We’re going to need a bigger bailout
Published on: March 31, 2020 • Duration: 17 minutes
This week we look at the combined attempts by governments and central banks to lift equity markets off their lows whilst keeping a lid on the US dollar. Are their efforts on target or is this equity upside merely month end re-balancing after the extreme moves through March? The bailouts are probably going to get bigger……much bigger.
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[00:00:04] Over the last week, the volatility in equity market has continued, but at least some of that volatility now is to the upside. Is it that we've reached peak fear? Is it to do with the interventions from central banks or is it merely that we got oversold and we're now seeing a rebalancing into month end? That's the big conversation. The beginning of March, we talked about how we could see an inflection point in equity markets around the expiry week of March, which was around about the 20th. Now we didn't see a low during that week. We actually saw what is currently the low, the day after, the first trading day after on the Monday, which is very similar to the lows we saw in December 2018. It could be easy to say that the reason why markets bounced last week is because of the stimulus where the Fed extended its QE from being $700 billion to now being unlimited. And this is because the take up of that initial 700 billion was 622 billion in the first six days. So they've now gone to QE Unlimited and so far the Fed's balance sheet is at 5 trillion, with some people expecting it to get to 9 trillion by the end of the year. We also saw the fiscal package being agreed. Now, these are enormous packages. These are enormous levels of accommodation. And so maybe that justifies the bounce. But I also think that when you have a sell off of that magnitude, you are going to get vicious bounce. And the question, therefore, is, is this a V-shaped bounce, as we saw in 2018, December 2018, even in early 2018 after von mageddon? And also when we go back to the summer of 2015, or is this merely an oversold bounce? Unfortunately, the jury is out. My guess and I'll come into the reasons why, is that this is an oversold bounce and it's largely to do with month end rebalancing. People always looking for reasons, but often when you have an excessive sell off in mid-month, then it creates an imbalance in things like your balance portfolios, bonds versus equities. There has clearly been significant capital and wealth destruction. So we are rebalancing on a smaller pot of capital, but nonetheless the rebalancing does have to take place. And what that means is that if you have bonds versus equities and equities sell off more than bonds, you need to rebalance back. Now, that means selling bonds to buy equities. I would have been worried about that. But effectively there's now an unlimited bid theoretically from the US Federal Reserve, because only a week ago the bond market, the world's most liquid market, was also broken, where bids were hard to find and the breakdown between the futures market and the cash market, etc.. Well, that bid is back in the market so that that rebalancing can probably take place. We've also seen some of the deleveraging take place as well to its maximum degree. Some of the volatility targeting funds, well, they reach levels of volatility where they had probably unwound the maximum amount of equity. Now as volatility drifts lower, there will start to maybe add back volatility. But I think this is one of the key things to think about going forward is that over the last five years, in fact, over the last 10 years in particular, the biggest buyer in the market was the share buybacks. But they've gone. Goldman Sachs is saying that at least 25 percent of what they expected is now off the table for the year and it'll probably much more of that. Dividends in the U.K. are being cut as well. Pension flows, pension flows were the other big buyers. So people earning their money and they put, they automatically save a bit of that into a pension fund. And that often went into these rules based funds like Smart Beta and risk parity. Well, those pension funds and those flows have dwindled to a trickle as well. So the buyers in the market are no longer there unless it becomes central banks. In Japan, that's already happened. It hasn't happened yet in Europe, in the US. But people think it's not long before central banks in those regions go from focusing on bonds, corporate bonds into equity. But so far, that's not the case. So the buyer is not there. But the move into the year and to month and I still think is is very significant, but we haven't even hit yet the basic Fibonacci retracement. I mentioned it in one of the flash updates. 2640. So people are saying we've had a 20 percent bounce. Therefore, we're in a new bull market. The magnitude of the sell off is such that the basic basic rebound we should expect to 2640 on the S&P has not actually happened yet. I think we're a few points short of that. So these these are the sort of sizes of moves that we've seen which demand a significant rebound. And if we don't get back to 2640, I would be quite worried. And the second thing people have been talking about and looking at, which is the dollar and this is part of the same issue, which is that the central banks are coming in to fight with stimulus. And I think we've got to come on to stimulus and what that means in a few minutes. But what do we get in terms of the dollar for dollar? And I'm thinking here that the DXY, which is 60 percent euro and 15 percent yen that had these enormous gyrations, some the biggest week a week gyrations that we've ever seen. First, the dollar was moving higher. And this is because of that dash for cash. We've talked about it before. The world system operates on dollars, even if you disagree with the dollar system, it hasn't moved away from being a dollar system. And if global trade is collapsing, which it is, and which is the same as commodity prices collapsing, which they are with oil touching below $20 once more this morning on Monday (this is WTI) therefore, if the dollar flows are declining when dollar denominated debt. This is cross-border dollar denominated debt is still extremely high. Then there was a demand for dollars. Central banks understood this. This is why the Fed has put swap lines in with a large number of other central banks. It desperately wants to stop dollar funding going out and the dollar rallying because a strong dollar is a tightening of global financial conditions. It's effectively like raising interest rates when everybody has dollar denominated debt. So the dollar index, the DXY has had these enormous gyrations. But I also like to look at EMFX. EMFX has also bounced a bit. It has not bounced much. So the real economy affects, markets are still struggling. And these you can see with the with the South African rand this morning, it was down nearly 2 percent once more. But funding issues in the G7 currencies have improved. We talked about the three month (this is the basis between yen and dollars). If I have yen and I desperately want dollars, how much does it cost me to swap or basically get a loan of dollars? that had blown out to a decade high only a few a few days ago. But now it's been tightening up, back to normality. For the euro and sterling is actually flipped. So rather than costing money, you get paid to do that swap from sterling into dollars. But that's right here, right now. What really matters is what goes on over the next two to three months where we're looking at these shut downs being much longer than expected. In the UK we were talking about three or four weeks. We're now talking about three months. The US was talking about Easter is now talking about the end of April. Remember, these aren't slowdowns. These are shutdowns in which very few transactions will take place. And therefore, the number of dollars in the system, particularly in the system outside the US, which is what matters really here outside the US system, the euro dollar system will be starved of dollars. Central banks attempt to fix that. And in the short term, it's worked well when you look at the DXY. In Europe there's been also a very good attempt to stabilize, particular the periphery, where we'd seen bond spreads between Bunds, Germany and Italy and Spain blowing out. Well, now there is talk of effectively taking the caps off the amount of bonds that can be bought and that's brought yields back into into a sort of level that they were two or three weeks ago. So the stresses in Europe have been pulled back to say normality, but in pull, pull back to a much, much better level. And Japan is also talking about coming again with yet more stimulus. So then the next question is, is this really stimulus or is this stabilization? And I think it's much more stabilization than stimulus. Yes, it improves things from where we were, but we were in basically a vertical decline to the downside. And what they've done is they've stabilized that decline, at least in asset prices, by stabilizing the shadow banking system and trying to get some of the liquidity into the banking system to get it into the real economy. The problem we have here is that the stimulus itself is huge, but not compared to the size of the global system. So we're talking 2 trillion fiscal in the US, 4 trillion, maybe up to 9 trillion of monetary from the central bank of the US. So the Federal Reserve, the global economy is around about 80 trillion. The US economy around about 19 trillion. The cash flows are even bigger and the things like the overall global exposure to derivatives is is off the charts at 500 trillion. But that's a growth, not a net figure. But this money is really going into a hole that's not top the hole up yet. It's not actually creating new demand from where we were prior to February. This is simply stablize and the cratering of demand and the cratering of supply that we have today. So this is not really a stimulus. And the other part part of it is while size matters, also, the aim matters and the timing matters. You've got to get it into the right parts of the economy. It's the real economy that is in pain here. Getting into the shadow banks and getting it to the banks is all good and well. But you've got to get it to individuals, small companies, small businesses in the UK. They were talking about 12 percent as the interest rate on these loans. Now they've quickly got those down to 5 percent or lower. They were talking about taking collateral of people's personal property. Again, this was not going to encourage people to take these loans. So these loans are not liquid loans. In some ways they're actually penal loans and only people are absolutely desperate would take them. And even then some people might say, well, actually, it's better to go bust now under these circumstances than necessarily have a death by a thousand cuts over the next two or three months when we still have no visibility on where we'll be in two or three months time. So these are the stimulus packages or stabilization packages, but they're still filling the crevasse that's opened up a crevasse that not only has opened up in the real economy, but it's revealed the weaknesses of the financial system as well, which was reliant on the corporate bid that's no longer there. Then the next question comes, too, is this deflationary or inflationary? Because this is helicopter money. This is MMT. And what is MMT and helicopter money? In its simplest sense, it's that the central banks are buyers and the governments are spenders. And the governments spend as much as they want to. And the central banks buy as much as the governments want to spend. And it's a sort of “I scratch your back, you scratch mine”. Now, in theory, the over the long term, this should be inflationary if you create unlimited liquidity. But then there's the real world versus the theoretical world. The real world is incredibly large and it's very hard to target with this stabilization or stimulus. Whichever way you want to call it. But you get your timing wrong in a world where we've got a lock down across pretty much all supply chains. Remember, these aren't in lockdown for three months in one country. They might be three months in one country and then with a lag, three months in another country. So overall, the period that the supply chains are effective could be well over half a year. If supply chains around. But you stimulate demand. But the only things that you can stimulate on the demand side are some of the essentials, like food, foodstuffs and maybe electrical goods. Then you could create short term inflation and it could be debilitating inflation because it'll be inflation on the very things that people are desperate for. In an environment where there is an outage of almost everything. But short term, there is definitely an inflationary risk. And we can see some of this in pork prices, which were already under duress in China because of the swineherd, the pork curds, which had been decimated. But now you're getting more supply chain shocks and that inflation has taken another leg higher. Well, what do we do in this environment? What do we buy? What can we look at? Is their price discovery? There is a potential here that central banks like the Fed could come in with what we call a yield curve cap, where they effectively buy bonds across the whole curve, limiting the level that yields can go, because if you're increasing debt, you want to control the cost of financing that debt. So the yield curve cap could come in along the lines that we've seen in Japan where they've tried to keep it (this is the year the Japanese 10 year JGB), they've tried to cap around about 10 basis points. Well, that won't be price discovery in the bond market. We're currently seeing price discovery. We have seen price discovery in equity markets and in corporate bond markets. But central banks are coming in. The corporate bond markets have lost price discovery there. Gold should do well in both the deflationary and inflationary environment because it's all about the real yields that matter and real yields. They've been highly volatile as well. But over the medium to long term, gold is a good thesis. Within corporate bonds it looks like they're going to focus on the high end. So investment grade, the top end of investment grade, the risky is still high yield. Yes, it's also bad because it had such an incredible sell off. But there's a lot of triple B's which are now being downgraded into the junk status. So the lower end of investment grade is being downgraded towards junk. And also, I think what we're seeing here is people drawing on their credit lines. This is the area that's the corporate area, which is under duress. So I think going forward here, two things which really stand out. I think this is an oversold bounce in the equity market. It could go higher. It could get up to twenty nine hundred. But these are all theoretical levels based on retracement fibonacci’s. Some people think that's voodoo, but it's a guidepost and nothing more. It doesn't feel like a V because the V of 2018 and 2015 took place because central banks came in before the financial framework was broken, i.e. before the buybacks dried up, before the pension flows stopped. And also the real world of cash flows is going to grind to a halt. So I do think that the lows in the equity market are still ahead of us. Volatility will remain high, but I think that the next lows that we see will be on a lower volatility than the one that we've just seen due to de-leveraging. Volatility itself where volatility remains high. But when you look at the VIX, it's around about 62. 30 day realized one month actual volatility in the market is in the 80s. So it's still very, very high in the real world. So the VIX is actually cheap volatility. You can say that the implied market is cheap to the real world. Although ten-day realized is short dated, it has now dropped from 127 down to 83, and that's normally gives us the lead, which will then put more pressure on the VIX and eventually of other varieties of volatility will follow. So that's the phase that we're in. I don't think this is time to go all into the market. Maybe buy some of those dullards here if you want to. Those that have income will still see the cash flows because they’re utilities. I wouldn't be going into stocks which rely on advertising because we're going to be down on those sorts of cash flows the next two to three months. And I still think that this will all end when the Nasdaq significantly underperforms the broad market. So far, the Nasdaq has been an incredible performer. People have added to the QQQ position, which is the the ETF based on the Nasdaq. Shares outstanding have got bigger, reaching a five year high throughout this big sell off. I think when they get to unwound, which shows that the final pain is there when people are selling the last of their winners, for me, that's when the big low will be in. I think that's going to be in sometime over the summer months. And I think that what we're seeing here is purely an oversold bounce with rebalancing given a bit of nitroglycerin by central banks, but it'll take a long time for that nitroglycerin to hit the real economy.