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As far as S&P trading weeks go, it went from Worst to First – Now What?

Does everyone out there love a rollercoaster ride, or do they simply churn up your insides to the point that you wished that you had never bought the ticket? Investors have been shaking their collective heads over the reality of our global financial markets, at least what the “New Normal” seems to suggest – a never ending, repeating cycle of wave after wave of minor corrections followed by minor recoveries. The last few weeks have been quite the ride of late, earning the moniker of “Worst” one week, to be replaced very soon thereafter with the best trading week since 2013 (See below):

S&P Chart

Last week was a breather of sorts, a chance to catch our breath. The week, however, did not start out that great, refusing to bounce back at least until Friday, when analysts began to conclude that a technical correction had taken place, a good thing. Signs were still positive that market foundations had not crumbled, that the road ahead was slightly better than the general public had perceived, and that the “Big One”, the one that Elizabeth is constantly in fear of hearing about, was still somewhere down the road.

There was nothing that special about last week. Yes, the Fed minutes were finally released. In their typical fashion, every syllable, comma, and vowel became suspect, each under microscopic examination to reveal the secret truths behind the possible actions of the Fed going forward. The key focus in 2018, as we have previously written about, is inflation. Anything and everything that might provide key insights in this area are the hidden treasures awaiting discovery. At the moment that analysts concluded that the Fed would not retreat from its normalization path, bond yields dropped, and stocks regained strength on Friday. That is one more week in the history books.

One “in-the-know” analyst summarized the situation as follows: “We’re exiting a prolonged bond bull market at a time when the Fed and other central banks are attempting to roll back the post-crisis policy regime. As if that wouldn’t already be an interesting enough setup, it’s now set against an unprecedented (in terms of timing) foray into expansionary fiscal policy in the U.S., which complicates things further… If you were wondering why stocks managed to break with recent precedent and rally strongly into the close, look no further than real 10-year yields, which had one of their largest one-day declines of the year on Friday.”

There are other “drivers”, as well, but then we know that the market is never as simple as we would like. Much has been written about de-leveraging and fund managers churning specific positions and capital flows, but at the end of the day, many fund managers have stood their respective grounds. The following analysis may seem to be a bit far a field, but a few number geeks actually track what holdings are in each manager’s portfolio, labeling them as “VIP” holdings, short for Very Important Positions. These favored positions outperformed the S&P during the past few tumultuous weeks, as depicted in the graphic presented below:

Hedge Fund Chart

If there is a “red herring” in the week that was, it would have to be the reaction of the USD index, following the release of the Fed’s January minutes. The Dollar weakened, or as one fellow put it: “The initial knee-jerk lower in the dollar clearly indicated that some folks were keying on the passages that referenced the doves’ reservations about the inflation outlook.” When the full picture emerged on Friday, however, the Dollar bounced back, if ever so slightly, a recognition that the Fed was confident in its growth forecasts and that it would proceed down the road with rate hikes in a predictable fashion.

The flurry of articles that accompanied this week’s action has returned to describing February as a “V-Shaped” month, i.e., the notion that investors buy on a dip is still alive and well. The market has corrected, a subset of investors has taken profits, but eager ones on the sidelines with cash have stepped in to enjoy a price break. Is there anything more to this notion than just “other people are buying?”

If you peruse the articles of this genre, you do not find hard and fast conclusions to grab on to for the months ahead. Most speak to the Fed and the ECB, and even the BoJ for that matter, having to pursue normalization, if only to give themselves more breathing room for when the real downturn occurs. With this key thought in mind, the result will be more than normal volatility, as financial markets adjust to each piece of data that hits the press. In the meantime, the buying appears to be concentrated in corporate buyback programs, if the following Goldman Sachs chart is to be believed:

Corporate Buyback
With the recent correction and tax-cut legislation in the books, Goldman is forecasting a 23% jump in corporate buybacks over the remainder of 2018. One comforting thought is that, “It helps that the largest source of demand for equities is to a great extent price insensitive (as the corporate bid is). More to the point, there is no question that buybacks have helped to underwrite the buy-the-dip mentality over the past several years. There is both an explicit element (they are actually buying shares) and an implicit element (the corporate bid makes other investors more confident in their own decision to stay long risk) to this dynamic.”

What does this mean for the long-term aspects of the U.S. Dollar going forward?

 

We have been delving into micro-level technical data points, but what happens when you pull back and look at the Big Picture? Do these short-term aspects carry any weight in the long term? Researchers at the Financial Times were curious about these same questions and started digging into historical data.

The current outlook is not optimistic: “It appears as if we are entering a new era of ever expanding federal budget deficits, and this is causing interest rates to rise, which changes the whole economic scene. Not only is this altering the domestic economic picture, but it also has implications for a much weaker value for the US dollar. The higher interest rates and the weaker US dollar will inhibit any hoped-for improvements in factor productivity for human as well as physical capital and result in constrained growth.”

The reasons for this rather dismal outlook are stated in another piece by Stanford economist John Cogan: “Since the late 1940s, entitlement claims on the nation’s output of goods and services have risen from less than 4 percent to 14 percent. If left unchecked, these programs will push government spending to levels never seen during peacetime. National defense and non-defense discretionary programs combined are no higher today than they were seven decades ago. Financing this spending will require either record levels of taxation or debt.”

Getting back to the Financial Times, their researchers published a startling report that examined “the relationship between US fiscal expansion – the tightness or looseness of US fiscal policy – and the value of the US dollar.” The chart below creates a picture that is disturbing at best:

Looser Fiscal
Two well-respected experts are quoted in the article:

 

  • Hans Redeker, a strategist at Morgan Stanley: “The booming global economy and rising capital demand mean the US will face stiffer international competition for capital to finance the deficit, which means it will have to offer higher rates or a cheaper exchange rate, both of which we have seen this year.”
  • Vasileios Gkionakis, head of currency research at UniCredit: “Based on the 2018 projected federal deficit, US fiscal policy will see a loosening, the magnitude of which has not been seen over the past 30 years.”

 

It does not require a degree in rocket science to see that something has got to give.

How will we know when to tell Elizabeth that the Big One is coming?

How will we know when the next financial crisis is imminent? This question has been bounced around for the past few years, and the only conclusion is that it must be another twelve months into the future. Politicians, policymakers, and central bankers have found innovative ways to kick the proverbial can down the road, but a long period of slow and low growth is not the song that will get officeholders re-elected. As for predicting ahead of time, the folks that do this type of thing generally opine that, “Each crisis looks different – until it actually happens. Then the similarities appear.”

One analyst also noted, “The cause will be too much debt supported by inflated assets. But of course, that doesn’t tell you much of anything. The trigger could be any of a number of things, and thus the timing is very uncertain.” When pressed for more information on possible “triggers”, these proposals came forward:

  • Whatever they are, they will look different than before;
  • There will be a singularly large asset class that has experienced a significant run up in price, financed by a great deal of “Dumb Money”, i.e., entities and people that are not expert in the market in question;
  • Regulatory laxity will be present, along with newly engineered financial products that were designed to raise the necessary capital, but also obfuscate risk;
  • Derivatives tied to volatility will exacerbate the problem;
  • The outflows of capital from bond funds will reach a tipping point.

The scenario above is similar in a way to previous meltdowns, but one thing is missing that could easily push everything over the edge much sooner – one major geo-political event, the notorious “Black Swan”.

Concluding Remarks

The major concern for 2018 is inflation, and analysts are now busy at work developing all kinds of early warning systems to signal that the inflation fuse has been lit. Veterans are looking to real yield indicators, the ones that reflect the market’s perception of inflationary pressures. One quote worth remembering is that, “The key thing there (again), is the nexus between inflation, the market’s perception of how the Fed will react to inflation/expectations, and the effect that perception has on real rates. That’s what’s going to drive equities going forward.”

The long-term implications of rising interest rates, the nominal side of the yield equation, will be severe, if US deficits continue to expand. The forecast for the U.S trade weighted Dollar is indisputable under this scenario of worsening events – The USD must weaken in the long term to depths far below what was witnessed a decade ago.

In other words, Elizabeth, fasten your seatbelt – the Big One is surely inevitable.

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Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.


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