WEEK 19 2023MAY06

Good morning. This is another episode of Two Grey Beards, where we talk about what happened in the market last week, what to look for next week, and what that means for your portfolio. Nick, what do you think happened last week? A lot of things happened last week, but the end result was a bit of nothing. So we had the Fed, we had the ECB, we had non-farm payrolls, and we had the

announcement about the refunding, i.e. how much money they’re going to raise. I’m sure you’ll talk about that. But as far as the central banks are concerned, both the ECB and the Fed hiked by 25. And they were hawkish hikes in so far as neither have said that they are stopping here or that they have potentially reached.

the terminal rate. The ECB very explicitly said that, no, they have not reached the terminal rate and that they are still on a journey and they will hike more. The only question is how far and how fast, while the Fed as expected went fully data dependent. And like clockwork, the first bit of data that we got, which was non-farm payroll was

You know, we can argue how hot it was, but what we can’t argue is that we were cold. The thing that impressed me is that average earnings keep on being much higher than the market expects and that that in no way can please the Fed. We do have one more NFP piece of data and next week we have CPI and one more CPI before the next FOMC.

If those disappoint, I think the Fed just cannot afford to stop. And that is not good news for any asset, let alone, you know, the fully priced cuts that we have in the market for the second half of the year. What do you think, Andy? Right. You know, I.

There was a big rally on Friday. A lot of people thought that was a big deal on non-farm payroll being warm to hot. Um, that sort of makes sense to me from a standpoint of what was actually happening, which is the market ended the week unchanged and the prior day, there was a fair degree of concern about PacWest Bank and the other one, Western Alliance Bank. And that proved to be at least for the time being, nothing.

And so that took some of the risk out of the stock market and the bond market responded as you might expect to a warm number by selling off some of those very, very significant cuts that got priced out of the market for this year as the fear that the banking crisis was going to require a Fed response, but the high-level point is after all that nothing happened.

Bonds are unchanged, stocks are unchanged, and gold came back off of its highs. We did have Apple earnings, and I’ll mention the two other points. Apple earnings were strong, but you know, in declining earnings, year over year, a significant decline in earnings year over year, but beating expectations, the stock rallied, which makes some sense, but not much. And worth a, you know, a small

a tiny bit of a percentage of the total S&P and NASDAQ returns. Prior to that, on Monday, the government announced that they were going to issue $1.2 trillion of debt in the coming quarter as soon as the debt ceiling is resolved. And that number was an eye-popping number and speaks to two things. One, is that they are going to want to rebuild their checking account as soon as possible after a debt ceiling is resolved.

And two, the deficit is increasing rapidly. The CBO, the Congressional Budget Office, projected a deficit of $1 trillion based on the spending that had been budgeted in the, I think it was in January when the budget passed. And that number is now likely to be re-forecast at 1.5 trillion as the very high capital gains tax returns from.

the selling that happened in 2022 is reduced. And even though wages are increasing, tax income is going to decline. But much more importantly, and we’ve highlighted this before, the cost of U.S. debt is rising. And so expectations of higher interest rates for longer will generate an increased deficit. That’s just how it works. We pay more out in interest, we pay interest to the Fed.

to fund the RRP program, the government is going into a rapidly increasing deficit without any change in spending. And so that’s a lot of debt. And so, you know, that’s the thing that may dislodge some of these very low shifts in asset prices that we’ve been experiencing pretty much all year. Net net week on week, very little keeps on changing. We might get some interweek volatility.

By the end of the day, ETFs like ARPA, which is basically, you know, 60-40 and a little bit of gold, it keeps on being very neutral on a week-to-week basis. So I guess people are re-leveraging from a volatility standpoint, because net-net realized volatility in this market is very low. And that means that certain funds have room to add risk.

to their portfolio simply because they calculate that it’s not going to hurt them very much because realize volatility is so low. I guess that is what is going on and that’s who the buyers are. Yeah, I think, you know, as a, having a portfolio that we’ve described as very conservative at 50% cash and roughly, and low on equities and low on bonds.

It wouldn’t surprise us that others have, other professional investors have taken a conservative stance on their portfolio. In fact, I’d be shocked if they hadn’t. So the question becomes, is there still a huge overhang of people that are poorly positioned, expecting rapid recovery? Or has the sort of wide-ranging portfolio held by investors,

been delevered, de-equitized, de-bondized over the course of the last 18 months. And if it has been, what that means is some other investor must have bought the things these smart, long-term investors have sold. And the reason why they were capable of buying those things was that these other investors…

is because they were perceived as being a low-risk portfolio. That could be what’s going on. So the question is now that there’s been a broad redistribution of risk across the global markets, and people have what they want, what will dislodge it? And the answer to that is basically two things. One, events, and the other is supply and demand.

And as I said at the beginning, $1.2 trillion of new government bonds is a lot of supply. So supply that we have not seen because of the debt ceiling. But demand reigns and demand is built as long as volatility remains low. And, you know, that’s what we’ve seen.

Yeah, the 1.2 trillion doesn’t scare me at all because the bond market can absorb any amount in a risk-off scenario. You know, you can absorb 10 trillion. Sure. Well, maybe not 10, but you know what I mean? It can absorb a hell of a lot if there are bond buyers and people are getting out of equities for fear. So really what we are saying is that if, uh, what is needed to get equities lower is

higher realized volatility and these volatility targeting funds having to sell some equities yeah and finding buyers at lower levels and that probably is going to take some time or as you say events and we just have to wait for it there’s not much else that we can do to the portfolio in the meantime sure so in terms of um looking forward what do you think happens next week well the

outstanding events going to be CPI and as I said we only have two CPIs before the next FYMC. I haven’t seen a single piece of cold data that’s been coming out of the US regarding inflation or regarding wages or regarding rents which go into the calculation of the PC and so on. So I have no reason to suspect

that the CPI and the PPI that’s the day after, they’re going to be anything but as expected or potentially higher. And therefore I don’t see any reason to do anything in Bondland. I certainly don’t see that there’s value at these levels which are discounting massive rate cuts by the end of this year. Yeah, one other bit of data is that as…

happens every other week there are a hundred billion dollars of threes, tens, and thirties auctions Tuesday, Wednesday, and Thursday we’ll keep an eye on that to see if there’s any pushback on what is pretty much fully priced in recessionary pricing in the bond market which is as I said absent in the equity market because people say

I like my portfolio because I have an upside in a non-recession case in equities and downside protected in bonds, but the prices of both have risen to levels where in a recession you might not get much more performance in bonds and you’ll get hurt in equities. And in a, you know, it takes time for a recession or no recession.

you might not get much upside for equities but you’ll get very hurt in bonds. And so we’ve moved to a price that is unattractive relative to cash and we have supply in front of us. So what do you think we should do for the portfolio? Well, I’ve just updated the monthly performances and we’re at 3.1 years to date which annualizes at about 9 percent.

and we’ve been very very defensive throughout this period and it just shows you that if you’re patient and you stick with cash yielding 5% plus it might be nominal but you still get to compound at a decent clip the only thing that slightly worries me is the fact that our FRN position is

very short duration by definition because it resets on three-month bills. And maybe we should add a little bit of duration in terms of, you know, bidding below. As we’ve said, we don’t like bonds at these prices. We think that they can cheapen up very easily. But, you know, our foreign

VWOB ETF has a very high monthly coupon of 5%, i.e. distributes at 5% every month, and also has a yield to maturity of over 7%. And it has a duration of about six and a half years. So if we added very little to that part, it prolongs our duration.

ever so slightly and it gives us a sort of future optionality. But I wouldn’t buy it here. I’d leave bids below in both VWOB and in other ETFs which are not dollar based. They are you invest in dollars but you don’t get the income in dollars just and that gives us optionality over the debt

If something bad happens there, the dollar is going to get absolutely killed. Right. So, uh, something like VW OB, but in local currency terms, that’s correct. And I’ll have currency, right? That’s correct. That is a whole load of a basket of different currencies because they invest in local bonds, which pay in local, uh, in local currencies. And then they translate it all into dollars whenever it needs to be.

Sure, that makes sense to me. So we have virtually no nominal duration except the VWOB. So adding to our duration with a, I wouldn’t buy a US bond here, but you’re talking about comparing a 7% yield to maturity with a 3 and 1 half percent yield to maturity bond available in the United States. Sounds like a plan for me.

EM exposure as well. So sounds good. I will address all that now in my segment. Okay, great. As far as the portfolio is concerned, we really didn’t do much. We sold the two lots of options in the S&Ps struck at 3,800. They close roughly unchanged from where we sold them and we don’t expect that.

to really become an issue over the course of the next month. You will find that naturally in the broker statement, which is in that tab. Otherwise, these are allocations. Should we get exercised, we will be around the 40 in the 40s on the equities, but we don’t think that that is a problem, certainly not a 3,800. The only orders we would enter are these

LEMB and VWOB buying 200 shares in each and as I mentioned that is just to increase slightly the duration of the fixed income that we have because we are very very short at the moment and that’s paid off. Still, we think that as time goes by we need to increase that duration and we need to average in.

So this is VWOB and the reason why 60-72, I’ve marked it here, technically that is the kind of level that I think we can get to. And don’t forget that this is something that yields you 5% every month. And as we mentioned, has a seven, over 7% yield to maturity. The other one that I’ve included is LEMB, which is much the same.

as VWOB but it’s in local currency and if you look at the ratio between one and the other the local currency one is beginning to break out on the ratio saying that one should favor LEMB. We go back to LEMB you know we put in a bid here at 3617 we are not going to chase this.

At some stage it comes back, so we’re not too bothered. And we’re only buying a few shares and increasing by a few percentage points the allocation. So we are really not chasing stuff, we’re not desperate. But we do think that over time, what you should do is slowly, slowly start averaging in into something which has a longer duration.

and very high yield like over 7%. I don’t think you can go wrong over the medium term. Finally, I’d like you to know that I’ve updated the monthly performance, and also naturally everything is in the broker statements tab. You have the monthly performance statement and also the weekly one. As you can see 3.21

So we’re annualizing around the 9% being very heavy in cash. And that I think is perfectly reasonable. In conclusion, I just like to remind you about the research tab, which is in the member’s area. And that leads you to the research which I update on a daily basis. And…

This is research that cost me many thousands of dollars from various research houses and brokerages and investment banks, and which I pass through. Anything that I think is relevant, even though it might not agree with my views of the markets, and anything that I think is well argued and cogent and potentially useful, I put in here.

on a daily basis when it’s published so you can have a look at it. I think it would be a shame if you don’t use that button and make use of all the wonderful resources of Morgan Stanley, Goldman Sachs, Barclays, Credit Suisse, and Credit Agricole. The list goes on and on and on. Have a great day. Have a great day. See you next week.

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