Expensive valuations was the key issue facing Indian markets, said Robert Buckland of Citi Group. He added that Citi was not too worried about politics in India, but their call is more because of the valuations.
Talking about the rising US bond yields, he said in a bond trading world, the yields going up to 3% is a big deal but in the real world, 3 percent interest rate is still pretty low.
According to him, equity markets can absorb bond yields upto 3.70 percent before they come under pressure.
There is no doubt that rising bond yields will cause disruption and is one of the key triggers for the current volatility but it is unlikely to kill the nine-year global bull market, said Buckland.
Watch Here: Expensive valuation of Indian market is an issue, says Citi Group Edited Excerpt: Q: I was reading your previous note and you say that you are still quite optimistic about 2018 but we have seen quite a bit of volatility this year, not unexpectedly. Now almost halfway through the year. How do you see the second half? Do you see the second half as the period where we eke out some gains or do you see more volatility? A: I think the main message I have been conveying to my clients around the world, I have been saying them over the last few months is that last year was a low volatility bull market and we transformed this year into a high volatility bull market; so we are still in a bull market. We went transitional way into a high volatility bear market but you are absolutely right, it is getting choppier.
What it means is that – your viewers, my clients, they have to be a bit braver. The dips will be bigger, there will be lots of reasons that people will tell you that those dips will turn into a bear market but we think it is too early to make that call. So we will be buying the bigger dips, if they occur.
Q: Do you have those set of indicators that many people have where – those boxes are ticked you say, now we are getting closer to a bear market. How is that list looking? A: We have this thing which is extremely popular among clients; 18 things that fall into place at the top of a bull market i.e. don’t buy the dips and we are still getting about three out of 18 of those boxes turning red. Q: How many usually do turn red? A: You get a number up to 8, 9, 10, 11, something like that before you start to get more worried. That where we got to in 2000 and you shouldn’t have bought the dips post 2000. That’s where we got to in 2007, you shouldn’t have bought the dips in 2007-08 of course. I think I have said this to you before.
It is like a miserable bull market this one is when we are really happy that it gets dangerous; still it’s a pretty miserable bull market which shows me that it’s not finished.
Q: Do you hear that a lot from your clients, a lot of skepticism still? A: Yes, sure. And a market suck everyone in; they suck you in, they suck me in, they suck investors in, they suck CEOs in, they suck everyone in. I do not feel like everyone sucked into this one. Q: What is your prognosis that we will grind out some gains or the second half turns out to be actually a very good second half of the year in terms of performance? A: I think we will get a decent year this year. We are forecasting gains if you bought on January 1 at 7-8-9 percent now, most indices rallied a bit recently so they are pretty flat a bit and that would imply maybe 6-7 percent returns over the rest of the year but it will be a choppy run, there will be some dips. If you buy into the dip you could turn that into 10 percent. Q: We have had 8-10 percent kind of dips. Do you see those kind of, which are big dips to buy, that kind of volatility even in store for the second half of the year? A: I think everyone is going to get used to higher volatility. Last year was an aberration. Incredibly low level of the VIX for instance in the US, very low levels of volatility. I think the biggest setback we had for two years was maybe 2-3-4 percent in the global stock market. Sure, we saw a 10 percent dip but I think 10 percent dips are more normal and last year was weird and that’s done. Q: What causes volatility this year? We know the usual current culprits but if you had to make a list of two or three things which still can cause or inject a lot of volatility, what would those be? A: I often get people asking me this – Rob, do you think there are more frightening events happening at the moment - Trump, whatever, political instability that are triggering this volatility. I think volatility is much a reflection of the market environment that will always be adverse events but it’s the ability of adverse event to really move share prices that it has changed this year compared to last year.
What that is telling me is stock market is jitterier, it’s more vulnerable to have those events; there were adverse events last year, we just didn’t do anything, we dipped 2-3 percent on them, not 7-8-9. So I think this market with rates tightening, with policy around the world generally tightening are more vulnerable to event and that is why you get bigger dips now than you got last year. So it is more market phenomenon than it is about events.
Q: But what would have be the nature or reasons behind this kind of skittishness that you are alluding to? A: We have never seen quantitative easing (QE) before and we are talking about central banks owning 30-40-50 percent of respective countries bull market. Let’s just take a step back and think about that. The central bank owning 30-40-50 percent of the national debt of their respective countries.
We have never seen anything like that. We are now starting to see that unwound a bit and that is the major thing that is driving skittishness is that the policy has been the loosest we have ever seen ever over the last 2-3-4-5 years because of QE. Policies now starting to be tightened, liquidity is being withdrawn and that’s why market is skittish and more responsive to whatever the events happen to be any one time.
Q: But do you still see it as a known devil. I mean everybody knows about it, talks about it. In that sense do you think the potential of the market to unwind completely is low or do you think it is still such a big event that if central banks are not able to pull it off, it might cause a huge amount of damage to markets? A: I think it’s very challenging. I think you get a bit of three steps forward, two steps back. So the three steps forward will be the central banks attempting to tighten policy and remember the way it works with QE is they do not sell.
Some people think QE is about selling those positions down. It’s not about that. They just stopped buying and that is what QE is all about and I think that as they stop buying and my clients, the private sector capital markets have to step up and start pricing risks. They will start pricing risk a little bit more expensive, if you want to think it that way round then central banks would do.
So what central banks intentionally doing is kind of compressing the price of risk. There were buyers of risk in the market that we would otherwise have to price in. As they step away we are going to have to start pricing that in and of course that makes us jumpy, right, because we are the ones who are going to have to do that job.
Q: What does the US bond yield telling you now because that has become the focus of a lot of attention and some even go to the extent of saying that the next big risk for global markets is actually the US corporate bond market? Do you agree with that assessment? A: It’s a big number. The US treasuries have just hit 3 percent. I think we should take a little bit of a step back and think. One of you told me that we would be worrying about US treasuries hitting 3 percent ten years ago when they were 7 percent or whatever.
So 3 percent is a very low number. Let’s not lose that perspective but you are right, I mean if you are a bond trader and you bought 1.6 which is the low they got to and they are now at 3, you lost a lot of money. So I think in the bond trading world yields going up to 3 is a big deal, of course it is but in the real world 3 percent interest rate is still pretty low.
So in the work that we have done, we think that equity markets can absorb bond yields up to about 3.5-3.7 before they really start to come under pressure. I think we are able to accommodate that and it will cause disruption, bond yield rising as we are saying at the moment is one of the facts behind the extra volatility that we are seeing but I do not see it killing this, where are we, nine year bull market. I do not see it doing that. So I think it is tricky for us to digest but we will digest it.
Q: What about the counter view that while everybody is stressing about bond yields going up and inflation coming back harder than people expect. Actually its growth that disappoints and we get a growth scare which kills this bull market not inflation. What probability would you assign to that? A: I think that is a good point. I would be much more worried if bond yields in the US went to 2.5 because we were worried about growth and we certainly thought they are not going to tighten policy; they are going to keep policy really lose then if bond yields went to 3.4, I think that is a good point. Equities in the end are more of an option of growth than they are on interest rates. Q: Now what do you tell your clients who are sitting in the US and saying what do we do with emerging markets (EM) right now? How difficult is it to convince somebody in the US today that he should leave the safe harbour of growth in his own country to actually look at something like emerging markets? A: That is a tough sell. The monster of this bull market has been the S&P, particularly to US base investors. It has just kind of crushed every contrarian call anyone has wanted to throw at it. One of the good things about last year is that EM kept up with the S&P, if anything outperformed it a little bit. One of the things that helped that, is the dollar was weak last year and there is a close relationship between the performance of emerging markets and the dollar. So weak dollar, good emerging markets.
I am afraid one of things that have changed this year is that markets are now starting to think about stronger dollar again and so I am afraid the S&P just carries on powering on and EM struggling now to keep up with it. We are overweight EM. The general pitch I use to clients is that they look relatively cheap compared to S&P – so trading 10-20 percent discount relative to the valuations in the S&P. So it is a value trade but it does not need the dollar to be weak to really work.
Q: Do you have a call on the dollar, do you believe that it might actually strengthen, putting pressure on EMs? A: Our view on the dollar is that this current rally that you are seeing will peter out. There was a similar rally in September-October when I was getting all the same sort of questions about dollar strength, does that change your strategy around, you are overweight EMs, that is the wrong thing to do when the dollar is strong.
At the moment the dollar is rallying because people think that the US economy is outperforming the rest of the world and therefore the US will tighten more than the rest of the world and that is kind of the reason why the dollar is rallying.
However, we think that the twin deficits that are now being built up in the US, enormous unfunded tax cuts that need to be financed from overseas capital markets and so on, we think they will prove a drag on the dollar later in the year. So we think that the dollar strength that we are seeing at the moment will peter out and that should help EM to get back on their feet relative to say the S&P.
Q: The other issues which a lot of investors monitor carefully in their EM trades is what crude oil is doing. That has also sprung a bit of a surprise this year, do you see it taking off USD 80 per barrel and stabilising at those kind of levels? A: I was just talking with my commodity colleagues about the oil price earlier this week and they generally feel that this rally in the oil price will be capped partly by shale being turned on again in the US, that its natural limiting mechanism in the US, they can kind of turn on production like the Saudi’s used to, Saudi’s have also been able to do, they can do that in the US now and that is one of the profound differences between oil markets now and maybe 10 years ago.
We are getting up to the prices where it makes it worth that while turning the taps on in shale in the US, and when we get up to these prices, that provides a cap and we think the cap is – we think breakeven on shale is probably USD 60-70. So the taps are going to be turning on as we speak, as those taps turn on, they will provide a cap and then drive oil down a little bit, maybe to USD 65-70 type region towards the end of this year and into next year. So, we think that the kind of upward margin oil will be capped by shale later this year.
Q: That is demand and supply, but there is a wild card in geopolitics. What US is doing in Iran, do you keep an eye on that and how do you see that panning out? A: Of course we do and that is the great unpredictable factor is what is going on in the Middle East. I think one of the very interesting things about Middle East politics is one of the reasons that the west took a lot of interest in it over the last 30 or 40 years. Of course it is through the mechanism of the oil price. So if things flared up in the Middle East, the western world really cared about it because it fed through into the oil price.
What is shale in the US and you got to remember – in a strange way, it does not exactly work like this, but it has made the US self-sufficient in oil. There is an enormous difference compared to 20-30 years ago when OPEC ruled the world, is the US being a self-producing oil economy means that their sensitivity to Middle East politics is reduced. So it allows the US to be a little bit more isolationist politically and it limits the ability of Middle East politics to really drive the global economy in the way that it was able to do of course profoundly in the 70s.
Again I would not underestimate the impact of shale and how it has changed the game in terms of oil price, that is why even with Middle East politics hotting up as we can clearly see, what is going on right now we do not necessarily mean things that will translate into an oil price of USD 100 plus which in the old world it might well have done.
Q: So you would say that if you had to rank risks, you would say the possibility of a trade war is actually a bigger risk than geopolitics this year? A: Yes I think and of course trade wars are a little bit connected with geopolitics, but maybe geopolitics feeding through into trade wars, is a bigger deal than geopolitics feeding through into the oil price which is the way we used to think of it.
Geopolitics feeding through into trade wars we think is probably more of a – and it is less of a kind of short term threat, you do not suddenly see trade collapsing by 20 percent in the way we can see the oil prices going up by 20 percent, but we think it is a more profound challenge to the global economy and therefore global stock markets perhaps than the oil challenges we used to watch in terms of geopolitics and the influence that had on the oil price.
Q: Where do things stand right now with the trade war from the recent dialogue that we have been hearing? A: It is hard to tell. So we get aggressive projections coming out of Washington and then they step back and then they go aggressive again and then they step back. So, what is the old saying you should take the President of the US seriously but not literally, we used to take him literally, we now take him seriously, but we understand that everything is negotiable; that is the thing that we are learning.
So you get these big statements, you should not take them too literally because of course then concessions are made and exceptions are made and all these sort of things, but it does look like the trade talk is now narrowing into China talk. It started off being trade talk and we were sending out to our clients all sorts of discussions of who trades with the US, this country, that country, Mexico, Canada, all of these sort of things and actually it looks more like being a China trade issue as oppose to a global trade issue if that makes sense.
Q: You are underweight India though. You are bullish emerging markets overall but within that context you are not very bullish on India relatively speaking. Is it just a function of crude oil or other issues? A: I think the main issue that my EM strategy colleague Markus Rosgen would highlight, he is a bit of a value guy and he always thinks that India just looks a little bit expensive.
We have got an asset class that we want to buy because it trades on a relatively cheap multiple, 13-15 times which is what emerging markets do, but I am afraid India trades on 19 times earnings. So it is a bit more of a valuation call. We like India, we just think a lot of it is in the price.
Q: You are saying we might grind out 7-8 percent kind of gains in the second half of the year. What would make you relook at that hypothesis, what will have to change for you to say look this is probably not going to happen now? A: I suppose I am watching, in a funny sort of way, I am watching – I know everyone else is as you said earlier fixated by bond yields hitting 3 percent, I am watching more closely some lead indicators of the world economy rolling over. So what we call purchasing manager indicators (PMI) which are kind of business confidence indicators which tend to capture how the economy is doing earlier than if we sit around waiting for industrial production or GDP figures or so on, in some parts of the world, those are rolling over.
They were positive and rising last year, now they are still positive, but they are falling; that has started to influence things like interest rate expectations, currency markets and so on and I worry that that rollover could turn into something more significant. We are nowhere near that level yet, but I am starting to get asked about do you think that we have seen the peak level of acceleration of this cycle.
The cycle is decelerating, it is still positive, it is decelerating, do you think that could actually be two years down the line and turning into a global recession. So I am probably more worried about the rolling over PMIs as we call them in the jargon than I am about high interest rates.
Q: That is an interesting point because a lot of people that we speak to are beginning to watch over their shoulder a little bit, it is because you are quite late in the cycle, it could extend two to three years more, but it has reached that point where people are beginning to get a little cautious about how much longer we can extend this bull run. A: Absolutely and so that is where our bear market checklist which is 18 factors comes in and on that I am just not getting enough boxes ticked. However, there are some quite late cycle type things that are going on out there, credit spreads are rising so that is the difference between corporate bond, borrowing rates, and treasury rates.
So, the risk premium that people ask for in the markets to take on credit risk, those are starting to rise, that is a classic late cycle thing. The VIX has started to rise, that is a late cycle thing. PMIs are starting to rollover, that is a classic late cycle thing.
So there are three or four of them falling into place as I said, but lots of other things that are missing. Big flows into markets are missing, M&A has picked up but it is not as high as it would normally be at the top of the cycle, equity issuances has picked up but it is not as high as it would be at the end of the cycle, capex is picking up but it is not as high as it would be at the end of the cycle. So, if you wanted to pick lots of late cycle things, I could find you three or four that tick the box, but I could also find you 10 or 11 that don’t.
Q: Going by past incidents, when you get into the late stages of a bull run, is it easy to spot that point where you say that, maybe we should have turned from here, we should have become more cautious or does it manifest itself mostly on hindsight? A: That is why we try and come up with these discipline list because at any one time there will always be reasons to sell and reasons to buy, that is why the price is where it is, right? I just don’t see enough reasons to sell now. I can see some reasons to sell, but I just don’t see enough. When we see more of our 18 boxes, maybe 8-10, we are not going to wait for 18, when we see more of our boxes being ticked, when M&A is strong enough for instance or IPOs are strong enough for instance, then I think that is the moment to stop flagging some caution.
I do get some investors saying to me, I don’t even care about the last two years of the bull market because I am running the risk of running into the first year of the bear market and you lose a lot more in the first year of the bear market than you make in the last two years of the bull market. So, the risk reward doesn’t add up. So, depending on your risk profile squeezing the last bits of juice out of the last two or three years of a bull market can be a dangerous thing.
Q: If you were to hazard a guess you would say there might be a couple of years left in this? A: At this point in the cycle, as I said in the beginning, the switch from a low volatility to high volatility bull market, this high volatility bull market you tend to get towards the end of the cycle typically lasting couple of years. Q: Tipping over from a bear to a bull cycle happened because of an accident, do you think this one also will be precipitated by an accident or does it rollover seamlessly or smoothly?
The elastic right now is starting to stretch, I don’t think it is at 1987 type levels. There will be something if we carry on in the way that I think, that will fall into place on D-day in two years’ time, that will snap that elastic back and perhaps we would say that was the trigger. All I can say to you is, I think the elastic is stretching but I don’t think it is right at the extreme yet.
A: That is the question I always get asked, what is the catalyst? I am very good at spotting catalysts in hindsight. I don’t know but what I can do is lay down the conditions that mean that whatever event occurs at the top of the market, turns into something much more serious than just a bull market setback, let us think about the crash in 1987 and we are still arguing over what the trigger was for that. The point is that the elastic in financial markets got stretched too wide and then something happened that snapped that elastic back.