Positioning Extremes Grow More Extreme
There are a few undisputable and universal forces when it comes to the financial markets. One of those all-powerful winds is the concept of risk trends which is referred to by many names such as ‘risk on, risk off’ or referenced unknowingly when we blindly attribute market wide movement to animal spirits through technical cues, smart versus dumb money, panic to greed. Another of these truisms is the allocation of capital. While total wealth does grow and contract, it is apportioned to some market whether that is emerging market equities to US Treasuries to home mattresses. In a global market, there is also distribution to different regions according to what country or collective economy presents the best opportunities. And, from this parsing of investment preference; we can learn a lot about the market; but one of the most elemental solutions is the global market’s general bearing for sentiment (the risk trends referenced before). There are no easy, definitive measures for allocations across such a wide universe of markets, but there are various measures for specific areas and key ports for which to apply measure such that we come to a good understanding of the markets’ health.
One of the most basic measures of preference on a regional basis is exchange rates. We have seen the USDCNH surge the past few months showing capital leave China and enter the US. That is likely a bi-product of trade wars and can signal deeper problems for China if they risk signaling to the world that there is capital flight that can disrupt their efforts to promote stability between economy and market. Given that there is certain control that Chinese authorities have over their systems, we could get more complicated in the evaluations by comparing the USDCNH to the USDHKD, look to derivatives or wait for the lagging economic data like the TICs from the US. Another good equivalence is the performance of ETFs. These derivatives are quickly becoming favorite products for global investors due to their supposed risk reduction through diversification (we heard the same thing with AAA rated subprime housing MBS 11 years ago) and the wide range of coverage they offer. There are measures of capital flowing into and out of specific, liquid ETFs (ie SPY, TLT, FXI) as well as general groups (all equity versus all bond).
Another measure of positioning is the use of leverage. We may not know what people are doing with their cash in many instances, but the use of borrowed funds is often better tracked as the ‘investors’ (or lenders) want to know their exposure. As it happens, in the US, there is record use of leverage by investors, consumers, corporations and the government. Further measures of positioning are the sample readings like that on the DailyFX Sentiment page which shows retail traders (who have a very short time frame and primarily fight existing trends) and the CFTC’s COT report of speculative futures. From the latter, this past week has shown a dramatic swing in Dollar interest from the biggest short in 5 years to the heaviest long in nearly 2 (all in a few months), Treasury net short has hit a dramatic record low, and gold flipping to net short for the first time since 2002 among other surprises. There is a lot to learn once you know what to look for and how to put it into context.
A Lesson from the 2013 Taper Tantrum Applied to a Global Scale
Back on June 19, 2013, then-Fed Governor Ben Bernanke announced that the US central bank would begin to ‘taper’ its theoretically open-ended bond buying stimulus program (known as QE3). By the time he stated their intention, the market had already suspected this was going to take place owing to the language of the group and the performance of data coming out of the economy. However, the announcement had a significant impact nonetheless. What resulted was termed the ‘taper tantrum’. In response to this news, US Treasury yields shot higher as the markets largest sovereign debt buyer at the time announced their intention to reduce purchases moving forward. And that had a material economic effect as the cost of US Dollar-based loans – particularly for foreign buyers who had exchange rate risks – started to shoot higher.
It therefore comes as little surprise that emerging market corporations that borrowed funds in Dollars shuddered at the news, and the EEM Emerging Market ETF showed the discontent. However, after some months of fear, conditions stabilized and borrowers and investors acclimated to the notion of higher costs. Even if they were exiting the active rate-depression game, they would still be low for a long period of time. What’s more other central banks like the ECB, BoJ and others were still at or near record lows with some pursuing equally massive stimulus programs. As such, complacency returned for some years after. Yet, where are we today?
We still have that telltale complacency – as mentioned above – but the foundation of confidence has continued to erode as global central banks have reached the end of the road. Either they are willfully plotting their own exit from their extraordinary accommodative states (like the ECB, BoE, BoC) or they are floundering as the market realizes they have essentially reached the extent of their influence (BoJ, SNB, RBNZ). Financial markets from equities to real estate have performed remarkably well in the interim, but economic activity and inflation plateaued long ago. That has produced an elevated risk exposure without the economics to fund the exposure. So, with exceptional risk, moderate economic potential, external pressures increasing (trade wars) and central banks either easing back or losing tractions; it is worth evaluating that 2013 ‘taper tantrum’ and consider what the possible implications would be if we raised the stakes from one country to the world.
Jackson Hole Symposium and US-China Trade Top Event Risk
The coming week carries one of the most deflated expectations for seasonal activity for the financial markets. The Labor Day holiday for the US (September 3 this year) traditional signals a change in ‘Summer Lull’ activity to a more active and liquid Fall trading. These activity levels are as much self-fulfilling prophecy as actual liquidity phenomena, but it occurs nevertheless. However, a footnote here before we analyze further. There are some dramatic examples in our recent past where volatility as exploded in August despite the conventions. The 2015 market-wide tumble triggered by Chinese exposure fears began in August and the same month in 2011 led to global losses for shares and other risk assets as the Eurozone debt crisis unfolded. We should never rely on market parables when we are employing our capital – especially when so many global risks are so plain, such as a possible Chinese crisis arising from the US-China trade war or Italy threatening Euro-area stability to register as echoes of history.
This said, the standard global economic docket is particularly thin over the next five days of active trade. It would be fitting to assume the markets are just going to drift down a lazy river if we did not appreciate the broader context. While the biggest risks to our immediate future are likely unknown fundamental waves, there are two themes that are scheduled and we can follow as they unfold. The first is the US-China trade war. The US Trade Representative’s office is expected to hold a public but off-camera hearing on Chinese tariffs throughout the week. It is worth reminding that the Treasury has left public feedback open until early September until they decide on whether or not to proceed with the $200 billion in new tariffs President Trump threated some weeks ago. More promising, US and Chinese officials are due to restart trade talks on Thursday and Friday. It was reported that this meeting will start to build a map that can take the countries back to more favorable terms such that the countries’ two Presidents can agree at the highest level when they meet in November.
The other high-level event to watch over the coming week is the Jackson Hole Symposium. The annual meeting of central bankers, business leaders and key financial lawmakers hosted by the Fed can cover crucial developments in global markets and the economy. The official theme of this conference is ‘Changing Market Structure and Implications for Monetary Policy’, but expect the conversation to touch many of the key themes mentioned above: global retreat from extreme easing, the failing effectiveness of stimulus, global pressures via trade wars and the extremely inflated levels of global capital markets.