For some folks, Wednesday’s risk rout came as a surprise.
See for a whole lot of investors, it’s not readily apparent that benchmarks can go down as well as up. And to the vol sellers out there, it was certainly starting to seem like forgoing carry out of a healthy respect for risk was an outright foolish thing to do in the current environment.
But usually when people start to feel like nothing can go wrong, the old “pennies in front of a steamroller” analogy applies. And while Wednesday’s market bloodbath and concurrent vol spike wasn’t all that black swan-ish in the grand scheme of things, on a 40-day rolling lookback window, it was a 4+-sigma event:
So what the fuck happened?
Well, we know what happened. Trump was effectively accused of obstructing justice by the FBI Director he fired and then subsequently Twitter threatened.
The better question is this: “why now?”
That is, Trump has been a walking constitutional crisis since the day he was inaugurated and he’s being acting like an autocrat from the word “go.” So with the ECB still in the game (for now) and with Kuroda still persisting blissfully in Never Never land (literally), why did everyone decide that Wednesday was the day it all had to come apart?
The first answer is simple: it has to unwind one day, so why not Wednesday?
But beyond that truism, there’s more nuance. Specifically, the apparent erosion of support from Republicans threatens the viability of the Trump agenda.
Here to talk a little more about this is Citi’s Hanz Lorenzen, who also mentions the flows data we highlighted this morning and the point Richard Breslow made on Thursday about watching credit for signs the fear is spreading and core positions are being unwound.
Strike a match and throw it to the ground. It burns out, nothing happens. Strike two. Nothing. Strike three – or four or however many – and suddenly one will like land on dry tinder and start a fire.
By Wednesday this week the market had absorbed a multitude of potentially unnerving political headlines, yet suddenly the something in markets ignited. Judging from media reports, ostensibly the growing probability of impeachment of President Trump was to blame, following reports of a memo written by now former FBI Director Comey claiming that the President had asked him to shut down the investigation into National Security Advisor Michael Flynn. Yet, in line with our political analyst, Tina Fordham, we consider it unlikely that a Republican-controlled House would muster enough voters for impeachment ahead of mid-terms next year.
In our view, the main reason markets suddenly responded was that the hitherto united Republican front was showing real signs of crumbling – and with it, prospects for the tax reforms that markets have so cherished took another hit.
As you would expect, that prompted a stronger reaction in the US than in Europe (Figure 1). Notably, the reaction was also much stronger in implied volatility than it was in risk premia – i.e. VIX, V2X etc. reacted more than proportionately compared to iTraxx EUR and CDX IG (Figure 2).
That suggests that central expectations haven’t shifted enough to drive people out of their core positions, but they wanted to hedge some of the tail again. That makes sense. Against a backdrop of implied vol across asset classes hitting multi-year lows, and the S&P on its second-longest streak without a correction in more than 60 years , hedges had become ever more painful to sit on. And, following the outcome of the first round of the French presidential election, capitulation was evident. One by one hedges have been taken off, leaving the market vulnerable to an unexpected event.
The desire to cut tail risk was evident in that the fallout continued on Thursday. At least to us, it is not clear that the appointment of a Special Counsel to investigate the Trump administration’s links to Russia should be seen as a market-negative. Granted, Mueller’s mandate is very broad and history shows that these investigations tend to morph from the issues that are in the public domain when they are launched into something very different by the time they are finished. That adds to long-term political uncertainty. Yet, equally it may provide some near-term stability, providing another outlet than the media for any disgruntled civil servants and reducing the pressure on the administration to make further comments in the short term. Note that the trade-weighted dollar, the DXY, which has been a good proxy for the Trump trade, rose on Thursday.
If the investigation sends the issue into the long(er) grass, then it is also understandable why the reaction in broader risk assets has been relatively contained. The modest rally today (Friday) confirms that there is no widespread panic. Away from Washington politics the immediate backdrop to many still looks more half full than half empty.
Central banks are still pumping enough liquidity into markets to support valuations by ensuring that there is more money than there are assets to buy – lately, the recycling of renewed reserve accumulation among EM central banks and SNB purchases has provided a further boost (Figure 3). A couple of weak inflation prints have reduced the market-implied probability of two further Fed hikes this year, while strong data in the Eurozone has not as yet prompted a major shift from the ECB.
Our equity strategists are predicting positive earnings growth in every major region for the first time since 2010, while analysts are, on balance, raising their bottom-up earnings forecasts for the first time in years. Moreover, YTD mutual fund inflows into equities are already close to surpassing the 2012 record, with synchronized inflows in every region for the first time since 2004. Flows into European and US credit has also been very decent at a time where, even after the recent surge in issuance , YTD net supply after CSPP purchases is barely even positive.
To top things off, we still get the impression that the consensus in credit, in line with our own thinking, is that spreads will widen in the medium term. The obvious implication is that many investors are not overly long risk and therefore susceptible to the sensation that they are missing out whenever the market rallies. It certainly feels like many fund managers that we speak to are more worried about the market rallying another basis point than they are about a basis point of widening.
Small wonder, then, that even the latest bout of political uncertainty is not really shifting the underlying mindset of the market, beyond a little bit of tail hedging. Indeed, every hurdle overcome is seen as testament to the resilience of the market.
Don’t look for the match, but for the combustible material
Yet the fortunes of the Trump administration are, to our minds, largely a distraction from the real underlying drivers. And, to our minds, there are real tensions building in other places, which are currently being ignored.
The changing mix between inflation expectations and real interest rates that we warned about earlier this year seems to be happening to some extent. While real rates have remained range-bound, reflecting perceptions about Fed policy, inflation expectations continue to slide (Figure 4), which, with a flattening yield curve, suggests that the rates market is getting less sanguine about medium-term growth. That does not send a positive message for credit.
Lending surveys are also painting a relatively weak picture (Figure 5), which is reflected in a slowing in global credit creation. The Chinese credit impulse, which has historically led a number of activity indicators, has fallen sharply.
And most of all, we still firmly believe the impact a reduction in ECB purchases (and only partial reinvestment by the Fed) will have on global liquidity next year is widely being underestimated. This will be the real litmus test of market resilience.
This week’s volatility serves as a useful reminder. Without question the spread widening and the rise in vol to date is more smouldering than actual fire, but there is a lot of dry tinder around markets. Breakevens in credit are very small and everyone is watching the same data and the same events, so reversals are likely to be quite abrupt the day when fund managers aren’t under the pressure of continued inflows.