Psychologically damaged

Markets continued to normalize.

Central banks to the rescue.

Although stocks closed out their second week of consecutive losses, under the surface, it appears that markets are continuing to normalize. Global equities gained throughout April, particularly in the US, where the S&P500 clocked the largest monthly gain since 1987. Meanwhile, economic data last week confirmed a steep contraction in growth around the globe. Many market participants continue to expect the data to worsen in the second quarter. In fixed income markets, yields remained stable throughout the week, reflecting expectations of the relatively weak economic data. Central banks in Europe, Japan, and the US continued to reinforce the message that they will do whatever it takes to support market functioning. As I alluded to last week, central bank actions have likely put a floor on riskier assets, which helps explain the glaring disconnect between the misfortunate state of the economy and the stellar performance of stocks.

Market breadth has become a bit of a problem.

The multi-year outperformance of the tech giants (Facebook, Amazon, Apple, Microsoft, and Google [FAAMG]) has resulted in a record high concentration of these stocks in the S&P500. The S&P500 index, being market-cap-weighted, assigns weights based on the market value of its constituents. The FAAMG now accounts for roughly 20 percent of the broader index, suggesting that these companies are the ones responsible for a large portion of the ebb and flow of the index. The chart below is from Goldman Sachs (GS) and shows the concentration of FAAMG across time. This earnings season, 73% of the S&P500 market cap have reported earnings with the majority of them missing expectations. Around 20 percent of companies missed expectations by more than one standard deviation, the most since the fourth quarter of 2008. GS goes on to say that there remains evidence that investors are "looking through" Q1 earnings as companies that miss expectations tend to underperform the broader index by less than 1 percent, the smallest magnitude since 2010. All of that to say that we're back into familiar territory where the most widely regarded equity benchmark around the globe is, almost by design, not expected to reflect economic fundamentals. Eventually, narrow market breadth is resolved the same way. The top 5 stocks either catch down, or the rest of the index catches up. Given the economic backdrop, it seems unlikely the latter will happen.

The economic fundamentals remain woeful.

Renewed US-China tensions are the latest macro risk.

The US administration is weighing options to punish Beijing on a lack of transparency during the early stages of the CoronaVirus outbreak. It is unclear what the US is planning on doing, although some have speculated that more tariffs or capital restrictions are on the table. Some senators have floated the thought of defaulting on Chinese held US Treasuries, an idea that wholeheartedly shows that some people have no idea how financial markets work. Larry Kudlow, the Director of the US economic council, tried to comfort markets by implying that President Trump would not proceed with some "ill-conceived" idea to default on US debt. I'm not sure that's reassuring. That's like me arguing with my neighbor about our property line and his wife telling me calmly not to worry; she has no plans to burn my house down over these fence posts. One has to wonder why that even crossed her mind in the first place. None of this is to say the US is wrong in pursuing accountability regarding COVID-19. It's just to state the obvious that layering on economic sanctions pending the worst Q2 data prints in a century of economic data is probably not going to bode well for markets.

Was it economic strength or a hall of mirrors?

It certainly seems as though a "V-shaped" recovery is becoming less likely by the week. It wasn't long ago that I was talking about the importance of the consumer in keeping the entire system afloat amidst a "draught," if you will, of business investment as a result of an increasingly precarious political environment. Well, the truth is, the game has changed, and consumers shouldering the burden of a lack of business spending is irrelevant today. The question going forward is to what extend the CoronaVirus experience has altered consumer psychology. This pandemic has exposed a shockingly large portion of the population that is one missed paycheque away from some form of insolvency. That's not the hallmark of a robust economy. With the economy set to open in stages, there's unfounded hope that things will go back to normal. It goes back to the idea that unless people can be guaranteed their safety, consumers likely won't spend as they did before. The WTO remains fairly bearish on the outlook, expecting trade volumes to decline anywhere from 13-33 percent in 2020. You read that right, in the worst-case scenario, world trade could fall by a third. With that decline, it's more than likely we will see permanent damage done to supply chains around the world.

Market breadth has an impact on systematic flows.

Market makers have flipped short gamma.

Going into last week, options dealers were net long gamma, meaning that their flows were acting as a shock absorber in markets. This means that, as markets fall, dealers are required to buy stock and vice versa. US equities closed off the week with two days of consecutive losses, which, coupled with some options expiring on Friday, have now pushed dealers into short gamma. That means that dealers will now be selling into weak markets and buying into strong markets. It looks like dealers will flip from short to long if the market pushes above around 2875. If that happens, that will put us back in the gamma "pocket" of insulating hedging flows. The chart below shows the estimated positioning of dealers going into Monday's cash open. The X-axis shows S&P500 index value, and the Y-axis shows the estimated gamma hedging required in US$ at each strike.

Momentum funds may reduce exposure this week.

Last week we saw momentum funds begin to increase equity exposure as volatility continued to normalize. That was a promising signal as dealers were long gamma (in the safe zone if you will), and momentum funds were going back into their legacy long S&P500 futures positioning. Unfortunately, following Friday's close, things are now up in the air. Momentum funds are likely to be net sellers on Monday by Nomura's estimates, and dealers are net short gamma. Why this has happened is actually because of problems I emphasized above due to market breadth. Both Amazon and Apple announced earnings on Thursday night and ignited some selling over certain aspects of the reports. Given that FAAMG now accounts for 20 percent of the overall S&P500 index, these five companies have an oversized impact on the broader index with the potential to trigger systematic flows. With Amazon falling 7 percent and Apple falling 1.5 percent, the broader index drifted lower triggering momentum selling. The good news in all of this is that volatility has remained fairly stable, keeping volatility control funds over shorter lookback windows as net buyers. However, that can all change if we start to see a sustained increase in volatility. As I had mentioned last week, I will begin to release a group of Explainer Series on all of these concepts over the coming months. For now, the bottom line is that markets appear to be in for a fairly choppy week.

Oil posted its first weekly gain in a month.

I've refrained from talking about oil because the situation in the market is pretty chaotic. The oil market is facing an unprecedented demand shock while simultaneously dealing with a price war between Saudi Arabia and Russia. I am going to do an explainer series on the oil market in the coming weeks but, for the time being, know that things going on in this market make for volatile trading. Without access to the underlying flows, most retail investors are probably better playing the odds the trading snake oils than barrels of crude oil (at least in the short-run). With that said, Goldman seems to think that the chaos may be over. The chart below shows their estimates of the impact of oil demand over the next few months.

Tiago Figueiredo