My way or the Huawei Vol. II ?

Summary

• Macro update — Glass half full?

• Gamma trap — It’s quiet … too quiet.

• Euro’s popularity — Will negative rates make landfall in the US?

Macro data this week came in with a relatively positive bias around the globe, suggesting that growth may be bottoming. Kicking things off with Europe, the latest data out of the bloc showed some positive signs with unemployment ticking lower and inflation coming in above expectations. Although good news, we shouldn't take the most recent reports out of context. Inflation is anything but a stone's throw away from the ECB's target, and a lower unemployment rate doesn't necessarily imply a recovery or, for that matter, inflationary pressures. Just look to the US if you're not convinced. In any event, the news helps reassert the narrative that the worst may be behind us, especially given the fact that Europe has been the poster child for the global manufacturing slump. Unfortunately, the positive economic data will continue to undermine the case for any fiscal stimulus in the bloc — something that many market participants view as a critical factor in kick starting global reflation. One of the other essential pieces of global reflation is China, who decided to surprise markets this week with a sharp rebound in manufacturing. The latest print suggests that the sector expanded last month and is welcome news after several heinous data releases (retail sales, industrial output, and fixed investment). Of course, China still faces a slew of issues, not least of which are surging consumer prices against falling producer prices, which have crushed company profits. The risk of rising onshore defaults continues to linger and, with PBOC stimulus coming in dribs and drabs, the latest manufacturing print provides little to change the broader narrative. 

Meanwhile, in South Korea, the Bank of Korea was the latest central bank to join the Fed, RBA and, RBNZ in a collective desire to stop cutting rates in hopes that the stimulus delivered throughout the year will be enough to resurrect growth. Remember that market participants view South Korea as a coal mine canary, given its exposure to the global economy. The BoK's recent decision to stop cutting rates, despite the country facing deflation and exports declining for 12 consecutive months, mainly came as a result of the Fed remaining on hold. The hope is that the recent developments in trade result in a more stable environment going forward. Meanwhile, for the Fed, the latest data continues to come in above expectations, and the underlying economy remains robust. US GDP estimates came slightly above expectations and, when taking in conjunction with the rest of the economic data, helped to calm market participants that were worried that the US had imported the foreign manufacturing malaise. As I mentioned last week, many market participants are raising eyebrows at the fact that the US has been winning the "financial asset war." Many think that the latest stock market rally will lead to more volatile trade remarks going into the December 15th deadline. The chart below shows a simple comparison of the US and Chinese equity markets and helps underscore just how far US equities have run relative to China.

Over the week, trade rhetoric worsened following President Trump's approval for a bill that was passed in the US in support of Hong Kong protestors. Although President Trump's hands were tied and the bill would have passed anyway, this will undoubtedly annoy Beijing. Worryingly, a Reuters report surfaced on Friday, suggesting that the US was considering new regulations to restrict Huawei suppliers. Earlier this year, the US attempted to ban US companies from doing business with Huawei, a Chinese telecommunications giant, on the means of national security. Remember that the Huawei CFO was detained in Canada late last year on behalf of the US government as a result of the Ban. The bottom line here is that even if a skinny deal is struck later this year, there is no doubt that a phase two deal is next to impossible. Even then, a phase one deal remains more elusive than it seems. A tweet out from the Global Times, a Chinese communist party mouthpiece, insisted that an agreement to postpone or otherwise abandon the tariff escalations would not be enough to secure an interim deal. If the tweet is correct, it has the potential to throw cold water on any progress. As I've argued in the past, this trade war is not just about trade but a wide range of topics, one of them being ideological differences. I won't get into this in this post but, for those interested, Vox does a great job illustrating this in a video that goes through the fall out of Daryl Morey's (Houston Rockets general manager) tweet about Hong Kong. In the meantime, I can't emphasize enough how vital a phase one deal is for risk assets going into year-end.

What's behind that eerie calm in the US equity market? The market consolidated last week as market participants were ramping up for Thanksgiving Weekend. The news flow surrounding trade hasn't been inspiring and, although markets have fully priced in some form of de-escalation in tariffs, there is room for a letdown. Remember that earlier this quarter, optimism (unfounded?) surrounding an elusive trade deal sparked a significant rotation into cyclical assets in response to rising bond yields. This rotation was amplified by bond risk, which had spread to equity markets as many investors were loading up on bond proxies after bonds had become too expensive. That rotation is over for the most part, and the market is now waiting for the economic data to confirm the expected inflection in the global downturn. Bond yields were roughly unchanged over the week, while equity markets continued to move higher. The S&P500 continues to run like it stole something, pushing 1-month historical volatility to the lows for the year. Intra-day trading ranges have also tightened up. One explanation for the eerie calm that has engulfed markets is surprise surprise, dealer gamma hedging. A few weeks ago, I mentioned that option greeks (delta and gamma) were flirting with record highs as a result of market participants reaching for upside in stocks through options. As Nomura's Charlie McElligott reports this week, with dealers net long gamma, their hedging dynamics help act as a shock absorber to any outsized moves in US equities. Dealer hedging flows are helping insulate the market from any drawdowns and have contributed to the slow grind higher. The chart below shows the number of contracts that need to be hedged in millions by strike price as well as expiry.

We can see that several contracts are expiring this week, and the market remains long gamma with a flip expected below 3100. This gamma feedback loop, which has pinned equities, is made even more dramatic with the significant net long position in short-volatility products where investors roll down the VIX curve in search of yield. These types of strategies result in a steeper term structure for the VIX as it involves selling the front end contract (pushing the price down) and buying the long-end contracts (pushing the price up). The above acts as a second-order effect on equities as lower spot volatility drives funds that use volatility as a toggle for asset allocation into larger equity allocations, which push equity prices higher and volatility lower (insert feedback loop). 

The Euro's popularity as a borrowing currency has surged this year, with annual sales of government bonds reaching over USD 50 billion. Europe has been at the forefront of the global manufacturing slump, forcing the ECB (European Central Bank) to continue to provide monetary stimulus. Earlier this year, in a somewhat controversial decision, the ECB announced a full-fledged easing package which contained a benchmark rate cut, a new tiered interest rate system as well as the promise to continue to purchase bonds until inflation reasserts itself in the bloc. Unsurprisingly, bond yields have fallen significantly since the start of the year, pushing many sovereign and corporate bond yields below zero. The lower bond yields created some rather sensational headlines where high yielding European debt was trading (ironically) with a negative return (there were nearly 100 companies that had their entire yield curves below zero). What fueled the massive rise in the market value of negative-yielding debt was a scramble for yield, which saw pension funds and other accredited investors climbing down the quality latter (or reaching for duration) in search of something with a decent return. With that in mind, the recent popularity of Euro-denominated debt shouldn't come as a surprise. Many companies are merely taking advantage of what is essentially free money and swapping it into their domestic currency. Traditionally, countries and companies issued in US dollars because the market for US dollars was deep and liquid. Although that arguably has not changed, the opportunity cost of issuing in USD over Euros certainly has. Recently, companies have been borrowing Euros to pay back their dollar-denominated debt to lower borrowing costs. All of the above gives rise to several questions regarding the broader implications of the whacky world of negative interest rates.

In the past, I've elaborated on some of the feedback loops negative rates have created, particularly for zombie companies who rely on perpetually lower rates to refinance their debt. Although valid, ill avoid going into these dynamics this time around and focus more on the implications for credit valuation and Fed policy. For starters, let's think about how negative rates completely flip traditional valuation on its head. In the past, the market has generally penalized companies that were highly leveraged (had more debt relative to equity) and has rewarded cash-rich companies. With negative rates, that changes. Companies can now "create" new assets by issuing debt, which turns into a stream of income as investors have to pay companies to borrow. Meanwhile, companies that choose to hold cash at the bank take on an interest expense by keeping money in their accounts. That brings us to the big question; If issuing debt turns into a stream of income, do companies that have more debt become more creditworthy relative to those who hold cash in the bank? If true, companies certainly have incentives to take on more debt. The idea of issuing more debt brings us neatly to corporate buybacks — when a company goes into the market and buys back (as the name suggests) shares to return money to shareholders through capital gains. In the world I described above, I could see corporate buybacks continuing as companies convert their capital structure to a more debt intensive structure. There are several reasons for this: it could lower overall borrowing costs and would increase their total assets. That's not to say that is the sole reason why companies are doing corporate buybacks; there is far more to the story than that. For those interested, Vox has another great video on corporate buybacks and inequality, which is worth a watch.

Unsurprisingly, the above has further implications for monetary policy in the US. Negative interest rates in Japan and Europe have forced many investors into the US in search of a positive return. As has been the case for most of the year, the US remains the cleanest dirty shirt in the market. As such, the demand for US assets has created a strong need for the US dollar. Unfortunately for the Fed, a strong US dollar is inherently deflationary as it lowers the price of imports while simultaneously reducing the competitiveness of US exports abroad. Not an ideal situation for a central bank who has been consistently undershooting its inflation target. Arguably, this was one of the reasons why the Fed entered into a "mid-cycle" adjustment earlier this year. That brings us to the heart of the issue — how long can Fed policy diverge from the rest of the world? That indirectly asks if interest rates will go negative in the US, and that's a question that frankly no one knows the answer to.

Tiago Figueiredo