We’ve been hearing about this OPEC output freeze for months now. Kuwait’s OPEC governor says the freeze will take place ahead of an April 17th summit, but Iran has already said it won’t participate and neither will the US. We knew this agreement was just noise back in January when oil prices shot up $7 in a matter of days, and the recent posturing is no different. Not only is OPEC a largely irrelevant organization, but oil’s problem is not excess supply; it’s lack of demand.The market narrative in both oil and stocks has turned quite bullish over the past few weeks with good reason. China, the epicenter of global weakness, looks better, PMI data from the US and Europe is back in expansion and, most importantly, Janet Yellen didn’t stand in front of the rally. But just as sentiment was overly negative in early February, it’s overly optimistic today. Trading volumes on stock exchanges have been light throughout this +13% rally, indicating a lack of conviction that fundamental conditions are improving. A weaker US dollar is the rising tide that floats all boats, but it’s unclear if the juice is worth the squeeze in that trade (more below). Prime brokerage data shows that short covering in ETFs could be exhausted, and oil looks like it’s the leading asset in the upcoming move.
Beyond overly bullish positioning many investors are fretting about Japan. The Yen is at its highest level relative to USD since October 2014. Last Friday we saw manufacturing data from across the globe, and it was almost universally improved except for Japan. Japanese PMI came in at 49.1, which wasn’t all that surprising considering vehicle production dropped -6.1% Y/Y in February. This slowdown is starting to filter into sentiment, which is evident in the latest Tankan Business outlook. Japanese businesses are as pessimistic as they’ve been since June 2013.
This is all against the backdrop of NIRP in Japan, which has been an unmitigated disaster. The unexpected jolt of negative rates has almost shut down credit markets. Public opinion of NIRP is extremely negative, bank lending has collapsed and not even the BoJ is buying commercial paper anymore. Instead of serving as an important source of cash for borrowers, the credit market has become a profit center for dealers looking to buy securities from investors and sell them to the central bank. By making the trade with the BOJ the only source of profit, markets are exposed to unexpected volatility when that trade ends – which is what we’re seeing in commercial paper.
Japanese officials are undoubtedly panicked about these developments, and scrambling to come up with a solution. But if we’ve learned anything about Japan over the past 25 years, it’s that the response will be too timid to turn the economy around. They’ve painted themselves into quite a corner, and there’s no obvious move to relieve the pressure. Resurgent growth in China would help, but the Chinese would simply be reclaiming market share they lost during Abenomics. A substantial drop in Japanese stocks wouldn’t be the end of the world, but should be enough to drag down the S&P 500 appreciably.
The Cup & Handle Fund is up around +2.0% YTD, and +8.5% Y/Y. The portfolio is having a good week after holding steady over the past month. We added a new relative value bet last week, and so far it’s performing just as expected. As some stocks start to establish trends we’ll be adding more directional positions. Our April letter went out last week, and has proven to be spot on thus far. I’ll be taking a few days off coming up, so if C&H appears next week it will be in abbreviated form, but please keep your messages and feedback coming. If you’d like to start receiving these letters click here.
With that I give you this week's letter:
As always, if you have any questions or comments or just want to vent, please send me an email at firstname.lastname@example.org.
Until next time, tread lightly out there,
Managing Editor – Cup & Handle Macro