The last week has been dominated by headlines around single stock squeezes in the names popularized on platforms such as Reddit. But this also creates a headache for US policy makers. After seeing most of their monetary efforts of the last decade turn into stock market inflation and not economic reflation, are they again in danger of seeing their fiscal efforts now going the same way? That’s the Big Conversation
Hi I’m Roger Hirst. Last week we highlighted the potential for equity volatility to pick up because of the record volumes of single stock options that were again beginning to surge through the US equity options market. We focused on stock replacements trades– where investors use relatively low levels of volatility to switch out of long stock positions and into long calls at the index level, in anticipation that these low levels of volatility couldn’t be sustained. Well, we’ve already had the first indication of the impact of this activity. Since that last episode, the VIX has already jumped toward the top of the 9-month range. The sudden pull back in the US equity market has revealed as much about the underlying risks to the current positioning as it has about the ongoing battle between leveraged shorts and aggressive retail longs. The JP Morgan quant team have however noted that US equities normally rise after such spikes in the VIX. The media has jumped on the story as a battle between the generations, between the institutions of Wall Street and the hordes of retail traders. Much of this does an injustice to both sides. Despite Elon Musk tweeting his outrage at short selling because “YOU U CAN’T SELL HOUSES U DON’T OWN AND U CAN’T SELL CARS U DON’T OWN”, well the hedging of assets has an ancient history. Maritime insurance goes back thousands of years. For decades, farmers have been selling crops they don’t own. As soon as exchanges developed, the concept of short selling in forward markets became integral to the smooth functioning agricultural commodities.
Now on the long side, the surge in GME, that’s GameStop, came off a base that had been already building throughout the second half of 2020. This wasn’t a sudden flash in the pan. The mainstream media may portray this as the Reddit rabble raging at the institutional machine, but that ignores the sophistication that has been used to coral a new wave of investors who have been empowered by technology and the quick access to data. This activity could be the wave front of future investing, where the combination of technology and cheap trading allows the disintermediation of institutions. Now whilst this is portrayed as a millennial phenomenon, it is a route that is open to pretty much anyone who wants to grasp the opportunities that advancements in technology can provide.
It reminds me of the changes in the 1970 as documented by the Sex Pistols documentary, the Filth and the Fury. The fashion of establishment figures of that time now looks completely outdated, whilst the anti-establishment style of the punk era looks perfectly normal today. And we may be seeing a similar change in the investing landscape in which new methods and styles are starting to express themselves. Regulators will no doubt be taking a close look at the current environment. And neither should we rule out the ability of other market participants to successfully evolve with these changes, but it’s unlikely that we will return to the old investing regime. We may forget it now, but the 1987 stock market crash was as much about new technologies as it was about overvaluation. But once these changes had been assimilated by investors, the market recovered and moved on. But going back to last week, however, the market action opened a small window onto the reflation narrative. Now if you recall, there are two types of reflation: Firstly there is the synchronized growth reflation in which we see co-ordinated growth on a global scale. The S&P underperforms the emerging markets during a period in which the dollar is in decline. But the dollar is in decline because demand for emerging market assets, with a higher beta, sucks capital away from the US. China helped to deliver a long period of global growth from 2002-2008. And the weak dollar was a consequence of growth.
The second type of reflation is dollar reflation in which the USD falls and this leads a move higher in dollar sensitive assets such as commodities and emerging markets. And this is what we have been experiencing over the last few months – the DXY is inverted on this chart. US real yields have been weaker than European real yields and this has helped the euro outperform even as the ECB has been the more aggressive central bank in both relative and absolute terms. But the key here is that the dollar is leading the price action.
Net speculative positioning in many of the dollar sensitive sectors has reached record levels.
But what was revealing about last week’s price action is how many of the reflation trades took a hit on the 27th January when GME went from a previous day’s close of $148 to an intra day high of $380, with its 10 day actual volatility hitting 500. Copper and the European miners fell, emerging markets were weak and the US dollar strengthened.
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But going back to it, why did so many reflation trades see profit taking when a few single stocks with a heavy short base were squeezed significantly higher? It’s because the reflation trade is a dollar trade built on speculative positions from so called fast money, like hedge funds, who have crowded into this trade. Now not all the hedge funds who were short these stocks would necessarily have been long these reflation assets, but the increase in volatility and the impact that it would have had on prime brokerage and exchange margin requirements would have led to some de-risking of books, basically trading books, and those books were clearly long the dollar-based reflation trade.
Now at this point we should also say a word about SILVER. This has also soared and has been again blamed on the Reddit and retail phenomenon. But silver is not a hedge fund short. Net speculative positioning in the futures market is marginally long. The shares outstanding (effectively the AUM) of the Silver Miners ETF are close to the highs and although short interest has increased, it is not significant. The move in silver, which is a reflation asset, is not due to the reflation narrative. In fact, some have argued that hedge funds are now already playing the social media game and generating a short squeeze on one of their favourite longs which until now had been underperforming the reflation narrative. And perhaps the biggest headache here is for the policy makers themselves and I’m not talking here about regulation, I’m talking about things like fiscal and monetary policy. We’ve just had over a decade in which central bankers have attempted to juice growth through what used to be unorthodox policy – though this policy of QE and negative interest rates is now completely common place. And yet despite all these efforts, actual real economic growth has been pitiful and that’s before we factor in the amount of government and corporate debt that it’s required to generate each successive unit of GDP compared to a few decades ago.
All they’ve achieved from these policies are the inflation of assets and the inflation of inequality and not the reflation of the real economy. The economic framework looked broken even before the pandemic hit the global economy. The point is that policy makers had already started to shift their focus from pure monetary policy to a mixture of monetary and fiscal policy, where government spending could do the heavy lifting.
So it would be understandable if policy makers are now starting to experience an uneasy feeling of déjà vu. What if the fiscal support packages are also being redirected from the real economy and into the stock market? And this is not something that has just appeared out of the blue.
The retail involvement in call options started to pick up prior to the pandemic, with Tesla the main focus at the end of 2019 and early 2020 when volumes started to surge – both from outright buying and as hedges for options. Broad based single stock option volumes then accelerated during the summer of 2020. And this was a process that has been building up a head of steam for some time, reaching an inflection point with GameStop in January. But, it does mean that policy makers need their fiscal policy to be far more directed rather than following the scattergun approach used so far. If the US equity market has far more appeal than the real economy – and some of the returns on offer to the nimble are higher than annual wages, then the equity market will continue to siphon off the fiscal support into non-productive asset markets. If commodity prices rise before growth kicks in – then that’s not good for reflation.
Policy makers have currently turned a blind eye to the rise in the equity market. However, a phrase I have used in past publications is that ‘THE HIGHER THE US EQUITY MARKET RISES, THE GREATER ARE THE RISKS FOR THE US ECONOMY,’ and what I mean by that is that as long as the US equity market and other assets are providing better opportunities than the real economy, then the real economy will be starved of capital.
The reflation trade and the rise in GameStop both reflect this redirection of capital, rather than true growth. Policy makers could well decide to change the incentives. Could it be better for the US economy if the Fed took some of the wind out of the equity market’s sails? Now right now that seems highly unlikely given the Fed’s determination to keep a lid on volatility and the constant backdrop it has provided for equities. But something needs to change. As I’ve already mentioned, last week we looked at the possibility of using lowish equity index volatility to start reducing risk by switching long positions into long calls and keeping some powder dry for a pull back. However, with the spike in the VIX that we have just seen, that boat may have already sailed even though volatility is now drifting back down again.
But there are still a couple of alternatives that I discussed In previous episodes of The Big Conversation this year, where volatility has not yet picked up. Bond and currency markets are still experiencing relatively low volatility. If levels of equity volatility have now risen too sharply in the short term, then you can still look at the macro hedges using the upside on the dollar or the upside on US bonds. The currency volatility index or CVIX is about two vol points below the five-year average (and even further below the 20-year average). Three month risk reversals on the euro, that is the difference between a 25 delta put and a 25 delta call, is currently around zero for the three month maturity. We should keep an eye on the 91 level of the DXY because this looks like the neckline of a reversal formation. If it breaks, we can target a move to 93, which would reverse most of the post-election weakness in the dollar. Similarly, we can look at bond volatility which is relatively low on a historical basis.
Last week we saw the long end of the bond market selling off and yields rising in the days following the spike in GameStop. This move in longer dated bonds, implies that hedge funds were liquidating their long assets in order to pay for their loss-making shorts. The front end of the curve has seen two-year yields retesting their lows. Now the back end of the curve may have been pricing in reflation risk, but the front end of the curve has not yet believed the growth story. Therefore, buying call options on the long end of the bond market appears to be a better bet than outright long positions on the underlying. If we get another value at risk (or VAR shock), then bonds could first head lower and yields higher because investors may need to sell some of the winners to pay for the losers. Long call options on the TLT will allow investors to ride out such moves.
So in summary, whilst there's been a lot of excitement about the motives and mechanics behind the recent moves in certain stocks, the price action again confirms that the US equity market is not connected to fundamentals but to liquidity in positioning. Rising equity markets are diverting capital away from the real economy towards these markets. Policymakers have so far been able to turn the other cheek. But ongoing dislocations may require a policy rethink in order to push capital into channels that help support real rather than illusory growth. In the next section, we’re going to take a quick look at the private equity and venture capital markets, where 2020 volumes were extremely robust and again reflect that for certain sectors, this remains an extremely attractive environment in which to do business.
Whilst the trends in private equity and venture capital may not lead directly to actionable opportunities, these sectors have been underpinning significant activity across financial markets. I spoke to Refinitiv's Merissa Selts and Gavin Penny about these trends and dealmaking.
So for private equity, buyout investment activity in US companies reached a 13-year high of $262.4 billion in 2020, a 23% increase compared to last year. The fourth quarter itself saw particularly high investment volumes and values, with over 1,079 transactions totaling $110 billion, over twice the deal values compared to the Q3 2020. Despite having a strong investment activity in 2020, there was a considerable decline in the volume of exits, with only 467 exits on record, the fewest in ten years. Exit values, however, totaled $154 billion, a 14% increase from last year. Fundraising in US-based buyout funds also saw a slightly weaker 2020, a total of 426 funds recorded closes during the year, raising a combined $341.9 billion in commitments, a decrease of 9% in capital raised compared to a year ago.
For venture capital, despite facing major challenges from the COVID-19 pandemic, the US VC industry remained resilient. Overall, 2020 posted a record high for investment value, the second-highest year for capital raised by VC funds and the second-highest year for completed VC-backed exit value. US VC investments reached a record high in terms of dollars of $124.8 billion from 5,084 transactions during full year 2020, a 16% increase by dollars despite a 4% downtick in numbers of deals compared to a year ago. VC fundraising reached a 20-year high of $72.7 billion from 608 unique funds during the full year 2020. an uptick of 23% by venture dollars and a 6% increase by number of funds compared to a year ago. And for exits a total of 509 VC-back exits were completed by US companies in 2020 worth a total of $138.1 billion, a 10% decline in values, but a 5% increase in numbers of exits compared to 2019, which is the highest year that we currently have on record.
2020 was an excellent year for volumes even if exits were down. US private equity and venture capital activity ramped up towards the end of last year, fueled by the same easy money dynamic that has lifted the US equity market. It will probably come as no surprise to learn which sectors benefited the most from some of this activity. Refinitiv's Gavin Penny explains:
Our top sector overall was in computer software and services, which raised over fifty billion in over two thousand transactions in 2020, including some of the top three deals of the year were all in the transportation sector. Rivian Automotive, manufacturer of electric trucks and SUVs. Waymo, developer of self-driving car technology and SpaceX in aerospace, all around two to two point five billion apiece. Financial services was also a big sector in venture capital in the United States in 2020, with the financial insurance, real estate, software and services very high flying with over 625 deals, including Robinhood, which raised over a billion dollars in 2020, in addition to the billion it raised just last week. And in 2020, actually, Robinhood saw its valuation rise by over three billion dollars in less than three months from eight point six billion to eleven point seven billion in September. Similar to venture capital, in the private equity buyout space, we saw top sectors included computer software with 579 deals and financial services with 360 deals. Now among all companies with significant buy out and private equity activity, nearly all saw significant declines in either deal values or deal volumes or both. What we have been seeing less of over the years are in 2020 especially, have been leveraged buyouts. They used to make up a much larger proportion of deals than they do now. But what we've been seeing in 2020 are add on acquisitions, portfolio companies acquiring other companies. Overall, private equity has really been the the top sector, especially when it comes to add on acquisitions by portfolio companies.
Because this is still an easy money environment in the US, we should probably expect 2021 to follow on with another set of healthy volumes.
It'll be hard to predict the sectors, but 2021 should be an excellent year for both venture capital and private equity. We've seen banner fundraising years. Venture capital fundraising in the United States has actually reached a 20 year high not seen since since the dot-com boom of the year 2000. President Joe Biden has laid out an ambitious plan for increasing venture capital to be made available to entrepreneurs, though increased government intervention has sometimes correlated with weaker returns in venture capital led countries like Canada. But with both venture capital and private equity buyout fundraising's have seen two straight years of very strong growth. As a leading indicator of future investment activity it suggests we'll see quite likely even more investment activity in the United States in 2021.
So VC and private equity still has a lot of dry powder, and the trend towards fewer listed companies looks likely to continue. That said, the incredible moves in some equity prices recently will be encouraging for IPOs taking advantages of valuations that have often broken down from fundamentals. But as long as policy makers are trying to run the economy hot, the conditions remain advantageous for financing both new and existing off market projects. And thanks to everyone for watching this week's episode of The Big Conversation, and I look forward to seeing you all again next week when we look at more of the essential stories in markets and finance. And you can now get The Big Conversation from Refinitiv as a flash update on your Alexa device or Google assistant. if you want to know more about how to download it to your smart speaker, please go to Refinitiv dot com / flash briefing.
