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JohnDFX last won the day on March 26 2019

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  1. From the Data, Growth is Top Concern Again If we were to gauge how much market movement is arising from scheduled event risk relative to those unexpected winds from the headlines, I would put greater emphasis on the latter. That can make for difficult trading conditions considering updates like the coronavirus spread do not abide a clear time and distinct categorical outcomes. In this kind of environment, it is more difficult to establish clear and productive trends as there is not a clear thread to be draw enough interest to hit critical mass. Instead, we are left with the risk that otherwise important updates could come at any time – bullish or bearish – which leaves a clear footprint of caution among those participants in the market. Jolts of volatility with unexpected breaks and limited follow through to quench traders’ thirst is instead the norm. It is very possible to adapt one’s own approach towards the markets with this backdrop in mind – even if the result is greater caution, shorter duration and fewer trades. As far as the data is concerned, there are a number of themes and regions to watch over the week before us. However, I will once again keep my principal focus on growth. That is in part because the ebb and flow of coronavirus headlines are leaving a tangible concern around the cumulative impact on growth – much like trade wars in previous months. Yet, from the economic calendar itself there is plenty to give direct insight on the health of key economies. In the first half of the week, we have Japanese 4Q GDP along with a growth forecast update from the Eurogroup and Bundesbank. The more comprehensive reading though is the February composite, manufacturing and service sector PMI releases from Australia, Japan, Germany, the Eurozone and the US, chronologically. That is a comprehensive and global overview of growth. Will it be market moving? Look to see how receptive the market is prepared to be for this more ‘mundane’ theme. ‘Markets Fall on Coronavirus’ and ‘Markets Rise on Coronavirus’ When it comes to fundamentals, there can be a steep learning curve to make the analysis technique functional in the average person’s arsenal. It isn’t surprising that there is only so much time to dedicate to this venture for many (even when it is their money at stake) or when they encounter too many instances of the analysis lining up without the commensurate reaction from the market. This often leads to statements like ‘these markets don’t make sense’ or an appetite to fall back on the more accessible technical side of the markets. However, I find one of the most important factors in interpreting fundamentals is to find what the most important and influential themes are to the greatest portion of the market and calculating a distinct interest into the equation when one shows itself through the noise of an overwhelming range of various factors pulling at our attention. As far as the systemic fundamental influences go, it seems that the intense but muddled impact of the coronavirus (COVID-19) still flashes its control over the markets. The warnings of tangible economic toll on the economy from this contagion are added to each week. This past week, the Federal Reserve and European Central Bank reiterated the risk through the official testimony of their respective heads while a number of their members issued individual remarks to much the same effect. Supranational groups are also warning caution. Standard & Poor’s offered the most prominent caution when it cut its 2020 GDP forecast for China by 0.7 percentage points to 5.0 percent while global growth could see its pace trimmed by 0.3 percentage points – China does account for nearly a third of global expansion. The importance of this risk is clear, but the influence is starting to be taken for granted to the point that seemingly every rise and fall is either the direct influence or allowance of this novel risk. In fact, if you check the worldwide search interest in Google Trends the past months containing the worlds ‘stock’, ‘market’, ‘falls’ and ‘coronavirus’ the results are almost exactly the same as ‘stock’, ‘market’, ‘rises’ and ‘coronavirus’ (see the attached picture). This is a short-cut many take in assigning a universal influence on a popular theme, which will inevitably breakdown and draw out the ire of investors attempting to follow the logic. Remember to always evaluate what the dominant fundamental theme is and acknowledge that this influence changes hands while also passing through periods where it dilutes across many different matters. Intervention in the FX Market Is Not That Uncommon Nor Is It Effective This is a topic I have touched upon previously in the context of the US Dollar and its supposed purity in the eyes of those that observe liquidity as a virtue. There is little doubt as to the currency’s superior depth as the BIS numbers are very clear on the status. However, that position doesn’t mean that outside forces will not attempt to nudge the market in a perceived favorable direction. Most notable in the hierarchy of critics as to the level of the benchmark currency is the US President Donald Trump who has repeatedly accused global peers (China, Japan, the Eurozone) of depressing their own currencies for competitive advantage while simultaneously lambasting Fed Chairman Jerome Powell for the period of monetary policy normalization that he claims has robbed the Dow of ten thousand points and driving up the Greenback. Given the complicated fallout that would follow attempted manipulation of this particular global financial lynchpin, I will continue to monitor it without my typical deep-seated doubt – as this White House is proving reliably unpredictable and the unexpected carries such a serious impact. In the meantime, there are more proactive efforts to alter the course of different currencies out in the wild. This past week, Brazil’s central bank let it be known that they had acted (via 20,000 swap contracts) to prop up the Real. The USD/BRL had advanced to record highs five consecutive sessions, leading the group to take action in an effort to break a slide that threatened to gather further speculative momentum. In the context of the average daily turnover of this very actively traded currency (it is one of the BRICS), the scale of the intervention could not be overwhelming the market through sheer volume. Instead, the idea is to shift market sentiment to align to the effort. Japan attempted the same back in 2011 to 2013 to very disappointing result. While Japan’s Ministry of Finance and Bank of Japan are still attempting to passively guide the Yen lower, there desperation has waned and so have their threats. In contrast, Switzerland has maintained the threats against the Franc as EUR/CHF – the focus rate for Swiss officials – has extended a decline to the lowest levels since third quarter 2015. As the markets continue to rebuff efforts of manipulation, believes of monetary policy ineffectiveness grow, pushing countries further into competitive devaluation and restrictive trade-based policies.
  2. An Economic Update on the Calendar and In the Public Eye Concern over the course of the global economy was revived this past week with a few troubled indicators raising awareness, but the real interest was what arose in the market-based measures. With the recovery in capital market measures, the meaningful divergence in performance from growth-sensitive assets like copper and crude oil (with a 13-day consecutive drop and 13-month low respectively). In fact, the 60-day correlation – a three-month relationship – between WTI crude oil and my preferred baseline of speculation, the S&P 500, flipped negative for the first time since September 2018. Perhaps the most loaded of the growth indicators that is once again raising concern was the 10-year to 3-month US Treasury yield curve whose inversion (a higher yield on the shorter duration than the longer) recently became mainstream recession signal watching. It was this segment of the curve which dove into negative territory this past August that the market seized upon as search interest in ‘recession’ exploded globally. The yield comparison flipped briefly once again this past week to further draw starker contrast to the performance of more financially-oriented market benchmarks. These market measures will be a prime feature in my analysis in the coming week and beyond. However, fundamental and data based charge is still the most potent motivation to elevate growth concerns into a dominant current for the financial system. In the week ahead, there are a few overt, big-picture 4Q GDP updates on tap. The UK’s previous quarter may have ushered in the ultimate course for a clean Brexit, but the cumulative pressure of fear around the Brexit impact was a vital feature of the backdrop. As the government attempts to strike trade deals with Europe and other countries in a very short time frame, the starting point set by the economic setback will feature prominently in Sterling traders’ view. Perhaps the most important government growth update on my list is the German 4Q figure. Not only is Germany the Eurozone’s largest member economy, it is particularly exposed to trade and manufacturing which have been negatively effected by global trade wars and the recession in factory activity. If this reading prints poorly, it could add a new troubling dimension to the world’s underlying health check. Outside of the official quarterly government updates, there is a host of monthly data that can give a more timely read on the health of the broader economy. The Japanese Eco Watchers economic sentiment survey Monday, US small business confidence figure (a group responsible for approximately 70 percent of payrolls) on Tuesday, Eurozone industrial production Wednesday, Chinese vehicle sales on Thursday and US retail sales on Friday offer a constellation of data to navigate. If there is decisive enthusiasm or fear around the health of the global economy, these measures will act as fuel to the fire. Monetary Policy Updates that Test the Limits of Confidence The Fed, ECB and BOJ rate decisions are behind us. Those are the three largest central banks of the developed world whose collective influence is commensurate with the scale of their respective balance sheets (massive). Yet, the influence of monetary policy is not simply on pause until March when the next updates are due from these groups (the 18th, 12th and 19th respectively). There is plenty in the headlines to keep us off kilter and fluctuations in market performance – particularly a bearish swoon – tends to draw the focus on this crucial building block of the past decade. High profile central bank updates in the week ahead will still come via the two largest central banks. Fed Chairman Jerome Powell is due to testify before the House and Senate on monetary policy and growth in back-to-back testimony on Tuesday and Wednesday. Last month’s FOMC update left us with the wait-and-see intention that we had expected, but the markets went back into Fed-speak interpretation mode looking for the pain points for when the central bank would shift back into an active dovish or hawkish policy mode. Overview of local economic figures was fairly steadfast but the mention of external risks was repeated. That will likely be reiterated on the Hill after a mention of the coronavirus as a unpredictable risk late last week. Similarly, ECB President Lagarde is due to present her central bank’s annual report at the European Parliament. It would not be surprising to see references to growth concerns, trade pressures and unorthodox concerns (like the coronavirus mentioned last week) alongside her official remarks. If you are looking for more direct – though less globally influential – updates on central bank activity, the Riksbank, Reserve Bank of New Zealand and Central Bank of Mexico are all on tap for official updates to their mix through the week. Given the Swedish group has its benchmark rate parked at zero and is closely linked to the actions of the ECB (which did not shift in the last update) no change is expected Wednesday morning. The same forecast for no change to the 1.00 percent baseline is set among economists plotting the RBNZ’s course. Yet, given this currency’s role as a ‘carry unit’ which depends more on the yield to be drawn rather the size of the New Zealand economy, the short-term and long-term influence of this bearing can prove a greater sensitivity to the nuance. The only bank in this trio expected to change rates is the Mexican policy authority. Both swaps and economists are forecasting a 25 basis point rate hike from 7.00 to 7.25%. For those that have followed the lack of follow through on a multi-year triangle breakout from USDMXN, perhaps this can urge the move along short of a clear risk-based move or overwhelming Dollar collapse. A Focus on China’s Scheduled and Unscheduled Updates In a financial world where complacency is a dominant feature of the landscape, it can particularly easy to simply write off the influence of China’s economic and financial updates. There is frequent – and in my opinion, well-deserved – debate over the accuracy of data that comes out of the country which could raise serious concern, but instead it has generated a very noticeable apathy. That said, the pressures continue to mount in headlines developments, the official growth readings continue to notch three decade lows and there are unmistakable financial steps being taken to push risk to the open market (such as a rising allowance for default on nonperforming loans). Given that China now represents over 15 percent of global GDP, the opacity of its data should raise greater concern among global growth watchers. With the risks laid bare, there are two fronts for Chinese updates that I will be watching: scheduled and unscheduled updates. For the former group, the inflation figures on Monday don’t register a high threat level – though it can speak to problems further down the line. Much more prominent a concern are the January Chinese vehicle sales. For an industry (auto manufacturing) that is a global recession, this is one of the largest the largest markets in the world – not to mention, it can be a great discretionary spending and financial health reflection. The foreign direct investment (FDI) figure is another measure worth close review. How much the world is investing in the country speaks to not only confidence in its health but the level of optimism among global investors that have praised the exceptional clip of expansion. Off the docket, the potential risks are much more profound. The headlines around the coronavirus have been particularly troubling for China – the originating country of the virus – with the numbers of infected and deaths rising. To stem the contagion, the government has gone to considerable lengths to shut down traffic through the major traffic centers which includes businesses which has a clear impact on economic growth. This has in turn lifted the demand for already-pressured liquidity levels across the Chinese financial system – a measure that is noticeably less stoic than what we see in economic measures. Furthermore, this abstract risk has pushed China to request flexibility from the US in the terms of the Phase One trade deal which adds additional burden to their economy. Yet, they know they can only ask for so much from a country that has very little tolerance for supporting other countries. China announced last week that it was cutting tariffs on $75 billion worth of US imports in half on February 14 which will appeal to the White House. Yet, whether that buys them leeway to redirect precious resources to stabilizing the local economy or not remains to be seen.
  3. The Economic Costs Versus the Sentiment Costs of the Coronavirus Interest in – or really, fear of – the spread of the Wuhan China-based coronavirus ballooned this past week. We could take an anecdotal peruse of the headlines, but I prefer something a little more quantitative. The global, financial-related search for ‘virus’ this past week hit its highest level in over 15 years according to Google. Their data only goes back to 2004, but there is a good chance that the SARS epidemic the year before gave it a run for the proverbial money. This level of attention will naturally draw out the speculation. In an environment defined by better balance, the investors could be a little more sanguine about the impact such an event would have on their portfolio as it can indeed be difficult to evaluate the direct economic toll such a situation will exact. Unfortunately, the status of the global financial situation is anything but poised. Benchmarks for speculative exposure (like US indices) are pushing record highs while traditional measures of growth and return are struggling. As we discussed last week, these more ambiguous risks can extort a heavier tax on a market. The imagination of the masses and the threat of a worst-case-scenario trepidation. Looking back to 2008 and 2000, the systemic risk was not necessarily US low-credit quality housing loans nor the exorbitant highs of tech stock shares – though they were certainly high visibility sparks. Consistency across these periods is the over-reach of enthusiasm, supporting a build up of exposure. I consider this a thematic extreme in leverage whereby we take on greater and greater exposure while the risks associated with the situation are progressively downplayed. Until, of course, the tipping point is reached. What do we look for from here if we are indeed transitioning? Aside from progressive retreat in capital markets and focus on the coronavirus headlines, look for evidence of liquidation and pressure in financing. The Implications of a Sentiment Plague on Growth, Trade and Monetary Policy As we look for the mutation of the global health threat into a full-tilt financial hazard, my focus is back on those principal themes I’ve been tracking for the past few years. Recession fears, trade wars and questions over the effectiveness of monetary policy have popped up with consequences for volatility at various times over the recent past; but they have generally fallen short of truly sending the global capital markets reeling. The decade-long bull trend persists. Yet, as genuine concern starts to take among otherwise optimistic investors, the cracks will become more visible. My chief apprehension rests with the state of global economic health. If you recall, back in August, there was a swift and sweeping faint in confidence around very public concern over the bearing of the global economy. Headlines and search interest in ‘recession’ spiked to the highest levels since the financial crisis at the time. The situation was such that the 10-year to 3-month Treasury yield curve inversion – an event and measure of wonks – suddenly because a main talking point among the average retail trader. Of course, the situation at the time was prompted by data that showed the now familiar ‘technical recession’ in manufacturing and worsening of the trade wars, but it was the outcome rather than the catalyst that upended the market. It is therefore worth noting that the same yield curve returned to inversion this past week. Growth-linked commodities crude and copper have also tumbled. This will likely intensify the focus in the week ahead on data that will range from Chinese PMIs to Hong Kong GDP to US service sector activity (ISM) to global auto industry activity (also in technical recession). Basic growth is not the only concern that will be exacerbated by a possible turn in sentiment and the virus that has urged the about face. We have already seen China take drastic actions to spread the spread of the contagion, but it still did not like the call by US authorities from announcing a health emergency and warning that travel between the countries could be more significantly restricted. As China and other countries feel the economic pinch, added pressure from steps like this will raise tensions. And, should a country like the US feel the blowback, its tendency has not been towards opening trade conditions but rather the opposite. Meanwhile, should conditions prove more difficult for investors, the assumptions of outside support to ease the pain will grow. There has been no more relied-upon source of respite for the markets over the past decades than the world’s largest central banks. It would be natural for the cries of help to be redirected towards them. And that would be the risk as these groups are already sporting extremely low – sometimes negative – rates and large stimulus programs. Their capacity to offer more help is severely limited and nothing would highlight that more than a fresh crisis. Consult the Technicals and Correlations for Sentiment We once again find ourselves in a situation where the market’s confidence is under significant strain but it is unclear whether this could be the tension that finally ushers in a lasting bear market. There are plenty of fundamental observers and traders that are willing to point to issues underlying economy and financial system to say this is it. However, value is always in the eye of the beholder. Should the historically tepid return still appeal and headline-worthy risks find a crowd willing to downplay, the run can persist. One of the difficulties to the balance in our system is that sentiment is not founded on the belief of a single person or entity but rather the collective view of a broad market of participants with different risks profiles and incentives. We are at the mercy of often-irrational speculative appetite. How do I deal with this irrationality? I like to incorporate technicals into the mix. Trying to apply tangible milestones of progress to key global market benchmarks can help reduce the discretionary we naturally apply to our probability assessments around a reality where the future cannot be intuited. There is as much flexibility in technicals as fundamentals particularly when we consider risk profiles. For example, if you were more risk tolerant, you may be willing to be more convinced of a sentiment reversal with a more proximate support. I am more conservative in this regard. That said, there are certain elements that I believe can be more generally applied when assessing global sentiment. At the top of my list is the collective performance of ‘risk-leaning’ (higher return via capital gains or yield) assets. The stronger the correlation and the further the progress towards a technical bear markets (20 percent correction from highs), the more stout the signal in my book.
  4. Coronavirus Adds Another Wild Card for Sentiment to Absorb When it comes to the standard themes I have been following closely these past few months – growth fears, trade wars and monetary policy effectiveness – there have been frequent updates and it hasn’t been particularly challenging to take their temperature at any particularly time. While the threat of a recession or trade war that threatens to encompass much of the world will not exactly inspire confidence among investors, the knowledge that there are regular updates along the way offers at least some relief. And, as we have seen through this economic and financial cycle, any relief is interpreted by a class of complacent speculators to push their advantage. Yet, the formula changes when the risks are more vague in terms of timing, duration and intensity. That was initially the situation with the US-Iran escalation earlier this month when the former executed an airstrike on the Quds Force general’s convoy and the latter retaliated with an missile attack on US bases in Iraq. However, when both sides offered their unique brand of conciliatory boasting, the market returned to its risk-seeking self. Looking out over the coming months, the approach of the US Presidential election will represent just such an abstract risk. For now, the focus is on something more erratic by its very nature: the spread of the coronavirus. Since the highly communicable virus first made the international headlines a little over a week ago, cases have spread well beyond the Chinese city of Wuhan where they were first reported and have seen people fall ill in surrounding Asian countries, Australia, France and the United States among other nations. It is difficult to determine exactly what impact this medical and social threat can have on markets and/or the economy, but highly-tuned sentiment can certainly amplify the reaction. Consider the cases of SARS in 2003 and swine flu in 2009 which had a material impact on market-based headlines – though whether that was owing to an already ‘raw’ confidence is up for debate. As more cases are reported of this pandemic are reported, it is worth watching whether the market responds to the additional uncertainty by de-risking any further. The Pull of the EURUSD The FX market is very large in terms of sheer liquidity. It is easy to group the entire asset class into a certain category of depth that adds an innate stoicism and inactivity that seems natural. While the ‘majors’ in the currency market are typically far less volatile than indices, commodities and a range of other popular asset classes on average; they are not themselves quiet. History has shown substantial volatility from even the deepest of the exchange rates, EURUSD – just look at the tumble the pair suffered from May 2014. That said, there is little doubt that currencies have suffered from the same lethargy that has overtaken most other financial markets. While the S&P 500-based VIX has consolidated back down around 12, the FX market equivalent has notched an even more extreme. The popular currency volatility measures from JPMorgan and Deutsche Bank have dropped back to record and near-record lows respectively. My own measure of an equally-weighted implied volatility of EURUSD, GBPUSD, USDJPY and AUDUSD has done the same. Naturally, when these conditions hit, defenses are progressively dropped. Traders don’t expect significant moves so default to either positioning for the carry (for which there is very little nowadays) or trade the range. That is the context with which we saw just a glimmer of activity from the EURUSD to end this past week. The ECB rate decision and then global January PMIs seemed to stir in investors enough attention to push the pair through its narrow three-month rising trend channel and what happened to be a 100-day moving average that was hovering around 1.1070. As far as technical developments go, few chart traders would likely consider this a systemic shift for the benchmark. Sure, it was running out of room with the much larger channel resistance capping upside progress below 1.1250, but the drop seemed a path of least resistance resolution with 1.0900/0875 still intact below to cap any serious concern of bearish momentum. Nevertheless, the boost to activity seemed to generate some serious attention in FX circles. This makes sense given the pair is the baseline for all of the FX market. According to the BIS, EURUSD accounts for 24% of all FX transactions while the Dollar is one side of 88% of all trades as of April and Euro 32%. Given that it has moved deeper into an established 2019 range, we should watch to see whether implied volatility settles. That said, there is some heavy event risk ahead to beat back the dark of inactivity. The Fed rate decision along with the US and Eurozone 4Q GDP readings are top events on this week’s docket. S&P 500 Goes 72 Days Without a 1 Percent Daily Change The world’s most heavily traded index (through derivatives and financial agents) has signaled extraordinary quiet through a number of remarkable statistics earned these past months and years. That is a understandable consequence of a market that continues to push to record highs. While the financial system has suffered very few shocks over the past decade and growth trends are generally steady, the environment doesn’t exude the economic potential nor the yield that normally encourages market participants to play down their risks and continually build their exposure to progressively lower rates of risk-adjusted returns. Eventually, the quiet will be so threadbare that speculators will see little choice other than to significantly reduce their exposure. Of course, the question is always “when”. For most, the spark is expected to be a trigger from the headlines like the failure of the Lehman Brothers back in 2008 was for the financial crisis that followed. Such developments can certainly rock the financial system and send markets careening. On the other hand, I think there is something to say about the environment that builds up to the symbolic lighting of the future. The SPX pushing record highs and the VIX settling back towards the lower bounds of its extreme range are one thing, but experiencing a long stretch of extremely quiet days adds incredulity to the mix. The same index has passed 71 consecutive trading days without a 1 percent move either higher or lower (see SPX_1pct_71 attached) . That is two days shy of the period through Oct 8th, 2018 just before the tumble in the 4Q accelerated, and still well short of the 95 day run through Jan 25th, 2018 that preceded the near-bearish shift (20 percent correction from highs) in that period. Looking further back, we have to go all the way to 1995 and then 1972 to find anything comparable. Clearly enough, this is exceptional; and market activity is mean reverting. When we see a balancing from extreme quiet, it isn’t usually a slow pickup to more reasonable levels but rather a dramatic restoration that eventually settles.
  5. Will the White House Pick a Fight with Europe? The long-awaited first step towards de-escalating the most taxing trade war in modern financial history – between the US and China – took place this past week. Representatives for both countries, US President Trump and Chinese Premier Liu He (notably not President Xi) participated in a very long signing ceremony. The contents of this first stage for finding a long-term and full compromise is important as is stands as the symbolic doorway with which these two superpowers can continue to work towards a true compromise that sees all the steep tariffs (largely put on by the US) rolled back and China take on the role of a norms abiding ‘developed economy’. That said, we are still critically lacking a path towards reversing the tariffs on $360 billion in goods already in place as well as acceptable monitoring for technology transfers and intellectual property protections. For now, we may find ourselves in a sort of purgatory for relationship between the two. Looking out over the week ahead, however, trade will remain top of mind. For one thing, the World Economic Forum in Davos is likely to address the scourge of trade war just as it did last year. As confrontational as the members were the last go around, the tensions did not actually boil over into actions that the market would have to account for in price. That said, we do have a particular possible flashpoint staged by officials. The US and France set a deadline of January 21st (Tuesday) for negotiations over the controversial digital tax that the latter announced for large tech companies last year. The White House considers this a burden disproportionately applied to US companies and has threatened to retaliate against France if it is not lifted. A $2.4 billion tariff has been threatened if an agreement could not be struck. In turn, France and the EU’s trade chief have remarked that they are prepared to retaliate should the US act to retaliate. Let’s also not forget that there is another front to this battle already underway. The US has pushed forward with import tax on $7.5 billion in European good in response to the WTO’s ruling that the EU had unfairly subsidized Airbus and that the US could pursue recompense. Turning the screws further, the US has threatened to pursue further tariffs after a follow up evaluation by the World Trade Organization’s report that Airbus aid was still not fully curbed. European officials will have their day though as a ruling by the same organization is due on Boeing and the United States’ support soon – likely this month. Will the US ease off? Monetary Policy Will Gain Traction When Questions Over Reach are Asked Monetary policy has been relegated to the backdrop as a systemic fundamental theme these past months, but its influence has not actually ebbed. The collective global yield (benchmarks set by the largest central banks) and additional stimulus infused into the system is still historically unprecedented. That reality seems to have simply become a natural part of our environment. Yet, a dependency on what was previously considered extraordinary monetary support – emergency stimulus – should not be viewed as a healthy foundation. For one thing, it leaves the world’s largest policymakers with very little in the way of ammunition to fight any future economic or financial fires that arise. Furthermore, the external support seems to have encouraged investors to bolster their exposure to ‘risk’ rather than seek value and help find balance in the system. In the schedule of large central bank meetings ahead, we will see this stretched situation for authorities and markets raised between the Bank of Japan (BOJ) and European Central Bank (ECB). The former will announce its policy mix Tuesday morning after the liquidity lull caused by the United States market holiday the previous day. This group is unlikely to change focus on the 10-year JGB yield target and its essentially-zero benchmark rate, but their reiteration of having room to do more if necessary and seemingly indefatigable optimism for a recovery in the future is drawing more and more skepticism from the market given the constant shortfall on objectives. They are perhaps the most over-extended of the major banks as a percentage of GDP. The ECB isn’t as exposed as its Japanese counterpart, but the changes this past year stand out more prominently. The return to QE and drop further into negative rates has more members of their board questioning what are the costs of this extreme policy. The group is due to announce the results to its review of framework which could either bring serious change to modern monetary policy or act as a foothold to skepticism over the old guard. Another central bank worth watching this week will be the Bank of Canada (BOC), which is not expected to alter its rate and struggles to stand as a model for global policy – whether the average or extremes. Instead, this group’s dovish or hawkish lean could offer influence to the Canadian currency. And, given their general perspective of balance, moderate shifts could give charge to pairs like USDCAD. Range, Breakout or Trend Conditions? This is a topic that I have raised before, but it deserves to be revisited at regular intervals as it can significantly influence your ability to navigate the markets. I think most would agree that conditions change, and it should thereby stand to reason that we should adapt to the evolution in order to reasonably pursue profitability. In general, I believe there are three types of market environment that we progress through depending on liquidity conditions, volatility and prevailing fundamental themes. Range or congestion, breakout and trend are three distinct environments that cycle progressively almost regardless of the time frame we consult. Naturally, if you have tuned your analysis to one of the three and/or established a trading strategy that is optimized for one, a systemic shift in the market will leave you adrift. It is absolutely possible to appreciate your conditions and adapt; but those that think they can create a one-size-fits-all approach are deluding themselves. So what kind of market conditions are we dealing with? This is something I ask myself at least at the start of every week. There are some very interesting cases to be made by a few key assets out there. US indices for example have been climbing fairly steadily these past three months. On that alone, we can call a trend. However, the pace of the Dow’s advance is extraordinarily restrained; and there are not many markets that reflect the same intent. Recently, a bid for risk-based catch up from the likes of the FTSE 100, the EEM emerging market ETF and debatably some of the Yen crosses look like they are just recently clearing prominent resistance levels. That may be true, but breakout is defined not by a laser-accurate level but the measure of follow through when it is cleared. There seems limited backing for follow through. That leaves congestion. There are plenty of false starts and large ranges to point out. Furthermore, remarkably low volatility levels doesn’t support the immediacy of breakout. FX Volatility measured by JPMorgan’s global measure has dropped to a record low this month. As a mean-reverting condition, activity will normalize; but it doesn’t have to do so immediately.
  6. Two Important Trade War Votes and A Lurking Threat We have had a few weeks of relative respite from the 2019’s constant headline generator: trade wars. That hiatus is past, however, as we are expecting key updates on global trade relations over the next few weeks. In an unusual twist though, the developments may be positive ones. Dead ahead on Wednesday January 15th we are expecting two opportunities to improve the collective growth trajectory. The most prominent of these is the planned signing of the Phase 1 trade deal between the United States and China in Washington DC. Though this deal was proposed back in October in an effort to ease the crush on business sentiment, we are only now coming to signatures. It is still unclear exactly what is entailed with this agreement besides the deferred tariff escalations due this past December, and it is likely the details are left ambiguous even though the two sides will declare it a black-and-white improvement. If we go back global indices or the USDCNH, the market is taking an optimistic view which will make it difficult to ‘impress’ while broadening the potential scenarios that ‘disappoint’. Easing more of the painful tariffs and seeing progress towards increased purchases as well as intellectual property rights policing is a matter for Phase 2 which President Trump waffles between commitment to steam ahead on and wait until after the election. Another update that was on the docket for Wednesday – but for which doubt has been revived – was the Senate vote on the USMCA accord, which is the proposed replacement to the NAFTA agreement. This is one of the final hurdles to restoring tangible trade program in North America, one of the largest trading blocs in the world. Despite what it represents, the market is remarkably sanguine on this topic from global sentiment to Dow to USDCAD or USDMXN. Speculative interests started discounting the risk in this regional spat some time ago when the White House started to show a different path towards negotiation than it was taking with China – not a ‘favorable’ approach but ‘not as bad’ as the US-China trade war. Similar to the situation with the aforementioned countries’ discussions, assumptions are set with heavy skew to discount an improvement and wide open for deterioration. As established as these trade negotiations have been with significant market attention along the way, the trouble brewing between the United States and Europe remains underappreciated. Perhaps due to the distraction of open economic warfare or the side effects of complacency, there has been little active discounting taken as the two largest developed economies have moved from threats to actions. After 2018’s metals tariffs by the US, the WTO ruling on Airbus subsidies by the EU spurred the White House to charge forward with more than $7 bln in tariffs on European imports. France decided late last year to apply a digital tax on large tech companies’ revenues in its country which raised the ire of the US, urging threats of reprisal all while the country remarked that it was considering further tariffs for an updated ruling by the WTO saying Europe had not yet fully halted unfair support for Airbus. France the US have reportedly set a commitment to find a compromise by the Davos Economic Forum next week. Further, the WTO is due to make its ruling on US support of Boeing sometime in the coming weeks. Will Growth Retake the Crown of Most Market Moving Theme…for the Week? Geopolitical risk was an unexpected top concern to open 2020 on thanks to the situation between the US and Iran which boiled over on escalating tensions between economic sanctions and an attack on a US embassy. Though the two countries have openly attacked counterpart’s key people and installations and their rhetoric is openly hostile, it seems that the situation is back to an uneasy suspension. Despite the market’s blasé attitude towards the situation, it is worth keeping a close eye on the situation. Further escalation towards outright war between the two can have substantial economic and financial implications – not to mention draw attention to the exposure to risk the markets have built over time. As we move forward with little appreciation for the threat in the backdrop, there is a theme that may find more reliable traction in the week ahead. Since the surge in fear of an impending global recession peaked in August/September, we have seen concern over the health of the economy all but vanish. That is not to say the situation has improved measurably. All that has happened is the developed world economies’ service sectors have generally avoided contraction and the US-China trade war averted steeper tariffs. Sentiment seems to be content with this situation, but it is difficult to gauge when interest will start to go down hill quickly – it certainly isn’t just a matter of an obscure Treasury yield curve event to decide. Data, while not always reliable for the seismic influence necessary to charge the markets, is at least a threat with a time stamp. There are a run of growth-related indicators on tap this week, but few of them has a ready claim to global influence. A monthly UK GDP, Japanese eco sentiment survey and US retail sales are just a few indicators that will carry local weight but seriously struggle to reach global proportion. The Chinese 4Q GDP on the other hand is a big picture update from the second largest individual economy in the world as well as a key trade war milestone. That said, this report has a tendency to see very little change nor does it surprise meaningfully relative to economist forecasts. Nevertheless, don’t fully discount it. Another event to take stock of is the start of the US 4Q earnings season. Banks are the focus with liquidity a more frequent topic of conversation given the Fed’s short-term funding efforts of late. I will also keep tabs on CSX, the railroad corporation, given its influence on trade and proxy nature to growth. Here too, the interpretation of a global growth concern would require a jump. An Appetite for Momentum Rather than Value Last week, I discussed the importance of knowing the collective motivation of the market whether you are a fundamentally-inclined traders or not. When we know that the financial system is on a course set by views of growth, rates of return, unorthodox monetary policy or some other unique but systemic influence; it is easier to spot when market movement will pick up, separate a short-term jolt from a true trend and recognize which scheduled event risk will gain traction versus that will be readily overlooked. An extension of this consideration is the separation between a market that is motivated by a clear drive or one that is otherwise fed by outright speculative appetite. Impetus doesn’t have to be a traditional measure of value like the outlook for growth. It can be the easing of potentially disastrous economic pressure as with the trade wars. Also, there can be a temporary convergence of influences (e.g. Fed cuts, trade tension easing and Brexit breakthrough) that tips enough momentum to look like a singular cause – though such runs usually peter out far earlier as one or more nodes falter. Alternatively, there are situations in which a climb or tumble from the market has no basis in fundamental perspective – whether singular or a patchwork. That is more properly defined as a market driven by either greed (when bullish) or fear (when bearish). These phases are not always so overt as to be a universal tacit agreement that we will let our collective enthusiasm or pessimism carry us undisturbed. There is often fundamental justification that is made to give a sense of greater conviction behind the self-indulgent trend, whereby events or themes that challenge the prevailing trend are downplayed and tepid measures of support are given much greater prominence. It is this market type that I believe we are in with risk-leaning assets – particularly US indices. There are various ways to establish this – capital flows, divergences in key assets, erosion of economic potential, etc – but I am currently partial to the reach of specific risk-leaning benchmarks. When base risk appetite is the foundation for investment appetite, there is less interest in seeking value for long-term potential and far more interest in the immediate return to be found in priced-based established momentum. One of my favorite examples of this is the relative performance of US equities relative to their global counterpart. The ratio of the S&P 500 to the VEU is just off a record high, and EPS potential I certainly not that remarkable.
  7. The Return of Geopolitical Risk (the US and Iran Again) For almost the entirety of this past year, the dominant force of motivation among investors fit within a rotation of just three major themes: trade wars, growth concerns and monetary policy. Even when these matters weren’t under full steam, their influence and too many instances of sudden changes in the fundamental weather meant that they lack of bearing led to a similar absence of conviction in speculative performance – momentum if not direction. All three of these matters stands to hold considerable influence over the global market going forward; but for now, there is a pause in their respective tempest. Just in time for a familiar alternative risk to step in: geopolitical uncertainty. Compared to trade wars or the Brexit which are more specifically a controlled break in economic relations, I consider geopolitical risks specifically issues that threaten the chance of escalation to a full-blown military conflict. The tension between the United States and Iran has been on the rise since the former announced that it was backing out of the Nuclear Treaty (JCPOA). Since then, we have seen plenty of threats and even actions to threaten oil shipping, but the measures were such that breaking the cycle of escalation wouldn’t threaten one side or the losing face. That may have very well changed this past week when the White House approved a drone strike on a convoy in Baghdad that killed Iranian Major General Qasem Soleimani. President Trump and officials stated that the decision was made to head off a planned attack on US military forces, but reasoning doesn’t curb the threat should Iran retaliate. The country has said that it was prepared to attack military targets while the US President said Saturday they were already targeting 52 Iranian sites should the country seek reprisal. The implications of hot or cold wars are extremely variable but the worst case scenarios can be severe for economies and financial markets. Such uncertainty is the very definition of risk. This situation may plateau allowing the market to simply lose interest over a long enough period. Then again, it could also catalyze without warning. How willing are investors to discount the uncertainty and how well hedged are they for greater risk? Central Banks are Trying to Head Off Carry Over Trade War Risk Trade relations seem to be thawing to enter the new year – or at least some of the more potent threats have yet to be acted upon – but that doesn’t mean the economy is imminently positioned to resume the carefree climb that existed before the manufactured hardship was applied. The impact from nearly two years of rising trade barriers has material carry over influence economically and some of the more critical pain absorbed in previous months may very well prove permanent. Consider the agricultural purchases that China is supposedly set to pursue in order to meet the Phase 1 trade deal and for which the government has supplied large subsidies to stabilize the industry during the trade dispute. Farm coalitions have warned that even if the tariffs were fully lifted – a prospect well into the future – they may never see their relationships reestablished. Sentiment (business, investor, consumer) has a lot to do with this equation, which makes the open threats along more established and critical lines like between the US and EU added pressure that we do not need. I visualize this as a large vehicle that is pumping its breaks but momentum continues to carry it closer to a critical cliff (an economic stall whereby external catalyst is no longer the critical ingredient). The world’s largest central banks no doubt see it in a similar fashion. Most policy statements or minutes have stated the concern around trade conditions as a serious external risk and many individual policy officials have expounded upon the unique risks that exist. This is likely the principle motivation behind the largest to add accommodation or hold open existing generous accommodation policies. The ECB was seeing unflattering growth figures and the uncertainty of Brexit, but is that enough to justify restarting QE and pushing benchmark discount rates even further into negative territory? And despite saying it anticipated no changes to policy last year before each meeting, it cut three times. Preemptive policy like this does not offer tangible benefit – rather it is the absence of greater pain that may or may not have been realized. On the other hand, there are very real costs that continue to accumulate like cholesterol in the veins of the financial system. My top concern was addressed in the FOMC minutes this past Friday when it was reported that some of the US bank’s members worried that extreme accommodation was encouraging excessive risk taking. Unlike inflation or employment (their dual mandate until they decide to change the mix), investor sentiment can turn quantitative to qualitative with no warning. Mind the Means for Market Performance to Gauge Persistence Why should we care what is driving markets higher so long as we are positioned to take advantage of the climb? Even dyed-in-the-wool analysts ask themselves this question at one time or another. Many pure technical traders answered this very quandary some years ago with a ‘we shouldn’t’ and likely never looked back. However, whether chart traders, analysts with a crisis of faith or hedge fund managers frustrated that market norms have been upended; everyone should account for the prime motivator of the masses. Knowing what is urging the masses to a bullish or bearish (or neutral) environment can tell us when the a trend will stall, when congestion turns to a break or we fast track a reversal. Timing sudden reversals or distinguishing temporary pauses from a stalled trend can be a serious struggle for many investors that shun the fundamental map. Keeping course doesn’t make you immune to the struggle, but it can certainly help avoid the worst of the pitfalls. I’ve said before, but it warrants repeating: the fundamental overview of the market is a factor of accumulation. There are thousands of motivations among traders to take or cut a position at any given time. Their collective actions renders the prevailing winds. Yet, not all of the causes are wholly unique. There are often dominant themes that dictate the actions of large swaths of investors. Trade wars, monetary policy shifts and recessions can be consuming matters that enough of the market responds to make it a systemic driver. Working out what dominant themes are actively controlling the reins or are lurking on the fringes can make analysis far more effective. Further, appreciating that the vast majority deployed in the system is controlled by participants that don’t have short-term duration and who don’t even consult charts help us to avoid the frequent cry ”these markets just don’t make sense!”
  8. Opening Week Liquidity – We are heading into the first trading days of the new year though it is not the first full trading week of 2020. That is an important distinction for those keeping tabs. Consider the throttling in activity and speculative appetite through the past week. The holiday conditions of the Western World drained market depth to effectively hobble any effort at establishing or extending trends – though there were a few notable sparks of volatility that were the result of the same illiquid backdrop. That is going to be even more pronounced in the week ahead. New Years is a bank holiday for virtually the entire financial system. That will make conviction even more difficult to muster. When trend development (momentum) and follow through on breakouts is difficult to muster, my default is typically to filter for opportunities that are more convincing range trades. However, the shallow markets will make volatility even more a complication to probability-based trading than normal. For anyone with less than a high level of risk tolerance, it may be better to sit on the sidelines until the follow week restores markets in earnest. Though market conditions are unusual this week, that doesn’t mean that there is an equivalent lack of technical or fundamental event risk. Consider the Dollar for example. The benchmark currency is on the verge of a reversal to a more-than 18-month bullish trend channel that also sports the most remarkable restraint in terms of activity level (ATR) seen on record. At the other end of the spectrum, you have the US indices which have pushed to record highs both through periods of low and high liquidity. On the fundamental side, there are a number of scheduled events that should register. Proxy growth readings are on tap for the largest economies with the run of Chinese government PMIs and the ISM’s US manufacturing report both due. The former is an overview of a country being pushed on too many sides and the latter reflects an actual recession in factory activity (not an isolated malady for the US). Manufacturing reports for other countries, the FOMC minutes, US trade report and a range of auto sector reports will also register on my radar. However, a more systemic matter to keep in mind is China’s plan to lift a range of tariffs on a host of global counterparts starting on January 1st – though this list does not include the US. Is this a shift towards more growth-supporting open trade or does it end up adding to the provocation with the US? Top Events for January Looking further ahead to the first full month of 2020, there is the regular density of high-level event risk across global powerhouses in both the developed and emerging market worlds. That said, I will keep my attention more actively directed towards systemic themes whose threat has posed serious threat to the long-disputed stability of a ten-plus year bull market. The most representative matter seems to be trade-related concern. Beyond China’s plans to lift tariffs against a range of counterparts this week, we should keep a close tab on release of details on the Phase 1 trade deal. Both sides have hailed their compromise since October yet we are still critically lacking for the practical terms that will usher us to a full de-escalation of economic tensions between the two largest players on the board. According to US Treasury Secretary Mnuchin, the two may sign early January. Trade issues aren’t unique to the US and China relationship. There are a number of active import taxes between the US and Europe at present. The US quickly slapped tariffs on certain provocative European imports (particular agricultural goods) after the WTO ruled this past year that the country could pursue over $7 billion in restitution for unfair subsidies afforded to Airbus. After a ruling earlier this month that the EU has still not lifted support for the airplane manufacturer, the US said it would consider escalating its effort. That decision could come in January. To add further complication, the WTO may deliver its decision on the US’s support of Boeing which could greenlight European tariffs which they would likely pursue wholeheartedly. Further, we are also waiting for the US to follow through on stated plans of retaliation for France’s digital tax that is raising cost to large US tech companies. Yet another front on trade to mind is the Senate’s decision to take up the USMCA agreement which could finally write off the replacement of NAFTA for a clear North American relationship – the first true resolution (for better or worse) of trade disputes. And of course, lest we forget, the extension of the Brexit decision expires on January 31st which is expected to see the previously struck withdrawal agreement push through after the conservative’s victory in the general election three weeks ago. The two other prominent themes that I’ve been following through 2019 find far less top level event risk to trigger provocation – though they can hardly be written off. Recession fears have notably abated since the US and China revived their confidence on the Phase 1 deal. That said, the quality of growth-related data has not improved materially, rather the interpretation of the same data has taken a more notable optimism. That could quickly fade by seeing capital market performance stagger. The markets are indeed that fickle and superficial. As for the effectiveness of monetary policy, there is one particular rate decision that is on my board: the January 29th FOMC rate decision. After reviewing its objectives through this past year, the world’s largest central bank is due to offer its assessment of what may need to change in its targets and policies. Depending on the mood of the market, this could be readily interpreted as evidence that monetary policy has lost its potency – and perhaps even its ability to maintain calm and buoyant asset prices, which would be a disaster if ever realized. Top Events for 2020 In the scope of an entire year, many fundamental developments will transpire that take control of both volatility and direction regionally and globally. Through that 12-month span, many of the most meaningful drivers are likely to be completely off the script that we have in scheduled events that we start off with in January. These developments that are related to generally known themes and carrying a significant level of impact can fit into the category of ‘grey swans’. Most are familiar with term ‘black swans’ which refers to extreme developments that were largely unexpected by the vast majority of market participants – and which are readily interpreted and retroactively explained to have been ’obvious’ after the fire is put out and the dust settles. We cannot reasonably speculate and trade around black swans because their extremely low probability makes for very bad trading statistics and worse timing. Grey swans on the other hand are far more reasonable. Through all the open-ended matters, there are a few particular matters with rough scheduling that I will watch as inordinately influential on local currencies and capital markets. The first is the Brexit transition deadline. According to the original timeline for transitioning from member of the Union to independent country with trade relations aligned with EU members, the situation should be wrapped up by end of December 2020. After the delays in agreement to the exit, it would be expected that there also be an extension requested of the transition – a period for which the UK would still be beholden to some unfavorable European laws. However, Prime Minister Johnson suggested after the election that he would attempt to make a request for extension illegal. This is a decision that is far out, but its impact will be felt constantly with interpretations of remarks and negotiation updates, with sudden spells of volatility and proactive restraint in progress for the Sterling. Another matter that is well accounted for is the state of the US-China trade war. Taking the optimistic interpretation and say Phase 1 is finally signed off on by all those that hold sway, we still need to move to Phase 2 which is the real heavy lifting. A demand of full tariff roll back by China and the US requiring committed purchases along with intellectual property protections are difficult to come to terms on. Will they accelerate progress to ward off an unintended recession or will China wait until after the US election before it takes the cost-benefit seriously? Speaking of the US election, this event will likely prove a global event with considerable build up in capital market performance. Generally speaking, the market is agnostic to party, however, the influence of protectionism amid populism that has taken hold in different regions of the world are difficult to miss at this point. Trade wars – at least in their present form – are a direct result of the ruling parties’ policy mix. What’s more in the US, the extreme bifurcation in political norms has created a familiar state of gridlock when it comes to pushing growth-supporting initiatives like the infrastructure investment fiscal stimulus that was part of the 2016 campaign trail while government shutdowns are a near constant threat as the deficit balloons to record highs. These are serious matters, but the market can decide to play the risks down as they have in the past. Yet, with a prominent election ahead, I suspect these matters will draw far more attention in 2020.
  9. What Was and Was Not Announced in the US-China Phase 1 Trade Deal Release the doves. The US and China announced last week that they finally were able to come to terms on the their long contentious Phase 1 trade deal. It seems to have conveniently slipped the market’s collective mind that the first stage of the promised reversal to the trade war was announced back on October 11. No tangible change had been put into place between then and now, but that didn’t slow the climb from risk benchmarks like the Dow. There is very good reason to be skeptical about how committed the two governments are to progress given the numerous starts and stops over the past six months (see the attached chart of the DIA). In an ideal scenario, the two sides flesh out the details to the armistice and offer breathing room to work on the Phase 2 leg. That said, US President Donald Trump gave a conflicting view of when the subsequent step of de-esclation would take place as he said it could happen before the election in November and then remarked that there was no reason to rush it. There are notably $250 billion in Chinese imports that are still being taxed at 25 percent, blacklisted entities and a currency manipulator designation among other barriers still in place. However, before we assess the difficulties of next steps, it is important to keep close tabs on the presumed efforts for this current chapter. Absent in the announcement were the size of Chinese purchases of US agricultural goods, enforcement procedures, structural change to IP protections, methods of tracking FX manipulation, procedures for dispute resolution or even a clear statement from Chinese officials (through state media) that they are in fact satisfied with the terms. We shouldn’t view the situation with complete skepticism though as there was very real avoidance of a painful acceleration in their standoff. The US backed off of a planned December 15th increase in the list of taxed imports from China to encompass virtually all of the country’s goods – and China deferred tariffs on US autos. That would have been another severe escalation in the trade war. Further, the White House’s decision to halve the 15 percent tariff rate on the $120 billion in Chinese imports announced back in September is the first meaningful step to actually ease tensions. While this is largely the avoidance of a further step to intensify a painful economic trade war, that may just be enough to stir speculative interest that traders have held on their sleeves. Risk Trends Now that Our Wishes Have Been Met Speaking of speculative interest, we should theoretically have all the necessary ingredients to push ahead with a strong close in global capital markets through the year’s end. On a structural basis, we have seen the capital markets climb with little regard to the troubling questions over traditional value for the better part of a decade – perhaps driven by the very generous policies of the world’s largest central banks – and 2019 has been particularly liberal with the buoyancy. Another layer to add to this favorable backdrop is the seasonal expectations associated to the month of December. Historically, ‘risk’ benchmarks like the S&P 500 climb through the final month of the year as much through habituation as anything tangible like tax harvesting. There is a reason it is called the ‘Santa Claus Rally’. And, rounding it all out, we were given a few very high-level, reassuring events to spur a sense of tangible optimism. The Phase 1 trade war agreement and a clear path for the Brexit negotiations between the UK and EU after the former’s general election are a measurable relief to global risk. With the market’s seeming default optimism, all of this should make for an easy response to extend the bid over November and the first half of December. And yet, this past Friday’s market activity did little to reassure that we were going on cruise control. While measures of implied (expected) volatility dropped in the aftermath of this dual update, the underlying speculative markets would not match with a charge higher. US indices, the best performing of the major assets I follow, marked a technical high with no meaningful progress. Where we could have mustered some conviction through associated risk measures playing catchup to the SPX, there two we were met with hesitation. That doesn’t mean that market has completely blown its opportunity to rouse conviction; but it draws serious, negative attention. A market that rises despite trouble in backing fundamentals and underlying value suggests a speculative default. That same backdrop failing to progress when concrete support is presented is troubled. The Last Liquid Week of the Trading Year Liquidity is exceptionally important when you are trading the markets. A good example of what happens at the opposite ends of the spectrum is the day-to-day activity by one of the top shares in the world (say Apple) and those that are on the ‘pink sheets’. The former can build on its gravity to progress a bullish run further than smaller counterparts from sheer size while also curbing panic selling that may otherwise afflict counterparts as its scale can be interpreted as safety. Alternatively, the smallest shares move in often erratic day-to-day swings and frequently see their value wiped out when risk aversion hits the broader financial system. Fundamental and technical analysis counts of course, but market depth and fluidity is a principal influence. Consider this for what we face over the next two weeks. We are heading into the final thrust of the trading year. Ahead, we face the last full week of the trading year. We’ve seen a clear deference for a risk-on bearing and predisposition towards keeping exposure fairly steady (no profit taking or meaningful hedge build up). Anything other than a slow volume trade of consolidation should be observed closely. A significant climb in capital markets would reflect an ‘all-in’ mentality that would register as quite extreme. Such a climb could be a cue for investors to launch a strong 2020 start, but it could also readily turn into a blow off top when it comes time to reassess value. Alternatively, any meaningful retreat given the prevailing winds, seasonal backing and sliding liquidity could signal risk aversion that is ready to override all the typical hurdles. Be mindful of the market’s next move and the quick assumptions that will be drawn from it.
  10. Anticipation and Scenarios Into the Sunday US Deadline for China Tariff Escalation The active week of trade ahead will be pocked by a few very high profile events which will tap into key themes. Monetary policy and Brexit updates – both with explicit growth implications – are top listings while liquidity is readily available. Yet, one of the most potent potential events ahead has a deadline that occurs over the weekend. The United States warned some months ago that it would increase the tariff list on Chinese imports if the two countries had not reached a meaningful compromise. Though the two countries seemed to agree to the concept of a Phase One deal back in mid-October before a planned escalation in the tax rate on existing tariffs, the details on this accord have thus far been notoriously absent. White House officials and President Trump himself have stated explicitly these past two weeks that they intend to follow through with the escalation if a bargain was not struck. Of course, what qualifies as acceptable to reach a stage one accord and ward off the onerous escalation is open to interpretation, so the future is ambiguously in the Administration’s hands. We have been here so many times before (see the image) that the markets have grown numb to the risks that exist should the outcome be poor. That is a particularly dangerous brand of complacency. With this uncertainty and hopefully a little more introspective appreciation of the risk it represents in mind, it is worth considering the scenarios. Through the active trading week, it is unlikely that US or Chinese authorities pull the plug early and make clear another wave of painful tariffs is in the cards. Rhetoric to reiterate what is at risk is very likely as both sides intend to pressure the other in their long-standing ‘game of chicken’ but that is par for course. That suggests that if there is any truly definitive development in this tense trade negotiation, it would more likely turn out to be a breakthrough that disarms the threat. That could very well offer a relief rally to risk assets, but there aren’t many that are deeply discounted at this point and it would struggle to recharge the year-end liquidity fade. More productive would be a rally for the Australian Dollar. The currency has suffered a crushing depreciation over the these past years as the same connection between the Australian and Chinese economy that helped the former avoid recession during the Great Financial Crisis is now steering it into the rocks. With AUDUSD also suffering from the lowest activity reading (25-day ATR) since 2002, conditions seem ripe for a spark. Alternatively, if we head into next weekend without a favorable resolution in hand, traders should consider thoroughly their risk tolerance with holding exposure as exchanges close through Friday. It is certainly possible that there is a last minute agreement in the hours before the stated US Trade Representative’s Office deadline, but that is a lot of assumption to put on the shoulders of politicians who have not committed to any significant de-escalation efforts since this trade war started. What’s more, the bullish case scenario is relative tepid as discussed above. Alternatively, the inability to strike an agreement, would increase the stress on global growth materially. Considering the US indices as a milestone for risk are just off record highs, there is worrying premium at risk should blind enthusiasm be crack. This revelation of pain could be made when Asian markets are online and thereby some liquidity to respond, but shallow market conditions amplify rather than absorb volatility shocks. Consider your risk tolerance. The Genuine Concern Underlying Both the Fed and ECB Rate Decisions There are a host of major central banks due to update their policy over the coming week. For the majority of them, no change is expected. That doesn’t come as much of a surprise given the general state of monetary policy across the globe as well as the condition in capital markets as of late. There has been a not-so-subtle escalation in global accommodation through 2019 that has included rate cuts (for some into or further into negative territory) and material purchases of assets. Growth measures of late may have also solidified the lackluster outlook, but the balance of risk assets removes some of the urgency to push support further into uncharted territory. There is a cost associated to everything, and the balance of global monetary policy is showing increasingly greater cost relative to the quickly fading benefit with each subsequent iteration. That is what traders should be truly monitoring when it comes to monetary policy events like these this week and into 2020; because should confidence founded on this support falter, the optimism that it has filled in for these past years will cause a likely-severe rebalancing of priorities. Now, we have seen serious questions over the effectiveness in monetary raised these past few months, but the concerns have been beat back after some short pangs of concern. That said, so long as the global economy continues to flounder despite the efforts; the risk of recognition of an inevitably-bankrupt strategy and pillar of current stability will rise when the largest actors maintain or escalate their efforts. Thus approaches the Fed and ECB policy meetings. The US central banks is first and on the hawkish end of the scale. They have come off of a series of three consecutive rate cuts which leaves their benchmark at 1.75 percent but it is expected that they will hold this month with no commitment with further easing into the future. We will get a better sense of their policy course moving forward with the planned Summary of Economic Projections (SEP), but they have not been particularly aggressive with their forecasts. The stability this may insinuate is undermined by the short-term funding pressure that has pushed the Fed to flood the repo market with liquidity. This has led to a sharp increase in the central bank’s balance sheet which they are quick to remark is not a return to traditional stimulus efforts. I would agree that it is not the ‘traditional’ QE effort, but its purpose is even more troubling: to fend off serious financial stability threats rather than to simply accelerate growth. Watch references to this in Chairman Powell’s press conference along with any insight into the discussions on general strategy that the board has been engaged. At the other end of the perceived policy spectrum, the dovish ECB is in just as profound straits as its US counterpart. With a negative deposit rate and actively engaged in quantitative easing (the traditional type), we already know that there is a serious measure of concern for this authority when it comes to growth and financial health. It is between his effort and the immediate concern of its effectiveness that we find the most tangible threat to a crack in the façade of cure-all monetary policy. There has been a well-publicized uprising in the rank of the ECB with a host of members openly questioning the effectiveness of their extreme accommodation and the dilemma it leaves them in should an actual economic downturn – or worse, financial seizure – necessitate an effective response. Will the market adopt and action these concerns? Take the Global Traders’ Perspective of the UK Election Passions inflame when it comes to politics – particularly if you are a citizen of the country heading to the polls. That said, when navigating the markets, it is very important to divorce one’s personal, social and even moral views of parties and candidates to consider the genuine implications to the financial system. That is easier said than done, but the mantra should be repeated. For the upcoming UK general election Thursday, there is a clearly impassioned populace. With Brexit still hanging over the future leader and party like the Sword of Damocles and economic activity sputtering, it is easy to see the financial line blur in the myriad of concerns. Is this a matter of economic recovery, the future of trade between the UK and its largest economic partner or just a binary assessment of whether the divorce will finally proceed to a conclusion? While there are many important implications from this event, I believe the market for the Pound – and certain capital asset benchmarks – will respond first and foremost to the favor for party and proximity to a majority. The closer the UK is to a unified position towards negotiations, the more likely a path will be decided for Brexit with deadlines being kept rather than pushed back. As an aside, an outcome that sees a reversal on the Article 50 could eventually charge the Sterling much higher, but it is a very low probability and would not be interpreted as such a possibility immediately after the General Election outcome necessary as a first step. This past week, we have seen remarkably volatility behind the Cable, EURGBP and other Pound crosses owing largely to the polls signaling a clearer support for the Conservative party (again not a party preference but rather the clarity it suggests) The volatility signals just how much activity could follow this event. DailyFX will be covering the election through the day and evening with live updates, outcome articles and forecasts for Brexit next steps.
  11. What Matters More to Risk: Healthy Growth or More Stimulus? This seems like it would be a simple question to answer from a textbook perspective; but if you’ve been active in your investment these past years, reality has clearly deviated from the theoretical. We have seen economic activity the world over progressively struggle for traction. This is not a question of interpretation or the reliability of the signals being triggered. There have been far too many realized indications of strain (global GDP, PMI activity reports and investment figures among many others) while warnings over the future course have come from wide-ranging and reliable sources (such as the IMF, WTO and numerous central banks). Yet, despite this obvious strain, capital markets have held their bid. Not all benchmarks – equities or otherwise – have performed as well as the key US indices, but their strength has generously surpassed more rudimentary measures of value nonetheless. While we can attribute this to some measure of complacency – pursuing return while remaining numb to growing risk – there is something that fosters that speculative abandon. In the moment, it can be difficult to recognize the unusual foundations of sentiment; but past years have clearly shown an assurance in monetary policy. While the early waves of unorthodox monetary policy, such as quantitative easing, were necessary to stabilize confidence in capital availability and financial stability, the subsequent rounds beyond 2013/2014 seemed to be more devoted to accelerating growth to some unclear goal of hitting a pace that could somehow be more self-sustaining to ‘buy out’ the major policy groups. Though economic activity has slowed, improvements in employment pacing have diminished and inflation targets have never been met consistently; the central banks pushed on. It may not seem this way yet, but such dependency is placing enormous pressure on the world’s monetary policy and setting it up for inevitable trouble. The debate that these groups have reached the end of their effective range is a common one, so it stands to reason that it is eventually applied to capital market inflation as readily as standard price growth. Any fits of desperation – even coordinated ones at this point – will highlight the strain. And, if fear is indeed triggered by questions over the efficacy of this backstop, there is no greater power to swoop in to save us. Top Fundamental Theme Updates for the Week Ahead These past months, I have been keep tabs on three principal fundamental themes that have drawn more consistent responsibility for global sentiment than anything else. Rather than arranging these considerations for their ultimate potential impact, I’d rank them thusly for their recent outsized influence: trade wars; recession fears and monetary policy. Each of matters has key event risk that can rise to the scale of universally market moving so long as there is an attentive and liquid environment and the events themselves issue some fundamentally-meaningful surprise. For trade wars, the US-China trade war concern will eschew monthly trade war figures for impromptu headlines referring to the two parties’ moods. The underappreciated risk remains other fronts of this external economic throttling. The Trump Administration still hasn’t given official word on the section 232 auto tariffs and is reportedly still mulling a section 301 investigation, but neither is certainly to offer update this week. One point of known contention next week is the US Trade Representative office’s findings on France’s controversial decision to apply digital tax on large tech companies – many that are domiciled in the US. Another, more nebulous risk is the NATO summit through the final 48 hours of the week. There will be many high-level topics, many of which revolve around economic competition and/or conflict fostered by the US. Health of the global economy – more specifically, fear of recession – is the next most omnipresent matter. As mentioned above, it is far more important than the market is accounting for which is why its influence should not be underestimated. There are more explicit growth measures on the horizon such as official 3Q GDP updates (Australian, Brazil, South Africa), timely PMIs (China, Italy and ‘Final’ readings for so many others) and sector-targeted readings for key economy economies (such as Germany’s industrial production update). The indicator I will be watching the most closely, however, will be the US service sector activity report from the ISM. The US economy – the world’s largest – has been running at a premium to most of its major counterparts; and the services sector is the largest source of GDP for the country. This is as much a risk of destabilizing as it is source of potential assurance. As for monetary policy, most would put the onus on the US employment report through the end of the week. I believe it will due more to distract with unfulfilled anticipation than it will provide actual market influence. The Fed is presently held hostage by the market’s demands more than anything as mundane as a dual mandate. There is greater potential at genuinely moving the needle on the surprise scale from either the Reserve Bank of Australia or Bank of Canada rate decisions. Yet, even if they do offer up surprises relative to forecast; they will struggle to catch the full attention of the global cadre. Given the dependency on monetary policy and line of doubt running through the system, I would watch ECB President Lagarde’s testimony to Parliament, looking for any unexpected changes to one of the most extreme efforts at accommodation across the world. What Type of Trading Should We Expect in December? One of the most overlooked questions by nearly ever trader is: ‘what kind of market am I facing?’ This isn’t a one-off existential analysis but rather an evaluation that should be raised at regular interval – if not before every trade. Though fundamentals and technicals matter for filtering out opportunities where they may arise, they are secondary to understanding the general shape of the environment. Asking whether there is enough liquidity in the system is important for establishing whether we could fuel consistent trends or foster enough volatility to afford significant moves. This and certain other factors are also important to determining whether we are more likely to encounter range, trend or breakout setups over our investing horizon, because why would you pursue trends when most assets in the market are offering ranges. For general current patterns, we have seen limited liquidity over these past few months – the period from which we usually see a revival from summer doldrums. We haven’t exactly faced any significant strains to test the availability of a market owing to the quiet climb in risk assets, but that may also starve any attempt at more systemic drives of enthusiasm – or what seems enthusiasm. In the event that we take a more troubling turn for the global financial system, the lack of market depth will lead to more erratic market conditions and could hasten the elevator ride down. Volatility is also exceptionally low – a serious function of liquidity. It is far too quiet, but history has shown that the final month of the year normally enjoys a positive drift for capital markets. That will represent a strong draw for keeping the status quo, but don’t overlook the possibility that ‘this time can be different’. Given the liquidity situation and the uneven conviction in global risk appetite, I see trends as particularly difficult to fuel. As such, I would need the greatest level of conviction to pursue any serious trends – which is over a week at this stage. Breakouts are more appealing, but the tenaciously deflated VIX (and most other assets’ volatility measures) means that a serious catalyst is of upmost importance to get the ball rolling. A further complication is that there are few truly inspiring ranges to count. If you look for too large a congestion pattern to resolve over a longer period of time, the time frame for follow through is likely to run up against liquidity issues. Those two types accounted for, ranges will likely be the most plentiful. That said, you still need volatility and technical milestones of merit to make such technical patterns worthy of pursuit.
  12. Trump Threatens to Move Forward With Dec 15 Tariff Escalation, Considers Section 301 There have been a few critical developments these past few weeks that could have significant deescalated the daunting momentum of global trade wars. However, with each small improvement, we are met with an asterisk that could quickly undermine the good will as well as an alternative stab to weaken the outlook for global trade. For the US-China engagement, the White House backed off of the planned tariff escalation scheduled for October 15th after the countries agreed in principal on a Phase One trade deal. Now over a month since that relief, the two countries have not made any material progress. Sure, there have been bouts of optimistic rhetoric, but the enthusiasm has fluctuated back to cynicism just as frequently. Whether ‘confidence’ or warnings, market participants have grown increasingly ambivalent to the situation. What can carry greater certainty as we move forward is the threat of an escalation in the scope of US tariffs on Chinese imports scheduled for December 15th. It was presumed that if the countries were working towards a first step to ultimate resolution, this jump would be avoided. However, multiple administration officials suggested the pressure would not be removed for fear of the President losing support from his base in an election lead up and to discourage China from pursuing a strategy that is founded on a different US government this time next year. Another seeming miss on the path towards further economic disaster was the passage of the October 14th deadline for the administration’s decision on whether or not to pursue auto tariffs. That date was itself the deferment after an extended review. While the White House has not said definitively that it was laying the Commerce Department’s investigation to rest, many believe that the matter is behind us owing to legal questions if not strategic ones. The European Trade Commissioner stated her belief that the risk has passed. That said, I would not forgot that this uncertainty is still somewhere in the wings. In the meantime, Europe still finds some of its agricultural exports to the US under a hefty 25% tariff rate, deciding whether and how to retaliate – and knowing there is a WTO ruling to come sometime near the beginning of 2020. Adding another layer of trouble, there was suggestion from some close to the US government’s strategy that the a Section 301 investigation may take the place of the 232 in order to keep the pressure on the EU (and potentially other major trade partners) to capitulate under trade pressure. This evaluation looks into broader trade practices rather than specific sectors under a national security assessment. Recession Risks Slowly Recharge Back in August, fear of an oncoming recession had hit troubling levels. With a host of warnings by supranational authorities (IMF), central banks and even governments; search interest in ‘recession’ through Google hitting a decade high; and a surprising mainstream interest in the otherwise wonkish interpretations of the Treasury yield curves; it was clear that there was serious concern about the further reach of the already mature global economy. Yet, with a few disarming updates and a shift in favor towards more speculative measures, the threat seemed to deflate through the subsequent two months. Now, to be clear, the economic trouble never really vanished. The US and Europe are still in extremely tepid course of expansion, there are certain key countries (Germany and Japan) that are oscillating quarters in contraction and China is running its slowest tempo in three decades. Instead, investors, governments and consumers simply just grew larger blind spots. This past week, it was even more difficult to ignore the signs of trouble ahead. The OECD lowered its outlook for global growth yet again to its worst standing in 10 years. The 2019 forecast stood at 2.9 percent with the 2020 projection nudged down another tick to the same pace. That is itself troubling and indicative of skepticism that a recovery is ‘around the corner’. To ensure that the world does not simply hold course on its current mix of beliefs and dependencies, the group extended its outlook to 2021 with a disconcerting 3.0 percent pace. That more distant prediction, it was mentioned, was only possible if significant risks like trade wars and China’s economic struggle leveled out. Warnings like these have come frequently and just as readily overlooked (OECD, IMF, World Bank, etc); but data is a little more black and white. Just this past Friday, the November PMIs crossed the wires with a clear warning in their mix. The Australian, Japanese, German and UK overview readings were all in contractionary territory (below 50). The Eurozone figure slowed to just barely positive territory (50.3) and only the US improved in a measurable way (to 51.9). Some may consider that US reading an opportunity to pursue a further run in the country’s assets to relative return. However, it should be said that a single country – even the world’s largest – would not hold back to the crushing tide of a global economic retrenchment. That is particularly true when we consider the excess built into the system through investment, borrowing and public debt. Trading Against Risk Versus Holding a Position Through Quiet Complacency is a danger in the financial markets just as much as it is in life. However, there is far more threat when we throw caution to the wind and actively pursue a line that attempts to extract ever-smaller rates of return as the risk profile we must adopt to chase it grows larger and larger. The evidence of complacency is abundant. Record high Dow and S&P 500 are perhaps the most obvious and the most aggressively rationalized. Consider the performance of this favorite capital market benchmark should represent some combination of ideal economic trajectory and/or the greatest potential for forward returns. There is nothing of the sort on our horizon, but many are perfectly happy to live on confidence central banks and previously-unmatched stability in the speculative future – the preferred opiates of the masses. Other risk-sensitive markets are not pushing such extraordinary levels, but the steadiness is still a feature. Meanwhile funding pressure is starting to show up even in the US short-term – arguably one of the most liquid areas of the global markets – but the rise in the Fed balance sheet is again putting most at ease. Yet, when we consider these conditions without the benefit of a blind faith in the unique profile of our present market mix, there are plenty of obvious threats that we face: including the trade wars, economic struggle and stretch valuations mentioned before. There is good reason to be concerned about the fundamental landmines that we continuously weave, but my principal concern is not with what straw breaks the camel’s back nor how indicative of the big picture it may be. Rather, the real risk is the collective exposure that the masses have taken. Adding to leverage despite the underlying risks with smaller returns to cushion any unfavorable winds, raises the serious threat of a panicked exodus from the financial markets. When leverage is applied, the losses accumulate much more quickly. I maintain that the best single asset analogy to the present conditions is the speculative interest behind the VIX futures contract. The net position has pushed a record short these past four consecutive weeks…despite the measure of activity already standing at an extreme low of approximately 12 throughout that period. This is a profound lack of reasonable return against an enormous amount of risk and in extraordinary volume.
  13. We Have Unresolved Trade War Issues Guided by Rumor or Complete Blackout We closed out this past week to a broad swell in risk appetite. This enthusiasm wasn’t consistent for the global markets throughout the week, however, with most of the asset benchmarks that I follow for scope were struggling until the Friday pop. The exception to the rule was once again the seemingly impervious US equity indices. Whether you were evaluating sentiment for the Dow and S&P 500 through the week or the global bump on Friday alone, the popular justification seems to have been the same: improvement on the trade war front. Given its importance to the course of the global economy, the contentious trade relationship between the US and China was naturally a point of regular speculation over the past week. The announcement of a ‘Phase One’ deal by the two economic powerhouses was announced back on Friday, October 11th. Since then, there has been far more speculation and rumor than there has been tangible policy change. Perhaps the only concrete development since that hailed breakthrough was the deferment of the planned October 15th tariffs escalation by the United States. This past week, the balance of headlines was neither consistent in trumpeting improvement nor did it offer foothold for genuine progress. Concern that China was cooling on agricultural goods purchases and balking at enforcement mechanisms while demanding rollback on existing tariffs contrasted the cheerleader-like language from some US officials (Trump, Ross and Kudlow). It is hard to tell which of these headlines gives us the most accurate picture of this important economic relationships, but there is more consistency in the market’s interpretation of it all. Skepticism has set in some time ago and it only deepens with each week that passes without black and white terms for the Phase One deal for Presidents Xi and Trump to sign off on. As an aside, reports that a deal could be approved on the deputy level should raise concern. It suggests that it is not something the leaders would want their names affixed to; which should be a ‘win’ that they would want credit for, but would instead be viewed as either a more mediocre step or capitulation by both sides that could receive blowback by both constituencies. Keep a wary eye on the headlines for updates on this discussion as we pass implicit deadlines and the contentious explicit dates, like the December 15th increase of the United States’ tariff list of Chinese goods. Perhaps even greater a threat of volatility – or opportunity for removing risk – is found in trade spats the US is fostering with the ‘rest of world’. This past Thursday was the supposed deadline for the Trump Administration to decide on the Commerce Department’s Section 232 evaluation for auto imports. This was the deadline after a previous six month extension. Through the weekend, there was still no word on whether import taxes on foreign autos and auto parts would be implemented, avoided or a decision postponed once again. Should it be delayed or completely avoided at this point, it would likely offer little boost to sentiment, but a sudden implementation would certainly trigger a significant slump in the global markets. Another dispute to keep on the radar is that between the US and EU. We have received very little insight on how negotiations are going between these two developed world leaders, but we know the US-applied tariffs on imported European agricultural goods is sowing ill-will among leaders. Dow: Recharged Rally, New Plateau or Blow-Off Top Though there is always room for debate, the performance of the US indices qualifies as one of the most remarkable of the global financial markets this past week. While ‘rest of world’ shares markets, emerging markets, junk bonds, carry and other sentiment-sensitive asset classes were sliding for most of the week, the Dow, S&P 500 and Nasdaq were holding steady or even advancing. This is not an unusual disparity of late. While the performance metrics change depending on your starting point, as a general benchmark for year-to-date 2019, a rolling 12-month comparison or plotting from the beginning of the recovery after the Great Financial Crisis concluded (roughly March 1, 2009), we find the ‘US market’ pacing the financial system. Determining the source of this outperformance can give critical insight into whether the bullishness will continue for local assets and whether it can establish more reliable traction across the world and asset classes moving forward. There are some traditional fundamental measures that can referenced as sources of relative strength. The broadest measure of economic growth for the United States is certainly not roaring by historical standards, but it has held rather steady at its moderately expansionary tempo through the past years. That has in turn afforded the Federal Reserve an economic backdrop that allowed for rate hikes up through 2018 and offers some support for their stated intention to level out the benchmark rate range around 1.50 percent for the foreseeable future. A rate of return from the US offering a substantial premium versus most liquid counterparts while also having room to operate should future risks demand response is also beneficial. However, I believe much of this backing to this climb to record highs is based in sheer speculative appetite. Investors are willing to commit to their complacency, but they prefer to seek exposure where the progress is most consistent as that is where the greatest theoretical return would be made – while some may also justify their decision from a supposition of safety out of that climb. Sentiment is fickle. Sometimes it can bulldoze through troubling updates while others it falters at any supposed crack. I would not, however, consider it reliable when you must dramatically increase exposure in order to extract further value out of the deal. If we consider the US indices’ particular outperformance paired with the lack of tangible fundamental catalyst through Friday, that impressive bullish breakout to end this past week does not look nearly as inspiring. Sure, the Dow gapped higher to clear out one of the most congested periods in the past few years (measured as a nine-day historical range as a percentage of spot), but follow through at progressive record highs requires steadily greater conviction. Unless something more tangible – like the wave off of auto tariffs – occurs, a recharged rally is really low on my probability list. A plateau would likely depend on some ‘catch up’ in other areas of the risk spectrum while pull of risk rebalance will be a constant force. An Steady End-of-Year Coast for S&P 500 and Risk Markets Ala 2017? If the genuine fundamental backdrop isn’t improving to support a stretch higher in capital markets, the next best thing seems to be complacency fueled by a perceived reduction in risk. We measure risk in the volatility of the underlying markets, and it is in that assessment that we find another questionable perspective whereby we seem to be pricing in perfection. The VIX volatility index has slid back to a remarkably deflated level around 12, which is the approximate low back to October 2018. Even more impressive though is the realized (versus implied) measures of activity. The past month (20-day) realized measure of volatility for the underlying S&P 500 is the lowest since the extreme quiet registered in the second half of 2017 – a period of such quiet itself, that we hadn’t seen anything comparable to it in half a century. We have further seen other exceptional readings such as the longest stretch with out a back-to-back loss for the same benchmark in decades and an exceptional record of days with lower than 1 percent registered moves from close to close. It is in other words very quiet. With this quiet and the blatant complacency the markets have fallen back upon, it is easy to understand the efforts to ‘justify’ the next steps for a contentious climb. Reference made to the extreme quiet – and still-impressive progress – forged through the latter half of 2017 makes an appealing case study for bulls that may lack a more traditional foundation of conviction. There is another, more common point upon which investors may rationalize their interest in pushing their penchant for steady capital gains that can compensate for lost, reliable income through financial investments: seasonality. November and December are two of the most favorable months in terms of gains for the S&P 500 of the calendar year going back three decades for reference. Volatility also tends to retreat over this period which would add to that same incredible compression through the end of 2017. Yet, be mindful of the reassurances you are willing to accept to keep on extreme risk. Just as many market participants will remember February 2018’s explosion as those that recall the third and fourth quarter of 2017. What’s more, there is even greater appreciation as to the exposure that has built behind this controversial speculative perch. A record net short positioning in VIX futures has made it into headline news. So has the general leverage in risk assets across the system – even record debt levels for consumers, governments, businesses and central banks. Suspension of reasonable risk rules paired with great awareness translates into a market that is more likely to be flighty and prone to avalanche. By all means, take advantage of prevailing trends; but don’t blindly continuously build your risk profile for steadily deteriorating return potential.
  14. The Cost of Drawing Out Trade Wars, Even If They Lift As with most global military wars of the past, economic engagements exact a toll on the participating countries – and their peers – long after the ceasefire is struck. That is what we need to remember as officials on both sides of the table in the US-China negotiations offer rhetoric that attempts to keep local confidence buoyant. In reality, both governments are trying to walk the fine line whereby local consumers, businesses and investors do not abandon the economy while still resonating a toughness such that their counterparts feel compelled to offer greater concession to make the ultimate compromise. While both sides have done a fairly decent job of not triggering acute crises in their respective financial systems, there is little doubt that the economic pain is accumulating. On the US side, the slowdown in growth is unmistakable but it is isn’t nearly as severe as some of its counterparts – though the fact that so many large economies are on the cusp of contraction should be very concerning to the single largest as a representative of the global course. Nevertheless, there has been a far more significant drop in US trade health, sentiment measures have slid across the system and the President seems to be concerned enough to call out the Fed regularly for not pursuing negative interest rates – not the most encouraging economic signal. In China, the impact is far more palpable, which is far more concerning than it would be for any other country. There is a well established perception that the Chinese government has greater control over the economy – or at the very least the perception around it. Growth at the lowest levels in decades, manufacturing that is contracting and industrial production that has clearly been throttled is very concerning. It would be extremely naïve to believe that a trade deal between these two economies would result in a renaissance of growth for either, much less both. Diplomacy can change on a dime, but economic performance alters course over the span of months, if not quarters. The curb on spending and investing intent both through local and foreign interests would take time revive to a productive clip even if market participants were that enthusiastic at the theoretic tipping point (which they won’t be). What’s more, there are many other issues plaguing the global economy and financial system beyond this particularly costly tiff; and a solution here does not compensate for those many other lines of restriction. All of this said, ‘hope’ can fill in for the practical and keep speculative assets buoyant. It is when recognition starts to set in among the masses – and whether it happens before a deal is struck or it dawns that there is not enough lift at the signing – that we will see the greatest market impact set in. The European Economy We are due a heavy run of high-level economic updates over the coming week. While I will certainly keep close tabs on the third quarter GDP readings from Japan and Russia – the third and eleventh largest economies respectively – my principal interest will be in the overview we will be given for Europe. There are many Eurozone, European Union and European area economies on the docket scheduled to report last quarter’s performance. Collectively, Europe is either the largest or second largest economy depending on what body you are referencing. That said, there are serious concerns over the health of this juggernaut of influence as warnings from official bodies, both governmental and supranational, have indicated that there is a worrying probability that the region’s expansion stalls. If that were to occur, it is very unlikely that the world will be able to avoid the inherent contagion. There are quite a few economies on deck whose own growth will matter significantly to the collective including: Norway, Netherlands, Finland and a host of the Eastern bloc. However, my focus will be fixed on two major economies in particular: the United Kingdom and Germany. For the former, there is a lot for which needs to be accounted. The UK is the sixth largest economy in the world (according to the IMF), and it now doubt feels the receding tide that has occurred across the world. That said, the more unique issue of Brexit is exacting its own toll on the country. While the threat of a no-deal divorce from the EU has not been realized owing to two extensions of the Article 50 date, anticipation of the pain that could eventually come to pass is throttling intent nonetheless. The consensus forecast among economists is for the country to have grown 0.4 percent over the third quarter. Such a reading is necessary after the -0.2 percent drop in 2Q. If we continue to head down this course of soft economy, striking a fruitful deal as a best outcome may still leave us on a lackluster path. Anything less could spell a serious problem. Germany’s health is to some extent the counterpoint to the UK’s performance in the Brexit situation. Yet, as a signal for Europe and the world overall, its health can exert far greater influence for setting our global path. Forecasts for the fourth largest economy in the world anticipate a -0.1 percent contraction. That would secure a technical recession which is defined by the NBER as two consecutive quarters of retrenchment (the previous quarter registered a -0.1 percent reading as well). While there are caveats to such a reading – it would be a mild reduction, it is in seasonally adjusted terms, the government has anticipated it to some extent – there is serious sentimental baggage that comes with the signature of a ‘recession’. Don’t think of these troubling signs as isolated, when they are so widespread. The Markets are Favoring No Further Fed Rate Cuts Through 2020 There is rare agreement it seems between the capital markets and the Federal Reserve at the moment. Most can readily recollect that world’s largest central bank cut its benchmark interest rate range (by 25 basis points) three consecutive meetings in a row. They may not remember however that the group had believed before each move that no cut was in the cards. Such situations do little to bolster confidence in the institution, which is serious when forward guidance is the principal tool for the developed world’s monetary policy mix. That said, the market was quite certain that easing was necessary owing to a modest flagging of inflation, just a hint of wavering in labor conditions pushing decades’ highs an of course a little stir in volatility in capital markets. After that run of three cuts, though, the market is now pricing in a 96 percent chance that the Fed will hold next month in its final 2019 meeting and a 55 percent probability that they will hold at the current level through December 2020. The FOMC’s own Summary of Economic Projections (SEP) had a hike by end of 2020, but I won’t quibble that optimism. They are generally on the same wave length. Aside from the atypical convergence of policy authority and market participant views, the outlook is particularly remarkable because it reflect expectations of economic health through the foreseeable future. Clearly the Fed does not expect the US economy to stall, much less contract, otherwise they would offer more cushion through preemptive policy. For the market’s part, their outlook accounts for the GDP component but it also reflects the general complacency around capital markets. There is no shame among speculators such that they expect Fed support whenever ‘risk’ benchmarks like the major US indices start to retreat. There is a not-so-subtle connection between American investors’ assessment of economic health and the performance of the capital markets as they push further record highs. That is in turn an unsustainable connection. Eventually, markets have to ease and its girth is simply far too great for the Fed (or all of the major banks collectively) to offset committed deleveraging. Their weight is based in their ability to encourage enthusiasm among economic participants (consumers, businesses, investors) not shifting all liability onto their own balance sheet. Therefore, if the market takes another tumble, the natural response will be an assumption that the Fed will put out the fire. When it eventually becomes clear that the central bank is reaching the full extent of its capabilities to keep everything afloat, we will enter into a new, troubling phase whereby recognition of artificial extremes in speculative markets could start a fire sale that overwhelms the complacency and external buffers that have kept the peace for so long.
  15. Critical Fundamental Themes to Keep Watch For Next Week: Volatility Slipping Back into Habit of Complacency as Liquidity Fills [Indices, VIX] US-China Trade War – Beyond the Point of De-Escalation? [AUDUSD, USDCNH, Indices] A Climb in Risk Appetite as More Fundamentals Fall Away [S&P 500, Dow] Recession Warnings In the Market Converging with Those in Data [Indices, Yields, Gold] Monetary Policy Ability to Stabilize Growth, Markets [EURUS, ECB, Fed, BOJ, Gold] Politics Increasingly Core to Market Outlook [S&P 500, Yields, Gold] Natural Growth Versus Monetary and Fiscal Stimulus-Led Growth [Indices, Dollar, Gold] UK PM Johnson – Parliament Fight Over No-Deal Cliff on Oct 31st [GBPUSD, EURGBP, FTSE100] US $7.5 Bln in WTO-Approved Tariffs Threatens US-EU Trade War + General Auto Tariffs Back to November [EURUSD, USDJPY, USDMXN, USDCAD] The Threat of Currency Wars [EURUSD, USDJPY, USDCNH, Risk Assets] Gov’t Bond Yields and Commodities as a Growth-Leaning Risk Asset [Dollar, Euro, Yields, Oil] Specific Safe Havens: Dollar, Treasuries, Gold, Yen [Dollar, EURUSD, GBPUSD, USDJPY, Gold] Excessive Leverage / Debt in Public and Private Channels [S&P 500, Yields, Gold] US-China Trade Progress: The Boy Who Cried ‘Progress’ My favorite flawed, risk benchmark in the United States S&P 500 index jumped to a record high through the end of this past week. A technicians overview would suggest that intensity of a gap higher, a daily candle that opened on the low and closed on the high as well as the clearance of a long-term rising wedge top added considerable luster to an already momentous achievement. It wasn’t a stretch to assign this thrust – shared by most risk-leaning assets – to either a general state of speculative complacency or perceived improvement in US-Chinese trade relationships (I believe it is a combination of both). After a few swings in rhetoric this past week, investors were bequeathed a rare perspective of enthusiasm in negotiations into the weekend. The headline that charged bulls reported on Chinese sources remarking that the two sides had reached a “consensus in principle” on the ’Phase One’ deal. It is important that this perspective would come from China rather than the US. Beijing has been the most dubious of its counterpart’s intent and commitment since the Washington changed direction dramatically following the G-20 meeting where both sides seemed to have struck an accord. The reported breakthrough in this first stage deal would requires China to purchase US agricultural goods, open financial services markets to US companies and maintain stability behind the Yuan (ironically, what would be technical manipulation). On the other hand China requires the US to ensure it is dropping the planned tariff escalation – to encompass essentially all of the country’s goods – on December 15th. If we see this effort move forward, it would indeed offer a significant measure of relief. How would we judge a step in the right direction without President’s Trump and Xi signing on a finished plan? An official date and time for a summit would represent a tangible milestone for intent. Yet, as important as it is to ease back on the accelerator of growth-killing trade restrictions, we should not treat this as a wellspring of untapped growth. This is avoiding greater pain. To fully de-escalate, we would theoretically need to see the passage of the ‘Phase Two’ which would have far more difficult requirements to agree upon. Agreement would need to be found on intellectual property rights, enforcement, state run enterprises and the full reversal of the onerous tariffs applied to this point. That is a high hill to climb for two countries that are attempting to use their size and position to avoid capitulation. Against this backdrop, we need to consider just how much lift such a first step deserves for something like US equities where it is technically already pricing in perfection. A More Extreme Signal of Risk Appetite Than SPX Record: Record Short VIX Interest I am a considerable skeptic when it comes to the record highs the major US equity indices reflect. From a landscape perspective, the S&P 500, Dow and Nasdaq are significantly higher that global equity counterparts and pushing far greater excess relative to alternative asset types with a risk connection. While you could point to relative yield, an assumption of growth or perhaps an element of safety in US assets; it is more than a stretch to afford this degree of premium relative to counterparts. Furthermore, speculative measures are broadly running far afield of traditional measures of value. We would expect peak growth, peak earnings and/or peak yield to push record highs on capital measures. We are far, far from those milestones. Yet, here we find ourselves. That is the biproduct of speculative conviction/complacency, growing leverage, extremely generous monetary policy and no small assumption that fiscal support will offer a backstop should the other two nodes fail. Should these joists of risk appetite be truly tested, it is very unlikely to hold up. Yet, as we track the fundamental weather between economic health updates, trade wars and monetary policy effectiveness; we are also finding optimists latching on to familiar runs such as seasonal norms. We have entered the month of November whereby the S&P 500 historically averages a strong advance as volume drops. The November/December climb is one of the most fruitful of the year and is often associated to holiday activity and other year-end efforts. Yet, another seasonal norm that raises serious questions is the expected drop in volatility through this month. We are already at extremely deflated levels as investors grow incredibly sanguine on the increasingly discussed risks. To assume we will just ride out with prices of perfection and a horizon with nary a wave of trouble is simply impractical. To give a sense of just how extreme the expectations are in volatility terms, we can look at the speculative positioning on VIX futures. The securitized product of what was meant as a hedge has attracted aggressive trading these past years. At present, the speculative interests in the future market are holding a record net-short position on the volatility measure. That is despite being substantially deflated. That smacks not just of complacency but of outright hubris. Top Event Risk - for Volatility Rather Than Systemic Trend - Through the Week When you are looking for the biggest fundamental impact, it is best to find the systemic undercurrents that can strike a nerve for the entire market and thereby develop true trends. However, those measures are not always clearly directed and properly motivated, as is the case seemingly for the week ahead unless something comes out of the blue. That doesn’t mean however, that we cannot expect event-driven volatility for different currencies and regions’ assets. Here are the events that I think can carry the greatest impact and why through each day this week. On Monday, there are some interesting events like the UK House of Commons voting on its new speaker, but it is new ECB President Christine Lagarde’s first official speech in her new role that is most interesting to me. There is a clear rift at the central bank which either threatens to curb the aggressive support it has issued these past years or threatens to call into question the effectiveness of their efforts – that latter scenario may happen regardless. On Tuesday, I will be watching two key events: the RBA rate decision and US service sector activity report from the ISM. The Australian Dollar is a carry currency and it depends heavily on its comparatively higher rate of return to draw foreign capital – especially now when the health of China is called into question. If this group offers a mere escalation of the dovish rhetoric – and not even a cut, the Aussie Dollar has some pent up premium that can be cut back. Ultimately, the US services report is one of the most important indicators overall because it represents the vast majority of output in the world’s largest economy. The manufacturing sector in the US has contracted for four months and services has been keeping overall growth afloat; but it has been showing signs of wear. On Wednesday, we are due Germany factory activity which is a good proxy for this key economy’s malaise as well as plenty of Fed speak. My top event though is the earnings report from Baidu, the Chinese search company. This is an important business update for the economy (as with the likes of Alibaba and Tencent) which can offer a more reliable gauge of the country’s health than even official and private figures that relate directly. The Eurogroup meeting on Thursday will produce the economic outlook from the European Union which can tell us how one of the largest economies collectives in the world is doing from their own perspective – far more important than a BOE decision and economic forecast which is constantly snowed in by the Brexit uncertainty. On Friday, Chinese trade will be a figure to watch, but I won’t hold my breath for volatility. Instead, the US consumer confidence figure from the University of Michigan can leverage bigger moves in US speculative markets given how aggressively they are priced.
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