Obviously, calling the top in markets hasn’t worked, and to the extent it’s always (i.e. historically) been an fool’s errand, the post-crisis easy money regime has made it an exercise in Einsteinian insanity.
The irony there shouldn’t be lost on anyone. The dynamic that’s made every would-be top-caller look foolish time and again is itself an example of Einsteinian insanity. That is, how many more trillions in fiat money do we need to print with nothing to show for it in terms of the inflation measures we’re supposedly aiming to boost, before we realize that i) the models are antiquated, ii) what we’re doing isn’t working, or iii) both?
So what we’re left with is one example of doing the same thing over and over again and expecting a different result (printing money and expecting real economy inflation to rise), resulting directly in another example of doing the same thing over and over again and expecting a different result (calling the top and/or calling for an imminent and sustainable vol. spike).
Currently, this is unfolding against a geopolitical backdrop that is absurdly precarious. As we’ve noted previously, it would be difficult to dream up a series of events more surreal than what we’ve seen unfold in the last 13 months if you tried. Between Brexit, Trump, a near-miss with Le Pen in France, and a North Korea that’s now armed with ICBMs capable of hitting the U.S. mainland, you literally “can’t make this shit up anymore.”
Throw in Syria, Venezuela, Yemen, Libya, and now the spat between Qatar and the Saudis (all things that were already going on or have been flash points in the past), and you’d be forgiven for thinking that the VIX is an optical illusion.
Consider, for instance, that the VIX sat below 10 for 10 consecutive sessions through July 26:
As far as I can tell – and I’m not 100% sure on this, so don’t quote me – that has never happened before.
The thing to note here is that the first exercise in Einsteinian insanity (central banks printing money to no avail in terms of hitting their inflation targets but to spectacular success in terms of creating financial asset price inflation) is about to come to an end as the Fed begins to normalize its balance sheet and the ECB starts to think seriously about an exit plan.
That would suggest that the second exercise in Einsteinian insanity (calling market tops) may no longer be doomed to failure. For his part, BofAML’s Michael Hartnett is going to give it a go. Consider these bullet points:
- August crack: we have penciled in autumn top; August crack in markets requires dollar swoon (DXY to 90) to coincide with unambiguous US labor/consumer weakness (payroll <100K) & flatter yield curve; end of “high yield” leadership should be early warning system, as would fatigue in equity “growth” leadership
- Positioning becoming more consistent with autumn top in risk assets: Bull & Bear indicator now 7.6, edging up toward “sell” level of 8; “active” equity funds seeing biggest inflows since 2014; disobedience of central banks beginning
Now, let’s bring in the geopolitical risk.
You might recall that a couple of weeks ago we brought you a series of posts on “games of chicken.” Here are those posts if you missed them:
- ‘Things Have Changed Dramatically’: Please Explain Why Markets Don’t Care About Nuclear War
- ‘Game Of Chicken’: Why Do Markets Think They’re So Damn ‘Impervious’?
In those pieces, we highlighted a note from BofAML in which David Woo set out to analyze political brinksmanship over tax reform and North Korea using a game-theoretic framework.
Well, fast forward two weeks (give or take) and we’re no closer on tax reform (in fact, we’re much further away after the most recent health care bill debacle) and we’re no closer to a resolution on North Korea (in fact, if we’re “closer” to anything, it’s a nuclear confrontation).
And so, naturally, Woo is out with a follow up called … drumroll …
Yes, let the “chicken dance begin.”
Here are some useful excerpts…
Throwing down the gauntlet
Two weeks ago we made the case that the market had yet to price in the risks
associated with two possible games of chicken:
- A showdown between President Trump and the GOP over tax reform in the fall
- A showdown between the US and China over North Korea between now and the fall
In our view, developments over the past two weeks have raised the probability of these two games of chicken actually being put into motion.
- After the failure of the Senate to pass healthcare reform last week, the GOP is
moving onto other issues. “At the top of that list is cutting taxes for middle class
families and fixing our broken tax code,” said Paul Ryan in a statement on July 28. All evidence suggests that tax reform will be the #1 focus in Washington after Congress returns from their summer recess on September 5.
- Despite the fact that there have been a narrowing of differences among the Big Six (Mnuchin, Cohn, Ryan, Brady, McConnel and Hatch) – notably the abandonment of the ideas of a border adjustment tax (BAT) and a domestic consumption-based tax system (i.e., a VAT) – the vagueness of the broad principles laid out by the Big Six on July 27 was hint that major differences remain.
- Mnuchin’s insistence at a Senate hearing on July 26 that moving to a territorial
system of corporate income tax system is a “very, very, very high” priority should be interpreted as suggesting that the administration is still pushing for a deep cut of the corporate tax rate. However, with both BAT and VAT ruled out, it is highly unclear how the corporate tax cut will be funded.
- President Trump’s interview with the WSJ on July 25 made it very clear that the
administration is considering financing a middle income tax cut by increasing taxes on the rich (“The truth is the people I care most about are the middle-income people in this country who have gotten screwed. And if there’s upward revision it’s going to be on high-income people”).
- Mnuchin said on July 26 that the administration is also looking at introducing an online sales tax that could be a source of funding for infrastructure spending.
- However, the GOP is divided over an online sales tax and a sharp increase in
personal income tax for the wealthy could cost the GOP important votes from their traditional support base in the 2018 mid-term elections.
- Meanwhile, the fact that Senate Republicans failed to pass healthcare reform over one vote highlights the challenge of getting anything done with a narrow majority of 52 seats.
- It is reasonable to assume that after the failure of healthcare reform Trump is
unlikely to leave tax reform to Congress.
- We argued that the 2018 budget resolution and the debt ceiling are the last levers President Trump has before he runs out of time on tax reform. Our game theory analysis suggests that he has a strong incentive to threaten a government shutdown or even a default in October in order to force the
party to fall in line behind a single tax reform plan.
Recent developments also reinforce our view that the risk is growing of a brinksmanship between US and China over North Korea:
- North Korea launched a second ICBM on July 28 that, according to some experts, has the range to strike major US cities.
- After the launch Rex Tillerson issued a statement in which China and Russia were singled out for bearing “unique and special responsibility for this growing threat to regional and global stability.”
- Even before the latest ICBM test, US and Chinese officials concluded the US-China Comprehensive Economic Dialogue two weeks ago without a joint statement. They also cancelled a planned closing new conference.
Washington is facing mounting pressure to stop North Korea from developing nuclear missiles that can reach the US. Unless Beijing takes concrete steps to bring North Korea under control, the risk is growing that the détente reached between Trump and Xi at Mar-a-Lago could be undone.
And so, this is the backdrop against which you are long risk (if you’re long risk) and/or short vol.
To the extent you think that’s going to be sustainable, good for you, but we would caution that you have now run out ahead of your fairy godmother…