In the foreword to their Q2 outlook, Barclays describes a phone call with an “exasperated” client who in late January was desperate to buy a dip that wouldn’t come.
How, he wondered, does one buy the dip if stocks only keep rising?
Well, “one” doesn’t. Rather, “one” is relegated to buying on any momentary, fleeting weakness or, more simply, one is left to buy “blips”.
How did we get to that point? Well, we’ve explained that on a number of occasions. Consider this excerpt from a February piece on market fragility:
The increasing rapidity with which intermittent flareups collapse has been a defining feature of markets over the past couple of years and this dynamic has become especially prevalent since Brexit.
Part and parcel of that dynamic is the idea that the central bank put has become self-sustaining – it runs on autopilot. Why wait on dovish forward guidance (or any other signal from the monetary gods) to buy the dip when you know with absolute certainty that in the unlikely event a drawdown proves to be some semblance of sustainable, policymakers will calm markets? If you know it’s coming, well then you should buy the dip now. This becomes a recursive exercise as everyone tries to frontrun everyone else and before you know it, dips and vol. spikes are mean reverting at a record pace as the prevailing dynamic optimizes around itself.
That was already operating by the time the Trump tax cuts were introduced and when January rolled around, the tax cut optimism collided with optimized dip buying and retail euphoria (e.g. millennials dumping money into E*Trade accounts, at least according to anecdotal evidence) and you ended up with frustrated Barclays clients searching in vain for entry points.
We haven’t checked back with him, but we assume market complacency is no longer his biggest concern.
Needless to say, the client Barclays describes needn’t have been concerned. There was a dip to buy in February and if he missed that, there was another one two weeks back and a pretty precipitous drawdown in FANG this week (although it was partially recouped on Friday).
So if Barclays did check back in with their client, what would they tell him if, for instance, he had since become worried not about finding a dip to buy, but rather about whether recent events suggests rallies should in fact be sold?
For one thing, Barclays would probably try and explain some of the lessons from February and, as I put it elsewhere on Friday, the inflation scare in February seemed to suggest that markets are particularly vulnerable to fears about the viability of the “Goldilocks” narrative that underpinned the low vol. regime for the entirety of 2017. Specifically, it seems like markets are hypersensitive to inflation data and attendant Fed concerns. What we saw in early February also underscores the extent to which markets “themselves” pose a risk. In short, what February proved was that concerns about the macro outlook (i.e. concerns about the viability of the “Goldilocks” narrative) can collide with market structure issues with dramatic consequences.
Well, here’s Barclays saying something similar:
Lessons from the February correction
February’s market correction now qualifies, we suppose, as economic history. But it leaves us with some lessons learned and a large enough shift in the market context to deserve some consideration.
We were surprised that markets were as susceptible to an outbreak of anxiety about inflation and monetary policy as they proved to be in February. We understand why investors assign so much significance to the ultra-supportive monetary environment. But we were taken aback that many responded so strongly to what was, in fact, only a weak sign of rising inflation. For example, the US core CPI print of 1.8% in February that made investors nervous should be considered in light of the fact that US core CPI averaged well above 2% in 2016. Similarly, the average hourly earnings series only got to 2.9% nominal (real wage growth below 1%) in February, and the trend reversed in the March report. Given the recent history of disappointed forecasts and false alarms of higher inflation, we would have expected a more skeptical approach to individual data points than we saw in early February. Lesson number one for us is that the market may react more strongly and with less skepticism to future evidence of inflationary pressures than we had previously thought.
More generally, we believe that we have exited the period of abnormally low volatility and muted responses to economic and political data of the past 12-18 months. There are a number of reasons why this could be true, despite the benign economic and monetary backdrop. Some investors may have been influenced in February by a sense that the positioning and asset valuations associated with the near-decade-long market rally may have approached their limits. The preceding year’s near-daily grind higher in price and lower in volatility certainly felt unusual, arguably artificial, and likely seemed unsustainable to many investors. At the same time, the move higher in safe bond yields has made allocation into such assets less punitive. Under these circumstances, it seems likely that investors will continue to respond more normally to news flow.
We do not think this should be overstated; after all, risk assets rebounded smartly after the February sell-off before giving up some of those gains on trade fears. For now, we think that the temptation to ‘buy on the dip’ is likely to limit market setbacks created by nervous reactions to events. But it seems likely that nervous reactions will be more frequent than they have been for the past year and a half.
One think I think is critical: you should be able to separate what happened in February from what happened this month. The selloffs were of a different sort and I would argue we’re going to be seeing more of both going forward. Here’s how I described the difference over at Dealbreaker the other day:
If you’re not a keen market observer, you might be inclined to attribute February’s crash in part to Trump, but that wouldn’t be entirely fair. Sure, there’s an argument to be made that his foray into late-cycle fiscal stimulus exacerbated the bond selloff (by skewing the supply/demand picture in the Treasury market at a time when the Fed is letting the balance sheet rundown) which in turn contributed to a tantrum-like dynamic that flipped the stock-bond return correlation positive and sent risk parity and 60/40 portfolios tumbling in early February. And yes, that fiscal backdrop amplified the AHE beat that accompanied the January jobs report (i.e. expansionary fiscal policy coupled with the first convincing signs of wage growth telegraphed a more hawkish Fed).
But the flash-crashing madness that characterized the week of February 5-February 9 was down to technical factors including the realization of the VIX ETP rebalance risk and a subsequent wave of systematic de-risking (some $200 billion of equity exposure was dumped by CTAs and risk parity). So really, it’s not fair to call what happened in February a “Trump crash”.
This month was different. The March 22 rout and its March 23 sequel were down to trade war jitters and also to concerns that Trump’s random Twitter threat to veto the $1.3 trillion spending bill was further evidence that the man in the Oval Office is becoming more unhinged by the week. His decision to use a press conference convened to discuss the signing of the spending bill to talk instead about “invisible” fighter jets and nuclear submarines didn’t do anything to allay people’s concerns.
Again, one question worth asking going forward is what happens when these two distinct types of risk-off events collide? What happens when Trump inadvertently exacerbates a technical selloff with some kind of economic or foreign policy blunder? What happens when an errant, hawkish Fed statement meets another above-consensus inflation print and that happens during the same week John Bolton says something even crazier than usual about Mideast policy? Etc. etc.
Good questions, all. And questions I imagine we may see answered in Q2.