Thoughts through the cycle: W4 June ’20

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Like a market – only different, from the RWC Diversified Return Investment team

  • The pandemic lockdown has forced many into performing unusual roles. From mask-making by grannies on their sewing machines to parents having to home-school their children while working from home, few have been unaffected by recent events. Things have gone further in Spain where an over-zealous furniture restorer has ‘re-worked’ a painting of The Conception by baroque master Murillo (‘Experts call for regulation after latest botched art restoration in Spain’, The Guardian, 23/06/2020). The striking results can be seen below, with the virgin Mary’s face reduced to a collection of features that are included in a face rather any normal resemblance. While a somewhat abstruse comparison, one might ask the question whether recent central bank hyperactivity has done a similar thing to financial markets in terms of distorting them beyond recognition, especially if one considers ‘what a recession normally looks like’. It kind of looks like a market, but is it really functioning as one?

Financial markets, pre-pandemic, and then following central bank interventions?

Source: The Guardian

  • While it is comforting in an argument to start with a proposition or axiom and to build from there, when addressing the market one often gets a clearer understanding of what is happening simply by looking at how it behaves, rather than adopting a pre-existing conception of how it should behave and proceeding on that basis. For example, one might think the stock market overvalued, but clearly the recent rally means someone has to think it offers upside, otherwise it would not be so resilient. Dismissing current buyers as dumb retail, price-insensitive systematic algos, or passive pension allocations answers nothing. Why the market trades as it does is what the question at hand. The distortion lies in the eye of the beholder.
  • Sometimes a brief episode in market activity can reveal (like a well-painted face) much of what is really at stake in the world, economically, financially and politically. Such a vignette occurred on the 22nd-23rd June, and is worth exploring in some depth as it reveals almost perfectly all the market’s combined hopes and fears.
  • The immediate backdrop has been the growing tension between the US and China. Whether or not this is truly a ‘Thucydides trap’ of the up-and-coming global contender challenging the existing super-power, it has been clear through the Sino-US trade war of 2018-9 that there may well be a new cold war brewing. Accusations that China was slow to tell the world about Covid-19 have only intensified the problem. China has been increasingly aggressive to its neighbours, with June seeing an unpleasant spat with India in the Himalayas, military flyovers of Taiwan, accusations of cyber-attacks by Australia, and moves in Hong Kong to subvert judicial independence and the basic law.
  • It was against this backdrop that Peter Navarro, director of the US Office of Trade and author of the book ‘Death by China’, said in an interview on Fox News (22nd June 2020) that the Sino-US trade deal was ‘over’, adding that, “It was at a time when they had already sent hundreds of thousands of people to this country to spread that virus, and it was just minutes after wheels up when that plane took off that we began to hear about this pandemic,”. The graph of the e-mini S&P 500 future below shows the immediate effect this had on risk sentiment. It also shows the effectiveness of the desperate efforts from the White House to row-back on the comments (immediate tweeting from President Trump, denials by director of the National Economic Council Kudlow, claims by Navarro himself that his comments were ‘taken out of context’).

Source: Bloomberg, 23rd June 2020

  • This explosive sell-off and equally explosive rally is very revealing. It shows the full extent of the White House’s paranoia about stock prices. It reveals too the market’s underlying fear of the growing cold war between China and the US. It shows how in an increasingly systematic, algo-driven, passive investing world, statements by politicians are generally taken as true so long as they are congruent with a risk-on sentiment, lower volatility, and mean-reversion in that context. Language-focused algos clearly cannot compute the political notion of being ‘economic with the truth’.
  • The White House claims that Phase 1 of the trade deal is being implemented and is going well – they do this on an almost daily basis, which is a little worrying itself. Soya bean sales to China are a key part of this narrative, as they fit into Trump’s re-election bid with respect to how well he is doing for the farming community. Data from Bloomberg suggests Chinese soybean imports are up 6.8% in 2020 to 33.9mm tonnes, with imports from Brazil surging in May by 60% year-on-year probably because the Brazilian Real has weakened so these beans are cheaper (‘China’s soybean imports surged in May on buying from Brazil’, Bloomberg, 08/06/2020). Imports from the US are therefore lagging, despite periodic ‘must-try-harder’ headlines about China honouring its commitments as well as constant claims by the White House that China is implementing the deal terms in full.
  • Unsurprisingly, bond yields fell on the Navarro headlines, with 10yr US Treasury yields briefly dropping 3 bps to 0.68%. This is not a big move – perhaps bonds have done their thing. More interestingly was the immediate weakness in the yuan and general strengthening of the dollar. The graph below shows a sharp spike in the yuan before Trump’s soothing tweet allayed the market’s fears. The U.S. Dollar Index (DYX) also spiked from 97 to 97.25 on the headlines. A key element of the market’s reflation theme is the desire for (or possibly need for) dollar weakness to confirm the recovery. That it spikes so sharply in risk-off situations perhaps reveals that reflation is more posture than actuality, and that there may well still be an overall shortage of dollars, especially in the offshore euro-dollar market. The paramount question of the yuan peg to the dollar and China’s closed capital account clearly form part of subconscious concerns within the market’s ongoing recovery narrative.

Source: Bloomberg, 23rd June 2020

  • Most interesting of all was that despite the spike in the dollar, the immediate move in gold was higher not lower. This is entirely at odds with recent positive correlation between equities and gold (note how gold, despite being the ultimate safe haven, was not spared in February and March’s crash). The graph below shows gold spiking up to the very top of its post 2011 trading range.
  • It is a bit of a mystery why gold has been flat-lining for much of May and June despite aggressive ongoing central bank quantitative measures and governments indicating more clearly that their fiscal intervention will be prolonged as V-shaped recovery hopes give way to swooshes, Us, Ws and other less-enticing recovery patterns. The move shown below perhaps shows that a breakout in gold is nearing – deep in the Sino-US conflict is the issue of the dollar and its apparent weaponisation by the Trump regime. Gold is often touted as a possible alternative for a China-centric sphere of influence with its own currency. If gold is also going to see a tail-wind from ongoing money creation by central banks, then the reasons for owning the metal seem to be strengthening.

Source: Bloomberg, 23rd June 2020

  • This short burst of market volatility was just that – very short. A tweet by President Trump was enough for the equity market to trade back exactly where it was before. This above all things shows that the overwhelming sentiment in the market is still that despite the fears in geopolitics or the real economy (not least catastrophic unemployment levels), governments and central banks are still in control.
  • For markets though, this normality does feel strained – this is not just the fear of what lies beneath. Data below from JP Morgan’s cross-asset desk shows how correlation has a 20yr high as central banks have flooded financial markets with liquidity. This is very much an everything rally (except for the US dollar that is), even when experience suggests that certain asset classes (credit and equities in particular) ought to be struggling given the ongoing recession. For now, at least, buyers do not appear especially discerning.

Source: J.P. Morgan, as at June 2020

  • One way of reconciling this is by seeing official action as keeping the market in stasis while the economy tries to recover from a once-in-a-century shock. The question is how long this stasis can be maintained without the money system itself starting to show real signs of strain, either in terms of inflation expectations, real bond yields, or foreign-exchange levels. The greater the effort to keep things the same, the stranger the picture that financial markets offers will be, especially if the recovery in the real economy fails to keep up with breath-taking pace set by global equity and credit markets.

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