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Hedging for a Reversal of Reflation | The Big Conversation | Refinitiv - YouTube
Channel: Real Vision Finance
[5]
[00:00:05] Last week, we looked at the popularity
of the reflation trade, which has built a
[8]
big consensus amongst the active investment
community.
[12]
But this is a very different type of reflation
trade to the one we saw in the early 2000s
[16]
and to a lesser extent, from 2016 to 2017.
[20]
So what sort of simple hedges should investors
think about to protect any gains that they're
[24]
making from this trade?
[26]
That's The Big Conversation.
[29]
[00:00:34] One of the key decisions that investors
have to make about this move in asset prices
[38]
is whether this is a reaction to a weaker
dollar or whether we're seeing true global
[42]
reflation, synchronized growth, driving these
asset prices.
[46]
Now the reflation narrative itself is very,
very compelling, but it's not a particularly
[49]
new one.
[50]
In fact, we had Julian Brigden of MI2 Partners
on this very show in August putting out there
[54]
his short dollar thesis and reflation trade
ideas.
[57]
But this narrative is really gained some steam
since the election and particularly since
[61]
the vaccine headlines on the 9th of November.
[64]
So I think we need to look at what it is that
maybe suggests this is global growth or otherwise,
[68]
or whether this is just a dollar move.
[71]
I think first we can look at the ratio of
gold vs. silver.
[74]
Now gold and silver, both precious metals,
both benefit from a lot more fiat currency,
[79]
so money printing, etc.
[80]
But if this is true, global reflation, so
industrial, economic reflation, then we should
[85]
expect certainly some significant outperformance
from silver.
[89]
Now what we can see in this chart is that
silver has outperformed through the second
[92]
half of last year.
[94]
But since November, since this narrative has
really picked up steam, silver has only marginally
[99]
outperformed.
[100]
It should really be a lot higher than gold
relative to where it was at the end of Q3.
[104]
So this ratio of silver versus gold, should
really be seeing silver doing a lot better
[109]
than it is if there was true, global growth
out there driving industrial demand.
[113]
In a similar vein, we can look at European
equities versus the S&P.
[118]
European equities themselves are not so sensitive
to currency, but what they are sensitive to
[122]
is demand in emerging markets.
[124]
So if emerging market demand is very, very
strong, that's usually good for European equities.
[128]
Again, what we can see here is that since
November, we have not seen much outperformance
[134]
if any, of European equities versus the S&P
all the outperformance over the last two and
[139]
a bit months came at the very beginning of
November after the election and after the
[143]
vaccine headlines.
[144]
But since then, when the narrative for reflation
has gathered steam, European equities have
[149]
not outperformed the US.
[152]
If there was true growth, we would expect
to see those European equities outperform.
[155]
Now this is a topping formation that we can
see here.
[158]
So there is potential, it may be that this
is a topping formation, lagging the one we
[161]
saw in emerging markets by a few weeks, but
nonetheless it has been very unimpressive
[165]
the performance of Europe versus the US.
[168]
And despite the stronger euro, people could
say, well, the stronger euro is a negative,
[172]
but in true reflation that industrial demand
will far outstrip any move in the currency
[177]
and we've not seen that so far.
[178]
So there are these various signs that this
is not true global reflation.
[181]
We looked at some last week as well.
[183]
But let's look at the dollar.
[184]
And what's interesting about the dollar is
that the dollar moved down, this leg down
[188]
that we've seen, has been bookended by the
election.
[191]
This leg started lower at the beginning of
November with the election victory for Biden
[194]
and then the vaccine.
[195]
And we've just seen the best four day period
of dollar outperformance since the Democrats
[201]
got the blue sweep by winning Georgia.
[203]
Profit taking on the dollar trade.
[206]
This feels like the dollar is the key determinant
of all these risk assets are not real true
[210]
global growth.
[211]
And this is something that we can see in this
next chart where we have copper versus the
[215]
Korean market, the Kospi 200 versus the dollar
index, which on this chart has been inverted.
[221]
They're pretty much the same chart over the
last three years.
[225]
Emerging markets, particularly Asia, tend
to be more sensitive than things like Europe,
[228]
and here we can see how those dollar sensitive
assets are reacting to the dollar move.
[233]
It's the dollar that's driving those risk
assets higher.
[236]
And it's not global growth that's driving
emerging market equities higher, which means
[239]
the dollar will be on the back foot.
[241]
It's the other way around.
[243]
So that brings us onto this narrative, which
is OK, fiscal, monetary, vaccine all together,
[249]
creating this reflation narrative.
[250]
And one of the big arguments within this is
that the Federal Reserve, in particular, the
[255]
central bank of the US, is going to be the
most aggressive.
[257]
And in some ways, there's a little bit of
an inconsistency here, because what we can
[261]
see is that the US Federal Reserve was aggressive
at the beginning.
[265]
So back in March, they expanded their balance
sheet very, very rapidly.
[269]
But since then, the ECB has caught up and
has overtaken the Fed in absolute terms.
[275]
So the Federal Reserve is not the most aggressive
central bank at the moment.
[279]
If we then look at central bank balance sheets
compared to GDP, we can actually see that
[283]
the US is lagging behind the ECB, and both
the ECB and the Federal Reserve are significantly
[289]
lagging behind the Bank of Japan.
[291]
So the Federal Reserve is neither the absolute
most aggressive central bank, nor is it in
[296]
relative terms anywhere near the most aggressive
central bank.
[299]
And what's part of this narrative is that,
well, OK, the Federal Reserve might be the
[303]
most aggressive, and I don't doubt that they
have more opportunity to react, we saw that
[306]
at the beginning of this whole pandemic.
[308]
They were the first and the hardest to react.
[310]
But then we look at the actual move in the
currency and the idea that the central bank
[315]
of the US is going to do more expansion, monetary
expansion, balance sheet expansion, and that's
[319]
going to drive the dollar lower.
[321]
What we can see here is actually when the
Federal Reserve was doing the least and the
[325]
ECB was being more aggressive, that's when
the euro started to go higher, going from
[330]
109 to 122.
[332]
So actually when the ECB was expanding its
balance sheet at the fastest rate is when
[338]
the euro rallied, not when the Federal Reserve
was expanding its balance sheet, pushing the
[342]
dollar lower.
[343]
So in some ways, that narrative that we've
been listening to, or has been some of the
[347]
common narrative, is inconsistent with what's
actually been happening.
[350]
Now these are coincidental moves.
[351]
I'm not saying that one necessarily influences
the other, but the euro has been going up
[356]
when the ECB has been the most aggressive
in expanding its balance sheet.
[360]
And so what does this really mean for the
US if this is not global reflation, but asset
[365]
prices reacting to a weaker dollar, pushing
reflation prices higher, then what we might
[370]
end up seeing is that reflation is being priced
in more aggressively into a lot of US assets,
[376]
and therefore we might start to see a growth
premium into the US.
[379]
Now, this has a couple of implications.
[381]
The first one is that policymakers tend to
react to risk assets.
[386]
If policymakers are seeing the US looking
much healthier, they will be less inclined
[390]
to do more.
[391]
And as I said before, the Fed reacted very,
very aggressively back on March 23 when there
[396]
was a crisis.
[397]
But as the crisis appeared to dissipate, as
risk assets moved higher, the Federal Reserve
[401]
has stepped back.
[402]
The US policymakers have stepped back.
[404]
They've not been as aggressive.
[405]
The point is that it needs the market to signal
that they need to be more aggressive before
[409]
they will be.
[410]
In the meantime, what we're seeing is that
we're seeing that growth premium coming into
[413]
the US.
[414]
Bond yields in the US are going higher.
[416]
So the 10 year yield has been breaking out,
it's now above one percent for the first time
[420]
since March.
[421]
We're seeing the yield curve steepen.
[422]
This is making US assets such as financials
and cyclicals look more attractive.
[427]
At the same time, we can see that in Germany,
the Bund is actually going nowhere.
[432]
It's been grinding slightly lower at the same
time that the US ten year yield has been grinding
[435]
higher and now breaking out.
[437]
This means that the differential between the
US and Europe is widening out once more.
[441]
Now, it's nowhere near where we were at the
beginning of 2020, when the US 10 year yield
[445]
was at one point eight percent and Bunds were
at 25 basis points.
[449]
But nonetheless, the spread is widening out.
[451]
This will start to make US bonds and yields
on US bonds look attractive to an international
[456]
investor.
[457]
The point here is that if you get reflation
assets in the US performing well whilst the
[461]
rest of the world, which needs global synchronized
reflation, is only reacting to the dollar,
[467]
eventually capital will get sucked back into
the US and that will allow support for the
[472]
dollar and may even drive it higher, just
when people are going all in on that global
[476]
reflation trade.
[477]
So if you think that this is a dollar move
and not a global synchronized growth reflation
[482]
move, then there is a blindingly obvious hedge
to put on.
[485]
And that's being long dollars, but long dollars.
[487]
I think through optionality.
[488]
What we're looking at here is a chart of volatility,
which is three month volatility of the euro
[494]
versus the US dollar.
[495]
And apart from three spikes that we can see
here, the actual volatility on those options
[500]
is around about the lows of the range over
the last 20 years.
[504]
So volatility in the FX market has been suppressed
by central banks.
[507]
So that makes options on the currency look
quite attractive.
[511]
At the same time, a chart we've shown before
is that the euro positioning is extreme.
[515]
So longs on the euro are just off their all-time
highs.
[519]
If we do see a pullback in this positioning,
as we can see on this chart, the euro has
[523]
often corrected back down between 5 and 10
percent.
[526]
So there's a risk that this dollar move could
reverse and positioning could unwind, because
[531]
a lot of these moves are speculative positions
from hedge funds chasing the reflation narrative
[536]
of the weaker dollar, not stronger global
growth.
[540]
We can also look at the difference between
puts and calls on the euro or the dollar to
[544]
see whether this is a reasonable trade to
think about in terms of hedging that reflation
[548]
trade.
[549]
When we look at the risk reversal, this is
the euro risk reversal, again, three months.
[553]
We can see that the difference between a 25
delta put and a 25 delta call on the euro
[558]
is about zero.
[559]
So one is equal to the other.
[560]
Now, there have been periods actually where
pricing the downside in the euro has been
[564]
much more, but it's round about neutral on
a three or four year view.
[568]
But nonetheless, it was suggested if you wanted
to buy the downside on the euro, the upside
[571]
on the dollar, it's a reasonably good time
based on the look back over the last four
[576]
or five years.
[577]
But of course, if we're hedging a portfolio
of reflation assets with currencies, we need
[582]
to adjust it for notional.
[583]
The reason being that commodities and equities,
the volatility is significantly higher than
[588]
most currencies.
[589]
If you look at something like copper and emerging
markets, we're talking 20, 30, 40 volatility
[593]
versus the CVIX, which is the volatility index
for a broad range of currencies.
[598]
And as we can see in this chart, the volatility
of the FX market is significantly lower than
[601]
the volatility of the equity market.
[603]
This is the CVIX versus the VIX, which is
the S&P 500.
[606]
What it means is you need slightly more notional
on your dollar hedge than you have on your
[610]
underlying reflation or commodity and equities
position.
[613]
It's a bit like thinking about when you had
or people used to have the bond versus equity
[618]
portfolios, where the bonds would decline
slightly when equities were rallying, but
[622]
when you had a collapse in equities, bonds
would rally and offset some of those losses,
[626]
but not all of those losses in the equity.
[628]
Similarly, you want to position in the dollar,
which will mitigate some of the losses, but
[632]
it's unlikely to actually offset them completely.
[635]
This is a hedge to reduce the losses if the
reflation trade turns out to be short lived
[639]
and based purely on the direction of the dollar.
[642]
Another hedge we can think about, and it's
not really a hedge, the short term moves,
[645]
but it's an opportunity that we might get
from the reflation trade.
[648]
We saw this on Friday when those yields on
the US 10 year started to move higher, nominal
[652]
yields, didn't bring the real yields higher,
but that was the potential.
[655]
But when real yields and nominal yields move
higher, we often see pullbacks in gold.
[659]
Gold came off three or four percent on that
Friday move.
[662]
These are opportunities to build gold positions
because going forward, I do expect there'll
[665]
be more fiscal, so there will be more monetary
debasement that will be good for gold.
[670]
And if we again go into a world where growth
is seen to be very, very weak and governments
[674]
and central banks have to do more, then that's
a great environment for gold, and probably
[679]
real yields will head lower once more and
gold will head higher.
[682]
So building gold positions into that weakness.
[685]
So it's all about keeping it simple.
[687]
This is a move in reflation assets on the
back of a weaker dollar, not a move in reflation
[691]
assets, because we've got global reflation.
[693]
Therefore, the hedge should be the first port
of call on the dollar.
[696]
That's the thing that's driving it.
[697]
If the dollar reverses, that's going to cause
all these other assets to roll over.
[701]
FX volatility looks relatively cheap versus
these other asset volatilities.
[706]
And so that's the easiest and the cheapest
way to do it.
[708]
You need to buy a little bit more notional,
but ultimately, if this is a dollar based
[713]
trade, currencies rarely move in a straight
line.
[715]
And we've come into the new year with a very
aggressive narrative from the active investment
[721]
community.
[722]
It's on one side of the boat and they can
move very, very quickly back to the other
[724]
side if we don't see global growth pick up
properly to drive this next leg higher.
[733]
[00:12:16] Early in the second quarter of
2020 Refinitiv's Cornelia Andersson joined
[739]
us to talk about the collapse in global M&A
volumes due to the pandemic.
[742]
Now whilst M&A activity rarely translates
into immediately actionable opportunities,
[747]
I still wanted to ask Cornelia about the evolving
trends that may impact markets in 2021.
[751]
[00:12:33] What a year 2020 was for M&A.
[755]
It was really a tale of two halves.
[758]
So in the first half we saw activity virtually
grind to a halt, and there was very little
[764]
going on.
[765]
Then as we approached the summer in the second
half of the year, we had an absolutely record
[770]
second half of the year for M&A activity.
[772]
So talk about a rebound.
[775]
We saw volumes return in the second half of
the year that took us almost up to where we
[780]
were in the year before.
[781]
What we've seen is really a situation where
as the year progressed, the large corporates
[788]
in particular spent the first half of the
year dealing with the shock of the initial
[792]
crisis.
[793]
So they spent a lot of time shoring up their
balance sheets, making sure that they had
[797]
access to appropriate funding.
[799]
And then as we moved into the summer, large
corporates largely got comfortable with the
[804]
new normal and they started to revise their
M&A strategy and they started to be open to
[810]
doing deals again.
[812]
So we have absolutely seen the return of the
megadeals.
[816]
So once again, the second half of 2020 was
a record time period for megadeals, and by
[822]
megadeals we mean transactions over 5 billion
dollars.
[826]
We saw almost a trillion dollars worth of
megadeals.
[828]
And these are really the large corporates
that are, they have deep pockets, they have
[833]
access to very cheap debt financing, as we
know, in this low interest environment, that
[837]
is a big driver of M&A activity, and with
a renewed sense of confidence.
[845]
[00:14:06] The obvious explanation for this
activity is that we are seeing consolidation
[849]
as well as sector specific concentration in
areas such as tech, where cash balances are
[854]
high and there is easy access to cheap capital.
[856]
[00:14:17] We're seeing a trend of consolidation
in several different industries.
[859]
The asset management industry in the UK, in
Europe and the UK is a very good example of
[865]
that, whereby we're really seeing the dominant
players focusing on their smaller rivals to
[873]
be able to achieve that scale, to manage the
cost basis, to tap into new customers in new
[878]
markets very, very effectively.
[880]
Overall technology had a massive year in terms
of M&A.
[884]
So we saw some very, very large transactions
there.
[887]
And what I personally find is very interesting
is the renewed focus on workflow and collaboration
[893]
tools.
[894]
So as a result of the economic crisis, we're
all working virtually now.
[898]
So there's a renewed interest in these types
of tools.
[901]
So a great example is Salesforce acquiring
Slack for 28 billion dollars, a megadeal,
[906]
a technology deal, a large corporate deal.
[910]
That deal really hits on the key trends that
we've seen in 2020.
[913]
One of the very interesting things is that
we're seen an uptick in cross-border deals.
[918]
Right, so you might almost assume that the
opposite would happen in this type of situation.
[923]
When there's a global crisis, we've also had
plenty of geopolitical tensions, we've had
[928]
uncertainty in lots of different local markets,
but we've actually seeing an increase in cross-border
[933]
deals, meaning that corporates are increasingly
looking for global opportunities.
[938]
If we look at the three major regions, we've
seen a downtick in activity in the Americas,
[943]
particularly the US, and instead we've seen
much more activity in Europe and in Asia.
[949]
In fact, six of the largest ten deals in 2020
took place in Europe.
[953]
And if we look at Asia, it's a very encouraging
story because Asia saw the impact of the pandemic
[960]
crisis first, but they've also seen the recovery
much sooner.
[964]
[00:16:04] Despite the collapse in deals in
the first half of 2020, private equity was
[968]
sitting on a lot of very dry powder and was
standing ready to deploy that capital.
[972]
[00:16:13] So yeah so there are a couple of
key trends, a couple of drivers of the dramatic
[978]
upturn in M&A activity that we saw in the
second half of 2020.
[983]
And one of the key drivers here is private
equity.
[986]
So back in April, we called up private equity
as one of the likely drivers of the recovery
[991]
in the Corona Correction series.
[994]
And if we look at the data, we see an increase
of 27 percent in financial sponsored backed
[1000]
buyouts.
[1001]
So these are really the transactions that
are driven by private equity firms.
[1005]
So interest rates are low, investors are willing
to invest in growth and there are plenty of
[1010]
opportunities as a result of the crisis that
were not available before.
[1016]
So it's really the perfect conditions for
private equity firms to execute.
[1020]
[00:17:01] Low interest rates have fueled
the late 2020 surge.
[1022]
Rates are set to remain low in 2021, but debts
have increased and yields are starting to
[1028]
rise, and this could impact future volumes.
[1029]
[00:17:10] So when it comes to the interest
rates, central banks across the world have
[1032]
certainly flagged that you know they're expecting
to remain in a lower interest rate environment
[1038]
for quite some time, so we're probably not
going to see any major impacts now, so that
[1043]
it's likely that debt financing will continue
to remain relatively cheap.
[1046]
However, we have had a record year on the
capital markets front as well, which means
[1053]
that there's a number of corporates that have
refinanced and they have raised additional
[1057]
capital and now are dealing with a fairly
heavy debt burden.
[1060]
So the question is, are they going to be able
to maintain that going into 2021 or are we
[1066]
going to see an increasing number of distressed
companies thereby resulting in distress driven
[1072]
M&A?
[1073]
So I think there's a good chance that we'll
see that towards the end of next year.
[1076]
Additionally, we will absolutely see more
megadeals next year.
[1079]
And that trend is not going to change where
we'll see more private equity.
[1083]
We'll also see technology continue to dominate
as a sector.
[1087]
[00:18:08] In many ways, M&A echoes the broader
financial markets.
[1090]
It's been a boom for companies with access
to cheap funding or sitting on cash piles.
[1095]
Large cap corporations with access to capital
markets have been in a strong position, but
[1099]
leverage has increased.
[1100]
Meanwhile smaller companies such as family
businesses have struggled to remain solvent.
[1105]
Historical returns to large cap companies
acquiring other large cap names have been
[1108]
poor.
[1109]
But in a world where passive flows favor the
largest listed corporations, the benefits
[1113]
in this cycle may be as much to do with fund
flows as they are to do with improving the
[1117]
business model.
[1118]
Big years of M&A have often preceded poor
years for markets such as 2000, 2007 and 2019.
[1123]
But as we've discussed before, maybe the influence
of central banks can break that historical
[1130]
pattern.
[1131]
[00:18:55] And you can now get The Big Conversation
from Refinitiv as a flash update on your Alexa
[1139]
device or Google assistant.
[1141]
If you want to know more about how to download
it to your smart speaker, please go to Refinitiv.com
[1146]
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