Everybody has a few bars to play in this song

Summary

• Market volatility — Gamma feedback loops.

• Populism and uncertainty — Everyone has a few bars to play in this song.

• Week ahead — Things may get choppy.

Last week US equities were battered by a combination of CTA deleveraging, and the dealer community being caught net short gamma. It was a fairly wild week for equities although you wouldn't have known it if you just looked at the week over week change. US equities ended the week down half a percent, while global equities were down anywhere from 2 to 3 percent. Over the last 12 months, equities have been stuck, unable to break higher. Much of this is due to the ongoing trade tensions which have dominated headlines earlier last year when the US imposed steel and aluminum tariffs. Since then, a combination of slower economic growth and escalating trade tensions have weighed on markets. This week, economic growth took center stage with the US manufacturing sector delivering a hefty body blow to anyone hoping economic growth was bottoming. The heinous US manufacturing print confirms cracks in the US economy and the payroll data out on Friday helped reinforce that message. The market was caught flat-footed as fears of a fresh "growth scare" pushed investors into fixed-income and out of equity. The news that Bernie Sanders, a Democratic presidential candidate, suffered a heart attack was also seen as bad news for equities in that it increased the odds of an Elizabeth Warren nomination. Germany's woeful manufacturing print last week coupled with several regional coal mine canaries beginning to roll over set a pretty somber tone for the week and the markets were fairly sheepish, to say the least. There was a risk that systematic flows from CTA's, momentum hedge funds, and dealer hedging would result in slippery markets and that's exactly what we got. The manufacturing release sent equities lower, triggering a large reversal from long to short among CTA's. Things were then made worse by dealers, who were net short gamma, accelerating the move lower which then resulted in even more CTA deleveraging (insert feedback loop here). I know I may have lost a few of you there, so let us unpack these last few sentences riddled with jargon. For new readers, CTA funds are momentum hedge funds. They buy when the market is going up and sell when the market is going down. One very crude way to “guess” the positioning of these funds is to look at the moving average of the closing price in the market over different intervals. Some popular intervals are the 50, 100 and 200-day moving averages. Now, I don’t fully believe that this witchcraft has any meaning on its own but, there is a lot of money tied to these types of indicators which impact order flow, and ultimately price. I’ve tacked some of this witchcraft onto the chart below that shows the daily close of the S&P500 ETF (SPY). The blue line is the 100-day moving average and the orange line is the 50-day.

It’s easy to see (after the fact of course) that CTA’s were short in May and August of this year and had begun building long positions at the start of September (once trade rhetoric had calmed down). We can see that this week the S&P500 broke below its 50-day and 100-day moving average, causing CTAs to sell. What made matters worse was that the dealer community was also short gamma. As a reminder, when dealers are “short gamma” this means that their hedging flows are moving in the same direction as the market — it’s like pouring lighter fluid on a campfire. When dealers are “long gamma” this means that their hedging flows are moving in the opposite direction as the market — in this case, dealers act as a shock absorber, stopping markets from going higher or lower. Given that dealers were short gamma, they were selling at the same time CTA's were, accelerating the decline and potentially triggering even more CTA selling at a lower level. Charlie McElligott, a quant strategist at Nomura, flagged that his 3-month CTA model had flipped 100 percent short while other analysts noted that this was one of the largest flips from long to short in the CTA complex. Why was this one so bad? The main issue was on the dealer side, they had a significant amount of outstanding put options which increase the amount of negative gamma that needed to be hedged on their books. The chart below shows that dealer gamma was about -11.8 billion, sitting at about the 4.8 percentile historically since 2013. 

I know this stuff is a bit overwhelming and I recommend reading Canada is not for sale on my website as I go into more detail on CTAs and dealer hedging dynamics. The main take away from this week is that it is very reminiscent of a story that has played out several times over the past several years. By the end of the week, equities had bounced nearly 3 percent and ended the week nearly flat, again a byproduct of dealers being short gamma (the feedback loop was working in the opposite direction). I can not emphasize enough how important it is to understand these dynamics, especially on weeks like last week, where markets can swing over a percent in either direction on any given day. The important thing to note here is that this is the "new normal". When the kindling and match sticks are all laid out, all it takes is one spark to set everything in motion. Of course, these feedback loops have always existed in the background but, one of the reasons they've become more influential today is due to the lack of market depth or liquidity. Investors are positioning for a recession. This means that investors are generally overweight bonds relative to equities. There are also plenty of investors who would prefer to hold cash and cash equivalents due to how uncertain the outlook is for global growth. Of course, this stems primarily from trade policy and the broader push for deglobalization.

The belief that deglobalization is feasible is not so much “wrong” as it is impossible, getting at the heart of the problem with economic nationalism. One of the biggest issues with the populist uprising over the past several years is the clear lack of concrete, well thought out, policy objectives. Think about Brexit, what does it even mean? Honestly, I don’t even think the people in the UK know; and that’s the problem. It’s like people voted for the government to do something and then left it for policymakers to figure out what that something was. Sure, at the time it had some symbolic meaning in that it reflected some form of public sentiment but today, 3 years later, it’s still not clear what the goals of Brexit are. Martin Kettle, a columnist for the Guardian, put it like this. Brexit was essentially many different dreams, some were about freedom, others about restoring greatness but the problem is that dreams aren’t reality. They don’t put food on the table and they don’t provide a sustainable path for the future. In that respect, the MAGA (make America great again) economy rests on a similar footing. As one analyst put it, the MAGA political movement makes about as much sense as a lawn business running the slogan “make yards great again!”. Yea, that sounds nice, but when you think about it, every lawn business is by definition competing to make lawns great again because who would be in the business of lawns, advertising to make them worse? The problem is that politicians running on these populist platforms have no legitimate policy ideas and the “solutions” they offer often collide with reality. Instead of taking the time to understand the complexities of the broken systems that allowed all of this fear, anger, and despair to accumulate, we get quick “fixes” with potentially disastrous long-term consequences. The political survival of parties like Marine Le Pen’s in France, Mateo Salvini’s in Italy, the Catalonian independence movement in Spain, Johnson’s Brexit saga in the UK, Bolsonaro's in Brazil and President Trump’s in America all rest on their ability to keep the “dream” they initially sold to voters alive. When that dream collides with reality, experts become boneheads and all news becomes fake news. I bet that’s why politicians have to take to social media, it’s a 24/7 job to try to keep supporters from coming around to how ludicrous some of these policies are. Don’t get me wrong, reality will always win in the long-run, but in the near-term, politicians will do or say whatever they can to avoid conceding the battle. This is where things come full circle. Investors, businesses and households need to plan for the different scenarios that these politicians are selling to voters. Take for example the trade dispute between Beijing and Washington, Trump isn’t trying to resolve the trade dispute, he’s trying to keep perpetuating the dream he’s selling to voters. That makes it nearly impossible for business', investors and households to pencil out proper scenarios around these disputes and make decisions because the underlying policy objectives are about as stable as a chair with 2 legs. This is clearly showing up in the data now, business investment is collapsing, consumer spending is starting to crack and investors are sitting on the sidelines just waiting for things to clear up.

I’m sympathetic to people who have lost their jobs due to global trade and we can argue all day about whether our trade policy is “right” or “wrong” but the fact of the matter is, there is no world where deglobalization is feasible. We’ve come too far, global supply chains are too interconnected. That horse has left the barn, it’s jumped the gate and it is probably out of the country by now. Oh, and it’s not coming back, like coal jobs in America, or tobacco farms in Canada. The real kicker in all this is that the hostility towards globalization is putting some serious strain on economic growth in an era where Monetary policy has their hands tied with low-interest rates. It looks like the only feasible way to avoid the next recession is some form of fiscal policy, which is going to be coordinated by politicians who have no policy objectives. That has the potential to be disastrous, but it seems to be the only hope. Mario Draghi took the first real step towards accepting this reality by announcing what, as near as makes no difference, was a perpetual bond purchase program. The hope here is that the central bank will essentially finance fiscal spending, stabilizing the bond market and allowing countries to run higher sovereign debt levels. If this sounds like a Ponzi scheme, it’s because it kind of is but it's a step in the right direction. The future will undoubtedly hold some coordination between fiscal and monetary policy. It’s not entirely clear that this system will work, critics have said that central bank asset purchases discourage fiscal stimulus by sending the signal that monetary policy will continue to shoulder the burden when push comes to shove. That’s a fair statement. The Fed is entering a similar problem, the stronger US dollar has essentially priced out foreigners from the US Treasury market, which is problematic because the Treasury plans to relentlessly issue more debt. It’s kind of like your aunt going around the table after Thanksgiving dinner with another round of turkey seeing if she gets any bites, everyone’s completely stuffed and there’s no way someone is mustering up the courage for round 2. Private sector balance sheets are full and there is more debt to go around... who is going to buy it? What I want to emphasize here is this concept of the “new normal”. Not just in the context of economic growth but rather, uncertainty. All of the things I’ve mentioned above are big issues with unclear solutions that will undoubtedly plague markets for the next decade. For now, weeks like last week will keep happening. Markets will remain slippery but don’t pin it solely on President Trump and the trade war. He may be the clearest manifestation of the problem but believe me, everyone has a few bars to play in this song. 

Coming off a pretty wild week, investors will now have to deal with the fact that the US is no longer bulletproof. Earlier this year I was talking about how “bad news is good news” for equities. That was predicated on the idea that a slowing economy helped support equity valuations by insuring that the Fed would continue to provide accommodative policy through lower interest rates. At the time, I had flagged the risk that a slowing economy would also lower the potential for earnings growth, which could very well offset, if not dominate, any impacts from lowering interest rates. Well, today, with signs that the US is now slowing, investors are now considering that very case. The US data over the past few months has been a mixed bag of good and bad prints but recently it appears that we’re getting worse. With economic fundamentals starting to slip stateside, consensus earnings expectations have followed suit, declining by 3 percent in Q3. This decline makes Q3 the first quarter of year over year negative earnings growth since 2016. The combination of a slowing economy and growing margin pressures have capped earnings growth and opportunities abroad have become far more uncertain due to the belief that deglobalization is possible. With trade talks resuming this week, let us not forget that last week President Trump announced that the US was considering capital restrictions on Chinese assets. Multiple desks on Wall Street have taken this risk seriously and they should, this is a bigger deal than most people realize. Goldman notes that total US exposure to Chinese equities amounted to some US$ 785 billion last month. Against all this, we still have the Fed who is now grappling with a funding squeeze and renewed recession fears. That complicates any sort of announcement the Fed may plan to make at their next meeting regarding a renewed asset purchase program. For those unfamiliar with the funding squeeze, please read Repo markets in the limelight on my website. As for where we stand on the systematic flow's front, it seems likely that we will be reactivating this negative gamma feedback loop I talked about above. If the macro data out this week doesn’t produce any convincing progress towards a more solid footing, then we may very well see the floor fall from under equities. If the data doesn’t spark any risk-off, we likely see a sharp grind higher. This week we also get the meeting minutes from the ECB and Fed — both of which will be interesting to read, particularly the Fed considering all of the funding pressures at the time.

Tiago Figueiredo