Weekly Inflated Opinions – #2

Our new weekly post – all our comments and views summarized and reviewed on a Monday morning.

Every week we will summarize our thoughts from the previous week, employing the following format;  What we thought (going into the week), What happened (during the week) and What changed for us. Enjoy……………………………….

What we thought

After a tumultuous week,  our thoughts could be summarized as follows;

Coming into the week, we felt there was little to worry about apart from the worriers themselves. The ubiquitous “chicken littles” have had more than their day and say. It seemed to us, that markets had positioned themselves for the worst, and hoped for the best. While far from mega-short risk assets, there were enough shorts to be squeezed on any good news.

1. We remained convinced we’d see further repair in major stock markets – perhaps new highs briefly – into year end, but recognized that even now, major stock markets have gone nowhere this year, on most time-periods of measurement.
2. Even the other Central Banks – ECB and BoJ – who are tempted to tinker, remain in “twerk” mode – preferring to shake it entertainingly, rather than actually change policy. This will of course get more difficult for both over time. Next year we will see the “race to replace” Draghi at the ECB, which will obviously require the inevitable verbal macho-talk of being tough and prudent with monetary policy, an attempt to sound more Teutonic than the actual German candidate. Similarly, with the Fed still “uneasing”, the BoJ will be challenged to adjust their yield curve strategy but should find it easiest to just remove the negative policy rate and allow the whole yield curve to shift up 10-15bps, then baton-down the long end yield structure (via purchases on bonds) to prevent crisis.
3. Expect next year to be a lot more about non-US themes, as the global multinationals are finally brought under control and policy uncertainty shifts to the ECB and BoJ. Again, a theme we will explore in a forthcoming post.
4. Therefore, in our minds, Brexit remained the only serious risk for contagion. But even there, only an accident should prevent the path of least resistance resulting in #MeRef2. So even there we see a far from apocalyptic result. Some worry that the Europeans have to agree to allow the UK to have a “do-over”, facing a decision from the European Court of Justice, but we’re confident that another referendum will suit their pallets as much as the UK.

What happened

There’s always a lot going on in a week, but in a few months time, there will be only one or two events markets remember, and one or two things they wished they’d paid attention to at the time. In that spirit, this is our review of a very long week.

G20 became Gee-wizz – after the weekend where G20, or at least US/China factions suggested that each side thought the other side had agreed to something, the consequent squeeze fooled the moving average followers that the bull was back, only to fade into Tuesday. After the pause for GWH Bush’s funeral on Wednesday,  markets were greeted with the ultimate head-fake – the arrest in Canada of Meng Wanzhou, CFO and daughter of the founder of China tech-jewel Huawei. Aledgedly on charges related to breaking the Iran sanctions before they were removed (and subsequently re-enacted), to most this looked like a sideswipe by a duplicitous US administration only days after a victorious trade “deal”.  Stocks duly collapsed several percent on Thursday. There were other tea-leaves in the bone china which pointed to disaster, the most ubiquitous being the “rarely watched” yield spread between 3yr and 5yr US Treasuries bonds. Obviously any yield curve inversion looks like a wolf to the chicken little sheppard, but this one had its day once the US justice department had made their extradition request. To add fuel to the fire, oil prices had been threatening to collapse too, until OPEC came to the rescue with an intended target 1.2mbpd production cut (so that was what the MBS/Putin high-five was about). Then just to cap the week, the US labor data was soggy and while virtually every one of those numbers would have been greeted with acclaim only 2 yrs ago, they now point to recession. With such soggy data,  the sound of a Fed governor being trotted out to sooth the ailing market surely helped. Oh and the French are revolting again.

Of all that, the things we’d like to focus on are the following;

US/China relations on a Huawei to hell? 

Nope – we stick to our view that this is still kabuki, well choreographed WWF-style wrestling, designed to serve the domestic agenda of the two leaders.

Trump left G20 with a dubious “win”, and given the setbacks in the midterms and growing unease as the Mueller investigation heads for its “series finale” – sure to be a cliffhanger – he needed a fillip. That said, the administration advisers were far from clear on whether POTUS had been briefed before the arrest, but suffice to say, the China-hawks on both sides of the aisle in Congress loved it. And surely the Chinese are outraged! Their ambassador has had to cancel all leave and sharpen his diplomatic pencil. Well actually no. Alongside the typical diplomatic outrage, we see the Chinese trade delegation to US sticking to their flights. So why would President Xi approve of this outrage against one of China’s jewel in the tech crown companies? Well firstly, there is the company itself. Huawei is so far ahead of the game, especially in the race for 5g, that it scares people. This excellent MIT article details some of the reasons Western surveillance services are bothered. But the idea that China has full control over a private company with enormous tech advantage may not be as certain as it seems. Xi has had quite a fight against corruption and ever more powerful “princelings” and one wonders what he makes of this dynasty behind Huawei. It’s hard to find out very much as a foreigner googling, but this article gives some idea.

In it, I stumbled across this picture – it’s the Huawei founder and father of Meng, Ren Zhengfei, and President Xi.

I wondered what the two were talking about. And while it’s just a moment taken out of context, it didn’t strike me as a picture of old friends sharing a joke. 

Then of course there is the other tech jewel – ZTE. One wonders if, had the Trojans smelt a rat and threatened to send the first Trojan horse back to the Greeks, only to find it was empty after all, would they have been so discourteous with a second?

Markets – Maybe all we have to fear is the fear-mongers themselves

The second facet of last week is the almost self fulfilling fear that’s over taken markets. For sure there are visible debt-avalanches sitting just above QE-lofted markets and the start of prolonged QT together with a Fed that doesn’t know when enough is enough and the end of the sugar-high from the tax cuts, makes collapse inevitable. 

Or does it? We think not. Expansions don’t die of old age, but they sure as hell die of depression, especially self administered. Take this chart showing how the recent price action resembles that of 1987.

While history might rhyme like a Freddie Mercury song, it rarely repeats. There have been very striking bubbles that have rhymed beautifully in their price action recently – Bitcoin and Netflix come to mind. But major stock indices have not. 

In our opinion they have simply churned market capital and sentiment, as we’d suggested they would at the beginning of the year. And even after 800 Dow point falls, remain in touching distance of their levels at the beginning of the year. 

So what could possibly go right? Well, as you’ll see below, the ECB and Brexit for a start, leveraged by a realization that once again the “reflation trade” of earlier in the year has not only failed, but wasn’t about the reflation of inflation anyway. To our keen eyes, inflation indices in the US and Europe are set to head lower into next year, taking the pressure off, and removing the excuse for, further central  bank withdrawal. And of course, the Chinese delegation could show up to discuss market opening. 

Brexit – May Day May Day – rinse repeat.

We have to discuss Brexit – and we can summarize a lot of noise by saying that nothing we saw last week swayed us from the conviction that a second poll is inevitable.  That said, our chief worry is that the path that outcome may be fraught with danger. The Government could fall. We find no comfort in the words of those that confidently suggest this party wouldn’t risk the loss of its mandate – having achieved almost that only a year ago. Secondly we worry that the way the second vote is awarded to the populous may be badly handled, leading to significant social disorder. Those denying such risk have forgotten the murder of MP Jo Cox and have missed the yellow-jacketed news from across the Channel. But apart from that, we feel that once the endpoint is obvious, financial markets will breath a huge sigh of relief. 

So what did we see that we felt markets have paid too little attention to?

The privilege of liquidity. Markets which remain liquid enough to offer an exit (or entry) should the need or desire arise, moved most last week. They moved a lot, awoke the volatility and standards deviation scorers, and got all the headlines. To us these are the markets to worry about least. Most of the move in euro-$ rate futures seemed to be old shorts exiting, and while new longs entered, we think open interest fell. Now they rightly point to a Fed pause next year – NOT a cut. No, to us, it’s the markets where liquidity is a mirage and prices are the palm trees in the middle of the mirage, that one should worry about. So far there has been precious little liquidation in credit markets, except for emerging markets, and even in the ETF space, the pressure seems low. One move that reminded us of the debacle of Long Term Capital 20 years ago, was the incessant widening of yield spreads of off-the-run Treasuries relative to the on-the-run benchmarks. Early days, but if liquidations were forced, rather than voluntary, liquidity will become a prized privilege.

What changed for us last week

Firstly, there are several things to look for this week, arguably the last week to do anything in financial markets before the holiday freeze starts to take hold of market liquidity.

We have Monday’s market opening. After such an awful market response last week, one is tuned to the ticker as we re-open, especially as the Wednesday pause for the funeral of GWH Bush was hardly refreshing. We’d be surprised if the ECJ decision didn’t follow their AG’s advice. 

Then we have “the vote” on Tuesday . UK Parliamentarians get the chance to decide (and decide they will, despite and question marks over the vote last week – see here) the fate of PM May’s withdrawal agreement – the “deal”. As well as settling the fate of the deal, the vote will likely settle the fate of the PM too. From our perspective, we remain convinced the deal is unworkable, and as such will be voted down. Then we can see several paths, some quite unpleasant, all leading, like Roman roads, to a second referendum. We’ll write more on that in a subsequent post.

Then, almost as crucial for markets, is the ECB meeting.

We think most have forgotten how significant the earlier meeting was 6 months ago – the last flight of the easy bee – and how it started the summer-long rise in major stock indices. This one is no the less important, as the ECB rubber stamps it’s already planned end to QE. But as we wrote in the earlier note, this is missing the point.

Firstly, if as we expect, the ECB flag no willingness to raise interest rates before Draghi leaves next winter, markets will have dodged another inconvenient truth. But much more important is the reinvestment program. We wrote “Those focused on the “quantitative tightening” of ending asset purchases miss an important point. The Fed used “reinvestment” of maturing assets to “smooth” the stimulatory impact many quarters after their purchases came to an end. Why does this matter ? Because the Easy Bee can buy longer dated bonds of countries struggling with short term solvency, preventing a funding crisis.  Some will argue they might be prolonging the agony of the bankrupt, but first they will prolong the agony of the speculator….”

In our minds, those words still hold true, and with the EU leaders also meeting on thursday/friday, having to sit uncomfortably on the budget fence they have built around Italy (and others) the knowledge that the ECB remains ready to help Italy through any funding challenges next year should be discomforting to the bears, if not as comforting to the bulls. If May loses on Tuesday, any mistake made by either the ECB or the EU heads of state, would surely be viewed in the spirit of that made by the ECB in the summer of 2008.

All in all, we remain convinced that major stocks can just as easily ride a short squeeze to new highs as plummet 1987-style.

For that reason we prefer the sidelines, feeling that risk taking is only for those with need rather than opportunity. 

Semper fi until next week.

 

NB – these are the (inflated) opinions of the author, and are NOT investment advice.