September 7, 2017

The Market Sentimentalist – Cock-A-Doodle-Do

by Amareos

Kim Jong-un’s decision to escalate further the geopolitical game of chicken with the US by continuing to lob missiles in the direction of Japan was all too predictable[1] (albeit the timing was uncertain) but that doesn’t make it any less unwelcome. In response, US President Trump strongly criticized North Korea’s actions and warned that “all options are on the table”, which logically includes the possibility of a US military response[2].

Normally, one would consider the military option as having an extremely low delta (ie. probability) with a politically negotiated settlement the more acceptable and hence more likely alternative. However, these are hardly normal times.

Kim Jong-un is seeking to exploit to the fullest extent possible the fact that US-China relations are strained, in no small part due to disagreement as to how to deal with his regime[3]. Additionally, the US President is struggling on the domestic political front. Not only is his administration in a state of flux, with Trump having sacked more senior staff members in his first year in office than any of his predecessors that we can recall, he also remains deeply unpopular with the majority of the electorate he is supposed to represent (acutely despised in many cases)[4].

The extent of his unpopularity is clearly illustrated by the very elevated readings of government anger sentiment that we observe in the US, both relative to its own history and in comparison with the other 100+ countries we track. Indeed, as the exhibit below confirms, aggregating across both traditional and social media, the US has the highest reading at present.

Exhibit 1: Crowd-Sourced Government Anger Sentiment

Source: www.amareos.com

Thomson Reuters News Analytics and MarketPsych Indices world news sentiment analysis tools can turn today’s unstructured data into actionable insight. Find out more about how to maximize your returns and spot event risks.

While Kim Jong-un and others may view Trump’s domestic political problems as a source of weakness, on the contrary it could well serve to increase his temptation to deploy the military option. At first glance, this may appear overly Orwellian – we are referring, of course, to the use of external threat to stifle domestic discontent, or as the astute British political writer and author more eloquently stated in his dystopian novel 1984

“the object of the war is not to make or prevent conquests of territory, but to keep the structure of society intact.”.

However, Bridgewater Chairman and CIO, Ray Dalio – hardly known for engaging in hyperbole – appears to be of a similar opinion judging by his latest Linkedin article where he states…

“Conflicts have now intensified to the point that fighting to the death is probably more likely than reconciliation.”[5]

We would not take it quite that far, but we do agree with the direction of travel (so to speak) of this view. Judged on the basis of the market reaction, this more pessimistic (realistic?) assessment does not appear to be shared by the majority of investors.

Despite an initial selloff, global asset markets proved surprisingly resilient to news of the latest North Korean missile launch. Global equity markets dipped as the story broke but quickly recovered with Wall Street even managing to close the day’s session in the green. Even more impressively, given its geographic proximity and the potential devastation a military conflict would entail, South Korean equities barely flinched, with the KOSPI index off less than 0.2% since the pre-missile-launch close, while the KRW was also largely unchanged.

What makes this resilience all the more remarkable is that a surge in geopolitical uncertainty is exactly the sort of catalyst one would expect to act as a trigger to a more sustained downturn, especially at a time when increasing numbers of Wall Street big guns have been warning about the overvalued nature of risk assets[6].

As a slight aside, increased geopolitical tension is not the only potential negative market catalyst that the crowd appears to be downplaying.  The argument over raising the US debt ceiling – a masochistic piece of legislation if ever there was one[7] – which periodically resurfaces and often leads to a bout of market volatility (as in 2011 and 2013) has flared up again. However, as can be seen in the exhibit below, US debt default sentiment which jumped sharply in the two aforementioned episodes remains low.

Exhibit 2: Crowd-Sourced Sentiment Debt Default – US

Source: www.amareos.com

No doubt, some would argue that the seemingly bulletproof nature of global risk assets is simply further evidence of a bubble mentality amongst investors. This is not a view we share. As we have noted in previous Market Insights discussing the outlook for global equities[8], we see no signs of such exuberance, something that would show up as very strongly positive skews in our crowd sentiment readings. Indeed, looking at the global equity sentiment heat map (see below), with the exception of the Hang Seng where sentiment is on the high side, crowd sentiment is only moderately above the long-run neutral readings.

Exhibit 3: Crowd-Sourced Sentiment –  Global Equities

Source: www.amareos.com

Excluding this, we consider the most plausible explanation for the resilience of global risk assets to be that investors still view a diplomatic solution to the North Korean crisis/problem/issue (call it what you will) as the single most-likely outcome. That Trump responded to a latest missile launch by issuing a restrained statement – albeit firmly worded – rather than blasting his response on Twitter, as he has been wont to do in the past, probably strengthened this impression[9].

Obviously, together with everyone else on the planet, we hope for such outcome (and not just because of the financial implications). However, hope is not an investment strategy and only betting on the single most-likely outcome is dangerous.

Nassim Taleb has repeatedly warned investors [10] that they should consider the full range of potential outcomes and their associated probabilities when making capital allocation decisions – sage advice. In this way, the potentially fatal financial effects of so-called Black Swan events – rare, low probability (ex ante that is, ex post hindsight bias kicks in and the probability is subsequently perceived as having been much closer to one), but high impact events – can be mitigated or lessened. (A military strike conflict with North Korea would clearly fit this definition of a Black Swan event.)

Moreover, as we outlined in our earlier Market Insight discussing Korea, and reiterate here, we judge the probability of military conflict to be higher than what we glean the market as a whole believes based on the recent price action. What’s more, we view this probability as increasing over time. Given this, it seems appropriate to consider what assets would best serve the interests of investors should such an eventuality occur.

Examining the immediate knee-jerk reaction, the usual list of safe-haven suspects all performed well. Government bonds, gold, the CHF and the JPY all rallied as the news of the North Korean missile launch hit the newswires. The cryptocurrency Bitcoin also jumped, hitting a new record high above USD 4,600, suggesting it too is perceived as a safe haven to geopolitical turmoil – no doubt much to the consternation of Howard Mark’s who has repeatedly complained that “it isn’t real[11]. For the most part, the aforementioned list of safe haven assets is uncontroversial to us, with one notable exception: the JPY.

The standard argument that the JPY being a safe haven asset arises from the fact that Japanese investors have considerable overseas financial holdings. In the event of a bout of risk aversion global investors anticipate some repatriation of these holdings, portfolio inflows that strengthen the JPY. We are familiar with this argument, but find it less than convincing in a scenario where North Korea is involved in a military conflict with the US (either acting alone or with others).

After all, consider the counter arguments. Japan is extremely likely – literally – to be in the direct firing line in any military conflict involving North Korea. Also, and this is a more general objection we have, the Japanese government has huge outstanding liabilities – a post war record-breaker in the developed world – of which a large and increasing proportion sits on the balance sheet of a central bank whose policy independence has, as a direct consequence, being steadily eroded[12]. These are hardly the attributes of a safe haven asset.

And yet, this perception amongst investors continues. Why? In our view, it is because investors often think of assets as having a specific, almost pre-defined, characteristics. For example, government bonds are considered safer than equities, which are in turn considered safer than junk bonds etc etc. Moreover, the widespread use of identifying safe haven assets via correlation serves to reinforce this belief. This is because it creates a positive feedback loop where assets that previously rallied during a bout of risk aversion are bought by investors in anticipate of gains – it is, in short, a self-fulfilling prophecy. This approach has the appearance of being mathematically and theoretically sound, but in reality it is not far removed from the conditioning behaviour Pavlov elicited from his dogs in his famous experiment[13].

Such a strategy may well serve investors well for a time, but continuing with the dog theme, eventually reality will come back to bite investors. Our advice: engage the brain before the Excel correlation function and give the JPY a wide-berth when considering hedges to the North Korean situation escalating into military conflict.

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Amareos crowd-sourced sentiment indicators are based on  Thomson Reuters MarketPsych Indices

 

FOOTNOTES:

[1] See: https://www.amareos.com/financialresearch/market-sentimentalist-strategic-impatience/

[2] Japanese PM Abe’s response was tougher calling the launch an “outrageous act” that “significantly undermines peace and security in the region” – see: https://www.washingtonpost.com/world/north-korean-missile-flies-over-japan-escalating-tensions-and-prompting-an-angry-response-from-tokyo/2017/08/28/e1975804-8c37-11e7-9c53-6a169beb0953_story.html?utm_term=.b124b5b89880

[3] China’s role in solving the North Korean issue is absolutely critical but difficult for reasons we discussed in the Market Insight referred to in footnote 1 above.

[4] Steve Bannon being the latest high profile exit. Perhaps, the first element of the US infrastructure investment programme should be the installation of a revolving door in the White House HR department. Just a thought.

[5] For the avoidance of doubt Dalio does not specify which conflict or conflicts he is referring too. It appears to us that it is more a generalized statement – see: https://www.linkedin.com/pulse/principles-divide-us-might-greater-than-those-bind-together-ray-dalio

[6] In his latest Memo to Oaktree clients co-Chairman Howard Marks, a person whose opinions we respect and have quoted in previous Market Insights (see: https://www.amareos.com/financialresearch/just-one-thing-you-need-to-know/) outlined his own concerns – see: https://www.oaktreecapital.com/insights/howard-marks-memos. We discussed many of the concerns raised by Mark’s in our last Market Insight – see: https://www.amareos.com/financialresearch/market-sentimentalist-worry-list/

[7] In the sense that it is unnecessary given the bond market is the ultimate arbiter of a country’s ability to borrow (or at least should be in a world where central banks are not heavily intervening as required by their ongoing QE programmes).

[8] See: https://www.amareos.com/financialresearch/the-market-sentimentalist-are-the-stars-aligned/

[9] In the last 24 hours Trump appeared to revert back to form tweeting – “The U.S. has been talking to North Korea, and paying them extortion money, for 25 years. Talking is not the answer!”

[10] Although his book Black Swan made the concept famous, we personally much preferred his earlier book Fooled By Randomness.

[11] The comments were contained in the Oaktree memo referenced in footnote 4 above. For those interested in our diametrically opposed view on Bitcoin please refer to our May 25th Market Insight written when Bitcoin was trading 50% lower than today’s price – see: https://www.amareos.com/financialresearch/the-market-sentimentalist-bitcoin-bubble-watch/

[12] Actually, we would go further and state that the BoJ has to all-intents and purposes lost policy independence and that any sense to the contrary is a paper-thin façade.

[13] See: https://www.simplypsychology.org/pavlov.html.

 

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