‘Some Worry’

“Some worry,” is an industry mainstay when it comes to language the financial media employs when they want to highlight an oft-repeated, campfire ghost story, but don’t necessarily want to delve too deeply into the specifics.

For example, “some worry” about credit ETF liquidity transformation (i.e., the structural “flaw,” wherein products like LQD and HYG promise intraday liquidity against an inherently less liquid pool of underlying assets).

Typically, “some worry” applies to purportedly esoteric things like market structure. But, as we’ve seen over the past year several years, this ostensible arcana can be important.

Failure to appreciate how esoteric factors influence the accumulation of risk, contributed to the implosion of the VIX ETP complex in February of 2018. After that event, everyone began to take note of the liquidity-vol-flows feedback loop, and how vol-selling and the long-term suppression of volatility can lead to the buildup of risk, similar to the situation that prevails just prior to an avalanche.

Similarly, it wasn’t until after the fact that the media picked up on the extent to which Reddit boards comprised of retail investors figured out how to forcibly enlist dealers in their quest to drive up prices for popular tech names over the summer (see here and here). That dynamic, by the way, is still going on. “‘Captain Insane-O’ levels of speculative RobinHood YOLO’ing in near-dated upside buying in the retail favorites [is] creating rolling ‘convexity events’ from the collective ‘weaponized (short) gamma’ impact of these option grabs on dealer hedging flows,” Nomura’s Charlie McElligott said this week.

In any case, “some worry” isn’t just confined to arcana. It’s equally effective as a generic introduction to a list of well-known risks, and when it comes to both the near- and medium-term, those risks have been catalogued exhaustively by analysts, despite the street’s generally upbeat view on risk assets both into year-end and in 2021.

On Friday, Kevin Muir, formerly head of equity derivatives at RBC Dominion, suggested the dollar could be due for a bounce, an outcome with the potential to derail risk sentiment, at least for a few days.

Another, more specific concern, is Tesla index inclusion, something Kevin talked about last month. Readers (and market participants more generally) have shown a keen interest in that event as a near-term risk factor.

For what it’s worth, JPMorgan says Tesla’s addition is “estimated to result in $57 billion selling of the existing S&P 500 index members, to make room.” Any associated volatility may be exacerbated “by Nasdaq rebalance, which is expected to be 3x larger than last year due to significant increase in stock concentration, i.e. reallocation away from Mega-cap tech to rest of Nasdaq universe,” the bank went on to say.

One assumes this could come on top of rebalancing flows associated with equities’ outperformance (versus bonds) over the quarter (figure below).

Shortly thereafter, the market will need to grapple with the Georgia runoffs. I’ve been over this on countless occasions. While some manner of new virus relief bill may come to fruition by year-end, the fate of fiscal stimulus under the Biden administration depends on the Senate.

While one imagines it would be difficult for Biden to push for any truly transformative policies while clinging to the slimmest of majorities, it is entirely possible that a Democratic Senate could pass, say, a trillion (or possibly more) in additional fiscal stimulus over Biden’s first term than would get passed otherwise. That would come on top of any spending associated with a virus relief bill passed during the lame duck session. As I put earlier this month, “unless you’re holding your breath for everyone in D.C. to suddenly embrace an MMT lens when it comes to government finance, more stimulus will mean more borrowing.” More borrowing is just another way of saying more Treasury supply, and that obviously has implications for the Fed in a world where monetary policy is expected to “partner” with fiscal policy to produce better, more utilitarian outcomes from stimulus.

Again, I’ve written voluminously on this, so at this point, it’s just a matter of incremental quotables, but that’s fine. JPMorgan calls the Georgia runoffs a “more meaningful, short-term risk” “The unexpected loss of both Republican seats could result in a ‘light blue sweep’ outcome, which could pose some downside for equities and re-introduce risk of anti-growth policy changes (i.e. tax increases),” the bank said.

There are two things I want to point out about that. First, I understand why everyone continues to describe a dual win for Democrats as “unexpected.” The assumption is that Perdue and Loeffler will prevail. I share that assumption, although I’m not enamored with it for ideological reasons. That said, the scant available polling showed both trailing as of December 12. I won’t even begin to suggest that polling is reliable, so I present the summary table (below) with the generic “it is what it is” disclaimer.

The second point I should make about the short quote above is that we (and by “we,” I mean everyone, regardless of partisan affiliation) should stop pretending as though tax increases are unequivocally “anti-growth.” They can be, but targeted tax increases aimed at engineering specific outcomes could easily be pro-growth. Imagine, for a moment, a special tax on the likes of Google, Facebook, and Amazon, the proceeds from which would go to fostering competition and innovation.

It isn’t my intent to turn this particular discussion into a prescriptive scold-a-thon, but suffice to say the evidence for supply-side economic “solutions” as reliable growth catalysts is mixed, at best. You can always construct a straw man wherein you juxtapose extreme examples of socialism with American capitalism, but that’s not a serious way to argue the point. However, Loeffler’s ad campaign relies heavily on that exact straw man: She ties Raphael Warnock to socialist dictators. Some of the ads I’ve seen on social media are wholly farcical, but nevertheless resonate with voters who don’t know any better. Sydney Powell’s “kraken” election lawsuit in the state (which was quickly tossed aside for being ridiculous) alleged a conspiracy orchestrated by, in part, the Venezuelan government.

It’s possible that in the melee (and that includes Donald Trump’s ongoing, made-for-TV theatrics), some would-be Republican runoff voters in Georgia will be so confused that they simply won’t turn out. That is not a prediction, by the way. They could just as easily show up in droves for Loeffler and Perdue as a way of exacting electoral “vengeance” on behalf of Trump. All I’m suggesting is that the message from the GOP in Georgia is somewhat confused and relies heavily on rhetoric that may be too far-fetched even for voters with an affinity for far-fetched smear campaigns.

In any case, it’s possible to suggest a dual-win for Democrats would be digested with alacrity by markets. “We expect this risk to be mostly manageable given Congress has pivoted to the center,” JPMorgan’s equity team said this week. They cite “less room for drastic changes.”

I wouldn’t necessarily disagree with the overall thrust of that assessment, but I would quibble at the margins. If the market were compelled to price-in a Democrat-controlled Senate literally overnight, there would be some indigestion. And as far as “drastic change” goes, that depends on your definition of “drastic.” A narrow majority isn’t going to pave the way for any kind of headline-grabbing, epochal Progressive shift in the country, that’s for sure. But it would force a rethink of assumptions about fiscal stimulus, borrowing, and spending, especially with Janet Yellen at Treasury.

“Some worry” that could eventually lead to inflation. “The market expects some firming of the cyclical component of inflation concurrent with cycle expansion in 2021 [but] longer term, the risk of structural increase in trend (i.e. average) inflation may be higher than any time in the last 25 years or so,” JPMorgan remarked, in their year-ahead outlook for equities.

The bank’s Dubravko Lakos-Bujas went on to say that “huge injection of money/QE, the Fed’s expressed tolerance of higher inflation for a while and large public debt pose an inflation tail risk, and could have significant negative implications for equity valuation / multiples and many quantitative strategies that are back tested in a mostly low inflation environment.”

Generally, the above captures the thrust of the main risks for markets in the near- to medium-term, and even touches on one longer-run worry.

Of course, the other two crucial considerations are the virus/vaccine and the persistence of central bank policy accommodation. Those two factors are the most important inputs of all, and you’ll note is that leaving them for the final paragraph(s) isn’t an attempt to bury the lede. Rather, when something becomes so obvious as to be almost tautological (e.g., the trajectory of the economy depends on whether vaccines are effective in controlling COVID-19) it’s no longer a consideration that falls into the “some worry” category. Rather, it’s something that gets mentioned in closing, in a paragraph that begins with “Of course,”.