Wednesday, 21 February 2018

GRReat - the Global Risk Repricing

First a recap -

10 days ago -

My best case is that no narrative can be ignored and all have their strengths.  But instead of them each being a separate diagnosis of different potential diseases they are all symptoms of a single greater one. They are all building into a great big superstorm of grief encapsulated in a super-narrative

Inflation, corrections, a spike in volatility (really an increased cost of insurance), problems in leverage, US bonds, problems in risk parity, China sell-offs, Junk bonds sell off, aren’t all separate but are all part of the same single story - the new super-narrative of ‘The great global risk repricing'

A sudden spasm of awakening to true risks may now be underway.  For years we have been saying that credit is too cheap and that junk bonds are way too expensive and that leverage has been practically free. I hate to hark back to QE, as we know that it has spawned a rash of ridiculous pricing, but this, folks, could be the big one with regards to waking up and smelling the coffee. Free money does not mean any risk.

This reassessment of risk perceptions can also include US Treasuries. If there is a chance that they are no longer the ultimate safe haven then the schism would have dire consequences for the stability of current investment theory. No, I am not saying that US Treasuries aren’t safe as houses, I am saying that all you have to have is people questioning them for problems to kick off as soon as Monday.

And that is why waiting for bonds to go up to know if this is over is all the more important, If they don’t then it is really bad news.

Currencies have worn this move fairly well. Yes, they have moved with the classics like AUDJPY doing the risk off thing, but considering the size of the equity moves they are hanging on in there. Most notably,  the popular position of short USD hasn't really seen much of an unwind but it should be considered as part of the short UST trade. This is not about rate differentials anymore, as we have seen the divergence of rate differentials vs FX widen for the past few months, but about underlying trust in the US to manage its affairs. It's part of the risk adjustment as the US and USD have moved a notch right along the scale between Switzerland and Zimbabwe.

So what do we do? the trader in me wanted to buy on Friday, so I did, but the pragmatist thinks this is far from over.

And then 7 days ago - Shorting the CPI and being stopped out. 

I have to say that today was a hero to zero day for me in equity land. I played the CPI figure perfectly as stocks decided that the inflation story really. really is a concern. Until it isn't. And that ‘until it isn’t’ occurred about 15 seconds after maximum 'it is a really, really big concern'. That was when perfection vanished in a puff of humility and the ‘natural bounce up off the lows'  spent the rest of the day grinding higher up to new highs.

I am not too shy to own up to the stock shorts costing me money. I hate grinds, they are worse than sharp moves mostly because sharp moves engulf your emotions in one hit, whilst grinds tie you naked to a chair and beat your bits with a knotted rope until you are finally put out of your misery by the pistol to the head of a stop loss.

But I JUST KNOW that  US stocks will now tank. But if I don't understand why equities are going up then I must get out. Understand? That where your narrative fits whatever it is you want it to fit, but unless someone takes a 3ft pipe bending machine to the current narrative of ‘it’s inflayshun innit’ to make it fit with today’s moves then I am afraid this narrative is broken

We are getting through narratives faster than plates in a Greek restaurant.

Since then.

I licked my wounds until Monday when I started shorting things again. I couldn’t bear to think about missing the big dump. Why Monday?

Momentum was fading and we had just had a new narrative on the block - Double deficit. The double-deficit was the next big thing. But double deficits are like herpes to many countries. Many have them but are mostly unnoticed. They are a pain and you don't want to give them to anyone but the worst they normally do is sting and everyone points, rings bells and shouts ‘unclean!’.  But when something else comes along they fade away into the background to reside in the ganglion of government statistics. A double deficit? How quaint.

We can have double deficits narrative and we can have inflation narrative and we can combine them in a theory of the US crowding out, but to combine them requires something to happen - risk assets have to reprice lower and the overall discount rate applied to US assets has to go up to compensate for future USD depreciation. Meanwhile, a bit of risk premium creeps into apparently risk free assets.

Now the inflation narrative is only supportive of stocks and commodities and emerging markets if it’s cost-push inflation. In this scenario, short end rates rally a touch as Fed lags as it is cost driven. But if the inflation is demand-pull inflation we have a different position as the Fed will tighten faster, real yields will go up, bear flattening the curve and stocks will fall as the market starts to worry about a potential recession from a potential Fed over tightening.

So we have both inflation and double deficit - stocks down
Cost-push inflation - stocks up
Demand-pull inflation - stocks down

Two out of three are down for stocks.

Today the Fed showed their hand and stocks fell.

And now?

I am hoping that the narrative will now find some clarity, but I am still very aware that this narrative is US-centric, yet major panicky moves are always contagious. So I am constantly watching everything else.

Europe - It’s a bit sad we have had the Brexit vote in the UK, not because of the result but because of the shading, it has put on the reporting of Europe. In the salons of London, it is considered terribly bad form to point to concerns in Europe because having declared an avid will to remain in the EU casting criticism on anything European is seen as handing sharp object s to the leavers.

The AfD is rising in popularity in Germany (I read something that they are now the 2nd most popular party).  Italian elections are on the way and have all the hallmarks of doing a Brexit/Trump in providing a ’shocking' result as the concerns of the basic voter are dismissed as socially incorrect and troubles shuffled under the official carpet.  Greece has just failed to get its latest round of bailout money, Ok, they will but it is a reminder that the new glass tower of the European economy is built upon the limestone caverns of past debt mismanagement and a sinkhole could open up at any moment.

Back in 2016, I think it was for my ‘thoughts for 2017', I suggested that Europe problems could be obscured as long as economic growth kept everyone happy. This is what we have seen. The concept of default risk has evaporated and even Italian banks have been able to offload what was previously considered as toxic waste under a new wrapper of 'high yield' to private hands. Let's also not forget what Portuguese government debt is yielding. Less than US treasuries the last time I looked - now there IS a changed narrative.

But I can’t forget what is out there and how every thread of favourably reassessed credit risk leads to the door of the ECB.

The concentration of credit risk that has flown into the ECB is stupendous. Of course, it isn’t default risk because the ECB can QE until its heart content. But how content will that heart continue to be when Draghi is replaced by Darth Weidmann, commander of the Bundeathstar. I saw comments that the SPD approved of his appointment. That’s not a story. The story would be if Syriza approved of his appointment. He is a very clever man to move onto that throne under the cover of a benign economy, but even today the PMIs of Europe began to disappoint.

We tend to look at whatever is the current issue with respect to the world rather than in balance with the rest of the world. When the EU has a crisis, it’s just an EU problem and the US is just fine. When Britain has a Brexit wobble then it's Britain's wobble and the EU is just fine. Rarely are the comparative strengths and weaknesses observed and considered. One part of the equation is anchored whilst the other is considered the variable.

But maybe it isn’t. We think this a US-centric issue in the markets but we must watch out and be impartial in our judgments. Though we have global growth masking other problems, once the problems arise, global growth can collapse.

I am still playing the macro short on risk but am desperate for low-risk yield. I just think that all risk is priced too low as we enter the Great 'Global Risk Repricing’ which I hereby copyright as the GRR. Grrrrrrr indeed.

When it occurs the central banks are going to have a knife edge to walk between loosening, to counter the restrictive function of higher risk premia and tightening, to counter the inflationary effects we are already seeing. As they say with great comedy. "the secret is in the t t t timing",

If they get it right, they won't have to do anything as tightening of risk premier does their job for them. GRReat.

But the risk rolls on.


Anonymous said...

My tool for "low risk" yield is 2x leveraged ETN's tracking high yield indices specifically MORL (smallest in this coz interest rates effect on Mortgage REITs) CEFL will add more on declines, SMHD equity exposure but beware high mortgage REIT exposure overlapping with MORL)

These are low risk as I define it as while the risk of total/near total loss is greater than even an ETF, at these yields I will have covered my initial cost ~ 5 yrs and the risk on the downside is not necessarily 2x - there is a degree of asymmetry here. MOST IMPORTANTLY it allows me to generate a 3% total portfolio yield with around 15% of my capital invested and the remaining 85% as dry powder/able to invest in something that might hold against inflation better than 3% yielding treasuries. Volatility decays is theoretically a factor even with these ETN's 1xmonthly reset. but maybe not in practice.

Should I decide that I want long market exposure I am looking at 3x leveraged QQQ ETF TQQQ as for every $33.33 I invest I get equivalent exposure of $100 in QQQ which tracks the performance of $100 of QQQ on the upside but a 25% drop in QQQ in absolute terms would mean a $16.67 loss (50% of 33.33) vs a $25 loss in 100k of QQQ. Again, asymmetric on the downside. If a situation causing a 25% drop in QQQ is not too cataclysmic I have $66.66 left with which to double up or invest in QQQ. Note I am aware the 1% fee is a huge drag LT. Daily re balancing seems on examination to not be the decay generating factor it initially appears to be.

Note a key risk mitigator is less cash used and thus exposed top loss than with unleveraged but % greater losses and also greater chance of total/near total loss.

To those who will @me, I am well aware what happened in VIX ETN's but welcome any knowledgeable pointing out of where I am in fact the greatest fool in the market after all.

Anonymous said...

but a 25% drop in QQQ in absolute terms would mean a $16.67 loss (50% of 33.33) vs a $25 loss in 100k of QQQ.

Whooops, flitting between 2x and 3x leveraged. Would result in a likewise $25 loss but have cash on hand to double up with.

Al said...

Second guessing where we are going with rates, I suspect we are around 1936/1937. People are thinking the depression is over and things are getting back to 'normal'. But as soon as public spending is slowed or rates edged up, the economy slumps back into a funk. All sorts of imbalances are necessary at this juncture to keep up appearances (fiscal, international trade, between rich and poor).

So, regardless of what inflation 'fears' exist right now, I suspect like shadows in the forest they will meld away into the night, way, way before we get to pre 'emergency' (i.e.'normal') rates of 5%.

Al said...

By the way. What is today's narrative?

Polemic said...

I m trying to buildca random narrative generator using html css and java embedded to run in a blig post. But cant get it to refer to the java based choice set. Out of my depth but trying!