Welcome to The Market Routine
On the scarcity of negative annual returns, and how a currency trade outside the US dollar is likely to make you money
Welcome to the first episode of The Market Routine
Dear Investor,
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The scarcity of negative annual returns
In 2022, US equities faced their worst annual return since the Great Financial Crisis of 2008, dropping by nearly 20%. This has led many investors to believe that 2023 will be a better year, as negative annual returns are often perceived as being rare. But just how accurate is this perception? In order to gain a better understanding, let's take a closer look at the historical data.
US Equities
Since 1928, the return on US equities has been negative for 26 years, or 27% of all years. This means that the odds of a negative calendar year return are slightly above one in four.
But what about the odds of a second year of negative returns? The chart above shows all observations of two or more consecutive years (red bars) in which the return on US equities was negative. As you can see, this has only happened four times since 1928. Based on historical data, the likelihood of another year in which equities go down is 15%. Also note that if we do experience another negative return, there's a 75% probability that the third year will also be negative. It's important to keep in mind, however, that the sample size is small.
What about Treasuries?
Now, most research on market behavior focuses solely on equities. But it's important to remember that we live in a multi-asset world. The fact that only commodities and gold managed to realize a positive return in 2022 highlights the importance of maintaining a broad asset class universe.
The chart below shows the annual returns on the US Treasury Bond. It has been negative in 'just' 19 years since 1928, or 20% of the time. Historically, negative Treasury Bond returns are scarcer than negative equity returns. Three out of those 19 years were followed by another negative annual return, translating to 16% of the time. Interestingly, this is marginally higher than for equities. However, the US Treasury Bond has never recorded three consecutive calendar years with a negative return. If that happens in 2023, it will be a first.
Fancy Corporate Bonds?
Lastly, let's take a look at US Corporate Bonds. If you're a fan of historical calendar year returns, you'll appreciate Corporate Bonds. Only in 16 out of the 95 years since 1928 did they realize a negative return. And only in two of those years (12.5% of the time) did Corporate Bonds go on to record another drop. The scarcity of negative Corporate Bond returns is remarkable, considering that they're riskier than Treasuries and, as a result, have realized a significantly higher return. It's worth noting that duration effects may be at play here.
In conclusion, when analyzing past market behavior, it's essential to get the data straight and to take a multi-asset perspective. By doing so, we can gain a better understanding of the rarity of negative returns and make more informed investment decisions.
The Market Routine continues with a currency trade idea that I believe has the potential for a decent payoff in the next couple of months. Thanks for reading!
Don't Fall for the Euro Hype: Invest in the Yen
Recently, the Euro has seen new highs against the US dollar as markets remain fixated on the Federal Reserve's monetary policy changes. However, investors should also pay attention to the Japanese Yen's performance against the Euro, as there may be money to be made here.
Here, I'll explore some of the key factors that investors should consider when evaluating the Euro-Yen currency pair. I’ll begin by looking at inflation and yield pressure in Japan, and how they may indicate increased inflation expectations. I'll also take a closer look at the relative economic momentum between the Eurozone and Japan, and how the trade balance in each region may impact the exchange rate between these two currencies.
Inflation on the rise
First, let's take a look at inflation in Japan. Recent data shows that core inflation in Tokyo, which is a leading indicator of national inflation, has come in higher than expected and hit 4.0% for the first time since 1982. This indicates that core inflation in Japan is increasing, similar to the trend in the Eurozone. In fact, with the Eurozone's core CPI at 5.2%, the gap between the two inflation levels is smaller than average. This means that, like the European Central Bank, the Bank of Japan is now facing inflation risks for the first time in many years.
Yield pressure
Additionally, the Japanese 10-year bond yield and the Japanese 10-year swap rate also provide further confirmation of inflationary pressures. The bond yield is directly impacted by the Bank of Japan's yield curve control, which caps the 10-year bond yield at 0.50%. However, recently, the yield briefly crossed that level, suggesting strong upward pressure on yields. The 10-year swap rate, which is not directly impacted by the Bank of Japan's bond buying and yield curve control, is currently at 0.88%. These figures suggest that investors should pay close attention to the Japanese bond market, as rising yields may indicate increased inflation expectations.
Follow momentum
When it comes to economic momentum, the Japanese economy has proven to be more resilient than that of the Eurozone. This can be seen in the ratio of the Japanese Manufacturing PMI to the Eurozone's PMI, which has risen above one, indicating that economic momentum is stronger in Japan than in the Eurozone. Additionally, the Yen to Euro exchange rate tends to loosely follow the relative economic momentum between the two countries. Furthermore, although both economies are sensitive to global growth, Japan is likely to benefit first from China's reopening, which suggests that the Yen to Euro exchange rate has some catching up to do.
Ballooning trade deficits
Both the Eurozone and Japan are heavily dependent on global trade. But due to the Eurozone's energy crisis, the Eurozone's trade balance has collapsed and is now deeply negative. On the other hand, the Japanese trade balance has also turned negative, but to a far lesser extent than that of the Eurozone. Historically, a rising trade deficit is often accompanied by a weaker currency.
Positioning divergence
Finally, it's worth noting that Euro-Yen positioning is (very) skewed towards the Euro, implying things can go quickly when sentiment turns. The chart below shows that investors have gone massively long the Euro against the US dollar in the last couple of months. With the exception of the months after Covid, net Non-Commercial Futures Positions - the difference between the long (bought) and short (sold) positions held by non-commercial traders – are close to record highs.
The opposite is true for the Japanese Yen. Futures traders remain significantly short the Yen against the US dollar and have not been long since March 2021.
In summary, while the Euro has seen strength recently, investors should pay attention to the rising inflation and yield pressure in Japan. Additionally, Japan's economy has proven to be more resilient, and is poised to benefit from China's reopening. Additionally, Japan's trade deficit is not as severe as that of the Eurozone. Therefore, investors should diversify their portfolios by selling the Euro and buying the Yen.