Market Insights

The Only Way is White House Apprentice X Factor

On Monday night the reality soap opera that is the White Horse delivered an almost unimaginable plot twist. The excitingly-named and expletively-driven Anthony Scaramucci was ignominiously deposed as Communications Chief only 10 days after the President announced his appointment. Indeed, in the Alice in Wonderland world in which we live, he actually left the job 15 days before he officially started. Court jester commentators thus had a field day, comparing White House turnover to an episode of Game of Thrones. Blondemoney’s father even departed promptly from the pub in order to catch the news. Truly it is must-see viewing for everyone when the office of the most powerful man in the world indulges in gossip-strewn self-immolation.

Before anyone gets on their high horse about degradation of the office, perhaps there should be a sidebar discussion on matters such as Monica Lewinsky’s dress or the Watergate tapes. That doesn’t concern us, however. What should concern us is that risky assets rallied hard, and particularly US assets, after the Republican clean sweep in November’s elections. Some of it because of an already burgeoning global reflationary force; some of it because the Republicans were expected to rip up, revolutionise and reform the tax system.

Eight months on and what do we have? Intractable and endless pained attempts to repeal Obamacare, let alone agreement on what to replace it with. Distractions about collusion with Russia. Sabre rattling over North Korea. Executive orders that inflame but don’t solve. Certainly nothing concrete that could boost the economy. Which is what the markets are supposed to discount, is it not?

Some argue that a navel-gazing government can be good for the economy. With politicians distracted by their own in-fighting, they meddle less, leaving an economy to find its own equilibrium. The excellent Janan Ganesh in the FT yesterday urges us to ‘enjoy the caress of weak government‘.

Theresa May has been hamstrung from doing anything too disastrous on Brexit, he argues, as a kind of quasi Cabinet government has broken out; ‘a precarious administration can fumble its way to more sensible outcomes than a leader who has what the French president Emmanuel Macron calls “Jupiterian” power.’

Perhaps this is why the White House’s regular reality TV “You’re Fired!” slot is greeted with barely a shrug by financial markets. Who cares about the President reordering the pawns on the chessboard, if it keeps him out of trouble?

 

There is one big reason: Power abhors a vacuum.

 

A team without a leader will eventually seek a new leader. The team disintegrates. The centrifugal force imposed by a leader harnesses the team. Without it, it will become unstable. It’s a bold step to consider the UK’s current governing powers as “cabinet government”, rather than just ‘a succession of Cabinet Ministers outlining mutually exclusive ideas about Brexit’ (as one of m’learned political friends puts it). With no discipline from the top, each minister is incentivised to go for the jugular and capture the power. Hence endless rounds of briefing and counter-briefing from the ever-more ideologically-bereft Dodo-ministers of Hammond, Johnson, Fox and Davis. We haven’t even seen this get into full swing yet. At some stage the realisation that the clock is ticking down on the UK’s inability to negotiate Brexit will hit the market hard. As will the understanding that the risk of a new government is not zero. In a minority government, the key is to carry the confidence of the public with you. So, as public mood ebbs and wails, things that seem unimaginable now can easily happen later. Tory dissenters, egged on by a pitchfork anti-hard-Brexit mob, join Corbyn to call a vote of no confidence and then form a new government within the 14 days required by the Fixed Term Parliament Act so as to avoid an election? Don’t count it out.

Meanwhile Trump is not mucking about with the chess pieces just to amuse himself between rounds of golf. He’s constantly testing the levers of power. Trying to bully and then coerce healthcare reform didn’t work. Travel bans didn’t work. At some point he’s going to stumble on the one that does. And that one is foreign policy.

Remember the MOAB dropped in Afghanistan on ISIS in April?

That came out of nowhere. For all the sniggering about Russia, or gossiping about his kids, this man still does have power. Indeed the greatest curb on a President’s power is the burden of expectation. Note that pretzel-choking George W Bush enacted massive tax cuts and war in Iraq, while Nobel Peace Prize-winning Obama’s healthcare reform may not survive. To borrow a Bush-ism, misunderestimating The Donald would not be wise. He’s already half way through a war of words with China over North Korea. Even the well-respected former Secretary of State Condoleezza Rice doesn’t believe N Korea can ever even get close to the possibility of having nuclear missiles. She has said that the US would have no choice but to stop them.

Let’s put this imminent threat of war, and collapsing governments, to one side. If I told you the last 9 days in the S&P has seen the lowest realised volatility in two decades, you probably wouldn’t care. Or be surprised. You might go out and sell some more volatility. It’s the summer. Central Bank aggregated balance sheets are still growing. Passive money is still buying any dips. So who cares? Putting this political nonsense to one side is the de facto stock position for stock investors.

It’s just reality TV soap opera nonsense, right?

Except the central banks are pulling back….
The passive money may eventually pull back….
If the politics becomes less of a game and more of a reality.

Anyone for a nice game of global thermonuclear war?

Reality TV is just about to get real.

We’re all passive now

The latest leg lower in the US Dollar has been attributed to an (over reaction?) to last night’s Fed meeting. The nuanced dropped words in the statement of “inflation has declined recently” and “running somewhat below 2%” apparently did enough to be interpreted as dovish, with the market expectation of another hike this year now down to 40%. Currencies are a relative game of course, and the point isn’t really that the Fed are dovish, just that they are less hawkish than earlier this year – just at the same time as a bunch of other central banks, such as the ECB and the BOE, have turned hawkish. The surprise shouldn’t really be that the US Dollar is weak, but rather that it’s not weaker, quicker.

The massively suppressed volatility across markets is lulling us into thinking that this isn’t a significant shift. It’s no wonder, when the VIX has printed a new record low of 8.84. There’s almost a resigned sigh that the US Dollar is taking a bit of a break for now from the monetary divergence story. With US 10 year yields sitting in the middle of the month’s 2.23-2.38%, and the 2 year only registering a range for the month of 0.10% (see below for the narrowing ranges), it just doesn’t feel like much has changed:

And so the Euro merrily ploughs on upwards, with 1.2000 easily now in sight before the ECB actually meet again on the 7th of September. It was trading on a 1.0500 handle as recently as April, just over 3 months ago. A 10% move for a quarter of the year would be regarded as a decent move in anyone’s book, let alone in a year when so many implied volatility indicators are hitting new lows. Indeed, absent the actual move in the market, it would still be headline-worthy to speculate on the reversal of central banks from “lower forever” to “let’s get normalisation going”. That’s a secular shift, not just from the last few years but from the decade since the response to the financial crisis. Even more so, given that the 2013 taper tantrum was supposed to be a cautionary tale, meaning that a) interest rates couldn’t be hiked without causing severe volatility and b) real economies were not strong enough to have the monetary medicine removed.

So what has changed in the past 18 months that has shifted the narrative?

The answer is that we are all passive now. We already knew that passive fund inflows were huge and have been growing over the past few years. But it’s in the past year or so that it has really accelerated. Partly this is just a vicious circle: Active funds are expensive –> money flows into passive –> opportunities for Active are eclipsed by constant “Buy the Dip” –> volatility is suppressed –> fewer active opportunities –> Active funds look even more expensive, and so on. Macro hedge funds are now on their knees, with many of the big names such as Caxton, Brevan and Moore still in the red this year, according to the HSBC funds report. Meanwhile BlackRock has taken in as much new money YTD as it did for the whole of last year. (A mere $141bn, no less). Passive ETF assets surpassed hedge fund assets two years ago and since then the gap has increased:

If passive assets are growing at an almost Moore’s Law exponential rate – and the BlackRock figure suggests it is potentially doubling each year – then it’s no wonder that any interest in the fundamentals is so depressed. The virtuous circle is complete. The more that assets go up, why bother with a stock picker? Instead, invest in the index at a fraction of the cost. It’s as if passive money is crowding out any interest in active money. But it’s not crowding out the opportunities. As just mentioned, EUR/USD has rallied significantly for entirely understandable reasons. The Fed is coming towards the end of its hiking cycle, not least because Trump might well force its dovish hand when Yellen is replaced next year; meanwhile the ECB no longer needs extremely stimulative policy with inflation returning, and faces similarly political pressures with a German election coming up.

The passive money is skewing the classic risk/reward equation that underpins all investments. Free money shouldn’t exist. Achieving big returns should require a concomitant increase in risk. But now, we are in a situation where stocks keep going up, credit spreads keep on narrowing, and bonds are bought even if they yield negatively.

The central banks started this Alice in Wonderland world. Deliberately, no less. Their easy money policies were designed to lift animal spirits out of their slump. The financial crisis had skewed the risk/reward equation too far in the other direction. No risk was being taken, despite the potential for return, heightening the chances of deflation and depression. They had to do something, and making the risk-free rate zero, or even negative, not just now but along the yield curve, was the Dali-esque shock required to shake the market out of its funk.

Now, with economies looking more stable, and the market mood less funky, they can pull back.

But oh dear… their skewing of the risk/return equation had its consequences. It paved the way for the passive/active imbalance. Which in turn, has skewed the risk/return equation too far in the other direction. It has become entrenched. Staving off the depression risk has now mandated an almost deliberate and inescapable euphoria.

How can you break a virtuous circle in which cheap money always wins? Introduce a risk that passive investment cannot measure. Political risk, as we have been discussing for some time, is the key suspect. Like the Truman Show, utopian life can continue until the exact moment you realise you’re sailing into a brick wall.

 

So, the biggest stories of the past few days? It’s not really the Fed or the ECB. It’s the fact that Trump’s administration is coming apart at the seams, as he rotates his patronage, most recently calling his Attorney General “very weak”. It’s that the Senate is still tied up in being unable to repeal Obamacare, pushing back further the opportunities for tax reform. Or in the UK, the fact that the Prime Minister has now lost her strategy director and writer of her ‘Hard’ Brexit Lancaster House speech.

The difficult part is that whilst you monitor this, you have to continue to think passively. A virtuous circle is tough to break. It will take a few attempts. But September looks a good bet for a crack to emerge, with the withdrawal of cheap money picking up as the Fed and ECB pull back from balance sheet expansion, and politicians returning from the beach. Until then, enjoy the unexpected ability to find returns while taking unusually low amounts of risk.

 

 

The fork in the road

Looking back on life, do you find it’s the small things upon which your memory lingers? At least, they seemed small at the time, but on reflection they turned out to be big. Really big. Life-changingly big. The phone call never returned. The stranger’s eye never caught. That time he ignored the cat. The birthday she missed.

We like to think it’s about the big set pieces: births, marriages, deaths, promotions, moving house. But in reality, it’s the unopened door that really changes the path. The road less travelled. Forks in the road turn up, but we only see them once we have sailed past.

Markets, being the prices of a probabilistic path of future outcomes, are supposed to spot all these forks and factor them in. For the past twenty years or so, absent the financial crisis, they have done that rather efficiently. A tweak to an inflation forecast here; a shift in growth patterns there. Of course, we all know what happened when something couldn’t be priced: the global economy came crashing down. What was a mortgage worth? What were a number of them bundled together worth? Or a product modelled on a bundling-together of a bundling-together? It may have been zero, or it may have been something, but the problem is that the market couldn’t price it. It was only when a bid returned to the market that some kind of sanity dawned.

We think we are far from that now, of course. Banks have rebuilt balance sheets. Regulators have created new supervisory regimes. Complex products are in retreat.

Yet something odd is going on, isn’t it?

The endless spiral upwards in stock markets just feels too much, doesn’t it? Even as we all understand that the world is in decent shape, economies are doing OK, most companies are alright, leverage is high but manageable… it just feels like it’s too quiet out there. As BAML have flagged up in this chart, we are now in the 4th longest consecutive period without the S&P experiencing a 5% pullback:

Why does this feel odd? If you look back at the decades that feature in BAML’s top 20 chart, the one with the most instances of these long quiet periods occurs in the 1990s, with the 2010s coming in second place. The 1990s were pretty volatile in places. That suggests we should be fearful: that after a long period of calm, we cannot help but fall into a period of shocks. And it usually comes from the small things. Something we didn’t even think about that much at the time. Was it clear that the Asian financial crisis would ultimately lead to the collapse of a supposedly brilliant market-risk-managing hedge fund, via a Russian debt default, that would almost bring down a US bank?

Afterwards, it’s obvious. The forks in the road were clear. Why didn’t anybody see them?

And now, we have some pretty clear indicators ahead:

  1. Inflation is turning

Chinese PPI was doing a great job of rushing back into positive territory, but it has stalled. World CPI is, as it often does, following suit:

2. Volatility is too low for the risks ahead

Here is our favourite cross asset vol chart, normalised for the recent lows in volatility of the summer of 2014. We haven’t quite hit all time lows in all volatilities but we are darn close. And unusually, all assets are behaving like this. There is very little volatility expected in stocks, bonds or currencies.

That might be absolutely fine, of course. And indeed, why worry? The monetary stimulus tap keeps on giving. Let’s not forget this chart of total central bank assets:

But we are in something more pernicious. We are now in a positive feedback loop: risky assets keep going up; financial conditions loosen; so volatility compresses; so risky assets go up, and so on. Just check out this GS chart on how US financial conditions continue to ease, even in a period over which the central bank has actually been hiking, and discussing running off the assets on its balance sheet:

Look at what’s causing the loosening: equities rallying and spreads tightening are a decent chunk of it. Along with the drop in Treasury yields – which once again comes from the hunt for yield that is generated precisely by the tightening of those credit spreads.

So why is volatility too low for the risks ahead? Well there happens to be a couple of forks in the road up ahead…

3a) Central Banks

Well for a start there is the fact that the monetary taps ARE turning off. The recent speech by the ECB’s Coeure celebrated the efficacy of QE in a kind of farewell retrospective. Draghi takes the floor in Jackson Hole in a few weeks, and ahead of the German election in September, the smart money has to be on him providing an eloquent argument for stepping back from QE. Not least because the Germans, quite specifically, are running out of bonds to buy. Then we have more and more noises from Japan about their QE. First we had “some BOJ officials” a week ago hinting they are “increasingly concerned” about the scale of their ETF purchases, followed closely by similar criticism from the head of Japan’s Stock Exchange no less. With PM Abe facing plunging support following a scandal, will he survive to retain his choice for BOJ Governor once Kuroda’s term ends in April next year?

3b) Politics

This is where we bleed into the joker in the pack. For all the talk of economics or the carry trade, the single biggest elephant in the room is politics. This is the fork on the road that it would appear everyone is missing. It’s great to think about where US or Japanese interest rates will be in a year’s time, but what if the people leading those central banks have gone completely? Trump just told the Wall Street Journal that Yellen is still in the running for the job, but hey so is the guy who’s supposed to be finding her replacement, Gary Cohn. And why does Trump like Yellen?

‘I’d like to see rates stay low. She’s historically been a low-interest-rate person’

Riiiiight. M’kay. Thus far the market has ignored that comment. Just like it ignored that Trump might struggle to get deals done in Congress, preferring instead to ride the reflation bandwagon following his surprise election. And just like it then ignored the rumblings of Russian-linked scandals, aside from a day or two of wobbling. Why? Because it’s difficult. Because it can’t be priced.

Politics is the securitised synthetic CDO squared of your nightmares. Not least when the probability path of anything political ebbs and flows with the national mood.

In conclusion…

The BIS, as ever, have nailed this in their latest annual report. Politics, they say, matters. More than central bank meetings:

Despite this, there is a sense that political risk has gone away. We think it’s over because those events were specific one-offs. A referendum. An election. Now, though, comes the messy business of governing. This is even harder for markets to deal with. It’s not a binary one-off event. It shows how far we have sunk into our own mindset that the BIS would even compare an election to a monetary policy meeting. The UK referendum has kicked off a tumultuous realignment in UK politics, that is up-ending conventional wisdom and completely throwing open how the UK economy will look in a few months’ time. It didn’t end there. It only just started. We now have to consider the non-zero risks of: The UK leaving the EU without a deal; the UK not leaving at all; a Jeremy Corbyn government; and another election before the end of the year. For a country running a deficit, these are serious risks. They may be darn hard to price, but they are up there ahead, looming. Great big forks in the road. Great big choices that will change the course of history.

For now, though, it’s buy dips, wear diamonds. Every indicator you can see is telling you to do so… so why wouldn’t you? I mean, you’ll change course when the big signal comes, right?

Repeat as you fall into sleep… The phone call never returned. The stranger’s eye never caught. That time he ignored the cat. The birthday she missed. 

The big fork is coming. And the US Dollar hitting 13 month lows just as the administration starts to really fall apart? That’s just the start of it.

 

Not all QEs are created equal

Sometime between Fed QE1/2/3 and the ECB dithering over crossing the QE rubicon, there was a debate over whether the actions of the two central banks would have the same impact on global markets. Could ECB QE really be as powerful as Fed QE? In a world where the US Dollar has been King for so long, there was already a suspicion on the answer. In a word: No. The Fed were all powerful in propping up global markets. Weren’t the ECB just papering over the cracks of a bankrupt monetary union? (This snobbishness, by the way, is yet another example of how financial markets assume a political view without even realising it… No, Europe isn’t always a basket case, fighting itself with its silly accents, while the US reigns supreme…!)

Well, the ECB’s Benoit Coeure has now offered some incontrovertible evidence that European QE is ruddy well having an impact, thank you very much. In his speech, “The international dimension of the ECB’s asset purchase programme”, we get some pretty eye watering analysis of just how effective it has been:

  1. It got money moving out of the Euro area

As Coeure points out:

‘At their peak around the middle of 2016, net capital outflows – measured here in terms of 12-month moving sums – reached nearly 5% of euro area GDP. Never before in the history of the euro area have capital flows been so high.’

So yeah, they got money moving alright.

2. And where did the money go? It went abroad…

Specifically, it went into foreign countries’ debt:

More specifically, it went into US Treasuries.

Let’s just let that sink in for a second. The Fed stopped QE, completing its taper, in October 2014. In January 2015, the ECB announced its Asset Purchase Programme. The effect of the ECB’s action was for domestic Eurozone investors to go out and buy other countries’ bonds. In effect, the ECB mandated another round of US QE.

3. Meanwhile they turbocharged their own QE….

They managed to get a significant portfolio shift into European equities. The ECB QE didn’t just work via lowering interest rates along the yield curve – it actually brought foreign investors back into European stocks:

As Coeure points out:

‘By the end of 2014, shortly before we announced purchases of government bonds, annual inflows into euro area stock markets by non-residents had reached 4% of euro area GDP – the highest on record. Policy stimulus and measures to repair the bank lending channel were clearly seen as having a positive effect overall on the euro area economy.’

So we’ve got the highest inflows into European equities from abroad, just as we’ve got the highest outflows from domestic Eurozone portfolios. Lots of records being broken. The QE programme was clearly having an impact.

The selling of European bonds in the chart above is the mechanical impact of the ECB having to buy up Eurozone bonds from wherever they could: and with ‘non-euro area investors…holding nearly 75% of German Bunds with maturities of seven to ten years’, this meant buying off a lot of foreigners. Not that they were too bothered:

‘In addition to yield differentials, the absolute yield level may also matter for investors, particularly if rates are negative. It may be no coincidence that net bond outflows were among the largest when ten-year German Bund yields hit a low of nearly -20 basis points last summer. In a recent survey among foreign central banks, 70% of the respondents reported that negative interest rates in the euro area had encouraged them to adjust their allocations to the euro.’

This had a currency impact, as foreigners sold their Euro bonds. That gave a second turbocharged boost to ECB QE, through the depreciation of the currency.

4. Didn’t Fed QE do all of this?

No, for a number of reasons. Firstly, foreign investors re-invested in the US even after their bonds were bought up, because they wanted exposure to the most liquid asset in the world. Secondly, this meant they retained an interest in the USD, so the currency didn’t take quite so much of a hit as the Euro. And finally, US investors went out into EM assets to find yield – whereas when the ECB started QE, EU investors could just go into the G4 for that yield:

‘Since the start of the APP in March 2015, ten-year US Treasuries have been yielding, on average, around 170 basis points more than ten-year Bunds – an enormous difference that, to a large extent, reflects the divergence in monetary policy cycles that emerged in the wake of the euro area’s sovereign debt crisis. As a result, portfolio rebalancing during the ECB’s asset purchase programme has been more attractive for investors than it was during the Fed’s QE programmes.’

In conclusion…

  • ECB QE had at least as much of an effect on the world as Fed QE
  • In fact, it had even more….
  • The EU bond buying ended up impacting the US Tsy market – the ECB were doing US QE by the back door, as they forced their domestic investors to buy bonds elsewhere
  • Negative rates forced a portfolio rebalance out of Eurozone bonds into equities – so European stock markets got even more of a kicker
  • And the currency was deliberately driven lower

So the ECB managed to do their own QE plus deliver it for the Fed; rescue their stock markets from depression; and reinflate through the currency.

It’s better than BOGOF at the supermarket, eh??

MORE IMPORTANTLY….

The ECB are about to unwind all of this. Why else would Coeure be making this speech now? He spends the final half of it explaining what a great favour they did to the world, which sounds exactly like what you might tell a drug addict after peddling him cheap drugs for years before pulling the plug. (“You enjoyed those years, didn’t you….??”)

That means a reversal of all of those effects:

  1. US bonds will no longer receive an ongoing bid.
  2. European equities will have to survive on their own two feet.
  3. The Euro depreciation will reverse.

This means that the greatest lie we were ever told was that the Fed taper was the end of the cheap money party. The Fed may have stopped QE and started raising rates, but the actual impact on their bond market is little. It’s as if it never happened. Just check out this chart of how the loose monetary policy has kept on coming and coming:

The taper tantrum hasn’t happened again because the tapering hasn’t really happened, at least not globally. So, if the ECB tomorrow signal that they’re starting to turn off the taps, and if Draghi lays out the path in his guest appearance at Jackson Hole in August, then just wait for the mother of all tantrums to emerge. I’ll scweam and scweam and scweam until I’m sick…

What if the FED never hikes again?

In the midst of all the discussions over hiking cycles, we have been pushing for the market to consider some much bigger potential questions: nuclear war, impeachments, powerless governments and the like.

Monetary policy divergence is an old story. It was, like many old stories, a good one. It had a comforting narrative and it worked. The US dollar went up as America indeed was on the path to being great again. Money was made as sense was made.

It’s always much tougher in these periods when various new narratives compete to be the driver. It’s still carry versus the economy versus politics. And as the last of these is still woefully misunderstood and unpriced, we are left with the economy and with carry.

There has now been a shift with regard to the economy. Is reflation running out of steam? We warned that Chinese PPI could be on a downward trajectory, and its last print saw it plateauing, albeit at the racy heights of 5.5%. Then US inflation disappointed. Even Uk inflation came in lower than expected today.

But then on the other hand we have carry. As the Bank of Canada showed last week, the carry rankings don’t stay static. When a central bank wants to shift, it shifts.

The problem with those old stories which made sense and made money, is that they’re very pervasive. They’re comforting. In these periods where the driver is shifting, we like to keep coming back to them. So, we are now back to monetary policy divergence, but at the margins the US Dollar is now the loser as other nations start cranking up the tightening lever. Same story, slightly different actors. (A bit like a female Doctor Who). Who’s hiking next, the RBA? Where is there not enough priced in?

This is all very nice, and will pan out a bit further in the suffusive heat of summer.

We are geared up now for Draghi to signal tapering in his August Jackson Hole speech, and maybe even hint at it at the ECB meeting on Thursday. We wonder how he will deal with the fact the Euro will rise, but we take it higher anyway.

We will ponder whether the US may ever raise rates again. Or if they do in December, is it just a sayonara shot from a departing Janet Yellen? Stories are now circulating that the man responsible for finding her replacement, Trump’s buddy Gary Cohn, might end up being her replacement himself.

Separately, stories circulate that the BOJ are concerned with their own levels of ETF purchases. The point is that QE is over. But we interpret it within our comforting monetary policy divergence story. In that story, there were currency wars as the central banks sought to outdo each other in their easing. Now, they’re seeking to outdo each other with their hiking. At some point we will realise that has much less benign implications for the economy, which will impact politics, which will impact volatility, which will impact the wisdom of the carry trade.

But for now, the shifts in monetary policy are still being seen through the comforting lens of that old story.

Let it lull you to sleep on the beach – for now.