SUBJECT: This is the Real Vision workshop on asset classes. Specifically, we want to look at what drives the performance of individual assets and then try to identify the relationships between them. Of course, this is a massive subject, so we're only going to scratch the surface here.
So when it comes to equities, for example, please don't expect us to go into a deep dive on how to read company accounts. We'll get to those details in a later course. As a start, we are trying to provide you with a top-down framework to understand and manage the financial world.
As Scott Bessent, a colleague of George Soros and Stan Druckenmiller, said, people always forget that 50% of a stocks move is the overall market, 30% is the industry group, and then maybe 20% is the extra alpha from stock picking. We'll also outline the main asset classes themselves and how these might be impacted by considerations, such as GDP growth or whether an asset is from a developed or developing region.
And finally, we'll look at some classic relationships that you can use that will hopefully inspire you to look for your own relationships across other assets and regions. By the end of this workshop, you should have the building blocks that you need to spot key trends within and across the main asset classes within financial markets.
In our discussion, James, Jamie, and I were outlining the different asset classes as the building blocks of the financial ecosystem. They're effectively the foundations of our investing environment. Now, while some investors have made a decent living just focusing on one asset class, it's probably better to have an understanding of all of them and how changes in one area can have an impact on another.
Now remember, we're trying to spot emerging trends and nail the inflection points where some of the greatest profits or losses can be made. So let's have a look at the asset classes broken down into their basic groups. We have stocks, which are grouped into country and regional indices that break down into sectors and industries. Most global indices and sectors can be traded via ETFs. As we will see later, understanding the components and drivers of individual sectors and indices will prove quite valuable.
Then there's fixed income, including bonds, credit, and other funding products. Commodities are all the basic resources, ranging from metals to energy and agriculture. And then underpinning everything, we have currencies, which are not really an asset per se, but they are the glue holding everything together.
An additional category could be crypto and decentralized finance, though this may represent a new ecosystem rather than a specific asset class. But once we've lined up the different asset classes, we can then see some of the interactions between the asset classes and spot a few of the investable relationships. We can see how GDP or a country's status as either a developed or emerging market can also have an impact on these trends and their volatility.
So let's start with the asset classes that generates the most interest for individual investors. And that, of course, is equities. Now, equities are arguably the most commonly traded asset class and a widely reported favorite of the financial media.
But there's more to it than simply buying and then hoping when the stock market is going up. We've probably all had family members telling us how certain shares are doing really, really well and maybe some others are not whilst being completely oblivious to the market drivers and fundamentals that's behind them.
So in this section, we'll look at some of the ways that people have built positions within the asset classes from both the professional sphere and from individual investors to give a flavor of the variety. Now, some of these may not be appropriate for your own requirements, but the initial thought process will have many similarities. There are many ways to manage an equity portfolio, but one of the most common styles within the hedge fund world is running an equity long/short book, which is actually relatively complicated.
In our discussion, Jamie talked about how he specialized in the insurance sector as a former long/short guy at Point72 His strategy focused on identifying pair trades where he felt there was a relative value opportunity. In other words, he would look to go longer stronger or better value company and short the weaker or more expensive company. And rather than being exposed to movements in the broad stock market, Jamie was betting on the so-called idiosyncratic risk of the individual companies in the same sector.
So if the market was going down in a given month, but company A had outperformed company B, then he would have made money regardless. Trading these inta-sector spreads can be quite complicated and requires an affinity for analyzing company accounts and things like earnings and understanding management. Try doing that with two mining companies, and you'll see just how complicated it really is.
But don't worry. It can be far simpler to trade long/short with a macro view, betting on sectors rather than individual companies. And these are known as inter-sector spreads. You'll still eliminate systemic risk so that your position shouldn't be affected by the moves in the general index, but you don't need to be an expert in the micro fundamentals of every company in every sector. Instead, you could go long and short using ETFs or a basket of the largest constituents.
For example, one of the trades that worked in 2021 was long energy and short the consumer discretionary sector by the ETS XLE and XLY. The macro view was that rising energy prices and inflation would put pressure on the consumer with households already facing the prospect of higher mortgage and other loan repayments, with the Fed beginning to hike interest rates. But rather than trying to become an expert in the intrinsic value of every company and inevitably missing the trade, this was a much simpler expression.
And we also talked about some hedge fund trades in 2007, which combined a long miner's position with a short in the mortgage banks in the UK during the initial phases of the great financial crash. Commodities were flying, but there were warning signs of the housing market crash that soon followed. This involved a little more research into some of the individual names on the short side, but that combination of a macro thesis and some micro fundamentals resulted in a really great trade.
Now, the point here is that as we saw in the market drivers section, we are constantly trying to marry the phase of the business cycle with the most appropriate expression within the equity market. For instance, if we are in a growth phase, then we might expect the value stocks and cyclical sectors, such as basic materials, industrials, and financials, to outperform. Towards the peak of the cycle, we might also see the energy sector doing well. And if inflation gathers pace, then real estate, consumer staples, and healthcare stocks could be a good bet.
But as the economy slows, investors will tend to seek more defensive growth names. If this looks likely to lead to a recession, then utilities might be one of the few hiding places for longs. Of course, you could instead short financials, industrials, and consumer discretionary stocks as a play on this, the recession.
And you can think of these relationships in terms of risk on versus risk off in beta. This chart shows the relationship between the ISM-- think the business cycle-- and investor risk appetite expressed as beta. Low beta trades tend to be in more defensive areas of the market, such as consumer staples and utilities and generally higher quality stocks. Higher beta trades tend to include small caps, cyclicals, and emerging market names.
And what's the hardest part is trying to determine which part of the business cycle we're in at any one point in time. We also have to keep checking that the chosen sector or stock is behaving as it should. They don't always conform to the relationships we've just outlined. And talking of high beta, commodities are another favorite in that space, too. But as a distinct asset class, they have their own unique fundamentals, as we were discussing when we were standing at the bar.
Now, arguably, the two most important factors in understanding commodities are supply and demand dynamics and the US dollar. And perhaps the clearest indication of the importance of supply and demand is the moves that we saw in commodities at the end of 2021 and the beginning of 2022, despite a strong US dollar. Supply was compromised by underinvestment after the commodity bust in 2014 and then the impact of the war in Ukraine, whilst demand remained relatively buoyant due to fiscal support. That was government spending and also the handouts.
But the US dollar also matters. Commodities, chiefly including oil, are generally denominated in dollar terms. And that's things like the petrodollar system and the balance of trade have historically defined that inverse relationship between the two assets. As the dollar weakens, commodities tend to go up and then vice versa.
And in this chart, the dollar index is inverted to make the trading relationship even clearer. Sometimes supply-demand imbalances and the dollar pull in the same direction, opening the door for massive moves in commodities. 2002 to 2008 was exactly that sort of period, when demand for commodities increased dramatically because of China while the dollar was also getting weaker. And this created a very, very favorable environment for nearly all commodities.
But as mentioned, in late 2021 and early 2022, this relationship broke down. Both the dollar and commodities rose simultaneously, which is atypical of the historical trading relationship. The demand-supply imbalance offset that rising dollar.
And when we get a clear break in solid long-term relationships, there should be a very clear reason in the fundamentals. Commodity supply chains were severely disrupted. So when we look at oil, we can see that the price of Brent crude rose over 50% in barely a couple of months, as did wheat when the focus turned to food supply chains and fertilizers. And many other commodities were also affected. So supply is absolutely key.
Outside of war, exogenous shocks such as the pandemic and unusual weather patterns are also major factors. Shortly after China joined the WTO in 2001, commodities went on a tear. And this undoubtedly created a secular shift in demand. But nearer-term, the fluctuations in China's economy and its policy response can also affect the outcome in commodities.
In 2016, China had started to loosen its policy and begun easing to stimulate growth, as can be seen in the upswing in the China credit impulse. In mid-January that year, commodities and commodity stocks bottomed. And from that point on, base metals and mining industry groups started outperforming the S&P 500 by a considerable margin.
It was a turning point that I, like many others, missed, because we were looking at Brexit and the US election later in that year. And it's a reminder that we should never focus too narrowly. Otherwise, we can miss, often with hindsight, what were some obvious opportunities. And charts like these clearly demonstrate the importance of China when it comes to commodities.
But there are other important demand drivers, too, such as domestic consumption and growth patterns and also secular trends, such as the shift towards renewables. Now, Raoul often talks about how the law of unintended consequences can impact various assets, and the rally in coal is a prime example. Rather than focus on renewables condemning fossil fuels to the annals of history, underinvestment has, in fact, made them even more attractive, particularly given the current limitations of clean energy.
And this became a near-term demand driver for the likes of coal and similar energy sources, as can be seen from the chart. And regardless of your personal opinions and even prejudices, you should always consider those unintended consequences of market moves and other things like policy decisions and exogenous factors. I want to shift gears slightly now to focus on positioning.
And there are two key players in the futures market for commodities, which the CFTC refers to as commercials and non-commercials. Well, I call those speculative positions as well. We briefly touched on this in the chart section and the euro earlier.
Now, commercials are entities whose trading predominantly reflects hedging in physical commodities. For example, a grains company might want to lock in the price of wheat for an expected harvest and may go to the futures market and enter a short position to guarantee that. The key point to make here is that commercials, they're not speculating on price. Rather, they're trying to avoid being exposed to price volatility by hedging their physical positions.
Non-commercials, on the other hand, are the group that we want to focus on. These guys are typically the fast money in the market, such as hedge funds and CTAs, who otherwise have no real interest in the physical commodities themselves. The CFTC publishes its commitments of traders report each week, revealing the net positions for commercial and non-commercial traders across pretty much every commodity.
And this can be incredibly insightful, as those non-commercial speculators will typically be more aggressive in their positioning. And this often leads to these short-term extremes where all the funds are suddenly positioned in the same way. And in simple terms, this can mean that there are no new buyers or sellers remaining to enter the trade and sustain the momentum.
Reversals often occur at these extremes. So you can look at something like the 52-week range, for example, and see whether the current net position is close to or at either end of it. If it is, then the underlying could be set for a reversion. And it can be used to similar effect in the FX market. In fact, the two asset classes can be quite highly correlated not just in terms of movements in the dollar impacting commodity prices, but also the other way around for currencies of commodity exporters. It's vital that you understand these relationships before trading any currency.
Emerging markets tend to be the major exporters of things like copper, iron ore, and gold, as well as in many cases food. But there are also other countries, such as Norway, Canada, Australia, who are also heavily involved in oil and mining and also agriculture. And take a look at the chart of the Aussie dollar versus copper.
As the price of copper increases, perhaps owing to Chinese stimulus or a pickup in global growth, for example, the Aussie dollar has tended to strengthen. And when the base metal takes a dive during, for instance, a recession, so, too, does Australia's currency. So in simple terms, if there is less buying of copper, then there's lower demand for Australia's exports. And as such, their currency could drop along with their expected GDP.
But recently, there has been a divergence in some of these dynamics. COVID supply issues and demand from renewables have been pushing the price of copper up, and a lack of volume means that equities in the Australian dollar, whilst benefiting, have not benefited as much as we might have expected. And that's yet another example that investing is not an exact science and therefore understanding the context and principles is often more important than those exact rules. And another such example can be seen here in the Norwegian krone against crude oil.
Whilst the currencies of exporters will be influenced by swings in their primary commodities, importers, such as Japan, may also need to consider what's going on in that space as well. Now, the main factor at play for the yen's weakness in early 2022 versus the dollar was the Bank of Japan anchoring rates at a time when many other key central banks were hiking. And this was encouraging domestic investors to look overseas for investments.
But the rally in commodities really added to that pressure on the yen in 2022. It basically got a whole lot more expensive for the Japanese to import the commodities that they needed. And in doing so, it increased the supply of yen in exchange for dollars, which turbocharged that weakening currency.
The interrelationship of many of these commodities and currencies will hopefully now be a little bit clearer, but there are other important fundamentals that also drive currencies and particularly where the economy trades more heavily in other goods and services. And there are these frameworks, such as BEER, REER, and FEER, which are ultimately based on concepts such as things like relative real interest rates.
So theoretically, if Country A paid an interest rate of 5% on cash, and Country B only offered 2%, then that 3% differential would support the currency of Country A in that A-B exchange rate. And, of course, when we talk about "real," this, of course, discounts it to account for the level of inflation.
If inflation in Country A was 3% greater than in Country B, then in real terms, there would be no benefit to the higher nominal interest rate being offered. Well, that's some of the theory anyway. But it does also form the basis for some of the so-called carry trades, where investors seek to own a basket of high-yielding currencies against those with lower relative real rates.
So for instance, for many years, the Australian dollar was seen as one of the more popular longs given the relatively high interest rate maintained by the Reserve Bank of Australia, which was to limit inflation given the cyclical nature of its economy being so heavily exposed to commodities. This made the carry trade especially attractive to Japanese investors given their persistently low interest rates owing to a lack of internal inflation.
But since the 2020 pandemic, the RBA has cut those Australian rates towards zero and made the Aussie dollar more of a funding currency in the carry trade, seeking high-yielding opportunities elsewhere. Emerging market currencies tend to benefit in the good times, as their export driven economies are boosted by global demand and also the search for risk and yield, which is pushing many investors out of developed countries with low interest rates to chase the returns in these countries and accepting their currencies and the higher interest rates, but also that higher risk.
And as we have seen with the Turkish lira, the outlook for the economy and its management may be a much bigger factor. And so therefore, once those good times are over, the tide often reverses in those high beta currencies. And the outflows tend to be extremely aggressive.
So a lot of these countries also come with strong political risks. There's also inflation risks, and there'll be a lot of other factors in there that could have an impact. And that's one of the reasons that you really need those higher interest rates for those investors to be compensated for this plethora of risks that are often embedded in some of these emerging markets. Clearly then, we need to keep an eye on the global economy, the level of inflation, and also that likely direction of interest rates.
But finally, we must just have a hat tip to the flight to safety qualities that some currencies may also have. The US dollar is often a currency which investors seek out if the global economy is going through one of those rough patches. It's effectively a flight to liquidity.
And this has been outlined by Brent Johnson in his dollar milkshake theory. And it's a factor that everyone should be aware of regardless of your structural view on the relative importance of the US dollar in the global system. And so with that, now we're going to have a look at the fixed income markets.