Tipping Point

Declining economic growth may become too much for equity markets to ignore

Photo by Michał Parzuchowski on Unsplash

Written October 2, 2019

Yesterday’s sharp deterioration in risk sentiment is a sign that the equity market and its patrons at the Fed may have a couple of serious problems: 1) The latest numbers from the Institute for Supply Management (ISM) suggests the US economy may be close to, or already in recession and 2) the Fed has been too slow to recognize it. Neither of these issues is exactly new news but the stock market’s seemingly oblivious reaction to the growing danger has been nothing short of remarkable. Until now.

The continued erosion of benchmark ISM survey data on U.S. manufacturing, its worst reading since 2009, was punctuated by a complete collapse in the forward-looking new export orders component. See https://bloom.bg/2oWfXgK. The disruption in commerce and global supply chains from trade wars is real and intensifying. Similarly, contractionary readings on factory production from China and Europe this week only added to the recessionary drumbeat.

It is undeniable that the Fed underestimated the deceleration in the economy. Their hesitancy to ease when signs of economic weakness first appeared earlier this year probably means that a recession is now inevitable. They missed the boat. Even if the Fed cut rates aggressively now it may not matter. And that possibility is starting to occur to investors who had come to rely on the Fed as a consistent backstop for asset prices.

It feels like the markets are at a tipping point. The major central banks have spent a decade throwing trillions at the economy and have little to show for it except for unprecedented levels of income inequality. But it hasn’t stopped them from pressing forward with more of the same policies. The renewed race to the bottom on interest rates is becoming less effective while at the same time increasingly desperate.

The failed WeWork IPO might have rung the proverbial bell in this era of easy money and stretched valuations. Fundamentals matter. Earnings, which they clearly don’t have, matter. Like Pets.com, the poster child of absurdity from an earlier bubble, WeWork will go down as an example of “what were they thinking?” for years to come. See https://bit.ly/2nE1y8N.

As I noted in my two previous pieces (see VIX Cheap as Impeachment Threat Grows and Liquidity Trumps Fundamentals), the most obvious trades in this shifting paradigm are to be long volatility and long the front-end rate market. Historically, October is more volatile than most other months. And the lurch lower in key economic data points could be the catalyst that makes volatility in equities, bonds, and FX all suddenly appear to be ridiculously underpriced.

Furthermore, anyone who doubts that the Fed could take rates back to zero, and quickly, has not looked at the U.S. dollar. The growing global dollar shortage, which we’ve written about extensively, is pushing the buck up through multi-decade resistance (see Fed Rate Cut: Too Little, Too Late). The long term dollar index (DXY) chart is very bullish, and if the USD gets legs it will make the 2018 emerging market selloff look tame by comparison. The Fed can’t afford for that to happen and will be forced to keep cutting rates to try to prevent it.

US dollar index (DXY). Breaking out higher.
Emerging market ETF (EEM). Look out below. A stronger USD leaves this sector very vulnerable.
CBOE volatility index (VIX). Cheap and bullish.

Liquidity Trumps Fundamentals

Inadequate funding a potential problem for markets

Photo by Robin Spielmann on Unsplash

Written September 26, 2019

Just like the equity market’s general complacency over the uncertainty created by a potential presidential impeachment, it is exhibiting a similar lack of interest in the ongoing liquidity squeeze in short-term funding markets.

A sharp spike in overnight financing rates last week due to a scarcity of bank reserves was initially dismissed as an unexpected confluence of technical factors.  Everything from quarterly tax bills, treasury auction settlements, and principal and interest payments were blamed for draining an unusual amount of money from the system and causing an acute shortage of free reserves.  Overnight rates were said to have traded as high as 10% before the Fed was forced to step in with emergency funds.  The panic passed but the underlying problem hasn’t gone away.  Lots of confusion still hangs over the money markets.  Financing remains tight, enough so that the Fed has had to supplement the system with cash every day since.  This is not normal and the longer it goes on the explanation that it is merely a temporary quirk becomes less credible.

As of now, the consensus opinion is that this problem will fix itself simply by a turn of the calendar past quarter-end (September 30).  That seems to be a big leap of faith.  In a Bloomberg piece today former Minneapolis Fed President Narayana Kocherlakota says that regulatory changes after the 2008 crisis, like more stringent capital and leverage requirements, have restricted the amount of free reserves in the financial system and banks’ willingness to lend those reserves among themselves. See https://bloom.bg/2mGcO3B. None of this was a problem while the Fed was expanding its balance sheet and providing almost limitless liquidity.  Only when the Fed began to shrink its balance sheet a year ago did this unintended consequence emerge. 

The explosion in the issuance of US dollar-based debt, both domestic and foreign, during the previous decade of easy money policies created a massive need to finance that debt.  What has now become obvious is that without additional liquidity provided by the Fed, there just aren’t enough dollars in the system to go around. Kocherlakota notes that “the financial system is acting like it has $1.3 billion in excess reserves rather than the actual $1.3 trillion.”

This means the Fed can forget about any plans they might have had for normalizing interest rates and reducing their balance sheet.  Quite the opposite, it slants the probabilities in the direction of even lower rates. The problem in the money markets is structural and has disrupted one of the financial markets’ most essential functions.  Until they figure out how to fix it, simple liquidity will become an ever-important consideration for investors.  Fundamental investment strategies don’t matter much if they can’t be financed.

The fourth quarter of 2019 will see two issues elevated that were not big considerations in the current quarter: domestic political uncertainty and liquidity uncertainty.  These factors should lead to a general increase in market volatility as well as heightened concern over funding availability. This will almost certainly force banks and asset managers to begin paring back positions for year-end earlier than ever. Additionally, rate cuts at Fed meetings in October (Oct 29-30) and December (Dec 10-11) will be in play as the Fed seeks to offset the slowing economy and keep funding pressures contained. 

The two simplest trade opportunities are 1) long equity volatility such as the VIX (see VIX Cheap as Impeachment Threat Grows) and 2) long Eurodollar interest rate futures, such as the Dec 2021 contract.  Policy rates in the U.S. are on their way to zero and there’s a lot left in this trade.

December 2021 Eurodollar Future

The Doctor is Calling

May 22, 2019

Copper is often referred to as the metal with a Ph.D. Because of its broad range of industrial uses, Dr. Copper has a well-deserved reputation as a predictive indicator for global macroeconomic trends.

Today’s break of nearly 1.5% is noteworthy but not exactly surprising as the trade war with China expands (see Huawei), impacting supply chains and hurting demand through higher costs. A survey by the American Chamber of Commerce in China revealed that a third of U.S. companies operating in China have either delayed or canceled investment decisions, and 41% of respondents were considering relocating (or had already relocated) manufacturing operations. See https://bit.ly/2YAac54 . This is huge.

What is surprising, however, is the ability of the equity markets to shrug off a major disruption in global economic activity and the potentially negative impact on corporate earnings. Volatility remains low, reflecting a belief that the Fed can control the outcome of the business cycle. Maybe they can, but as we approach the tenth anniversary of the current expansion that bet becomes less attractive.

If 2018 taught us anything, the credit and equity sectors can depart from weakening macro trends for only so long. Though copper began breaking down in June of last year the S&P essentially ignored it until October, but the adjustment was quick and ugly (see chart below.) A similar divergent scenario appears to be unfolding, this time made worse by intensifying trade-related pressures and leaving stocks increasingly vulnerable. The Doctor’s prognosis for the markets is not good.