Wait, is that guy on fire?

Summary

• Macro narrative — Bottoming in growth?

• Market dynamics — Convexity hedging.

• Hong Kong — Don’t try catching a falling knife.

• The week ahead — Bonds at a crossroads.

The latest string of economic data painted a mixed picture on the macro outlook but market participants remain optimistic that a rebound in growth is imminent. The de-escalation in the US-China trade war coupled with constructive progress away from a hard Brexit has reduced the perceived geopolitical risk in the market. Market participants are also coming around to the idea that the global push for monetary accommodation has had enough time to work its way through the system and should begin to show in the economic data. That’s not a guarantee that growth will pick up, but it has shifted sentiment in the market and resulted in higher stock prices and bond yields. As I’ve mentioned over the last few weeks, business investment has collapsed around global, shifting much of the burden of growth onto the consumer. Fortunately, consumer spending has remained robust despite the risk that higher interest rates may begin to hurt consumption. Indeed that was the fear in September when retail sales in the US contracted year over year (YoY). The good news is that retails sales rebounded last month, the bad news is that the details of the report weren’t that great. US Inflation remains suppressed and printed below expectations, playing into the Fed’s narrative of subdued inflation which continues to justify an accommodative stance despite a strong underlying economy. This inflation print garnered more attention given Fed Chair Powell’s emphasis that it would take a dramatic spike in inflation to put rate hikes back on the table at the last FOMC meeting. That signals a completely asymmetric policy going forward which is important considering that the Fed is currently reviewing it’s policy framework and is expected to deliver their findings in the first half of 2020. Many have speculated a change in their mandate to average inflation targeting. Powell’s address at Capitol Hill on Wednesday struck a cautious cord, highlighting “sluggish growth and trade developments” which have “weighed on the economy and pose ongoing risks”. He also reiterated that the Fed remains ready to respond if developments emerge that cause a material reassessment of the outlook. What a material reassessment of the  entails is up to the market to figure out. Reports that President Trump was planning on introducing a 15 percent tax cut for the middle class would likely fit the bill of a “material reassessment” but seems unlikely for now. Meanwhile, in Europe, Germany avoided entering a recession last quarter, eking out a 0.1 percent expansion YoY.  Although one would think this was good news, the narrow miss effectively guarantees that Germany will stick to their fiscal guns and avoid any spending. The Reserve Bank of New Zealand (RBNZ) also turned a few heads this week after they unexpectedly left rates unchanged last Wednesday. This might seem redundant but remember that the RBNZ was one of the first central banks to cut rates this year and has long been viewed as a proxy (along with Australia) for the health of the Chinese economy. Of course, data out of China tells a different story. Inflation last week hit a 7-year high on the back of surging pork prices which puts the Peoples Bank of China (PBOC) in a tough place. The most recent activity data showed that retail sales and industrial production remain sluggish while imports have contracted for 6 consecutive months. The problem here is that the Chinese economy needs stimulus but now the central bank faces a consumer inflation problem. The PBOC’s monetary policy report released this week takes a half-hearted approach to stimulus and liquidity, reflecting themes I’ve talked at length about here and here. Of course, China still has the means to pump out a full-blown stimulus program should they deem it necessary. That’s something that other central banks would die to have nowadays. 

The S&P500 has logged 6 consecutive weekly gains, something that has not happened since the goldilocks period back in 2017. The recent rally sprang to its feet after 2 positive macro catalysts, the phase one trade deal and the progress on Brexit, collided with market positioning, which at the time was skewed to the downside. Although I’ve avoided talking about it in this newsletter, some of the bigger bond rallies this year have been tied to convexity hedging, a mechanical process that happens in the fixed income market. You can picture this as dealers selling protection against an economic crash. As the global outlook began to deteriorate, it became more likely that the dealers would have to deliver on their protection and began buying protection themselves. The point ofl this is that the decline in bond yields, which stoked recession fears, was driven largely by mechanical factors from asymmetric positioning from dealers. The recent pullback in yields was expected but, once again, seems to be overdone as it was exasperated by CTAs, momentum trading hedge funds, which began to sell their positions a few weeks ago. The chart below comes from Nomura and shows the one week change in Treasury bond future positioning. It shows the largest 1 week unwind since 2016. 

Supporting this, a popular long-term bond ETF, TLT, saw the biggest one week outflow in the fund's history last week. The reality is, a lot of the duration trade (that includes any form of bond proxy) has been hit fairly hard over the last few weeks. Of course, these positions could continue to get hammered if the economic data begins to come in better than expected. Sentiment has begun to shift and I don’t doubt that investors are beginning to shift to more cyclical assets. However, if the data doesn’t impress I think there’s scope for another duration push. For index investors, this doesn’t matter, anything that ends with new all-time highs can’t be that bad right? I won’t fault anyone for thinking that although, I would caution investors that option delta and gamma remain very high. This tells us that many investors are reaching for upside in US equities through options rather than outright owning the index. President Trump's speech on Wednesday was anything but reassuring, suggesting that a trade deal is all but done for December. I’m willing to bet that asset managers will start unwinding their exposure to US equities going into year end unless the trade rhetoric gets better. As for short-volatility, the latest CFTC data shows that short volatility is back, with a record number of speculators shorting volatility. The front end of the VIX term structure has been battered relative to the rest of the curve, making any sort of VIX roll down strategy yielding a higher return. The chart below shows the spread between the second and first month where a higher number shows a steeper curve.

That’s screaming for a pullback. As US cross-asset macro strategies Charlie McElligot once said, “if you’re short vol, you make money but eventually die. If you’re long vol, you die before you make money”.

Hong Kong protests took a turn for the worst this week, putting a damper on sentiment and sending the Hang Seng equity index lower by nearly 5 percent. The intensifying unrest in Hong Kong (HK) has severely impacted the city which posted a 3.2 percent decline in growth year over year a few weeks ago. That’s the stark reality of a city that has been protesting for nearly 36 weeks. Retail sales and tourism numbers have completely collapsed while some countries are asking their foreign students to pack up and leave. Last week was particularly bad; that guy’s on fire bad to be exact after a protestor was shot and a man was literally set on fire. Many investors now fear that the city is on the brink of outright chaos with no end in sight. Although the protests started with an extradition bill which was later withdrawn, it took HK’s Chief Executive, Carrie Lam, too long to formalize the withdrawal. During that time, the list of grievances grew, amid charges of excessive use of force and tear gas by police, Bloomberg writes. The recent developments served as a reality check to investors who have been trying to catch the falling knife that is HK's equity market. With pressure on China mounting, many expect some form of Chinese intervention. Indeed, China’s People’s Liberation Army (PLA) soldiers were helping residents clean up debris from protestors which could stoke further controversy about HK’s autonomous status. Further to that, earlier last week an influential Chinese state-backed media news outlet announced that the HK government was expected to announce a weekend curfew. Although the statement was later withdrawn and proven unfounded, one can’t help but wonder if this served as a test to see how the city would respond. Another cause for concern comes from the foreign exchange market, where liquidity has been tightening and forward rates on the HK dollar now sit at multi-decade highs. Things may yet get worse in the coming weeks with the district council elections on November 24th and there are plenty of other catalysts that Bloomberg highlights in the article linked above.

Markets will likely consolidate this week as they wait for further developments on trade and some juicy macro data. This week we will get the meeting minutes from the ECB, Fed, and the RBA (Reserve Bank of Australia). Although it seems a phase one deal will likely be struck by the end of the year, the recent commentary from President Trump suggests that there will be a bumpy road ahead. As I’ve highlighted in the past, with equities perched at all-time highs, it’s not unreasonable to think that President Trump could ramp up trade rhetoric to try to get something more out of China. China is grappling with their own issues and the PBOC cut their 7-day repo rate by 5 bps on Sunday night, highlighting the vulnerability of their economy. As for macro data, we will get plenty of flash manufacturing PMI’s which will help set a gauge for manufacturing. Although to be fair, it seems as though the manufacturing malaise is now old news. Bonds are in a tricky place, with yields having risen significantly due to CTA deleveraging and optimism (unfounded perhaps), there is no real reason for yields to continue to rise unless the economic data suggests a bottoming. Meanwhile, the S&P500 has been anchored between 2 key strikes, 3100 and 3150 — when these options expire it should free up some room for equities to move around a bit more.

Tiago Figueiredo