In our note on May 1st, we said that 'Sell in May' this year may turn into 'Buy in May,' driven by re-risking of volatility targeting strategies, trend followers, and a significant uptick in buyback activity. In the following 2 weeks, the market rallied ~5% on virtually no positive news. Given that the average historical return for the month of May was -0.3%, the seasonality trend was clearly broken this year. While Nasdaq and Small caps proceeded to reach all-time highs, the S&P 500 stalled in the second half of May in the 2700-2750 range, as it was negatively impacted by the re-emergence of market-damaging trade initiatives (see below).
Our view is that the re-risking is likely to continue during the summer as volatility stays contained and investors increase equity positions. Volatility is likely to be contained due to summer seasonality, dealers' long convexity positions, and lower correlations after a large spike in Q1. Investors' exposure to equities is still relatively low. Systematic strategies de-risked on account of the high realized volatility in Q1 and discretionary investors de-risked on account of various macro fear narratives (including inflation, 10Y >3%, trade war with China, Syria/Iran, Emerging Markets, PMI slowdown, Italy, dollar, quantitative tightening, etc.) and, despite the recent rally, have not meaningfully re-risked. For instance the HFRX global hedge fund index beta to equities is at its lowest point (0th percentile) in 5 years (and 11th percentile over the past 10 years). Foreign investors pulled money out of US equities in March due to trade war concerns, which resulted in the largest outflows since 2015 (Fed TIC data), and ETF and mutual fund inflows in Apr/May have only recovered half of the outflows from Feb/Mar. Recently, the market is showing more resilience to various political risks and some of the US outflows may revert given the recent negative political developments in Europe. The large YoY increase in buyback activity also continues to add support for equities.
Focusing on the equity exposure of systematic investors, we look at volatility targeting, a widely used portfolio risk management approach. We surveyed over 500 institutional investors at our NY Macro Quantitative and Derivatives Conference last month, and found that 71% of these investors use some form of volatility targeting. When volatility goes up (such as in February and March) these investors sell equities, and when volatility goes down they buy. An important question is which volatility measure is being used to time the market. The same survey found that 43% of volatility targeters use relatively fast signals (shorter than 3 months), 24% use 3M-6M signals, and 33% use signals slower than 6M. Faster signals were already prompting some re-risking in May and June (e.g., 2M volatility recently declined by half, but is still twice the January level), and this will continue during the summer with the addition of slower signals that will also start to re-risk.
Trade wars
In 2016, we argued that the probability of Trump winning the presidency was higher than the consensus and that it would likely be positive for equities. This double out-of-consensus view materialized as the new administration enacted pro-market policies such as tax reform. However, since this March, the impact of trade and protectionist policies became a significant market headwind. It is a broad consensus across academia, business leaders and market practitioners that trade wars and protectionism are a lose-lose economic proposition. Earlier in March we argued that the current administration cannot afford a disruptive trade war that would destabilize equity markets in an election year. While we still think this is true, trade tensions continue to inflict damage to investor psychology and business confidence. A negotiation strategy that includes bluffing/threats can be successful in a two-party negotiation setup, but is more likely to deliver self-defeating results in a complex system such as global trade (e.g., think of supply chain disruptions, the uncertainty it introduces in long-term planning, etc.). We have attempted to quantify how the market value was impacted by trade war policies since March. By attributing the trade-related news flow (positive or negative) to the performance of the US market, we estimated the impact on US equities to be negative 4.5% (with a margin of error of +/-1%, Figure 1). Taking the current market capitalization, this translates into $1.25T of value destruction for US companies. For a comparison, this is about 2/3 of the value of total fiscal stimulus. The value destroyed by a trade war might be reversible if policies are reversed, while the positive impact of fiscal measures is likely to remain. This would likely catalyze a ~4% market rally. However, if this uncertainty hangs over the market for a more extended period of time, the damage becomes more permanent and the probability of a disruptive tail event increases.
Figure 1: Market impact of 'Trade War' policies Source: J.P. Morgan QDS.
Figure 2: DM-EM and EM country correlations are near decade lows; Left inset: EM on the verge of breaking 50/100/200d moving avgs Right inset: EM performance is correlated to US inflation Source: J.P. Morgan QDS.
Value in Emerging Market Equities
Immediately after the presidential election in 2016, we argued that the impact on USD would be negative and the impact on Emerging Markets positive. By the beginning of this year, DXY index was ~10% lower and EM equities ~40% higher (in USD terms). Since April, almost half of the DXY drop reversed, and EM equities dropped by 10%. Investors are increasingly asking whether EM equities are at the brink of a new crisis or present an attractive buying opportunity. First we want to note that the narrative behind the consensus 'weak dollar' view from the beginning of this year did not change - the issues of the high US fiscal deficit and protectionist policies that historically led to a weaker USD remain. In addition, the last Fed minutes reveal an incrementally dovish shift (symmetric inflation target, remarks on level of neutral rate, etc.). After the reduction in speculative dollar shorts, which boosted the dollar and negatively impacted EM, it is not clear why there would need to be a continuation of the USD rally that threatens Emerging Markets.
The correlation within EM equities as well as the correlation between EM and DM equities is near the lowest point in a decade (Figure 2). This makes EM equity exposure attractive from a portfolio diversification perspective (e.g., the correlation between EM countries is now lower than between DM sectors). The low correlation between EM equities (countries) also suggests there is currently no systemic EM pressure build-up, such as the one observed in 2015. Since peaking in 2007, Emerging Market equities are down 15%. Not only have they never recovered from the great financial crisis, but they are trailing the S&P 500 by over 100%. If one believes that global growth will continue, there is the potential for EM equities to close some part of that large gap. Given the close correlation of EM equities to US inflation (Figure 2, right inset), they can also serve as a portfolio inflation hedge. Finally, over the past year, we noticed a trend of CTA strategies including smaller and less liquid markets such as EM equities. The current momentum of EM equities is negative, indicating that this market segment is shorted by these investors. However, we note that various momentum signals are all aligned, and a relatively small move up could result in a rapid change from negative to positive momentum, prompting trend followers to close shorts and go long. For instance a ~1% move higher would at the same time breach 50d, 100d, and 200d moving averages, leading to short covering and inflows (Figure 2, left inset).
Given my reservations on some of the characteristics of this up leg -- panicky, narrow concentration, lack of concern about the ending of QE, Deutsche Bank and higher interest rates) since last week, I am raising a portion of my short sell stop in the SPDR S&P 500 ETF (SPY) to $275.50.
Yesterday it was retail on fire. Today it is banks on fire in the market without memory from day to day. This daily intensity of leadership strikes me as panicky buying and could be another warning sign.
Position: LONG BAC large C large WFC large JPM large
I have sold the balance of my Macy's (M) long at $40.40 just now. I placed M on my Best Ideas List only 7 1/2 months ago at $19.39. It has been a wonderful parade. But, all parades end.
I plan to reduce the size of my Macy's (M) long position from medium- to small- sized today, given the rapid climb in the share price and the reduced reward v risk.
The ten year US note yield is up by four basis points (to 2.96%) - likely in response to higher rates in Italy (see Peter's comments) and Germany. Should help my fav sector, banks.
Peter Boockvar on trade and productivity (I don't think the numbers are market moving):
The April trade deficit narrowed to $46.2b from $47.2b in March. That was about $3b less than expected and as a result should lead to a rise in Q2 GDP forecasts by a few tenths. Exports were up .3% m/o/m to a new record high, helped by our new energy export business, while imports fell by .2%. The possibility of and now implementation of some tariffs will filter thru in coming months and quarters but for now the dollar numbers are low. That said, the uncertainty created is being felt as many businesses and industries have expressed tariff trepidation in the most recent confidence surveys.
To this last point, Brown Forman, the producer of Jack Daniels and which Tennessee whiskey is now on the Mexican tariff list, today said in giving its 2019 outlook said that in part due to "concerns over potential retaliatory tariffs on American spirits" it is "difficult to accurately predict future results." I am not an expert on Mexican liquor habits though so I don't know how much Jack they drink.
20 yr view of US EXPORTS
Somewhat dated because we are 2/3 of the way done with Q2, Q1 productivity was revised down to a .4% q/o/q annualized gain from .6% initially. This lead to higher unit labor costs of 2.9% q/o/q annualized, the most since Q1 2017. Looking y/o/y, productivity was still up 1.3% y/o/y which continues a better trend, although more work needs to be done. Unit labor costs were also up 1.3% y/o/y. I believe the time of higher wages is upon us and in order to protect corporate profit margins, a greater rise in productivity is going to be needed.
Smart move by Twitter (TWTR) into this week's S&P add. The company is selling $1 billion of subordinated convertible notes. I expect the shares to drop by -$1.00 to -$1.50 today even though there is incremental demand from the S&P add. Twitter was placed on my Best Ideas List at $15.75 fourteen months ago. The stock closed at $39.80.
Peter Boockvar says the ECB story was confirmed today:
Italian bonds are weaker again with the 2 yr yield up 17 bps to 1.18% and the 10 yr yield is up by 6 bps to 2.85%. There is not however any flight to safety in German, French, UK and US bonds because of the response to the story yesterday that June was a live meeting for the ECB in terms of discussing the end of QE.
The ECB Chief Economist Peter Praet confirmed that story today by saying "It's clear that next week the Governing Council will have to make this assessment, the assessment on whether the progress so far has been sufficient to warrant a gradual unwinding of our net asset purchases." The recent inflation data out of the eurozone puts pressure on them to do this and the euro is rallying today for a 2nd day. Another council member Klaas Knot is more specific, "It's reasonable to announce the end of the net asset purchases soon."
I'll guess that they will taper again in October with an eventual end by year end. The volatility in the European bond market I believe has just begun but I don't think that should surprise anyone considering the microscopic yields seen in the region.
Not surprisingly with the rise in stocks, market sentiment has gotten more bullish according to II. Bulls rose to 52.9, the highest in about 3 months, up from 50 last week. Bears fell 1.5 pts to 17.7, the least since late March. II said "Skeptical editors appeared less willing to defend their outlook." Again, sentiment always follows price and the spread between bulls and bears is getting stretched again, although not yet to where it was back in January.
Thanks to a 9 bps w/o/w decline in the average 30 yr mortgage rate to 4.75%, the lowest since April 20th thanks to the US Treasury rally over the past week (though which has now reversed itself), mortgage applications bounced after a month of declines. Purchases grew by 4.2% w/o/w after a 7.5% drop over the previous 5 weeks. They are also up 9% y/o/y. Refi's were up by 3.8% w/o/w but still down 17% y/o/y.
At least for now, instead of getting trade deals done with the stick of steel and aluminum tariffs, we have instead invited tariffs back on us. Yesterday Mexico said they were putting 25% tariffs on cheese, steel, and Tennessee whiskey and 20% taxes on pork, apples and potatoes. The value totals around $3b. Today, the EU said they will initiate about $3b of taxes on US exports. Last week Canada said they were implementing about $13b of taxes on a variety of products. These dollar amounts are modest in the scheme of a $19T US economy but I thought the point of our tariffs on them was to get them to negotiate with us but instead it's just inviting more tariffs. Let's hope this stays under control.
We've seen a few emerging market central banks raise rates to stem the declines in their currencies which is tinder for higher inflation. Today, India joined the club with a 25 bps rate hike unexpectedly. It's the first rate hike in 4 years and it did help to rally the rupee. The hike came with one hr to go in the Sensex trading and the index initially fell but bounced back.
In Japan, regular base pay rose 1.2% y/o/y for a 2nd straight month in April and that is the best rate of increase since 1997. The BoJ is finally getting what it wants but unfortunately they want higher inflation too which offsets the wage gains. Bonus pay did fall almost 10% but after jumping in the two prior months. JGB yields did rise in response but the yen is weaker which helped the Nikkei rally about .40%.
* Be alert to a change in the market * It could come fast
"Yesterday a child came out to wonder Caught a dragonfly inside a jar Fearful when the sky was full of thunder And tearful at the falling of a star And the seasons they go round and round And the painted ponies go up and down We're captive on the carousel of time We can't return we can only look behind From where we came And go round and round and round In the circle game..."
Ever since The Great Recession in 2007-09, large macroeconomic factors have shaped asset prices.
Early on, quantitative easing in the U.S. and then around the world drove both equity and fixed income prices higher.
The speed of market reaction to macro events like the debt crises in Greece and most recently in Italy, the Brexit vote, geopolitical developments, the surprising election of President Trump and the reduction in corporate tax rates became compressed in time -- in large measure because of a changing market structure (as the role of passive ETFs and quant strategies - volatility trending and risk parity, etc. - began to dominate trading).
It is for these reasons and others it is important for short term traders and even short- to intermediate term investors to be tactically prepared to react quickly to macro developments.
It is especially valuable to be prepared for change in a maturing global economic recovery and a near 10 year Bull Market. And, of course in a flat and interconnected world the cumulative impact on the real economy is immediate and sizable.
Defense against abrupt changes may include:
* Higher than normal cash reserves * A diversified and liquid stock portfolio * Low priced downside protection
Just some brief thoughts on a lazy Wednesday morning.
Back To The Markets
"The market's momentum remains positive though it is increasingly selective.
We are in a brave new investment world, one that is dominated by machines and algos - who are agnostic to balance sheets, income statements and private market value. As such, I am trying to adapt and to hold, given an investment mandate of delivering alpha, by taking advantage of what Mr. Market provides us rather than what we believe "should be."
However, for the multiple reasons mentioned in "The Hotel Europa", I believe the outlook for the markets in the second half of 2018 is poor.
In other words, though currently long, my finger is on the (short) trigger - watching patiently for a change in price momentum."
