It is easy to see a sea of red across U.S., European and Asian markets and recall flashbacks of October 1987 -- or 2008, even. How is this any different -- yet another unwind, as the one seen in February of this year? It was just on October 3 that Trump gloatingly congratulated himself and his team for achieving what no other administration had done in history.
He tweeted, "The Stock Market just reached an All-Time High during my Administration for the 102nd Time, a presidential record, by far, for less than two years." What a difference a week makes. Now we hear him saying "the market was due a correction" and "the Fed has gone crazy." Of course, typical of any politician, throw blame rather than accept it.
The Fed has just been doing their job, in line with central bank policy. The U.S. economy has been on a solid footing and showing robust growth. To combat overheating, especially in light of excess monetary accommodation, it has been the right thing to do. Otherwise, inflation would get out of control and stunt that growth rapidly. The Fed has been prudent. We can hardly say the same about Trump. He has single-handedly accelerated the emerging market/dollar/China collapse by using the dollar as his personal weapon to coerce his partners into submission. Mexico, Canada and the rest folded. China yet stands pat?
The dollar is the kryptonite of most developing countries, as they continue to raise debt to fund their growth, but then mishandle central bank policy (Turkey, Argentina, etc.) and end up going bankrupt when their funding costs sky rocket. Trump knows this. China is another beast, given it has been growing its FX reserves and current account surplus to offset the rising debt service costs. But shutting down trade to one of their largest markets kills most manufacturing centres in China. Hitting it where it hurts. With growth slowing down and debt costs higher, it has been a double whammy for these economies.
What was the straw that broke the camel's back? Last week, as U.S. 10-year bond yields spiked past 3.2%, investors long the back end of the curve liquidated -- causing a sharper selloff -- which spooked equity markets, as higher yields imply lower discount valuations.
Equities are generally longer-duration assets, so with a higher "r," their present value is lower. Techs are a great example of this. If one were to look through the selloff, it has been mostly about Nasdaq and the technology sector (note that greater than 40% of S&P 500 performance is tech sector related and largely down to a handful of names), so naturally the S&P 500 fell aggressively overnight, as well. According to the latest Fund Manager surveys, techs have been the most over-owned space amongst retail, institutions, going down to everyone and their mom.
Last week after the yield spike, risk parity funds, which balance their liabilities via bond/equity allocation, saw themselves mismatched -- and this made matters worse, as it forced them to adjust allocations in each to come back in line. We all know the market is driven by CTAs (commodity trading advisors -- who use momentum-driven strategies where trillions of dollars of liquidity is invested to chase trends, pushing them further until something changes).
According to the latest update from Nomura's cross-asset quant, CTA deleveraging finally kicked in, creating -$66 billion of SPX for sale, as it signalled long positions to be cut from +97% down to +77% -- and then down to +57% if the S&P 500 broke below 2895. It's like clockwork, and it is not about fundamentals.
That change (or alarm) was triggered yesterday, when CTAs who were defending any pullbacks in U.S. markets (technology in particular) started selling too. Hence the aggressive ~ 7% selloff in even large-cap quality names like Amazon (AMZN) , Microsoft (MSFT) and Adobe (ADBE) . Ignoring names like Ali Baba (BABA) and Netflix (NFLX) that were also down significantly because value investors have been long and hurting over the last two months on the back of weaker earnings and margin compression. Value names have been a trap. But last week, even solid quality large-cap names were beaten to the ground.
In the sea of chaos, to most people's surprise, U.S. bonds actually rallied (yields lower!) and the dollar fell (usually the dollar rises in times of recession, as a safe-haven trade). All this bears similarities to a massive liquidation, capitulation as all winners of the year were sold and all the laggards bought. Classic unwind.
What to do now? Trump wants the Fed to stop raising rates, to fund their leveraging growth and fiscal boost of the economy. But the Fed also needs a reason to stop doing so, i.e. market collapse or negative data prints to justify it. Perhaps this sell off is exactly the type of data the Fed can use to say "hold off on the gradual rate hikes" until the economy gets on a more solid footing. What happens? The dollar will fall massively, bonds will rally, markets will rally as the "lower for longer rates" mantra is chanted across trading floors of emerging markets.
One cannot even rule out some sort of "U.S./China" agreement announced over the next few weeks, right before mid-term elections. If that were to happen, it is best to hold onto your highest-quality fundamental long ideas, as everything can snap back as fast as it did back in March this year.
One thing is certain, the dollar rally is over. Commodities have been behaving themselves over the past week, despite the market selloff. Miners are down 15% but copper is flat. It does not add up, but then again, when there is liquidation, there is no logic. If the dollar does fall, beware -- commodities will rally.
It is best to be short oil stocks as if there really is a growth unwind/collapse. How can oil, whose demand is predicated on emerging markets (where cost in local currency has skyrocketed), still be rising? At a time when supply is rising too. The majors -- ExxonMobil (XOM) , Total (TOT) , Equinor (EQNR) , Royal Dutch Shell -- all seem expensive and Brent overpriced at $80+/bbl.
Choose your winners and losers. At times of indiscriminate selling, it is time to be cerebral and stick to fundamentals. The problem is that everyone is used to running long-only books. No one likes shorting, but there are expensive stocks out there, just people too scared to short. This is where Hedge Fund strategies can come in handy.
