unemployment rate data suggest that the US recovery remains robust, even though wage growth pressures are subdued. In th
8 October 2014
LSR Portfolio Tactics Asset class focus:
The other deflation trade
Multi Asset
We have argued before (see Chartbook October 2014) that, longer term, there’s scope for the Treasury-Bund differential to widen much further than current levels. We show that a related argument applies to the Treasury-Gilt differential, since the UK has been importing Eurozone disinflation through trade linkages and currency strength. We buy Dec 2014 Gilt future against Dec 2014 US Treasuries future to express this view in our model portfolio.
Fixed Income Currencies Equities Commodities
The widening Treasuries-Bund 10-year differential has been one of the most successful consensus views in global rates over the previous 12 months given the sharp decline in Eurozone inflation around the same time as US growth has accelerated and the Fed has been tapering asset purchases. While we have argued before that structurally this differential can widen much further (see Chartbook October 2014), from a tactical perspective, the marginal reward to risk in this “Eurozone deflation” trade is now significantly diminished in our view. But we think there is another relative-value macro-divergence trade that hasn’t quite become consensus yet: the Treasuries-Gilt differential. The arguments for the Treasuries leg of the macro divergence are based on factors such as end of Fed QE and growth acceleration in the US. We focus on the UK leg of the proposed trade. With strong trade linkages with the Eurozone, the UK and Eurozone inflation cycles have been tightly correlated with Eurozone CPI often leading the UK CPI, presumably because the Eurozone is the larger trading partner (see the first chart below). Divergences in the paths of the two y/y CPI series have been temporary. Moreover, with sterling strengthening more than 10% against the euro since July 2013 (6% since March 2014), further import of Eurozone disinflation is likely. Indeed, as the second chart below illustrates, past episodes of sustained sterling strength relative to the euro have also brought sustained declines in UK CPI inflation relative to the Eurozone CPI inflation. The impact of the recent sharp decline in EUR/GBP since March is arguably still ahead of us.
Trade linkages and currency strength likely to cause the UK to import Eurozone disinflation Eurozone CPI 6
UK CPI
Eurozone-UK CPI (rhs)
0.93
Eurozone CPI has led UK CPI historically
5
EUR/GBP
0.5
0.91
0.0
0.89 4
-0.5
0.87 3 2
-1.0
0.83
-1.5
0.81
1
2008
2009
2010
2011
2012
2013
-2.0
0.79
Historical divergences have been brief
0 -1 2007
0.85
-2.5
0.77 2014
0.75 2010
-3.0 2011
2012
2013
2014
LSR Portfolio Tactics
LSR Investment Strategy
8 October 2014
Relative slowdown in the UK has been sharp Gilt-Bund 10y
…and is likely to be reflected in inflation
UK-Eurozone PMI (rhs)
1.6
Gilt-Bund 10y 11 10
1.4
UK-Eurozone CPI
3.0 2.5
9 1.2
2.0 8
1.0
7
0.8 0.6
1.5
6
1.0
5
0.5
4 0.0
0.4 3 0.2 0.0 2011
2 1 2012
2013
2014
-0.5 -1.0 2010
2011
2012
2013
2014
One implication of the analysis above is that Gilt yields could actually fall further from the current levels. Indeed, the two charts above show that 10-year Gilt yield is looking a bit elevated relative to the 10-year Bund yield given the sharp decline in the Markit UK composite PMI relative to the Markit Eurozone composite PMI and the likelihood of UK CPI following the Eurozone CPI lower. A similar divergence appears for the 10-year Gilt yield relative to the 10-year Treasury yield in the two charts below. The Markit UK composite PMI has declined sharply relative to the Markit US composite PMI and UK CPI inflation has slowed significantly relative to US CPI inflation. The implications of the relative growth and inflation fundamentals are unmistakable: the Gilt-Treasury 10-year differential has probably much further to fall.
Gilt yield high given slowdown in growth … Gilt-UST 10y
… and especially CPI inflation
UK-US PMI (rhs)
0.3
Gilt-UST 10y 14 12
0.2
UK-US CPI (rhs)
1.0
4.5 4.0
0.8
3.5
10 8
0.1
6 0.0
3.0
0.6
2.5 0.4
2.0
4 2
-0.1
0
1.5
0.2
1.0 0.0
0.5
-2
-0.2
0.0
-0.2 -4
-0.3 2011
-6 2012
2013
2014
-0.5 -0.4 2009
-1.0 2010
2011
2012
2013
2014
2
LSR Investment Strategy
LSR Portfolio Tactics 8 October 2014
One potential complication for our view could be the widely-held expectation that the Bank of England is about to embark on rate hikes, while the Fed will probably not hike till mid-2015. For one, we believe there are risks to both views. However, even if we grant that the Bank will hike first, we think that in the absence of inflationary pressures in the economy and given the likelihood of the UK importing Eurozone disinflation, any rate hikes will only serve to flatten the curve rather than raise the level of the curve. On the other hand, the most recent non-farm payrolls and unemployment rate data suggest that the US recovery remains robust, even though wage growth pressures are subdued. In this scenario, we believe the relative real-activity fundamentals are likely to be the dominant driver of long-end differentials. On balance, our view is that the UK’s exposure to the Eurozone is just too great to make the notion of a structural divergence between Gilts and Bunds sustainable. Hence, we believe Gilt yields should grind lower while Treasury yields rise as the Fed’s asset purchase programme draws to a close. Coming to the model portfolio updates, we have allocated a 20% weight to our new Gilt-Treasury trade and reduced the weight on the German 2/10y steepener by the same amount in order to reduce portfolio concentration in government bonds. With these changes, the portfolio volatility now stands at 4.6%.
Andrea Cicione and Eugenio Montersino
3
LSR Portfolio Tactics
LSR Investment Strategy
8 October 2014
Model portfolio: composition Opening Date
Theme China adjustment
Trade
Position description
Short AUD / long MXN
17/09/14
Entry Price ($)
Current Price ($)
428.27
427.05
15.0% AUD/MXN
Fed taper timetable clarified
Weight
Long UK equity future
-15.0% 9.6%
Abs Perf
Contrib. (bps)
90,964
0.5%
9
90,964
-0.3%
9 -12
Running P&L
-140,441
0.8%
19/12/13
FTSE 100 Mar-14 future
0.0%
6,574.41
6,568.00
-34,671
-0.1%
-3
20/03/14
FTSE 100 Jun-14 future
0.0%
6,605.59
6,820.00
268,423
3.2%
26
29/06/14
FTSE 100 Sep-14 future
0.0%
6,726.01
6,877.50
115,110
2.3%
11
18/09/14
FTSE 100 Dec-14 future
9.6%
6,791.68
6,476.00
-489,303
-4.6%
-46
American Phoenix
252.2% Short Eurodollar Dec-15 future
06/11/13
1,377,467
222.2% Eurodollar Dec-15 future
Long USD basket
-222.2%
99.03
99.00
25.1%
132
377,433
0.2%
37
377,433
0.0%
37 67
704,701
3.5%
14/05/14
USD/CHF
8.6%
98.56
103.58
385,200
5.1%
36
05/03/14
USD/GBP
8.4%
148.06
153.35
250,305
3.6%
24
07/08/13
USD/SGD
8.1%
113.02
114.52
69,197
1.3%
7
0.0%
1,809.06
2,022.46
4.9%
2,004.70
1,928.00
Long S&P 500 06/08/14
4.9% S&P500 Sep-14 future
18/09/14
S&P500 Dec-14 future Euro Area deflation risk
German 2/10y Steepener
80.0%
295,333
8.0%
28
498,589
11.8%
47
-203,256
-3.8%
-19
-663,097
-0.7%
-62
09/04/14
Bund 10y Jun-14 future
0.0%
144.31
146.12
-174,294
1.3%
-17
04/06/14
Bund 10y Sep-14 future
0.0%
145.15
151.09
-631,673
4.1%
-59
03/09/14
Bund 10y Dec-14 future
-5.3%
148.90
150.11
-79,151
0.8%
-7
09/04/14
Schatz 2y Jun-14 future
0.0%
110.47
110.63
94,725
0.1%
9
04/06/14
Schatz 2y Sep-14 future
0.0%
110.64
110.80
102,077
0.1%
10
03/09/14
Schatz 2y Dec-14 future
25.7%
110.92
110.98
25,219
0.0%
2
Relative Value opportunities
128.7% Long US Value / short US Growth
-1,270,380
9.8%
-118
-717,380
-2.9%
-67
18/06/14
Russell1000 Growth
-9.8%
90.20
89.86
-899,460
-0.4%
-84
18/06/14
Russell1000 Value
9.7%
100.68
98.24
182,080
-2.4%
17
-322,054
-6.1%
-30 -60
Long Brazil / short China
4.6%
26/08/14
iShare MSCI Brazil
4.4%
53.19
46.72
-645,381
-12.2%
26/08/14
iShare MSCI China
-4.7%
50.78
47.68
323,327
-6.1%
30
-426,024
-4.2%
-40
Long Brent / short WTI
9.0%
30/07/14
Brent Dec-14 fut
8.8%
106.22
92.57
-1,506,394
-12.8%
-141
30/07/14
WTI Oil Dec-14 fut
-9.2%
96.02
87.98
1,080,370
-8.4%
101
153,379
1.0%
15
153,379
-1.0%
15
41,699
0.1%
4
Short PLN / long HUF 24/09/14
14.9% PLN/HUF
Long US HY / Short US IG
-14.9%
367.40
363.84
70.3%
24/09/14
CDX US HY
12.0%
106.39
106.79
47,794
0.4%
5
24/09/14
CDX US IG
-58.3%
101.72
101.72
20
0.0%
0 0
Long Gilts / short USTs
0
0.0%
08/10/14
Gilts 10y Dec-14 future
20.1% 20.1%
114.51
114.50
0
0.0%
0
08/10/14
USTs 10y Dec-14 future
-20.1%
125.99
126.00
0
0.0%
0
The model portfolio is constructed using an optimization that aims to maximize the portfolio’s expected Sharpe ratio. This means maximizing expected return while minimizing expected risk, looking for high diversification among trades (volatilities and correlations are estimated using a dynamic auto-regressive model). Optimization and portfolio composition are constrained to avoid excessive risk taking and concentration: net exposure is limited to a maximum of 100%, total leverage to a maximum of 3x, a single asset class cannot represent more than 50% of the portfolio risk and a single trade should generally not represent more than 25% of it. Currency positions are represented by total return indices to incorporate carry.
4
LSR Portfolio Tactics
LSR Investment Strategy
8 October 2014
Model portfolio: performance Performance since inception (5-Jun-13) to 7-Oct-14
Portfolio NAV
Portfolio
HFRI Global Macro
Since Inception return
4.81%
2.98%
Annualized Return
3.56%
2.21%
Volatility (ann.)
3.90%
3.44%
Sharpe ratio
0.76
0.47
Alpha (vs HFRI)
4.24%
Risk- free, c umulative HFRI Mac ro (hedge fund return index)
109 107 105 103
Beta (vs HFRI)
-0.36
Correlation (vs HFRI)
-0.44
Correlation (vs MSCI World)
0.05
Correlation (vs JPM GBI)
101
0.28
Max drawdown
-3.31%
-2.85%
99 97 4Jun
13Aug
22Oct
31Dec
11Mar
20May
29Jul
7Oct
Positions: historical sensitivity to the global business cycle 10 Long S&P500
Leading Indicator below trend but improving
8
Leading Indicator above trend and improving
Long UK equity future
Leading Indicator changes Beta
6 Long Brazil / short China
4
Portfolio
2
Short ED Dec-15 future Long US V alue / short US long Brent / short WTI German 2/10y Steepener Growth Long US HY / Short US IG Short PLN / long HUF Long Gilts / short USTs Short AUD / long MXN
-2
Long USD / short GBP, CHF & SGD
-4 -6 -8 -10
Leading Indicator below trend and weakening -0.4
-0.3
-0.2
Leading Indicator above trend but weakening -0.1
0.0
0.1
0.2
0.3
0.4
Leading Indicator levels Beta
5
LSR Portfolio Tactics
LSR Investment Strategy
8 October 2014
Risk analysis Weight
Volatilty
% Contrib. to Risk
VaR 95%
Leading Indicator Beta
Long USD / short GBP, CHF & SGD
25%
5.9%
14.8%
1.1%
-2.99
Short Eurodollar Dec-15 future
220%
0.7%
12.0%
0.9%
0.38
Long UK equity future
10%
14.6%
13.0%
1.0%
7.84
Long S&P500
5%
16.7%
6.9%
0.5%
9.78
German 2/10y Steepener
20%
0.6%
0.6%
0.0%
-0.24
Long US Value / short US Growth
10%
3.5%
0.3%
0.0%
0.40
long Brent / short WTI
10%
11.9%
4.6%
0.3%
-0.30
Long Brazil / short China
5%
29.3%
16.0%
1.2%
5.78
Short AUD / long MXN
15%
7.2%
9.4%
0.7%
-0.83
Short PLN / long HUF
15%
6.1%
3.8%
0.3%
-1.11
Long US HY / Short US IG
70%
2.5%
12.2%
0.9%
0.30
Long Gilts / short USTs
20%
4.8%
6.4%
0.5%
-0.67
4.6%
100.0%
7.5%
1.39
Trade
Total
'Weight' represents the trade's nominal portfolio weight; 'Volatility' is the annualized volatility estimated with our dynamic auto-regressive model; '%Contribution to Risk' shows how the portfolio risk is allocated (trades with higher contribution are the ones that drive portfolio volatility the most); 'VaR 95%' represents the contribution of each trade to the portfolio Value at Risk at 95% confidence level; 'Leading Indicator Beta' is the sensitivity of each trade to movement of the Global Leading Indicator.
6
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