A Return to Extreme Volatility and Realization It Won’t Stay This Quiet for Long 

Any way you cut it, the markets are experiencing extreme levels of inactivity. And, for those that are satisfied with the superficial and textbook interpretations of the mainstream measures, this seems like a cue to leverage exposure and commit to the decade-long bull trend which blossomed under the controlled conditions. Previously, traders would have been readily satisfied by the readings and thrown in with the assumptions. However, there is an unmistakable air of skepticism surrounding activity measures with indicators of exposure and uneven performance for ‘risk’ assets drawing focus back to the extreme bouts of volatility this past year. While market participants have shown a penchant for overlooking troubling fundamental backdrop and conveniently forgetting previous lurches in the financial system, the proximity and severity between the February-March and October-December storms were too prominent to simply slip quietly into afterthought. With that said, the question then must be raised as to what could trigger another wave of concern. While the best motivations for trend development in my opinion are systemic fundamental themes that can draw the largest swaths of market participants; during these periods of speculative interlude complacency can raise disputes over the urgency of otherwise serious themes. When we get into these self-sustaining periods of complacency, one of the best sparks to break clear of speculative opportunism borne of quiet is to see a uncomplicated slump across the capital markets. In other words, price-determined risk aversion. 

While the strongest indication that the markets are succumbing to their own fears is an intense deleveraging across all or most assets with a heavy dependency on speculative appetite, there can be fairly reliable precursors before we get to that undisputed scale. At present, one of my favorite leading indicators is the S&P 500. Representing the most ubiquitous asset class in the capital markets and in the largest economy, it is well placed at the center of focus. Further, its outperformance in this role has once again afforded it a position of carrying a heavy mantle of keeping the fires stoked in other assets and regions due to its approximate return to record highs over the past quarter. Most other preferred assets for the trading rank are significantly behind in their recovery efforts – rest of world equities measured by the VEU index is only now passing the midpoint of its 2018 losses. This attention isn’t just a benefit to the markets though. If the US indices were to falter in an overt and troubling way, it can spell disaster for other areas of the financial system that were considered far less resilient. A stall for the S&P 500 and Dow before overtaking a record high could certainly achieve this throttling for global sentiment, but a more complete obliteration of future efforts to recharge confidence would likely come from a scenario whereby the benchmarks overtake their respective highs, struggle briefly to mark new progress and then collapse. Currently, we find measures of volatility like the VIX back at lows last seen in October which is appropriate comparison. Yet, in other asset classes we find more incredible readings like FX implied volatility at levels that are only comparable to a few points in history (like the Summer of 2014). In historical terms, the Dollar’s range (an equally-weighted index) over the past 200-days is the smallest on records back to when the Euro started trading two decades ago. This misplaced association of confidence and lack of preparation sets up the market to be extremely exposed to a mere slump escalating into something more catastrophic. Trade with caution and diligence.

China GDP Next Week’s Top Event – Could the World Survive Its Stall? 

In a holiday-shortened week with speculative focus blurred, the top event risk is unmistakable. The Chinese 1Q GDP reading will come along with a run of monthly readings for March that are influential in their own right. While the employment, retail sales, industrial production and other monthly data are worth taking stock of to establish direction for specific nodes of the broader economy – important for projecting where problems or resurgent growth could arise in the future – it is all superseded by the comprehensive growth report in the short term. The world’s second largest economy is expected to slow even further from a 6.4 percent annual pace to a fresh multi-decade low 6.3 percent. That will still sit comfortably within the growth target lowered from 6.5 percent to a range of 6.0 to 6.5 percent the last National Peoples’ Congress. Nevertheless, the international market’s more critical eye towards growth and unorthodox threats will disproportionately raise the risk for impact form a negative outcome. The implications for China and its markets are relative straightforward when it comes to the forecast for the soft landing that officials are trying to engineer against the backdrop of struggling global growth and amid a trade war. Though rhetoric around negotiations with the United States has improved, a year’s worth of economic pain has built up. The March trade balance offered a timely mixed picture this past week with a significant surplus for the month resulting from a distinct drop in imports (a poor reflection of domestic economic health). 

For the global economy, this particular economic update holds significant weight over assumptions for the future. As the world’s second largest economy and the stalwart through the Great Financial Crisis, a slide that seems to be picking up momentum outside the central authorities’ control will leverage serious concern about what the smaller economies with significant less control are facing. For countries that supply China with the many raw materials that it consumes for its unmatched manufacturing machine (Australia, New Zealand, etc), the restriction in export demand and likely drop in foreign investment flows will expose an unbalanced economy. For the rest of the world, the buffer China has maintained will mean the country’s demand for trade partners’ goods will not pose the greatest risk, but rather its carefully-controlled financial connections will represent the true destabilizing influence. Potential delay in impending efforts like the Belt and Road initiative and the tentative vow to ramp up purchase of US goods are tepid relative to the cascading exposure we would see if the country was forced to repatriate in order to shore up its own system which is heavily built upon leveraged and low-quality lending initiatives. The question I would pose is whether the world could survive a stall in Chinese growth – which would occur well above 0.0 percent GDP – given how troubled the globe’s future currently looks? I doubt it. Should China tip into a market-defined economic stagnation or contraction, it would infer one of the key players in the world’s stage has lost control over its reliable ability to plan and direct activity. The environment that would force that loss of control would be a serious threat to the rest of the world as the shock would eventually hit other shores like a financial tsunami. 

Brexit Delayed Six Months and Pound Range Trading Reinforced 

A sense of relief washed over the Pound this past week – though not that kind that can readily supply buoyancy to the battered currency. In an increasingly familiar story line in Europe, we have found the Brexit situation has resorted to the comfortable solution of punting an unsavory decision to a time significantly into the future. This is the same path we have seen taken when it comes to Europe’s monetary policy (ECB), political standoffs and external diplomatic issues. This is not to say everyone is simply defaulting to this delay. This results from serious impasse between parties that believe strongly in their solutions as well as the folly in crossing their red lines. At the direction of Parliament, UK Prime Minister Theresa May requested an extension from the European Union, with an initial suggestion of a hold out until June 30th. After a long summit, the EU-27 agreed to a six month delay that would move the cutoff date to October 31st. In the interim period, the UK is expected to participate in the EU Parliamentary elections which will take place starting May 23rd and for which some in May’s party and her own government are piqued. The question on most peoples’ minds are whether the additional time will offer the opportunity to overcome the impasse or whether it will just draw out the misery. According to the IMF, uncertainty will only accumulate greater economic deterioration over time – and given the state of data over the past year in particular, that is not difficult to understand. 

In terms of how that translates into the competitive position of the Sterling and UK-based assets, many would see this as a window for a speculative influx on discounted markets. In previous years when complacency was de rigueur, that is almost certainly what would have transpired. An appetite for even marginally underpriced assets would have triggered an avalanche of speculative influx which would have quickly sent GBPUSD above 1.3500 and the FTSE 100 rushing towards 7,900. However, as discussed above, there is a deeper sense of skepticism built into the system. As such, the sudden drop in implied volatility measured by currency options or the CME’s index is as likely to short circuit momentum as it is to prompt it. Whether you agree or not as to the potential in the Sterling moving forward, think it through to establish a bias and set criteria for when that view shifts. Having thought the situation through beforehand will better set your expectations for an event like the GBPUSD’s inevitable break from a wedge this past month with boundaries currently stationed at 1.3125 and 1.3050. If you think a more robust recovery is possible then you may see more intent on a bullish break – and be confounded by a move lower.