Early last month, BofAML’s Barnaby Martin described what he characterized as a “non-stop event risk cabaret”. That was an allusion to the multiple “left-field events” that have rattled markets since the halcyon days of mid-January.
There was the inflation scare that ultimately helped precipitate the VIX explosion and subsequent deleveraging by systematic investors, for instance. And then there was the spike in real rates stateside. There was also the blowout in LIBOR. And the turmoil in Italian bonds. And how about the ongoing malaise in emerging markets catalyzed by a combination of Fed tightening and idiosyncratic flareups that prompted the collapse of the Argentine peso and the egregious slide in the Turkish lira? Oh, and then there’s the ongoing bear market in Chinese equities and the near-bear market price action in European autos and banks. And on and on.
The sheer number of black swan landings has been nothing short of remarkable and it’s not too difficult to point fingers when it comes to assigning causation.
“We have long argued that the true significance of the increased incidence of ‘market mishaps’ this year is not the direct contagion from them, but the indirect implication they hold for what has happened, and is continuing to happen, to market technicals”, Citi’s Matt King wrote, in a piece dated August 17, adding that “the off-market ‘marginal buying’ that was propping up valuations as a result of new money entering markets, from credit creation in China and from global central bank liquidity creation, has all but stopped.”
In other words, the liquidity tide is going out and the dynamics that drove investors down the quality ladder and out the risk curve are reversing. That means markets that were priced to perfection (e.g., HY, EM, etc.) will now widen out to better reflect the risks inherent in owning, well, in owning risky assets.
The turning of the liquidity tide has been discussed here at length on too many occasions to count, but one of the more recent exhaustive takes can be found in “Dollar Liquidity Dynamics: An Epochal Shift Is Coming“.
That post draws heavily on the work of Nedbank’s Neel Heyenke and Mehul Daya. The Nedbank research we cited in that linked August 4 post has since shown up in a number of places, and on Thursday, Heyenke and Daya’s visuals were featured in an FTAlphaville article that also features a chart from the above-mentioned Barnaby Martin, who just released a followup to the “risk cabaret” piece.
In the original risk cabaret note, Martin suggested there’s another common thread besides central bank tightening that helps to explain some of 2018’s various shocks.
“While these appear like a series of disconnected shocks, a common thread to some of them is that they are a consequence of populism and the protectionist, antagonistic and deglobalization lurch by western leaders”, he wrote.
In the Nedbank note mentioned above, the bank’s analysts suggested that while the following indelible image is generally seen as emblematic of the shifting geopolitical sands (read: deglobalization and the demise of multilateralism), it has profound market implications as well.
(A handout photograph from the German government shows a group of leaders at the Group of Seven summit, including German Chancellor Angela Merkel and President Trump, in Canada on June 9, 2018)
Well, in his latest, BofAML’s Martin follows up on everything said above. To wit:
The non-stop event risk cabaret is still playing. After “Vixplosion” in February, US LIBOR surging in March, inflation worries in April, Italy stress in May, trade fears in June and tech tumult in July, EM currencies have been the market’s nemesis in August. The common thread with 2018’s macro “shocks” is that they are symptoms of a world now characterized by desynchronised growth, politics and liquidity support. And we think that populism has been an instigator of this backdrop this year.
He goes on to flag the paradox inherent in the necessity of EM central banks hiking rates in order to shore up their currencies in the face of hawkish Fed policy and a surging dollar.
The orthodox response to EM currency stress is central bank rate hikes. But this will serve to exacerbate the Fedinspired liquidity drain already at work across markets. Note that year-to-date, the number of central bank rate hikes across the globe has shot up, and the pace is now almost on par with the pre-Lehman peak. And with less liquidity comes less “crowding” by markets into risky assets. Thus, investors should prepare for an ongoing period of high performance dispersion and idiosyncratic risk, in our view.
In the same vein, note that EM rate hikes have the potential to exacerbate the reversal of the synchronous global growth narrative that helped underpin the low vol. regime that characterized 2017. Martin talked about that in a separate piece out earlier this month, profiled here.
On the subject of EM vulnerability, Martin reminds you that Turkey’s external borrowing as a % of GDP is what really stands out (i.e., more so than simply looking at the nominal amount of USD debt outstanding).
Although the dollar rebounded on Thursday, the five-day slump in the greenback helped reignite risk sentiment and going forward, the fate of global markets hangs on whether dollar liquidity continues to evaporate.
And with that, we’ll leave you with some excerpts from the latest piece by Nedbank’s Heyenke and Daya.
Most investors understand that as the money supply explodes it will lead to higher consumer inflation as the value of money falls. Yet most equity investors believe the price of an asset is only derived from the demand and supply of the underlying product or service of that specific corporate. The change in money and credit and the price thereof has a major impact on asset prices. As the interest rates converged to the zero lower bound the changing quantum of money has become the dominant driver of asset prices and currencies. The dollar monetary base, which is basically the US trade deficit, exploded over the last 30 years. This growth has been a major contributor of asset inflation. Ask yourself, “how is it possible that assets can out-perform the GDP over such an extended period?”
Simultaneous with the above trend of growth in the monetary base since 1988, the credit creation in the financial system evolved and bank gearing went up from 14 times to over 40 times. This explosion in money and credit triggered a break higher in this relative out of a 80-year old band. Unfortunately the highly geared financial system also made the markets very vulnerable to frequent shocks as is evident on this relative. The relative is currently close to the previous highs.