[00:00:05] Was the recent pullback in the US equity markets merely a blow-off from the excesses that had built up during the Summer’s option fueled demand for tech stocks? Or is this the beginning of a longer downturn? What should we be looking for signs that this pullback might be something more than just an air-pocket in an over-bought equity market? That’s The Big Conversation. 

On Monday, US equities were rebounding again. Was the sell-off over the last week the beginning of a protracted reversal or just a breather on the way to higher prices? First, we need to decide whether this summer’s acceleration in options activity is going to have a long lasting and destabilizing effect on risk assets. As we discussed last week, the primary players in the summer squeeze higher in tech were the retail accounts, who were building huge aggregate options positions via persistent, but small scale purchases of 50 contracts or fewer per transaction (50 contracts gives rights over 5000 shares). In total, these volumes have been accounting for over 50% of total options volume, overtaking the efforts of institutional investors. The institutional tech specialist, who has been dubbed the “options whale”, was building positions which would have affected the volatility markets more than the underlying equity. Many of their positions were delta neutral, where a call or call spread is offset by the sale of the underlying stock, which removes the directional bias. The simultaneous purchase and sale of calls at different strikes will also reduce the volatility impact. A long call spread is when a call option is purchased where the strike of the option is near the money and at the same time a call is sold where the strike is further out of the money e.g. if the stock is trading at 100 dollars, you might buy a call at 105 dollars and sell another one at 110 dollars. The selling of a higher strike call reduces the overall impact because it partially offsets the lower strike long call position. As an example: when you buy a 105 call versus a stock at 100, the actual exposure of that option might be 25% of the stock. So, if one contract is 100 shares, then the market maker who sells the call will buy 25 shares to be hedged. But, if the investor sells the 110 call, the market maker would buy that call and sell stock to be hedged. The 110 call might have a delta of 15% or 15 shares. Therefore if the market maker sells the 105/110 call spread to the investor, the lower strike requires a purchase of 25 shares and the higher strike requires a sale of 15 shares, thus the net position that the market maker enters into is a purchase of 10 shares to be full hedged on the call spread. Thus, the directional impact on the stock is reduced. A very large scale buyer of hedged call spreads will, however, still be putting upward pressure on the implied volatility – this is the option price itself, but even here, the nature of call spreads will also limit the scale of the demand for that volatility – they might be buying volatility at the 105 strike, but they are also selling it at the 110 strike. Therefore, the real drivers of both the squeeze higher in prices and volatility are the retail players. Not only were they buying options outright, but according to Susquehana, an options market maker, they are buying short dated options with only two weeks less left before they expire. As discussed last week, the gamma, or the amount of stock needed to hedge a change in the underlying stock price, increases as expiry approaches. The retail crowd were driving up the implied volatility of the options and driving up the price of the underlying stocks. But the structural risks to the market are not as great as we might think. Yes, there is a sense of euphoria in that the market has been getting overbought, but the retail crowd are buying options, which limits losses to the amount of the premium paid. Now, if these traders are putting all their free cash flow into options premium, then they can wipe out their savings entirely and if they have borrowed money – i.e. trading on margin, then they could be left with losses in excess of their capital. But this is not the same as 1987 when retail traders were selling options in order to generate income. In these instances, losses can be unlimited. In early 2018, when we had the vomageddon experience, it was again driven by investors who had been selling volatility as an income strategy. Even in March of this year, short volatility positions were under significant pressure, as we can see from the move higher in the volatility-of-volatility index (the VVIX for short). Today, the VVIX has hardly budged. There is not the same level of embedded short volatility and furthermore, selling implied volatility today makes sense if it is significantly in excess of the actual volatility of the underlying asset. If you can sell volatility at an implied volatility of 30 and the market is moving around on an actual volatility of 20, a well managed position should be able to make money. Today’s long volatility positions are not as structurally damaging as would be an excessive build-up of short volatility. Market makers are paid to take on these risks and manage them, although the moves have become extreme.  When Apple’s share price was rising, so was volatility. But when the share price reversed and fell, volatility fell as well. This again implies that retail traders were buying calls – which is the right to buy the stock, pushing up both the level of volatility and the share price. As the stock fell, these traders were selling to try and lock in profits or reduce losses, selling both the stock and selling volatility. This feels much more like transient, rather than entrenched market activity. Losses will still hurt, but as long as leverage has not been used, the wounded should still be able to fight another day. And remember, some of the squeeze higher in implied volatility is because, as we approach the US election, the VIX curve moves up sharply. Soon the front month contract will be October, where the future is currently at 32. I don’t think the options market is necessarily the place to look for signs of contagion. Therefore, what should we be looking for to see if this has morphed into something more structural than merely short term over exuberance? Many assets have experienced explicit intervention from the Federal reserve, who are buying various types of bonds in the secondary market. When we look at US 5 year investment grade credit default swaps, we can see that the spread hardly moved even when the VIX was pushing higher. The market pricing of credit is still showing few signs of fear, suggesting that the recent move lower in the equity market is merely unwinding some of the excesses of the last couple of months. If we compare the Investment Grade and High Yield ETFs with the S&P 500, we can see this more clearly, with the S&P having spiked higher and then unwound most of these gains during a period in which the corporate bond ETFs had already peaked and plateaued. This looks like a round trip of euphoria for the equity market. In many ways this is borne out by the put call ratio from the CBOE – this also reached a short-term low (meaning lots of calls and far fewer puts) before reversing over the last few days. Here, the put call ratio has been inverted and although we can say that the ratio recently reached an extreme, over the last couple of years the ratio is largely coincident with the performance of the equity market. The ratio and the S&P reversed together. This still implies that the pull back in the S&P and Nasdaq were an equity specific story. The Wall Street Journal has also outlined how unusual the summer activity has been. Single stock option volumes in terms of nominal exposure reached 140% of the underlying stock activity. Its very rare that the nominal value of single stock options is in excess of the volume of cash equities. Three years ago, single stock options were closer to 40% of the cash volumes. Sentiment Trader research house also show that the largest volume in single stock options were on shares which were having the best performance – price led the interest in options which then supported the performance of the individual stocks. If huge amounts of leverage had been applied, then this would be worrying, but these call positions were initiated from the long side. And given that the moves in the equity market are probably self-contained, it is unlikely that the US Federal Reserve will announce any additional support at the FOMC meeting on Wednesday of this week. The Fed are probably relieved that some of the excesses have been removed.  They will still be closely monitoring the performance of equities, where the Nasdaq has bounced off the 50 day moving average. If needed, the Fed can intervene between meetings as they did in March and April, but it is unlikely that we will see the sort of catastrophic declines in risk assets that we saw in March. If anything, the expectations for downside from here will be a grinding move, a death by 1000 cuts, if the jobless numbers begin to pick up and there’s an absence of any extension to the furlough schemes. Obviously, this will be highly politicized over the next few weeks, with neither side wanting to be seen as unsupportive for jobs. Remember, this is a market that is driven by flows and not fundamentals, though some of the technical indicators now reflect the influx of individual investors who were largely absent in the market prior to this year. Before February, when the volumes of single stock options started to pick up, the equity market was almost entirely driven by 401k inflows channeled through rules based funds such as Risk Parity, plus the ongoing corporate buybacks that are still a feature today in the tech sector, but have dropped off across most of the old economy stocks who have needed to take government support. Bond yields are also unlikely to give us any clues about the future outcome. There should still be some downside to yields if the slow death of the non-tech corporate sector continue. But, if defaults rise, whilst credit spreads remain tight, then it is unlikely that we will see a risk off rally in bonds. If bond yields were to start rising too quickly, then the US Fed would no doubt talk up yield curve control strategies in which target specific levels of yield. That therefore leaves currencies as the most likely release valve for increased levels of risk. A weaker dollar has been a boon for commodities and should have been a huge positive for EM equities. But EM equities have marginally outperformed the S&P500 over the last couple of months. The big level to watch on the ratio of the S&P500 ETF vs the MSCI EM ETF is the neckline of a potential head and shoulders formation. If this breaks, EM equities outperformance would start to accelerate. So far, the tone for EM has been set by the underperformance of the EMFX complex. The weakness in the dollar over the last couple of months has been predominantly against G10 currencies, especially the Euro and other European FX. Some of the basket-case currencies, such as the Turkish Lira, have continued to weaken versus the dollar even as the Euro has rallied. Eurozone policy makers are already starting to worry about the strength of the Euro, although there aren’t as many policy tools at their disposal, having only just signed off on a significant package of support. If the recent dollar bounce off the lows, start to build momentum, then financial conditions will start to tighten and this will cap risk assets. September has historically been one of the trickier months for financial markets, but the weakness that we have seen recently has been mainly been confined to equities, with a small spill over across multi asset portfolios that forced a risk reduction in some commodities. Credit remains artificially well behaved and bond yields have been in a tight range. The US dollar is therefore the most likely candidate to give us clues of any further contagion. 

[00:11:40] Brexit’s Back. In the last couple of days, the UK’s currency has started to react to some new developments in the Brexit negotiations and uncertainty about an extension to the furlough schemes. Goldman Sachs are increasing their risks that the UK undergoes a clean Brexit, with no deal in place. Given the enormity of the corona crisis, it’s not surprising that the Brexit discussions had become far less newsworthy within the British media. But the time-lines are now getting tight. The UK wants a new deal agreed by the EU summit on October 15th – that’s one month away. That deal needs to be ratified by 31st December of this year otherwise the UK exits the transition period with no deal – making a clean break.The currency market has only just started repricing this uncertainty. The dollar had been on the back foot versus European currencies, with the euro leading the charge after the European Union completed its bailout package and long-term budget proposals in July, helping sterling rally even as negotiations started to falter a few weeks ago. The euro surged from 1.12 to 1.20 and this helped other European currencies, including the British Pound, rally as well. Even as the discussions between the UK and the EU were deteriorating, sterling was still touching the two-year highs at 1.34. This has now changed. Sterling has reversed back below 1.30 and against the euro it is closing in on the 10 year lows. Bearish bets on sterling have increased dramatically in the last couple of weeks. The volatility of puts over calls on Sterling versus the dollar – these are the risk reversals, has surged in favour of bearish bets, indicated by the sharp decline in the line on this chart. Sterling volatility has also been pushing higher, compared to broader based measures of FX volatility which are still relatively subdued. Normally, when sterling is falling, we see the UK’s FTSE 100 start to outperform because many of the large cap names in the index generate revenues overseas, which, once converted back into sterling, bolster earnings in local currency. So far, this hasn’t happened. We can see that the DAX has performed extremely well versus the FTSE during the corona crisis period, mainly because the UK’s FTSE is made up of old economy and value names that have struggled during this period. The DAX has, in fact, outperformed most of Europe, also making new all-time highs versus the Stoxx600 (though the DAX index is calculated with a different methodology).Non the less, we would have expected the FTSE100 performance to improve if the pound is weaker. If the pound is heading back to the 1.20 region versus the dollar and new ten year lows versus the euro, then the FTSE should start to reverse some of its recent relative underperformance, though I don’t think it will be as emphatic as we have seen during other periods when sterling has been on the back foot. UK banks are also pricing in a clean, or no deal Brexit in that they’ve been underperforming both their US and European counterparts. The currency should be the release valve for the UK’s monetary and fiscal policy. A recent Reuters poll showed that investors overwhelmingly expect the BoE to extend its QE program, with the majority of those expecting it to happen in the next couple of months. So far, the BoE has expanded its balance sheet at a rate that is on a par with the US Federal Reserve, but lagging that of the ECB and way off the pace of the Bank of Japan (who, incidentally, are expecting to maintain their current policy path even after Abe’s departure). The UK certainly has more firepower at its disposal. Equally important will be the decision by Chancellor Rishi Sunak over whether to end or extend the current furlough scheme. It is soon due to roll off, but already politicians are lining up to demand that the job support continues, with fears that otherwise there could be a loss of up to millions of jobs. Even prior to the COVID crisis, the UK’s newly elected Conservative Party was going to break with tradition and boost its fiscal spending. With sovereignty over its own currency and an extension to its QE program, the primary release valve should be the currency. We have already seen the UK’s bond yields converge with those of the US. Most of this is due to the dramatic declines in the US yield. Whilst this may make the hunt for yield via US assets less attractive for UK investors (which should support the UK’s currency), the government will crank up the printing presses and this should continue to put additional pressure on sterling. We can loosely use a 1.18 to 1.35 range for sterling. Around 1.18 is where sterling traded when a clean break was previously expected (and excluding the COVID lows). The 1.35 level is where optimism over a deal was high. We could view a weaker currency as a negative because it will impact inflation, pushing the prices of imported goods higher. But, in an environment in which global trade volumes have declined, the UK will benefit from a weaker currency.There may be a much lower Brexit negotiation tolerance from Europe as well. During the pandemic period, Germany’s exports to the UK have dropped sharply. The threat of lower UK demand for German goods was always one of the UK’s bargaining tools, but if demand has already fallen, Germany will be making the adjustments already - a dry run for the impact that might have been expected if the UK makes a clean Brexit. A new bout of Brexit uncertainty will lead to a slowing down of direct foreign investment. Of course, this could all be resolved in the next few weeks of negotiations, but the window remains for uncertainty.

The Chancellor has still to decide – either extend the furlough and keep the printing presses running, or let the support roll off and watch the unemployment rate shoot up again. Both of these would be negative for the UK currency. The UK therefore has a better shot than most countries at reaching a higher inflation target – not that this would be good timing for many of the population that are already reeling under the effects of the Covid crisis. But inflation hedges would make sense for the UK – even though inflation currently remains subdued. Bond yields should go up – but this is a world of either QE or Yield Curve Control (or both) and therefore I don’t think we’ll get much of a reaction there, unless we get a big change in the global regime, led by the US. Sterling is now a little oversold, but sterling should still fall further rom here to adjust to the uncertainty– helping the UK to make a welcome adjustment to offset the slowdown. This should not be considered a negative outcome. One of the key advantages of having sovereignty over a currency is the ability to make adjustments in adversity. 

[00:18:00] Prior to the COVID crisis picking up momentum in March, gold had been performing well even when the USD was strengthening. Gold was primarily following the move in US real yields, which have sunk back to record lows in the last few months. Gold is inverted on this chart. Over the last couple months, gold has also received a boost from a weaker US dollar. And the tailwinds for gold have been well documented. It has been the second biggest consensus for US investors, though it has been a distant second to US mega cap tech. But how stretched is gold now? Firstly, it would be reasonable to anticipate that monetary and fiscal support will continue. Although it is unlikely that the Fed will ramp their QE program any further at this week’s FOMC meeting, an additional fiscal package is expected, because of the ongoing threat of job losses now that the current furlough schemes have rolled off. The combination of fiscal and monetary support has driven inflation expectations back to where they were at the beginning of the year, unwinding that COVID shock. They may not have exceeded these levels, but higher inflation expectations will get priced in if more fiscal support is expected. What is key is that inflation doesn’t need to appear any time soon, only that the expectation that it will arrive in the nearish future. In terms of positioning, various parts of the gold sector are not particularly stretched. When we look at shares outstanding, which is like open interest, for the main gold ETF the GLD, it has reached, but not exceeded the previous highs of a few years ago. When we look at positioning in the gold futures market, net non-commercial (also known as speculative) positions have actually been falling in recent weeks. Yes, overall the positions are toward the upper end of the range, but they are by no means excessive. There is a similar story for gold miner ETFs. Positions have built up toward the top end of the long range and given that gold prices have recently made new all-time highs, it would appear that the consensus is still more verbal than actual. Institutional investors have still not yet fully embraced the move. In a world where policy makers are in the driving seat for asset prices, it is clear that gold has not been engaged with anywhere near the same gusto as the US tech sector. Gold is being driven by fundamentals, but if it picks up the flow story that is currently driving tech shares, then the upside potential could be quite spectacular from here. 

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