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Focus on the Big Questions

As you might expect for a student of politics, philosophy and economics (also known as “General Studies”), the current state of play is about as exciting as it could possibly be. Look how Trump is crunching the historic separation of powers! See how the UK demands a better representation of its trading powers! Hear the populace roar as it divides into combative factions! As we search for what it means for the future, we look to the past, and engage in paroxysms of joy as we wax lyrical on the return of a bipolar global system. A loyal BM reader, and History PhD, remarked just last night over a glass of vino that the classic battle of East vs West is as old as time, and the resurgence of China/Russia is just another swing back in the pendulum of global geopolitics.

So much, so beard-stroking, so pipe-smoking. You need to know what it means for your portfolio.

As we know, the battle lines for this year are Protectionism vs Reflationism. We know how the latter plays out because we’ve seen it manifest itself since curves started to steepen last September – as Chinese Producer Prices started to accelerate higher:

In this world, the US Dollar rallies. But what happens in Protectionism world? Well then you get inflation alright, but at the cost of growth, as Trump slaps tariffs on someone, who slap tariffs on someone else, who threaten economic or even physical retaliation… and on we go. In that world, capital is brought back home. The reduction of investment could see dumping of USD assets, leading many to conclude this scenario would be horrible USD negative, what with their current account deficit and all. But then again, it could lead to vast repatriation, with demand for USDs outstripping supply. Either way, you could see a 10% rally in the Dollar followed by a 20% sell-off. People talk about ‘Trump-as-Reagan’ potentially delivering the Volcker-esque early 1980s monumental rally in the US Dollar. But if we do get that, it will be with double the amount of volatility. Why? Precisely for all those fascinating reasons given in the first paragraph – because this new world order is going to smash people over the head with its new paradigm. It will take us time and a lot of volatility to adjust. We are not just talking about one eccentric man becoming President and doing unexpected things; we are talking about populism gripping the world, deliberately dividing its people and disrupting all of our institutions of government. We needed to be woken up because it turns out some very big questions indeed have not been answered. What kind of nation do we want to be? What values do we hold? Should a nation export values as well as goods?

Markets should be agnostic to politics. But flows speak volumes. Dumping of assets creates re-pricing.

And we are about to see a re-pricing of risk, as the market wakes up to the fact that we are now in the world of the Big Political And Economic Questions. Don’t get dragged into whether it’s good or bad; don’t conflate your personal view of Trump/Brexit as that of the whole market; don’t, as Gordon Gekko himself said, get emotional about stocks Bud. But do realise that whether we are focusing on Protectionism or Reflation as the theme, there will be wildly different outcomes, and you need to make sure you haven’t got too much risk that’s predicated on only one of those themes winning out. We’ve been doing Reflation since September; now Protectionism – and the roll-back of globalisation – is about to take centre stage. Forget the Fed and non-farm payrolls: when is the Trade War going to start?

The Power of the Pen

It’s a busy week, with Fed, BOE and BOJ meetings, not to mention latest payroll and ISM data from the US. Throw in the PMIs and flash Eurozone CPI data, and usually we would be getting overexcited about how to pick through the minutiae of all of these signals. Central bank rate paths would be mapped out; business cycles would be plotted; probability paths would be compared with positioning and market pricing would adjust. Oh but now we are going to have to learn something new. All of this could be wiped out in a heartbeat with the swipe of a pen. The new leader of the free world has just realised how powerful he is. Not only can he move 100s of thousands of people around the globe as if he’s playing with a real life Risk board, but he can generate headlines that dominate the ENTIRE WORLD as he does so. And all this with the stroke of a pen. The only amazing thing about all of this is that anyone is amazed. Firstly, he’s carrying out campaign promises; secondly, he’s currently at his most powerful; thirdly, he’s always been a deal maker who will use whatever tools he can to shake up the chessboard; and finally, he loves it. All of it. He’s Living The Dream. He is ripping up the rulebook, and so should you. You can worry about payrolls if you like, but more important this week will be his choice for the Supreme Court plus any new executive orders that relate to trade. The weekend’s activities mean that he is going to be deliberately disruptive. He is going to put America First. He will be testing the Separation of Powers to their limit, because that’s what he was elected to do. Why else did the voters not only elect him but also give the Republicans a clean sweep?

Blondemoney pauses here because we are now going to enter a reflective moment for Uncomfortable Truths. With this kind of disruption, we are going to see the world order scrambled and recreated in a way that we have not seen for a generation. Some of it may be good, some of it may be bad, and your particular choice of which it is will no doubt depend on your political compass. But this blog is not here for judgement. It’s here to explain how markets could react.

And the big point right now is that the market hasn’t ripped up its rulebook. It’s also in danger of getting drawn into the emotion. There seems to be a sense that stocks “can’t” keep going up, because all this stuff is bad. The rational argument then follows that Trump is destroying growth with his plans. Maybe. Maybe foreign investors will dump US Tsys in retaliation; maybe investment will stay away due to uncertainty. But maybe Paul Ryan will get Congress to enact significant tax reform; and maybe the rally in business optimism will revive animal spirits. Maybe then we’ll get massive inflation and maybe then Trump will staff the Fed full of doves. This, like Risk, is a multi-stage, multi-player game. Compared to the relatively straightforward task this week of decoding the Bank of England’s inflation report (Clue: There’s going to be lots of inflation), there’s no wonder we don’t know how to trade it yet.

The up-ending of the normal logic is flagged in a BBRG article today about bears vanishing from the S&P 500. They point out that short interest is at its lowest in 3 years, and that a desire to get long stocks in a cheap way is leading to proliferation of call buying. This means that the put/call ratio is at levels not seen since the Dot-com bust and the global financial crisis:


Regular readers know that #FOMO has ruled supreme for the past few years. All of the central bank QE mandated the risk rally: buy the dip. Even in the past couple of years, as volatility has risen, it’s only in the sense of flash crashes. These were cracks in the ice. We got a bigger crack in the first couple months of last year, but even that was pushed away as “lower-for-longer” turned into “lower forever” and lowflation remained the name of the game. It was always about the soothing power of cheap money. But at the end of last year we reached the end of the road. Cheap money is no more. Inflation is back. And now throw in the kind of political risk that we haven’t seen since before we declared Communism dead and Capitalism the winner. It will turn out that the Great Moderation was about more than just a virtuous cycle of increasing growth; it was a Great Moderation of politics, where all the big questions had been answered, all politicians were the same, and the End of History. But that was the anomaly.

So should we continue to fly headlong into the risk rally now that this is all changing?

Well if people are trying to buy something expensive through a mechanism that they think is cheap, like call options, then the reality tends to be that they still bought it very expensively. What could be the trigger for this reassessment? A few more strokes of the President’s pen

Shouting is OK

So, now we have the battle lines drawn for this year. Global reflation on the one hand; protectionism on the other. One boosts growth; the other reduces it. And within each growth scenario, each country could have wildly different outcomes for their economy.

Meanwhile the policies that will lead to more emphasis on one or the other are now being thrashed out very loudly and very publicly. In fact, trade deals by their nature require a very public kind of negotiation. They say, Hey, we want to be friends with you, because we’ve got something you want, and we’ve got something you want. It’s a game of poker, and if you want to raise the stakes, you can use something very specific to bluff: the one true power of a politician, which is the support of their electorate. Hence the need to signal effectively through the media, and the need to stoke up noisy support from time to time.

That’s how we end up with the US President and the Mexican President indulging in what appears to be a schoolyard huff. “You pay”, “No, YOU pay”, “Fine, don’t turn up”, “Fine, I WON’T THEN”. This unedifying display seems to feed into the “liberal elite” perspective that Trump and populist politics has ushered in a dreadfully uncouth and therefore useless political era. No, No, No, as Maggie once said (there will be much more reference to Maggie before the Trump term is out!). Remember the 1980s? Remember the 70s or 60s, even. Times when politicians could argue. Times when there were big topics to fight about. Communism v Capitalism. Nuclear power v Opening borders. Etc. We needed the big loud debate because there were big debates to be had.

Oh but then the Berlin Wall fell, all the communist countries embraced capitalism, and capitalism won! Then inflation was conquered and the business cycle was won! Hurrah, and indeed huzzah for it was the end of history. But it turns out that the period of the late 90s through to the collapse of Lehman was the outlier. The loud shouting between our leaders is only going to grow. And what is so wrong with that? Why not question the benefits of immigration or free trade? Maybe the war was never won. Just a battle. And as Maggie said, you may have to fight a battle more than once to win it.

Aaaaaand relax

Much as he might hate this, it’s not all about Trump. The fact is that the global economy was already on a reflating trend before his election. Curves were steepening from early October and after a well-earned Christmas break, have been doing the same since the new year began.The difference this time is that the US Dollar is not joining in with an outperformance

Perhaps the world is catching onto the fact that this is a global reflation trade? Chinese PPI is roaring back into positive territory, but world CPI is yet to catch up. Sure, World CPI does sometimes never quite catch up to the Chinese levels, but the divergence now is stark:

Note that Chinese industrial profits overnight fell to lowest increase in a year, as profit margins start to bite. Eventually they’re going to have to start raising prices… just at the point where protectionist policies might make them more expensive anyway! It’s the fear of this protectionism and “bad inflation” (after years of Bad Deflation) that is leading to some confusion over why equity markets haven’t taken more of a hit. The thing is, they did. Given the long-only bias of equity markets, what with continual money sloshing around needing to be put to work to earn some kind of return, it’s actually negative when they tread water. That means some selling interest, or at least a slowing of the pace of buying. So now they’re starting to take off again, this is in line with a resumption of the reflation trend. It’s as if investors took a deep breath over the Trump inauguration, and they’re now breathing out. Allied to which, volatility levels in equities are just so low. Now, that doesn’t mean they always will be, and if anything it suggests that rebuilding positions now will ultimately lead to an excess of leverage in the wrong place. But, somehow the Trump election served to create a divergence between asset classes that left equities in super calm territory – here’s our favourite cross-asset vol chart:

The thing is, Trump was supposed to mean uncertainty which meant Bad Things. But not all his uncertainty is bad. Small business optimism is rocketing through the roof. Infrastructure projects are on the agenda. Tax cuts! Big changes which could be very good for a whole bunch of stocks. And now we get into the positive feedback loop of all of this. If 1) global reflation is back; 2) Trump might not be All Bad; 3) volatility looks well behaved then………… why not get into one of the market’s favourite things, and that’s carry? Hence our favourite “positive risk” indicator, the basket-case but yield-heavy South African Rand, is at one year highs:

Time for some optimism, folks?

The Court of Public Opinion

The reaction and even anticipation for today’s Supreme Court ruling on the UK government’s triggering of Article 50 is a salutary tale for the markets. Yay, they thought, this is an actual event with a specific time and a binary outcome! Kinda like a central bank meeting! We like those.

But then, politics rather overtook it, didn’t it. Hence the timing of Theresa May’s speech last week. The question is not If Brexit, but What Brexit. She, like all good leaders, moved the narrative on. Now the German Finance Minister pops up to urge a Switzerland style model; etc. Some in the markets now cling to the point that it has to pass the House of Commons and the House of Lords before it’s a done deal. Sure, procedurally it does. But this isn’t like a central bank being forced to meet its mandate. The Court of Law doesn’t matter. It’s the Court of Public Opinion that does.

Politicians derive their power from electorates and then harness it to drive their agenda. With even at least some of the Remainers now convinced the fight lies on as soft a brexit as possible, rather than none at all, why would a Majority in the Lords back a Minority of The people? Sure they’re unelected and required for scrutiny. But we have never had such a direct mandate from the British electorate since the referendum to go into the EU over 40 years ago.

The point is that there would be riots on the streets if it’s blocked. There were already marches in Washington after Hillary won more of the popular vote…. and there will be more of these to come.

Markets need to wake up and smell the political coffee. The voters matter more than central banks now.