Depth Charge

Summary

• G20 update — China/US ceasefire 2.0.

• Economic update — The aforementioned economic slowdown continues.

• An equity rally that no one owns.
  

At the G20 over the weekend the US and China both agreed to a cease-fire, pushing equities higher. The agreement struck between the US and China was broadly in line with expectations, with the US indicating that they would hold off increasing tariffs to 25 percent. Both China and the US agreed to work to roll back non-tariff barriers (primarily restrictions on tech) and that China would begin buying agriculture products from the US. Surprisingly, President Trump agreed to take a less aggressive stance on Huawei, allowing US companies to sell products to Huawei as long as the company was not the sole supplier of the product (If Huawei could purchase the same product from another non-US supplier then US companies can sell them that product). This caught the market by surprise but was viewed as a positive development, highlighting that, when push comes to shove, President Trump will act in the best interests of US businesses. Even if the President had not loosened the stance on Huawei, several chip manufacturing companies (Micron to name one) had found a legal way to circumvent the blacklist, with reports suggesting that companies had already begun shipping products to China. In my mind, this highlights just how difficult the ban was to implement, especially when you consider the challenges FedEx was facing (article here). These developments also raise questions surrounding the legitimacy of the use of national security as a basis for tariffing countries, remember that the President threatened tariffs on German automobiles using the same argument. Regardless, the market reaction was broadly positive. Huawei bonds rallied on the news while mainland shares surged with the CSI 300 index (Shanghai/Shenzhen stock exchange) up 3 percent. Global equities moved higher, although I can’t help but draw parallels between the agreement struck in Buenos Aires last December, just days before the Huawei CFO was arrested in Canada. There appears to be little indication of any progress on the sticking points that caused the negotiations to breakdown in the first place and, it is unlikely that this ceasefire removes any uncertainty regarding trade policy going forward. Let’s not forget that the US is in a tight spot. China can play the long game, and has shown willingness to do so by attacking FedEx and threatening to ban rare earth metals. There is no limit to President Xi’s term, unlike in the US, and it is reasonable to think that Xi may prolong talks in hopes of negotiating with a president that is more open to striking a favorable deal for China. Apart from China and the US, Russia and Saudi Arabia agreed that OPEC will extend their agreement to cut production for another 9 months and, to wrap up with the G20, the US and North Korea also agreed to restart nuclear talks after the President's visit to North Korea.

Markets continued to trade off of the sugar high from the G20 despite the increasingly dire economic data. Monday served up another set of foreboding economic indicators, highlighting that the world economy remains in a fairly deep manufacturing recession (article here). Swiss manufacturing data saw the largest decline in 7 years, while Spain registered it’s worst reading since 2013. Despite economic data in Europe starting to come in above expectations, the situation in Europe remains dire with the latest composite manufacturing print shrinking for the 5th consecutive month. These developments come off of the heels of data in Asia where South Korean exports continue to decline and PMI’s (Purchase Managers Index — a proxy for manufacturing production) remains in contractionary territory. Chinese PMI’s also posted the second consecutive contractionary print, hitting the lowest level since 2009. Meanwhile, in the US, a sub-50 print from the MNI Chicago PMI survey gave the US it’s first contractionary business indicator last week, and this week, the latest ISM PMI pointed to the slowest expansion in manufacturing since October 2016. Although the US continues to remain the cleanest dirty shirt in the market, much of the US’ resiliency to the global slowdown came as a result of the, now waning, fiscal impulse from the tax cuts. The recent weakness in economic data reinforces the need for the Fed to lower rates and will likely offset any positive developments on the trade front, likely providing equities with a boost going into the summer. The case for a melt-up in equities over the summer seems fairly strong given the optimism on trade, expectations for accommodative monetary policy and, most importantly, under positioning in equity markets. One of the most important characteristics of the year to date rally in equities has been the lack of participation and relatively little market depth. The rally in equities since the start of the year has been one that, in many ways, has no owner. With increasing uncertainty in the market, investors have generally been sitting on the sidelines waiting for a clearer picture before committing their capital. Cash levels from the latest Bank of America Global Fund Managers have reached the highest levels since 2016. There are a plethora of reasons for investors to be wary, with the usual suspects being trade tensions, Brexit and Italy to name a few. However, one overlooked source of uncertainty comes from the late cycle fiscal stimulus (the Trump tax cuts), which effectively extended the business cycle. The recent inflows into bonds, and more broadly, US interest rate products (the “stretched” positioning I was talking about last week) is largely a reflection of the waning impulse from the tax cuts, as market participants are now preparing for the end of the business cycle (which may entail a recession). In an environment like this, the preference is to own bonds over equities and that’s generally what we are seeing in the market. The chart below is from Nomura’s quant team and shows the 21-day rolling beta coefficient of a long-short equity hedge fund index to the S&P500. For those who are not familiar with beta, it is essentially how correlated the returns of a fund are to the returns of the market (in this case the S&P500). The higher the coefficient the more exposure the fund has to US equities. As we can see from the chart below, the beta of the equity hedge fund is low relative to where it was historically, implying that hedge funds are generally underweight US equities.

So how can equities move higher when investors are clearly not interested in owning them? Well, the answer lies in the structure of the market, particularly, the lack of depth in the market. Market depth is essentially the markets ability to absorb large orders without moving the price too much. Picture it like this, if I am trying to buy 1 million oranges at a farmers market, chances are I would wipe the market clean and end up paying more than I would have had I gone to a big box retailer like Costco. Well under normal market conditions, the equity market is a big box retailer. However, since December, the market has behaved more like a farmers market, with more and more investors sitting on the sidelines waiting out the uncertainty. Ok, so that explains why the price can move higher… but who is buying equities? Well, a large portion of the demand for equities has come from corporations buying back their stock (I will touch on this more of next week), while another source has been just dealers hedging out their exposure (again a topic for another email). Now that trade talks have restarted, there is a chance that market sentiment improves and we see some investors increase their exposure to equities. Given how “thin” the market is, it may push equities higher, kicking in the FOMO (fear of missing out) effect, wherein as equities grind higher, investors eventually get forced back into the market due to the fear of underperforming their benchmarks. This sets the stage for the summer rally. Now, this hinges on the assumption that trade talks progress in a manner that doesn’t completely price out a Fed rate cut but also doesn’t completely collapse global growth, which on its own is a tall order. The week ahead will be critical, not only for looking at the market's reaction to the trade truce, but also the reaction to the economic data. If we get a strong non-farm payroll report and the market stumbles, we could very well be back in the case where good news is actually bad news, highlighting once again the monetary policy remains in the driver seat. In closing, and given this marks the end of the first half of 2019, I figured I would include a chart from Reuters that shows global asset performance year to date.

Tiago Figueiredo