‘Theme Overload’.

“Littered with landmines” – that’s how I’ve variously described the macro landscape for the duration of 2018.

On any given day, there’s so much to process that divining an overarching narrative is well nigh impossible. In fact, the geopolitical risks are now so myriad, the market potholes so multitudinous, that making a comprehensive list of all the relevant variables is very nearly as difficult a task as making sense of that same list assuming you can construct it in the first place.

To be sure, there are common threads – ties that bind, if you will. Here are four key themes:

1. The semi-global populist upsurge that began to usurp centrist politics in Western democracies in 2015 continues to simmer. Populist politics has precipitated anti-globalist sentiment that’s served to erode the legitimacy of the multilateral institutions that define the post-War world. The rise of nationalism and isolationism threatens to undermine the synchronous growth narrative that was a key pillar of 2017’s low vol. regime. In addition, nativism threatens to upend global trade and commerce with ramifications that will echo for decades. Populism also threatens to undermine implicit and explicit commitments to fiscal discipline, and that, in turn, imperils debt dynamics, with Italy serving as a kind of testing ground for what happens when fiscal profligacy collides with the rollback of central bank support for government debt markets.
2. Developed market central banks are taking the first tentative steps down the road to normalization after nearly a decade of monetary accommodation. The re-emancipation of markets is generally seen as desirable, but after so many years operating in an environment backstopped by trillions in liquidity, nobody knows what the actual clearing prices are for risk assets. Price discovery is making a comeback, but at what cost (figuratively and literally)? The Fed’s head start on the normalization push has driven up yields on USD “cash”, with the effect of sapping demand for risky assets, valuations on which are still artificially inflated by the lingering effects of ZIRP, NIRP and QE.
3. The Trump administration’s decision to pile fiscal stimulus atop a late-stage expansion has served to overheat the U.S. economy, forcing the Fed to lean more hawkish than it otherwise might. Meanwhile, the threat of tariff-related price pressures only adds to Fed angst and thus to the propensity for the committee to remain committed to the rate path. The hawkish Fed has underpinned the dollar by driving rate differentials between the U.S. and the rest of the world wider. The stronger dollar, in turn, weighs heavily on emerging market assets and on developing economies who took advantage of the global hunt for yield to accumulate foreign currency debt. The reversal of those flows imperils emerging markets that rely heavily on external funding.
4. Modern market structure – characterized as it is by the proliferation of systematic strategies, passive investing and computerized market making – leaves markets vulnerable to fragility events, flash crashes and liquidity vacuums. The post-crisis regulatory regime has left dealers unwilling to lend their balance sheets, creating a historic disparity between investors and the Street that could exacerbate a fire sale in the event the liquidity mismatch in, for instance, high yield and emerging market debt ETFs is laid bare.

Coping with this complex reality is difficult and can at times seem overwhelming to stewards of capital and even to seasoned traders who are by definition adept at navigating choppy waters. Making sense of things now requires a cross-disciplinary approach that is quite simply out of reach for the vast majority of market participants whose academic training is limited to a single field of study and whose ability to synthesize geopolitical undercurrents and market themes is thus inherently circumscribed.

Given all of the above, it comes as no surprise that in the latest installment of BofAML’s European credit investor survey, the bank’s Barnaby Martin finds that “theme overload” is prevalent among respondents.

“There are simply too many macro narratives now for the market to process on a daily basis”, Martin writes, adding that “this goes a long way to explaining why risk rallies have been conspicuously short-lived in ‘18.”

While the survey shows “populism” once again topping the list of biggest perceived worries among IG investors (for the first time since the French elections), it won out by a thin margin.

“Investors are almost equally preoccupied with other issues, such as market liquidity vanishing, bubbles in credit, geopolitics and trade wars”, Martin goes on to write, before noting that “high-yield investors have started to register a growing worry about rising defaults, after expressing few concerns in August’s survey.”

(BofAML)

Here is the breakdown which shows that while concerns about Italy prompted 17% of respondents to identify “populism” as the key concern, evaporating liquidity was not far behind (14%), while “bubbles” garnered 11% of the vote and “geopolitical conflict” 10%.

(BofAML)

Other highlights from the survey include palpable jitters among Euro HY investors about spread widening after CSPP ends (“life without a backstop buyer”) and concerns that EM assets do not yet represent a buying opportunity (these knives have further to fall yet).

But the overarching message from the survey is that market participants have seemingly reached the limits of their capacity to process incoming information.

In 2017, this was not a problem. Why? Certainly not because the list of macro concerns wasn’t similarly long or because the interplay between those concerns wasn’t equally complex.

Rather, because in 2017, well-anchored inflation, synchronous global growth, and a reliably transparent Fed created a “noisy status quo” (to quote Deutsche Bank’s Aleksandar Kocic). Amid the noise, people simply waited for resolution. In the interim, they monetized that time spent waiting by selling vol.

In 2018, the short vol. trade in all its various manifestations is still prevalent, but these days, time spent waiting feels a little less like reading a magazine waiting on a tire rotation and a little more like waiting in the doctor’s office to find out why you were called in for a face-to-face after getting a chest X-ray.