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Episode 32

Will reality return with the reopening?

Published on: June 11, 2020 • Duration: 18 minutes

This week we look at the latest conversations about monetary policies that continue to stack the rebound in favor of risk assets and large corporates, at the expense of the real economy. Are these policies continuing to damage the economy despite the recovery in equities? The Chatter looks at the sell-off in the US dollar and puts the bull vs bear debate in historical context. The Whisper looks at the potential rise of both bankruptcies and the zombie company.

  • The speed of the economic shutdown and the size of the response has seen risk assets break records in both the collapse and the rebound in prices. Some of the extreme moves may have been further distorted by an uneven return to economic activity. But the signals from these assets may begin to reverse now that economies are attempting to re-open That's The Big Conversation. 

    The U.S. dollar has been on the back foot for some time now. It could be that the size of the U.S. rescue package is finally having an impact although the bulk of the announcements were made by mid-April, during which time the U.S. dollar was generally strengthening versus the euro and the broad based emerging market currency index. The most recent bout of U.S. dollar weakness, did get going around the same time as Fed Chairman Powell's now infamous comments on the 60 Minutes TV program, 'that there was really no limit to what they can do with these lending programs.' However, it is more likely that the recent weakness in the dollar is more about confidence in the rebound of the global economy. With the currency moving through the risk-on part of the dollar smile. So what's the dollar smile? Well, I think it's a phrase that was coined by macro strategist Stephen Li Jen to describe different states of the dollar. And I'll use the dollar in 2016 by way of a description. The dollar is strong during periods of uncertainty and risk off. And this was the case at the end of 2015 and beginning of 2016, when the oil and commodity bust had created a profits recession that was centered upon commodity extraction and its related service sectors. The dollar is weak when there are periods of globally coordinated growth. Other higher beta currencies, such as emerging market and commodity currencies, lead the charge. And this was the period in the middle of 2016 which took place after a series of efforts to support growth, and these included the U.S. Federal Reserve dialing back its rate hiking intentions, China adding record levels of new credit in absolute terms to its domestic economy, and an alleged agreement was reached to weaken the dollar at the G20 meeting in Shanghai, unofficially known as the Shanghai Accord. The other side of the dollar smile is a return to dollar strength. In this instance, it's when U.S. growth is expected to outpace global growth. The dollar was strong after the election of Donald Trump, and a clean sweep for the Republicans, which saw focus placed on the domestic U.S. economy. These three states roughly equate to the dollar smile, we're most likely in the middle section right now, i.e. strength in higher beta currencies rather than weakness in the dollar per say - though obviously they are two sides of the same coin. Dollar weakness then reinforces the feedback loop because a weaker dollar helps to loosen global financial conditions, which is a positive for risk assets. But Europe has also helped to play its part. Now, there's always going to be uncertainty in Europe. It's the nature of having so many countries with a currency union and an even larger selection within the broader European Union. But when the crisis first struck, the US responded decisively and in size, whilst the response from Europe took time to build momentum. Initially, the total U.S. stimulus was around twice the size of Europe's and perhaps the US dollar should have weakened even more than it did. The DXY is only back to where it was at the beginning of the year, but the Fed has increased the balance sheet by around three trillion dollars. However, with the latest monetary announcement from the European Central Bank and an expanded fiscal package from both the EU and Germany, the totals are now closer to parity, though Europe still lags in terms of implementation. The European Union budget that was unveiled last week contained 500 billion euros of proposed nonrefundable grants. A small step on the rocky road to debt mutualization and a fiscal union. If passed, this does reduce the Italian tail risk, but these numbers are still small in the grand scheme of things. And this package still needs to be approved by 27 EU member states. The 'frugal four' of Sweden, Denmark, the Netherlands and Austria look like they will become the frugal five, with Finland also expressing displeasure at the nonrefundable elements of the proposal. The euro has broken out of a trading range for a second time, though it's still below the highs that were made during the early part of the Corona Crisis. However, in the longer term charts, we can see that it's bouncing off a major support level, but remains within a 10 year downtrend. And the top of that trend would be around about one point one six five. There's also an argument because trade flows have collapsed and dollar payments have been deferred. There's been a natural decline in the immediate demand for dollars. No one has been required to make repayments, therefore the dash for dollar cash has been quelled for now. So as the global economy begins to try and normalize, that demand for dollars could well return. Infact the combination of the Fed's dollar funding swap lines and the deferral of payments has reduced the likelihood of a default in companies that have been able to access those swap lines, indirectly. These companies could have defaulted on dollar payments, but now they will have to ensure that they have sufficient dollars to lubricate the reopening of their operations whenever that may be. We may already be seeing this in the currency swap markets or basis trades. When the crisis kicked in, demand for borrowing dollars surged and the cost of swapping, for instance, Japanese yen into dollars increased. And this is the sharp decline in the line on this chart. But once the Federal Reserve opened its swap lines, the funding costs completely reversed into positive territory. This is where swapping yen into dollars produced a positive carry. More recently, this basis has been edging back towards neutral territory where swapping yen into dollars again incurs a charge. Will the Feds 450 billion dollar swap line be sufficient when activities attempt to normalize? So what should we be looking at for a potential turnaround in risk sentiment? Well, we could look at some of the early movers. The Nasdaq and a selection of tech stocks have been leading the charge, but their relative performance has been much more vulnerable and variable of late. There has been some high volume distribution taking place as investors rotate out of the winners into the laggards such as equities that will respond to the reopening of the economy. However, this doesn't yet look like a reversal of fortune for the Nasdaq, but rather a broadening out of the rally. The early warning of the global slowdown came from real economy assets, particularly those in China's macro sphere, such as copper and oil. Copper had turned lower in early January, but has now recovered 62 percent of that decline. So far, it's shown little sign of reversal, but we should be watching these levels closely. Oil such as West Texas Crude has had a remarkable move higher, but should be stressed that only the price of oil for delivery against the May futures contract went into negative territory. If the oil price is defined as the price of the most liquid contract, then the low is around six dollars fifty in the June contract, on the day that the May contract expired. The low for the other global benchmark, Brent Crude, traded out of London only fell to sixteen dollars. That incredible period in April, however, did remove significant open interest from the financials products such as ETFs and tradable commodity indices. Trading volumes have been much lighter since then and have been spread across the front few months to reduce the expiry and roll risk. Still, the oil price rally has now almost closed the gap that had opened up on the initiation of the price war. Like with copper this is an area to watch for a loss of momentum in an asset that is still driven by real economy demand, while speculative positions have ground back to a two year high. Perhaps some of the most intriguing price action has been that of the Australian dollar. When the Corona Crisis first struck, the Aussie dollar accelerated the downtrend that had been place for a couple of years with an almost vertical collapse from 66 cents to the US dollar, down to fifty five in a matter of days during the peak of the deleveraging. The rebound is taken the currency back to the levels at the start of the year. The size of the rebound, like the price action in many assets, has caught many people by surprise. But as with the observation of dollar activity outlined earlier, the strength of the Australian dollar may also be a result of the temporary collapse in activity and the deferral of many dollar denominated payments. Global capital flows have collapsed, especially for finished products. But notwithstanding Australia's current spat with China over agricultural commodities, their demand for industrial commodities has rebounded even if it's diminished versus a few years ago. With China having been in and out of lockdown first, there is now imbalance, i.e China is buying more goods from Australia whilst Australians are buying fewer goods from overseas. The Australian trade surplus has recently soared to new highs, and this is probably helped the rebound in the Australian dollar off the lows. But if real economies are once again attempting to normalize, then those relative imbalances that currently favors the Aussie dollar could go into reverse. So I'd keep an eye on the Aussie dollar, it led many commodity and emerging market currencies higher from the March lows with significant early outperformance. It has largely traded in lockstep with copper over the last 10 years, but certainly seems to have outperformed in this rebound. Successful domestic policy response to Covid-19 is one potential source of support, but the rebound may well be a reflection of the staggered return of global trade flows. Once dollar deferrals roll off and trade flows start to equalize, the Australian dollar could start to drift lower, and it may even herald the beginning of a reversal in global risk trades. 

    On Tuesday, having reached the 70 cents level versus the US dollar, the Aussie dollar dropped one point five percent at one point intra day, even as the euro was rallying. Now, that doesn't mean that momentum has changed, but after a month with barely a pullback, it's worth keeping a very close eye for any signs that this early mover in the rebound is now starting to lose steam. 

    The U.S. economy has now officially entered a recession, and this can't have been a surprise to anyone given the speed and severity of the downturn, in which demand was not just delayed but destroyed. The Atlanta Fed Nowcast remains deep in negative territory for the second quarter of 2020 having recently fallen below 50 percent on a seasonally adjusted annual rate. Despite the steep decline, attention has turned to the potential for reopening the U.S. economy, mirroring similar optimism that is sweeping parts of Europe. Optimism has been further fueled by the unexpected uptick in the US non-farm payrolls last Friday, when a forecast decline of seven point five million people ended up being an increase in jobs to the tune of 2.5 million people. Now, there is still some suspicion that these figures have been distorted by seasonal factors, and the Bureau of Labor Statistics themselves admitted that the unemployment rate may be three percent higher than the thirteen point three percent that was also announced on Friday. It may also be that employers were rehiring in order to qualify for changing government support packages. Continuing claims, the gray line on this chart, has remained resolutely above the 20 million mark throughout May. Nonetheless, attention has firmly turned to a recovery. And we've mentioned in many previous episodes of The Big Conversation that we should be prepared for a V shaped recovery in the data. This is purely a function of the magnitude of the initial decline. But the caveat is that a recovery in the data is not the same as a return to previous levels of activity. The terminal point of the recovery still matters. In many service industries, a rebound of 95 percent would still be a significant decline in activity when compared to the pre-crisis levels that prevailed in February and earlier. Use of real time data such as retail traffic provides a clearer update on the actual recovery whilst we wait for the official data, which is generally at least one month old. The Safegarph index of U.S. retail traffic, index to 100 on March the 1st, has indeed shown a significant recovery since early April though the trajectory has now started to flatten out at around 85 percent of the previous activity. It's a clear recovery, but not a return to previous levels of activity. The Unacast index of U.S. retail traffic has also recovered off the early April low, but there has been an alarming drop in recent days, suggesting that the nationwide protests are having a significant impact on consumer behavior. The real time data shows the risks with extrapolating the performance of the economy from the performance of the equity market. We saw a similar scenario with the bond market last year, where significant flows were generated by banks trying to reduce their capital charges by switching loans into bonds on their balance sheets. This helped fuel a powerful bond market rally and decline in yields. Although there was indeed an economic weakness bubbling beneath the surface, investors extrapolated a recession from the moving yields and no, the bond yields were not priced in the current Covid induced slowdown of 2020. Now, clearly, there is a link between equities and the economy, though currently equities are less a discounting mechanism of future earnings, are much more about current flows in which the US Federal Reserve are currently the world heavyweight champions. The current recession may indeed be short and sharp, and although the equity market fell throughout the recessions of 2001 and 2008, it's not uncommon for the S&P to recoup all of its losses within a recession like it did in 1982 and 1991. But the key remains the level of pre-existing vulnerability in the underlying economy. If the experience of the last few months encourages households to now voluntarily delever their balance sheets compared to 2008, where the crisis led to a short lived and involuntary deleveraging, then there is a risk that consumers are setting up for the potential of a double dip recession. The first recession was on the back of a liquidity crisis which has been solved by central banks. The second could be on the back of the wave of insolvencies if consumers now decide to change their behavior in response to the economic shock. 

    Over the last few weeks, openings of equity trading accounts for retail investors have been surging. Robin Hood has apparently added three million new accounts this year, with over half of them coming from new users. Volumes in some recovery sectors have absolutely exploded. The airline ETF JETS US barely traded one million shares per day a couple of months ago. Over the last few days, daily volumes have regularly topped 20 million shares. Stocks which have been flirting with bankruptcy have seen their prices soar. At one point, Hertz, which filed for bankruptcy a couple of weeks ago, was up over 600 percent in three trading sessions on massive volumes. Chesapeake Energy gained 500 percent in two sessions, again on a staggering increase in volume before collapsing over 70 percent after a trading halt on Tuesday June the 9th. This all reminds me of the activity in the peak of the dot com bubble 20 years ago, where shell investment companies that had no assets and only a vague idea of a business plan could be valued in the hundreds of millions of dollars. Obviously, most of these eventually fell back to zero. Though companies that file for bankruptcy today can legitimately remain as tradable entities for a significant period of time. Whilst it feels that recent equity momentum has no end, it's also worth mapping out a few future technical signposts that might impact markets in June. In early March, I pointed out that the quarterly expiry on the S&P 500 can occasionally coincide with a major inflection point or reversal if the index had been aggressively trending into the expiry. Now, that wasn't a prediction. It was merely an observation. The quarterly expiry was on March the 20th and the low was on the next trading day March the twenty third. It was clearly helped by the U.S. Federal Reserve announcing QE infinity on the same day. We also saw a low on December the 24th and 26th of 2018, a couple of trading days after the quarterly December expiry on the 21st. So do expiries matter? Well there should always be an increase in volumes by market makers as they roll or unwind client positions. But the quarterly expiries, rather than the monthly expiries, are particularly relevant because they generally have the largest open interest in index options on the U.S. market, such as the S&P 500 and NASDAQ. Single stocks tend to have open interest too higher that level, but these have other factors at play. The big quarterly expiries of March, June, September and December, which can sometimes act as an accelerant and an inflection point of an existing trend. But these are not hard and fast rules because there simply aren't enough data points to create any confidence. But in what currently seems like a one way momentum tape, it's worth keeping an eye on this up and coming June expiry, which takes place on Friday the 19th. And they're always on the third Friday of the month in the US and most of Europe. And finally, it's also worth thinking about the quarter end rebalancing. Now this is still some way off, and there's most of June to play for, but given the rally in stocks since the end of March, and bonds that have hardly moved over that time period, then the natural rebalancing should be to sell equities and to buy bonds. That's still a potential trade for the end of the month, but both this and expiry are certainly some future dates that we should keep in the back of our minds.