The Daily Prophet: Time to Focus on Return of Capital Strategies

Connecting the dots in global markets.

Is there anybody left recommending risk assets? It sure seems like if there are, they are few and far between. The number of influential prognosticators warning about the risk of investing in assets such as corporate bonds and equities is growing exponentially. Last week it was Oaktree Capital Group co-Chairman Howard Marks and former Federal Reserve Chairman Alan Greenspan. This week, it’s the likes of DoubleLine Capital Chief Executive Officer Jeffrey Gundlach, HSBC Holdings’ head of fixed-income research Steven Major and Pantheon Macroeconomics Chief Economist Ian Shepherdson.

What seems to have everybody so worked up is not so much the prospect for an imminent event such as recession that would cause markets to reprice, but rather the sense that prices are hard to justify given the current fundamentals. That’s increasingly becoming clear in the market for corporate debt securities. Yes, the global economy is enjoying a synchronized uptrend, but the forecasted growth rate of 3.5 percent is nowhere near pre-crisis levels, and not strong enough to justify yield spreads that in recent days shrank to 1.51 percentage points as measured by the Bank of America Merrill Lynch Global Corporate & High Yield Index. That’s the narrowest spread since 2007. The market will get a big test this week as British American Tobacco Plc plans to sell $17.25 billion of bonds in the second-largest deal of the year to refinance its buyout of Reynolds American Inc. Elon Musk’s Tesla Inc. is seeking to raise $1.5 billion to support the electric-car maker’s new mass-market Model 3.

For HSBC’s Major, "low volatility across asset classes may give a false sense of security and bond markets may be caught napping," he wrote in a note published Monday. "The risk is that with increasingly interconnected capital markets, driven by years of international spillover from quantitative easing, local triggers can have a more global impact than before." Shepherdson is worried that investors have become too complacent and need to be prepared for the possibility that the Fed will follow through on its plans to raise interest rates. “I’m nervous about pretty much everything,” Shepherdson said Tuesday in an interview on Bloomberg Television, when asked where investors are being well-compensated for their risks. “There comes a point in most investment cycles where you’ve got to start thinking the return on capital is rather less important than the return of capital -- just keeping your money. Not losing anything becomes important.”

Perhaps that unease helps explain what happened at Tuesday's auction of $24 billion in three-year notes. When it comes to U.S. government securities -- the ultimate haven in times of turmoil -- sometimes the prices and yields you see on the screen don’t tell the whole story. That was the case Tuesday, as yields jumped across the curve in a sign of broad weakness. Then came the auction, which, as traders say, was a blowout -- but in a good way. The bids from investors totaled 3.13 times the amount being offered, the highest so-called bid-to-cover ratio for that maturity since December 2015. In another bullish signal, a class of investors that includes foreign central banks bought 64.1 percent of the amount sold. That’s only the sixth time since the Treasury began selling three-year notes on a monthly basis in 2009 that indirect bidders took down more than 60 percent of an auction. "As this part of the curve is highly sensitive to expectations for Fed policy, if the markets could speak, they are saying the Fed is almost done with rate hikes,’’ Peter Boockvar, chief market analyst at the Lindsey Group, wrote in a research note. The sales continue Wednesday, when the Treasury offers $23 billion of 10-year notes, and Thursday, when $15 billion of 30-year bonds are put on the auction block.

Hedge funds may be getting pounded in most corners of the world -- suffering outflows and forced to trim fees to appease clients. But there’s one place they’re still turning a hefty profit: emerging markets, according to Bloomberg News’s Ben Bartenstein and Aline Oyamada. Leveraged funds focused on developing nations returned 14 percent in the first seven months of 2017, according to Hedge Fund Research Inc. That’s on track to be the best year since 2009, when they returned 20 percent on average. It’s more than triple the 3.7 percent return posted by the benchmark index of all hedge funds. Emerging markets are outperforming their developed-nation counterparts this year on the back of faster growth and narrower current-account deficits, as well as low interest rates from Japan to Europe to the U.S. that make riskier assets more appealing. The first half of the year saw the best string of monthly gains for emerging-market equities since 1993. Emerging-market bonds "still trade at a much wider spread than U.S. corporate bonds at each rating level,” said Robert Rauch, a money manager at Gramercy Fund Management who helps oversee $5.8 billion. “On the equity side, EM equities have lagged the U.S. indices for years, so they look relatively cheap as well.”

The yuan strengthened past 6.7 to the dollar for the first time since October amid signs that China has curbed the outflow of capital and its trade surplus is firmly on the rise. The currency’s 1.7 percent appreciation since the end of May has found renewed momentum amid signs of stronger domestic economic growth. Also on Wednesday, the government said the nation’s trade surplus widened for a fifth month in July as export growth remained solid and imports moderated. Demand for Chinese products by foreigners has proven resilient, while at home stronger-than-expected output is supporting robust import demand, according to Bloomberg News’s Miao Han and Kevin Hamlin. The latest data may only serve to fan more rhetoric from U.S. President Donald Trump, who has taken a tough stance on countries that run large trade surpluses with America. The White House may be considering a probe of alleged intellectual property violations, which could risk igniting trade tensions. "Trade uncertainty has increased," Liu Liu, an economist at China International Capital Corp. in Beijing, wrote in a report after the data. "While trade frictions in certain areas may increase, a large-scale trade war is unlikely. As the second largest world importer, China has significant bargaining power in trade negotiations."

The improved outlook in China, home to the world’s second-largest economy, is reverberating through many markets. Take aluminum, which extended its position as the best-performing commodity this year as prices jumped to over $2,000 a metric ton for the first time since 2014. Prices have rallied as China ramps up efforts to curtail illegal or polluting capacity, according to Bloomberg News’s Mark Burton. The metal added 2.2 percent to $2,008 as of 3:58 p.m. in London, bringing gains for the year to about 19 percent, the biggest rally among 22 raw materials on the Bloomberg Commodity Index. China’s Shandong province, the top aluminum-producing hub, called for the closure of 3.21 million tons a year of illegal aluminum capacity by end of July, according to a statement on Shandong NDRC's website dated July 24. The cuts are deeper than expected, said Citigroup analyst Jack Shang. "It does feel like China’s supply-side reform is deepening, and aluminum is definitely one of our favorite metals,” said Xiao Fu, head of global commodities strategy at BOCI Global Commodities U.K. "It’s not just about supply. There’s a significant shift in demand taking place as well as China diversifies and upgrades its industry. That’s creating demand for aluminum in lightweight vehicles, and the aerospace industry is looking very healthy in the longer term as well."

When the Bank of Canada raised interest rates last month, becoming the first Group of Seven country to join the U.S. in doing so, the move was seen as an attempt to rein in the red-hot housing market that many fear was overheating. Yes, Canada is in the midst of one of its strongest growth spurts since the 2008-2009 recession, with the expansion accelerating to an above-3 percent pace over the past four quarters, but surging home prices have become worrisome. The average benchmark selling price of a single-family detached home in the greater Vancouver area now exceeds C$1.61 million ($1.27 million), according to the local Real Estate Board. Data on Wednesday is likely to show no real slowdown. The government may say housing starts rose by 205,000 units in July, just slightly off June’s pace of 212,900, according to a median estimate of economists surveyed by Bloomberg. A separate report may show building permits dropped 1.9 percent in June following the big increase of 8.9 percent in May.

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The Debt-Ceiling Spoilers Have No Leverage: Jonathan Bernstein

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