falling rates = less and later likelihood of Fed rate hikes. The
odds of the Fed on hold into 2016 are rising, which is not necessarily a good thing, as the Fed’s ability to
begin rate hikes would also suggest some confidence in returning to “normal” operating conditions.
The UK continues to be the canary in the coalmine for U.S. policymakers. Forecasts a year ago
suggested the BOE would be the first to hike rates, and gilt yields rose while sterling strengthened. BOE
rate hike expectations have now been pushed out to 2016 – expect U.S. rate hike expectations to follow,
which, together with weak oil, should be enough to cool the dollar’s ascent for a while.
The UK has confronted what I have called the natural governor effect of the current geo-economic
climate. The governor effect suggests that developed market economies are too weak to stomach strong
currencies and high rates, particularly given their state of “chronic demand deficiency,” as the FT’s
Martin Wolf puts it. The U.S. may be next. This demand weakness can be laid at the doorstep of flat real
wages in the developed world for the past several years, which reinforces rising inequality (a U.S.
election issue), the disinflationary environment, and the degree of difficulty CB action has had gaining
traction.
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Itaú Corretora de Valores S.A. is the securities arm of Itaú Unibanco Group. Itaú BBA is a registered mark used by Itaú Corretora de Valores S.A.
Jay Pelosky is Principal of J2Z
Advisory, LLC.
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Global Connections – January 21, 2015
Objects That May Go Into Motion
What about objects that may go into motion? For example, the ECB and QE – will it finally happen? Yes
is the answer, but this begs another question – will QE have any meaningful effect or did the ECB wait
too long? Or perhaps the ECB is smarter than most realize and waited not because it had to, but
because it wanted to. Why? Because what if the European economy is actually bottoming and QE is
meant to buttress a modest but real recovery spurred by euro weakness (IP is up for the past 3 months,
M1 growth is strong), some consumer demand (record-low Germany UER, rising EU retail sales) and an
infrastructure investment program. What if?
Another object that may go into motion is more worrisome, and that is the prospect for China’s RMB to
weaken over the course of 2015 (see 2015 Outlook – Tough Choices Ahead, published December 2,
2014). The U.S. and China have been the main sources of global credit stimulus since 2009. Recently
both have been pulling back, with the Fed ending QE and China trying to rein in credit demand.
The 2015 version of credit stimulus is the willingness of both the U.S. and China to allow other countries
to undercut them in global markets via currency depreciation. The USD strength is well known, but few
appreciate that the RMB fell by only 2% versus the USD in 2014, versus a broad EM FX index falling
12% and the yen and euro falling appreciably more.
2015 Tail Risk Update
China suffers from very low inflation in CPI terms (currently at 1.5%) and has suffered from deflation in
PPI terms for several years. December’s PPI reading was -3.3%, a record low symbolic of the pressures
facing China’s producers. Should China decide to help this segment of its economy (an important source
of labor demand), a controlled 10%-15% depreciation of the RMB could be on the cards. This could
send another deflationary wave into the global economy, via the manufacturing space, amid further
currency declines in the rest of Asia as it tries to stay abreast of the China price.
This scenario is the top geo-economic tail risk for 2015. Another tail risk is the economic soufflé
argument, where the global economy sinks under a negative surprise such as a much weaker-thanexpected U.S. economy, a European recession or Chinese growth shortfall. The third tail risk highlighted
in the 2015 Outlook focused on a U.S. economic upside surprise, creating fear that the Fed was behind
the curve and leading to a rate spike. Recent events suggest the risk of such a scenario playing out has
declined.
One nagging worry is the prospect of markets losing faith in Central Banks’ (CB) ability to influence
events as sovereign rates approach zero and even go negative. The Swiss National Bank’s (SNB)
recent move suggests CB policy may already be shifting from QE/zero rate to negative rate policy as
investors pay up for safety (the cost of negative rates) to protect against the risk of larger losses (see
Every Country for Itself, published May 30, 2014).
Markets are awash in capital, yet thirsting for liquidity. Should a loss of faith occur, risk assets could sell
off at a time when monetary authorities have exhausted much of their ammo. With more and more of the
DM sovereign-bond market trading at negative rates, the end game of this policy mix seems well worth
thinking through.
Objects in Motion – Takeaways

Oil Price – V-Shaped Recovery Unlikely

Global Inflation – Continue Lower

Global Rates – Remain Under Downward Pressure

USD – Ready for a Rest

Deflation Risk – Rising
Itaú BBA
2
Global Connections – January 21, 2015
Portfolio Considerations & Implications
Our focus lies at the intersection of global economics, policy and portfolio construction. The geoeconomic and policy context has been laid out – what about the portfolio implications?
The Greater the Uncertainty, the Greater the Cash Level
The speed and magnitude of oil’s decline has meaningfully raised the uncertainty level. A good rule of
thumb is the greater the uncertainty, the greater the cash level. Raising cash should be simple – sell
whatever you don’t have very firm conviction in for an environment similar to what has been laid out
above. The SNB decision reinforces this suggestion.
Objects in motion tend to stay in motion – the dollar and rates were covered above – what about stocks?
For the past few years, the equity decision has been made simple by the U.S. equity market’s relentless
move higher, absorbing more and more interest until there is very little interest in any equity market
outside the U.S.
As highlighted in the 2015 Outlook piece, the question of staying long U.S. equity or moving to the nonU.S. developed markets is perhaps the equity investors’ toughest choice. From this armchair, the U.S.
market’s risk-reward profile seems to be declining. It is fully priced on an absolute, and certainly on a
relative, basis. It has been bolstered by stock buybacks (up 25% Y/Y in 3Q14 with an amazing USD 1.6
trillion spent since 2011), has a long line of IPOs in front of it, and is priced as the best house on the
block (U.S. equity outperformance widest since 2001). Thus the poor upside/downside outlook.
On a go-forward basis, it’s worth considering that developed economy non-financial corporates might be
about to face what investors have had to deal with for years, namely the lack of a tailwind. For investors
it is the lack of returns on cash. For operating companies, it is the inability to raise prices in a
disinflationary/deflationary environment. Generating sales growth, if not profits, will become much
tougher in the months and quarters ahead. Given that the U.S. equity market is fully priced, and thus
more dependent on earnings growth to justify rising stock prices, this may become an issue fairly quickly.
As Barton Biggs used to say about beaten-down assets, news doesn’t have to get better, it just has to
get less bad. Here lies the essence of the 2015 opportunity: non-U.S. DM news only has to get less bad
for these markets to outperform AS LONG AS the U.S. equity market does not crash. It is hard to see
the U.S. surprising on the upside in terms of economic growth, corporate earnings, etc. A crash is also
hard to see given the global capital glut.
Japan
Japan, a huge energy importer, is a major beneficiary of USD 50 oil, which almost completely rebalances
its trade profile (the inflation target is a different matter). This is one reason why yen weakness is not as
necessary today as it seemed even six weeks ago. Japan, as every sentient being knows, also has a
demographic problem – it is getting older and its population is shrinking. It just might be, however, that
this problem is actually a near-term opportunity. Full employment in Japan is likely to lead to wage gains
(watch Spring wage rounds) and thus a pickup in consumption, an earnings recovery, rising valuations
and an outperforming stock market in 2015. Talk about making lemonade out of lemons! Oh, and please
note that a few weeks ago close to 40% of trading volume in Japanese equity was on the short side (a
record?). Don’t forget the big buyer either, as the GPIF continues to add to equities.
A preholiday lunch with a senior macro trader at a top-tier U.S. investment bank yielded this nugget: No
one has any interest whatsoever in anything other than U.S. equities. Now while that may be a bit of an
exaggeration, it is not too far off the mark with the short position in Japan (as noted above) and the near
wholesale selloff of European equities in the past month or so. Even the potential success stories like
Spain are down roughly 20% in USD terms; and the banks (a favored sector), likewise round-tripping
and back to 2011-12 levels, even with cleaner balance sheets (2014 loan portfolio sales up 133%),
stronger capital levels (highest debt sales since 2007) and the near certainty that the ECB will engage in
QE at month’s end.
Itaú BBA
3
Global Connections – January 21, 2015
The Surprise of 2015
Many U.S. equity investors focus on the first part of January to get a sense of how the market is likely to
do for the full year. Right now it does not look good. If investors conclude that the U.S. has limited
upside and the news gets a little less bad in Japan and in Europe, then watch out for the surprise of
2015…U.S. equity underperformance. The U.S. market looks like a crowded trade and yet not a single
Wall St. strategist has the S&P ending 2015 with negative full-year returns. While this is not a huge
surprise, given the six up years in a row and double-digit returns in each of the last three years; I think a
plus or minus 5% S&P 2015 return is very doable, and, if so, expect the non-U.S. DM, namely Japan
and Europe but perhaps also the UK, to outperform.
The 2014 surprise was that long duration debt did really well (see 2014 & the Fight Against Deflation,
published November 25, 2013). 2015’s surprise could well be non-U.S. DM equity market
outperformance. The additional surprise might be that they do so in local currency as well as on a USD
basis. Put cash to work in these markets, split between hedged and un-hedged vehicles.
Fixed Income
On the fixed income side, the good news is that rate spike risk (the bête noire of the markets) has been
taken out of 2015’s calculus via the oil shock. The bad news is that last year’s huge rally in sovereign
and high-quality corporate credit has taken away a lot of upside.
UST continue to look attractive on a relative basis (10-year UST yield @ 1.74% versus 0.30% in
Germany and 0.20% in Japan), while deflation risk and reduced supply support sovereigns in Europe
and Japan. With QE likely in Europe and continuing in Japan, it is hard to see rates backing up in any
meaningful way. Adding to long duration UST on pullbacks makes sense.
U.S. preferreds are a top fixed income choice for this year, many of which yield 6% or better, pay
monthly and have very supportive charts. US MBS and HY are also attractive, though the fall in rates
has increased the refinancing risk for MBS. US HY now yields over 7%, while the energy risk has been
pretty well captured and the space trades better than it has in months. One has to always ask what is in
the price, and here it seems like much of the downside has been priced in. Non-traditional yield plays
such as infrastructure and real estate remain of interest.
Emerging Markets
What about Emerging Markets? Mexico remains the favored equity destination. A cheap peso, down
close to 15% versus the dollar, a stock market that is more fairly valued given a similar 15% decline, an
economy that is becoming more and more integrated with its northern neighbor, and an energy sector
that will open as the year progresses, are all supportive. It’s also worth noting that while Mexico as a
crude exporter has hedged 2015 sales at a price some 50% above spot, it also imports refined products
that will now be much cheaper. India is also becoming more attractive as weak oil leads to inflation
declines, which allow for rate cuts – valuation remains challenging, as does execution risk in terms of
government policy.
USD-denominated sovereign EM debt remains attractive. Default risk exists (Venezuela, Ukraine), but
seems priced in together with corporate default risk and compensated with a 6% yield. The technical
picture is also supportive, with 2015 sovereign net issuance back to 2008 levels.
Finally, in discussing objects in motion, one might consider energy-related yield plays. Vehicles with
hedged production and yields that are not completely at risk of being eliminated could do well. These
assets seem to be stabilizing ahead of the oil price. Yours truly is in the space, sizing properly (one
hopes) and being more trading-driven than usual.
One thing is for certain, while another name for Newton’s First Law is the “Law of Inertia”, investors
cannot afford to be inert in 2015…stay focused, my friends!
Itaú BBA
4
Global Connections – January 21, 2015
Jay Pelosky is Principal of J2Z Advisory, LLC, a global asset allocation and portfolio strategy
consultancy for institutional investors. Jay advises clients and invests personally based on insights
gained from 30 years of financial market experience in over 45 countries. For the past decade, he has
invested his own capital in a global, multi-asset, ETF-based Asset Allocation strategy. He sits on the
board of Franklin Holdings (Bermuda) Ltd. and serves on the advisory board of Carmel Asset
Management. Jay teaches a graduate level course, The Art and Practice of Global Investing, at The
George Washington University and is a founding member of the New America Foundation’s World
Economic Roundtable. His formal Wall Street career spanned twenty years and included positions on
both the buy-side and sell-side. At Morgan Stanley, he launched the Firm’s global asset allocation and
global equity strategy research products. He also formed and co-chaired the research department’s
asset allocation committee. Jay created the firm’s Global Emerging Market Strategy (GEMS) product
and initiated its equity investment, research, and strategy efforts in Latin America.
[email protected]
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Global Connections – January 21, 2015
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