The Lobster King is among us

Let the good times roll.

Markets continue basking in good vibes.

Economic data has begun to show signs of bottoming, and reopening continues to progress without any signs of letting up. The threat of further trade war rhetoric picked up this weekend in one of the most ridiculous exchanges I've ever heard. President Trump threatened to tariff EU cars due to a lobster tariff (and in the process named Peter Navarro the Lobster king). Of course, the threat of geopolitical risk is still rampant, along with the prospect of a second wave of infections. Despite this, many market participants prefer to focus on the good news rather than the bad. That has become increasingly easier to do, given the unprecedented fiscal and monetary policy being pumped into the system. With Europe pushing towards some form of fiscal union and Germany FINALLY opening up its checkbook, there is some hope that we may finally escape the vaunted low growth/inflation/interest rate world we have been trapped in for nearly a decade.

Those pushing for a V-shaped recovery finally got some evidence of it.

Around the world, economic data has continued to come in above expectations. Manufacturing and service data shows that the sectors appear to be bottoming in many regions. In China, manufacturing has rebounded and reached levels last seen in 2010. Normally, I would be quick to dismiss this as another example of China "cooking the books," but the fact that we've seen a pick up across the globe lends some legitimacy to the numbers. That aside, the biggest surprise on the data front came on Friday when job numbers in both US and Canada came in well above expectations. Although I've long dubbed the Canadian labor market data as a random number generator, the US printed an equally absurd number that puzzled the majority of the market. The May numbers are truly astonishing and mark a biblical reversal of the labor market from April. The chart below shows a breakdown of the jobs numbers by sector relative to last year. Despite the US gaining over 2 million jobs, the labour market is still a pile of smouldering ashes. At this point, it is worth mentioning that this data also does not align with the unemployment claims, which indicated that an additional 1.9 million Americans filed for unemployment this week. That brings the rolling total of people filing for unemployment up to just over 43 million, highlighting the dire reality of the state of the economy.

A massacre in the legacy long-duration trade

The great rotation.

The optimism in markets is materializing in a large rotation under the surface in equity markets. Bond proxies, such as growth, low-volatility, momentum, and defensives, are being sold in favor of value, high-beta, and cyclical stocks. In short, companies that have underperformed over the last decade are being bought, and companies that have done well are being sold. This rotation helps explain why the NASDAQ, a tech index, underperformed the broader S&P500 index over the past month. The rotation is coming as a result of several factors; the first is a fiscal stimulus, particularly in Europe. The second is increasing chatter about yield curve control, where monetary policy targets interest rates on longer maturities along with overnight rates. The last, and probably the easiest for folks to understand, is the fact that the economy is reopening, and economic data is getting better. The chart below shows the relative performance of momentum relative to value.

The equity rotation is linked to the prospect of higher interest rates.

All of the factors I outlined above are conducive to higher interest rates. Indeed, we are starting to see inflation expectations increase, and long-term interest rates rise. With central banks around the world bringing interest rates down to zero and indicating that they will remain at that level for the foreseeable future, any economic shock will be forced into long-term interest rates. This implies that the yield curve will become steeper, as long-term interest rates rise faster than short-term interest rates. A steeper yield curve has an asymmetric impact on both company valuations, and also the ability of companies to roll over debt. In terms of valuation, companies whose cash flows are further out in the future, typically growth companies, will suffer more than companies with cashflows with shorter duration. Although these rotations happen from time to time, they are often cut short on account of some economic shift that forces central banks into more accommodation. Although saying "this time is different" is undoubtedly someone's famous last words, this time may very well be different. When you consider the amount of stimulus already injected into the veins of the still slumbering economy, it is possible that we've already overstimulated this sleeping beast, and that once it wakes up, it will rip out the IVs, eat the nearest nurse and run snarling through the hospital lobby right out the door. If that happens, long-term rates will skyrocket, and decade long laggards of the index will finally have their time to shine.

Systematic flows have likely been keeping markets stable.

"When the looting starts, the shooting starts."

Financial media has been plastered with the breathtaking recovery in stocks beset against tales of widespread economic calamity and social unrest. Ray Dalio has spoken about the state of American capitalism for years now, and, in the most recent post, he highlighted that the likelihood that things will change is slim. I'm not going to disagree with him on this. The racism problem is intertwined with poverty and crime, which leads to inadequate education and systemic disadvantages. Although the protests are great for bringing racism issues to the frontlines, the problem is far larger than police brutality. The pandemic has exposed the sheer number of people who live one missed paycheque away from some form of insolvency. Although stocks have staged a herculean comeback, that's irrelevant for most people, particularly those of color (see chart below). The top 10 percent of Americans own 88 percent of the stock market. The massive rebound has worsened the inequality issue, and the Fed's efforts to backstop/save the economy have undoubtedly exacerbated the problem by inflating asset prices. These are issues that are going to plague American for the foreseeable future, and it's mostly tied to the stock market being out of touch with the real economy.

Source: Heisenberg Report

Market maker hedging has insulated the market from any shocks.

With markets slowly beginning to normalize, the systematic community is starting to be dragged back into the market. Market makers have remained long gamma, which means that their hedging will act as a volatility suppresser. The chart below shows an update of the gamma profile as of Friday. As long as we stay above 3000 on the S&P500, the market should remain stable.

We will likely see a lot of buying from the systematic community next week.

By some account, much of the recovery has been driven by retail volume along with CTAs, which use momentum signals to enter the market. With volatility markets beginning to fall to pre-pandemic levels, we will likely see the volatility control and risk-parity investors begin to increase exposure. With the most volatile days of March set to drop out of the 3-month lookback window in the coming weeks, we should see daily volatility control funds begin to increase exposure in size. The chart below shows the current allocation to the S&P500 for various lookback windows.

Liquidity remains near all-time lows.

Regular readers will know how often I am pounding the table on the importance of liquidity and the feedback loops that can occur when trading is thin. In reality, its akin to sailing a ship in shallow water in the sense that things are far more likely to go wrong than if you were sailing in the open ocean. The chart below is a new indicator I replicated from Soc Gen that serves as a proxy for liquidity in the futures market.

The index takes the total volume and divides it by the daily trading range for each day. The index shows that liquidity has never really recovered after 2018 when the VIX short-volatility ETFs products went extinct. For those wondering how this liquidity indicator relates to volatility, as liquidity decreases, market volatility increases. The chart below shows that this relationship is exponential and helps explain that, when things go wrong, they tend to go wrong quickly.

Tiago Figueiredo