Market Insights

Meaningful Vote

As of the time of writing, here is our snapshot of Parliament based on each MP’s First Preference when it comes to Brexit:

This leads us to our prediction for the result of the Meaningful Vote:

  1. Does the margin of loss matter? Not really.
    • Theresa “Nothing. Has. Changed” May already has the steamroller of alternative versions of her deal ready to roll, as The Sun leakedlast night (“Merkel has offered last minute help“).
    • Parliamentary Procedure will be used to continue to wrest control from the Government’s hands: The Boles / Letwin / Morgan ‘coup’ to force an alternative Plan B by Committee will advance, whatever happens.
    • Parliament still doesn’t know what it as a majority wants, meaning a Second Referendum and a General Election can still be argued to provide methods to break the impasse
    • Brexiteers can happily tick the clock down to No Deal as long as the impasse persists
  2. But it does mean the gloves are finally coming off. 
    • Hands will be declared, but some are backing multiple horses, to mix our metaphors. Backing a People’s Vote, Norway, Theresa’s Deal and Renegotiating the Backstop are all positions that could be consistently held by one person at the same time.
    • Therefore handing control to Parliament does NOT prevent No Deal nor secure a softer Brexit. While Parliament fiddles, the path to avoid No Deal burns. The majority against it will eventually have to come up with an alternative solution to rally around.
  3. The most useful information tomorrow will come from the Amendments. The scale of votes for each Amendment should give an indication of future tactics and start to reveal MP preferences:
    • Mann’s Amendment is considered a sop to Labour MPs
    • Swire’s Amendment is a way to sell the temporary nature of the Backstop
    • Murrison’s Amendment, ditto.
      • Given the EU27 have said they won’t budge on the Backstop, these Amendments are still unicorns at this stage
    • Benn’s Amendment is a cunning Schrodinger’s way to reject TM’s Deal and at the same time reject No Deal
      • Lovely, but means nothing unless an alternative to No Deal can be found
      • It’s also Lovely for Theresa. If this Amendment were passed, it would kill the vote on TM’s Deal, meaning she wouldn’t have to suffer the ignominy of the worst Government defeat in history
      • Given this, at the time of writing, we hear Benn might pull his Amendment in order to inflict a massive defeat on the Government
      • We also heard yesterday that the Brexiteer ERG would paradoxically vote FOR TM’s Deal if this Amendment stands – in order to keep the path to No Deal open by virtue of the DUP then dropping the Govt.
    • Yes, we are into that level of tactics.
  4. Parliament is united against Theresa…
    • Whether an MP wants to Remain, Leave, or just win power, it suits them all to take Theresa’s Deal down.
    • That’s not going to change. Substitute “Theresa’s Deal” for almost any other option and you’ll have the same outcome. As we wrote in our Brexit Roadmap (email us for a copy):
      • Remember though how many in Parliament benefit from the current administration wearing the blame of a bad Brexit. And then realise that they will not come to its rescue. Not unless or until they can emerge as the champions. And if Brexit can’t be saved because it’s too complex, it must go down with the Government.
        Theresa May survives only because it’s in the interests of the players in the game. No one wants to take on the poisoned chalice at this stage. It must fail, and badly, before anyone can take up the mantle and deliver the hard decisions that a renegotiation with your closest trading partner entails
        .’
  5. ….but disunited over the ultimate direction.
    • Handing power to Parliament will only serve to make this clear.
    • As any of you who have ever served on a Committee will know, they rarely make decisions quickly.
    • Let alone when they come from different Parties, have different ideologies, and different beliefs about our relationship with Europe.
  6. The Labour Party is the only way to avoid No Deal. 
    • Parliamentary arithmetic broadly divides as one-third either extreme Brexiteer or Remainer, two-thirds centrist – but with the pragmatists split by Pprty.
    • The Labour Party’s inconsistent but politically understandable plan to give the Government enough rope to hang itself is going to run out of road.
    • Over half of Labour’s MPs have a negative stance on Jeremy Corbyn, but the leadership rules make him thus far irreplaceable. At some stage the momentum will turn against Momentum. Without it, nothing can ever be agreed. Labour MPs will need a crisis to break cover.

In a way then, this is the Meaningless Vote. Whatever happens, good lord even if she wins it, the game goes on. Anything is now up for grabs. We continue to see recommendations to buy GBP as this is ‘all priced in’. We beg to differ. Chaos awaits.

The Brexit Roadmap

Email us to Purchase the Figures behind Our Predictions

In our six-page report, we present why we are headed for No Deal.

Despite last night’s defeat for the Government on the Finance Bill amendment that limits setting aside funds for No Deal contingencies, Parliament still needs to vote for an alternative. But there is no majority for anything else. 

  1. Here are MPs’ first preferences for what they want from Brexit:
  2. And here are the numbers once certain factions club together:

Conclusion #1: Theresa May needs Labour MP votes.

But:

  • 155 of 257 Labour-held constituencies voted to Leave.
  • 90% of Labour MPs voted to Remain
  • 75% of Labour Party members want a Second Referendum
  • Corbyn wants an election before being tainted by the Brexit mess

Conclusion #2: Labour holds an impossible position.

In the battle of The Great Protestor Jeremy vs The Great Administrator Theresa, no one will lead. Both positions are passive.

Conclusion #3: Events will force their hands.

A crisis is needed to break the deadlock. Then 4 options could prevent No Deal:

  1. Pragmatists of all parties fall into line and pass May’s Deal (with EU concessions?)
  2. A new government emerges via a 14 day post-No Confidence period or an Election
  3. A government of national unity (GNU) emerges as Labour MPs defy the whip
  4. Article 50 is extended to allow for either a Second Referendum or a General Election

Conclusion #4: A new era of political instability is upon us.

Click here to view the full report.

This Week = Next Year

This is now the second worst December in the history of the S&P500. It’s the fifth fastest that it has ever dropped 17% from an all time high. The sheer speed and size of its decline has everyone asking if it’s a portent of doom for the economy, or just a kind of flash crash capitulation. Is it a policy mistake from the Fed? Is it Trump’s manhandling of his staff and Congress?

No, it’s just what happens when people look ahead, feel uncertain, and move into cash.

But that in itself isn’t enough. Those choices don’t usually have historically significant impacts on pricing.

It is what happens when the system is inherently unstable. It’s what happens when liquidity disappears. It’s what happens when hidden leverage is revealed.

It’s Flows + Liquidity + Leverage + Risk = mayhem. 

This isn’t a flash in the pan. This is the future.

Flows

1. Lipper data shows a massive shift recently: $81bn has gone into Money Market funds in one week, more than they typically take in for a year. $100bn has come out of Equity funds (ex ETFs) in three weeks.

2.  Meanwhile ETFs have taken in $26bn in the week to 20 Dec. Mixture of equity and bond funds, mixture of big and small:

3. Hurrah then! Passive ETFs beat Active, they’re the port in the storm!

Not quite.

4. ETFs are being used like futures. Those inflows can be market maker hedges against outflows in other ETFs. Or places to park money before moving it onwards. They’re the pressure valve for short-term traders.

5. But long-term investors still use them. Many of the ETFs on this list are “mom and pop” favourites. Buy the dip is alive and well. It’s just being drowned out by the big institutions.

6. And there have been significant outflows. This Bloomberg story flags up how one big investor pulled out of all of Vanguard’s Sector ETFs during 12noon-1pm NY time on Monday. It wasn’t just about taking x% or y$bn out of each one. It’s clearly a decision to cut all of their positions, as the flows show:

The highlighted sectors are those which were reclassified by MSCI as of 28th September. Conspiracy theorists might note that this is when volatility started to increase in the S&P500. They’re also the ones where this investor made some of the biggest shifts in terms of the % of AUM of the ETF.

Liquidity

7. The thing is, ETFs are as liquid as anything else in December markets, i.e. not very. And volumes have been huge. HYG, the favoured High Yield ETF, traded $5.5bn yesterday, more than Facebook, and well above its recent average:

8. At the same time, liquidity in single stocks it as its worst for a decade, as Goldman point out:

9. The market can’t handle these big flows. So yesterday the HYG traded at its widest deviation from its intrinsic value since February’s vol-mageddon. (Intrinsic value reflects the pricing of all of the components of the index at that point):

10. You wouldn’t know this if you weren’t watching intra-day, particularly as the IV is only available on various expensive trading platforms. If you’re merely a private investor who wants to check if your ETF is tracking its underlying, you just see this on the ETF issuer’s website:

A mere -0.20% discount. Very run of the mill. Not that you can easily check back to see how that fits in to what’s happened in the past. You can only see a quarter of history at a time, and you can only see a bar chart range. Maybe that doesn’t matter. You’re a long term investor. You’ll be exiting at the NAV of the day. That can’t deviate much from the underlying index. Can it?

Leverage

11. This is where the hidden leverage comes in.
– To keep an ETF tightly tracking an index, its market makers must be able to arbitrage away any of these differences to its intrinsic value. That’s fine, until the underlying assets become less tradeable. Then the arbitrage is impaired.
– Losses start to mount for the market maker. They step away from the market.
– Prices for the ETF itself widen. Those using the ETF as a hedge start to worry.
– Flows come out of the ETF and market makers must hedge themselves in a market with less and less liquidity, both for the underlying asset and for the ETF itself.
And so on the vicious circle goes.

In reality the arbitrage is usually done by a machine. It doesn’t actually go and do anything to all 972 bonds in the HYG. They’ll choose the quickest and cheapest most closely correlated instrument. Which has historically been the S&P500. Here’s the 3 month correlation between HYG and SPY this year, it has basically been around 70%:

12. The tracking characteristic of an ETF therefore creates a shadow position. That multiplies up exposures. As prices shift, these exposures must be managed. That delta hedging process is akin to a massive derivative position on the S&P500.

13. …which means stock markets are entirely prey to something called short gamma. As our friend @SqueezeMetrics pointed out yesterday, ‘we are very deep into short gamma land. About 200 SPX points away from 0 GEX. Volatility until we can dig ourselves out.’

Risk

The tinder to light this fire can then simply be a risk that forces a shift in people’s positions. Fear of a more volatile Trump ahead now that his own advisors are all leaving? A more unpredictable Fed now that they’ve done 9 hikes? Liquidity disappearing as the Fed sticks to Quantitative Tightening? Brexit hurtling towards No Deal? France rioting? Hungary rioting? China hacking?

Let’s not go all Billy Joel We Didn’t Start The Fire.

The truth is that this week is just a harbinger of what is to come next year. Keep an eye on the flows. Everything else is in place for more volatility ahead.

Letters

If, by the time you read this, 48 letters expressing No Confidence in Theresa May as Conservative Party leader have been received by Graham Brady, then:

  1. The vote should take place within 24 hours
  2. If TM gains votes from 158 of her MPs (half the parliamentary party) then she stays as leader and cannot be challenged again for 12 months
  3. Expectations are already being trailed that a loss of over 100 would be enough to make her go.
    – We would disagree. Any woman witnessing Thatcher’s enforced departure would not leave the top job unless the numbers make it so.
  4. Even the most extreme Brexiteers and Remainers fear they don’t have enough momentum to carry half of the party with them. That’s why they couldn’t move until TM was knocked out onto the canvas. They had to be certain she was gone.
  5. But even now, Conservative MPs face a dilemma. 
    – Once TM goes, one of the final candidates won’t be Brexity enough for Brexiteers or Remainy enough for Remainers. That means both factions have a 50% chance of losing out.
  6. The odds however favour the Brexiteers. The final decision on leader comes down to the Conservative Party membership, and they’re certainly on the harder Brexit side of things.
  7. In trying to move the odds in their favour, it’s no surprise that neither Brexiteer nor Remainer can yet agree on who their own candidate should be.
    – Leading ERG member Steve Baker has told Brexiteers who quit the Cabinet to “work out between them which one of them is going to be our candidate to unite the country” – i.e. Boris Johnson, Dominic Raab, Esther McVey and David Davis

So the calculation runs thus:

  • Are you confident that if TM goes, you’ll get someone you prefer in her place?
  • For Brexiteers, the answer is probably Yes. For Remainers, it’s less clear cut.
  • Or are you just so sick of the shambles, you just want to gamble

So how many Tory MPs are Remainers?

Here’s our MP by MP analysis which shows the shape of the Conservative Party on our scale of -15 for most Remain MP to +15 to most Leave MP:

One third of the Party ranks at a zero or below. This is the Remainer rump.

And where can Theresa May find her magical 158 MPs? Everyone ranking at +2 or below would get her there.

Is there a compromise candidate who could tempt some of those away from her?  Well here’s a map of Cabinet MPs from just before Raab resigned:

Can Javid, at +5, become a kind of compromise candidate? Likes Leave enough to please the membership but Remain enough to calm his Remainer colleagues?

He won’t get the chance if 158 MPs decide they prefer the devil they know. So this contest will only be called when it has the momentum the Prime Minister’s detractors desire. It might be tomorrow. If it’s not, it is still coming. The end game of power, and the chance to shape the Brexit of your dreams, are within your grasp. It’s just a question of timing.

And while it lurks, the Labour Party can continue to hold fire on their own No Confidence vote, despite Vince Cable and Nicola Sturgeon publicly lambasting Jeremy Corbyn for not doing so already. Why pull the trigger if the Conservative Party can set off some friendly fire shots that weaken their already divided party?

Even if TM wins, she won’t be out of the woods. The pressure cooker will still be steaming. Every attempt to try to preserve the status quo is tinder for the fire for those who desire a very different Brexit outcome.

The upshot for financial markets is that we are entering a much more significant crisis period. The chances of either No Deal or No Brexit are rising. All these months of inaction were not a reason to be calm about the future. They were merely time for some shadow boxing and weapons stockpiling before the bombs start to go off. We continue to expect a sharp dislocation in GBP assets in the next couple of weeks as this becomes apparent.