Saturday, 10 February 2018

What happens next? The great global risk repricing.

Following swiftly on from the last post's synopsis of the changing narratives of last week, in the famous words of a UK TV sports quiz show, it's time for "What happen's next"? When a clip is shown and the contestants have to guess the, normally unlikely, outcome.

The clip shows US equities falling over, bashing heir head and looking dead only to spasm as we freeze the frame. So .. what happens next?

Friday felt like fear but the rally into the close makes this all the harder to call as both camps have ammunition.

For the bounce -

Nothing has really changed, the US economy is doing well, indeed it’s very success is what has triggered this fall.

Company earnings are booming and are not going to fall. In fact dividend yield on stocks has just gone up 10% due to the price drop. Thank you.

We needed a healthy correction. That was it. The weak holders are now out and will no doubt be sucked in slowly as prices rise again pushing them up further. Effectively we have more marginal buyers wanting to get back on the bus now they have been thrown off.

It isn't that bad, we are only back to last Noveber prices.

Why should overseas investors in overseas stocks be concerned about domestic US inflation? European investors in European stocks, where the ECB is still slow to drain liquidity, should see more reason to buy.

The size of that fall and the way it worked over the last two days saw the market move from 'unconcerned' to 'doubtful' to 'fear', only to see everything rebound into the close on Friday. We are done.

It was indeed just a volatility blow out, the ripples are settling.

It was a typical February positional wash out across all asset classes, hanging on an excuse of the labour data that tripped some ridiculous leverage in silly products. Over positioning of the year favorites has been rationalised and we can get on with it all again.

And for the trouble ahead -

It ain’t over until the fat cow squeals. the fat cow being the sacred cow position of short US treasuries.

If USTreasuies because what I saw as fear on Friday isn’t anywhere near fear yet and we are still in a complacent mode. this complacency can be reflected in headlines I saw on Friday saying we had ‘entered a corrective phase’ #. Entered a corrective phase? we entered a corrective phase two weeks ago! The sign should say; “Thank you for visiting corrective phase, only 2 days to meltdown, drive safely!"

Volatility lingers - from my last post on the last two week's action

One of the consequences of measures of volatility moving is that it affects how much leverage you can have in your portfolio. The lower the volatility in an asset the lower the assumption of risk in holding it. Value at Risk, or VaR models, dominate bank, traditional fund and, most importantly, algorithmic funds. When the number you use as a volatility input increase you have to reduce your holdings even if you still consider your base argument for holding them valid. It depends on the time frame of allocations, these can be instant in high-frequency models, to monthly for old-fashioned real money to really slow with retail. Value and volatility shocks linger in the darkest crevasses of portfolio management for ages. It's like oil on beaches after tanker spills.

That US Stocks are only back to where they were in November, meaning that losses for many are only lost profits not losses versus original investment, can be read as suggesting that many are still long.  I know this is nitpicking for mark to market, especially with a year-end real in between, but for retail it’s a psychological 'get out of jail' card. You can bet that every IFA out here is telling their clients not to worry. Probably because they haven’t yet worked out the reason to sell. This is a tell that there are many trapped longs out there praying for buyers to come back in.

But who? Real money funds have not liquidated on this and are probably as caught as retail. yet they have been sitting off record loads of cash so what are they going to spend to buy with. the wall of retail certainty will have dried up too. Of course, we will have the ‘just a dip’ buyers return but that doesn't mean it’s over. As we saw last Tuesday, buying dips and seeing a run-up doesn't mean you are right.

If this really is a US inflation story then why indeed are global stocks melting? The case for buying says that if this is US Centric that we need not fear in rest of the world. But the corollary is that as everyone else assets are dumping then this is not US-centric and the narrative is wrong.

The inflation story may just be the next narrative that will be questioned and thrown away as greater fear of unknown emerges.

This has become a global risk sell-off for equities and has started to become a general risk sell-off, but rather than looking at my usual ‘February, favourite trade squeeze’ what if this is something else?

What I am suggesting -

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, aspike 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 consdiered as part of the short UST trade. This is not about rate differentials anymore, as we have seen the divergence of rate difererentials vs FX widen for the pat few months, but about underlying trust in the US to manage its affairs. It's part of the risk adjustment as the US and US has 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.

I will run my long with a trailing stop ready for part 2 as so far that may have only been part 1.i and 1.ii.

I can't help but think that gold is looking exceedingly attractive.


BlackRaven said...

I said in Jan I thought vol was a good buy, which you agreed with and was massively out of consensus. It's more than made my year. I'm not going to do anything for a bit. I know a lot of people are talking about an analogue with 96, or 66, etc, but I really feel like it might be more like an 07. I feel it's pretty worrying that the 10yr note hasn't rallied at all. I'm a crap macro trader, I used to trade converts, vol and credit. Saying that, I found the year end forecast being put forward at the start of the year shocking. Analysts migrated their multiples to adjusted earnings and are massively extrapolating imho. I would be very surprised with spoo true eps being 120-110 instead of 150+ this year. sure q4 was good and there is a tax break but its almost an assumption of a totally different operating environment to get to these massive eps numbers. whereas sales per share are growing at low single digits not 20% per year. I think the analogue with 07 works better because I remember very well the appeals to economic growth, buybacks, lack of corporate leverage, etc. I don't think we are on the verge of an 08, but I do think equities could be volatile and we could see sell offs later in the year after hitting highs again.

Shawn said...

I think you can thread the needle there---if you recall back to 2007 the market got pretty ugly in August, recovered...sort of...went sideways for a little while before making a series of lower highs and lower lows for nearly a year before it all went up in smoke in Sept 08.

I could see this being a Aug '07 type of event. That doesn't mean we're going down the same path, but you could see a scenario where the market chops around, maybe puts in a decent rally or two, before more cockroaches emerge. That's consistent with maybe corporate profits not quite being as rosy as analysts were expecting, but the whole world not hitting the eject button on equity allocations.

Polemic said...

In 2007 it was Northern Rock that kicked it off where mispriced risk first emerged. 2008 was the same thing x100. I think The whole thing was a revaluation of remarking risk to reality rather than risk to book. In that respect this could be similar. In the UK we have had Carillion and Capita go under 'from nowhere' on a remarking of the actual risks rather than assuming gocernment guarantees. You could say this is the corporate equivilent of QE risk questioning where state is guaranteeing the finance world.

Unless you are insuring a car, insurance has been dirt cheap. No more.

Al said...

"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."

Indeed. And the other take: this market is to be traded, not held. And throw away all those books about diversification of assets.

NeverSayNever said...

A simple view: BAA corp bond index is at 4.48% (credit spread ~1.62%). Unless estimated corporate earnings take a dramatic turn down and / or credit spreads begin to significantly widen (? i.e. expecting that a recession is on the horizon) money managers have quite a bit of room to now buy insurance in this 'great risk repricing' world before they can justify to their clients that they are no longer invested in the market.