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Episode 7

Bear market catalysts

Published on: December 11, 2019 • Duration: 15 minutes

This week we let you in on the risks and the catalysts in the US equity market and what could be the potential signs of a reversal. The market chatter looks at the impact of the sales tax on Japanese consumers and how this might affect international retail capital flows. And the whisper looks at why brokers want extra capital buffers at the clearing houses.

  • [00:00:04] There's a building expectation for a major market reversal, and I think much of this fear is based off the belief that there has been a massive build up of risk within financial markets. Now whilst this is true, there is still a significant difference between the evidence of a build up in risk on the one hand and on the other, the catalyst that could turn these pockets of risks into an actual major market correction. And that's the big conversation. 

    [00:00:34] The volume of triple B credit, the size of stock buybacks, extreme levels of equity market valuation, pension deficits, excessive use of leverage and derivatives. These are all areas of concern that, if triggered, could turn a recession or risk off event into something far more serious with greater consequences for the global economy. But these are not reasons why an economy or a market should go into reverse. They may act as an accelerant, exacerbating the turn, but none of them are actually a catalyst themselves. The stock of corporate credit, the size of buybacks and extreme equity valuations are in many ways a function of central bank policy, which, if anything, is about to get supercharged with fiscal policy rather than shirk back towards tightening mode equity valuations. Now they can stay elevated for an extended period of time. But that mainly gives clues about the possible extent of a pullback, but not the cause. Valuations didn't pop the dot.com bubble. Similarly, pension deficits, along with debt and demographics, will again contribute to the severity of a risk event, but they won't be the cause. These are issues that have been stalking these markets and will continue to do so in the future. So when we look at all these, these may be accelerants. But what should we be looking for in terms of the signs of risk? Well, firstly, geography matters when people talk about a global recession. What they're really talking about is an event in which the US plays a major part. Remember in 1997, there was an Asian crisis and a collapse across many emerging markets. Now, even though vast swathes of the global economy were caught up in this, the crashes across many stock markets and currencies didn't really affect the U.S. economy. In fact, the US equity markets soldiered on through those initial phases of the slowdown. Even when Hong Kong dropped by 45 percent at the end of that year, the U.S. equity market had only a minor stumble and then continued to rally. There was a profits recession eventually, with the S&P falling 20 percent in 1998. But that was on the back of the Russian contagion and when Long-Term Capital Management, the hedge fund, imploded. But there was still no fully fledged economic recession, and central banks were able to levitate stock markets with a concerted round of coordinated rate cuts. Also in 2011 2012, we had the eurozone experience where we had a significant slowdown with the spectre of a debt default across a number of nations within the currency bloc. Countries like Greece saw their GDP fall dramatically. And yet, despite this existential crisis in Europe coming hot on the heels of the great financial crisis, the US again did not go into another recession and neither did the global economy. The point is, the last two global recessions have had a U.S. recession at the centre. In 2001, the US was in the midst of the dot com crash. Equity valuations had become extreme. Earnings were flatlining a bit like today's setup. But when it turned, it impacted Main Street's as well as Wall Street. European and Asian stock markets were also caught up in both the upside euphoria and then that downside bust in 2008 to 2009. Indeed, from 2003 until 2008, the global economy had been feeding and leveraging off low interest rates and in particular, low U.S. interest rates. And so leverage became an extreme. Housing bubbles appeared in numerous regions, not just the US but also across Europe and leveraged also a supercharged demand for commodities that had arisen out of China, embracing its own new growth model. So although equity markets didn't reach extreme valuations of the dot com era leverage, it found its way into huge swathes of the US and global financial system, again having an impact on Main Street as well as Wall Street through the housing market and credit bubble. Today, it is fair to say that there is an everything bubble. Certainly the bond and credit markets look extremely frothy. The median U.S. equity valuation is higher today than it was in 2000 because back then it was dominated by a very small number of extremely hot stocks. But there is an ongoing debate about whether the US is already in recession. Now, in many ways, both the recession and the non recession camps are right. There was a profits recession in the shale patch in the US in 2015. There is an ongoing bricks and mortar retail recession in the US and many parts of Europe. And there has been a global auto recession and probably a manufacturing recession exacerbated by the ongoing uncertainty around trade tariffs. But none of these recessions have been coincident. These recessions have been isolated sectors or isolated geographies rather than synchronized across a number of sectors or regions. And as a result, we have not yet experienced a true global recession. So, therefore, what could be the catalyst? What is it that could be the trip wire that detonates these pockets of risk? Yield curves? Well, we've talked about these before and they’re not a cause of recession. They may be a sign that a recession is coming. But a recent inversion and re steepening of the US yield curve has not followed the same path as the inversion that preceded previous market peaks and recessions. Could it be a global slowdown? Well, China is obviously a far bigger component of the global economy today, and the leadership there are trying to steer a new course. And it has clearly impacted global growth, particularly manufacturing. But as discussed, the last two global recessions were caused by retrenchment within the US rather than the US retrenching because of weaknesses elsewhere. Could the catalyst be inflation? Well, it probably tops a lot of people's lists in terms of risks. And a fear of growth and inflation,leading to a tightening cycle by the Fed has been at the very heart of the last three US recessions, with high rates being the tipping point of an over leveraged equity market in 2000 and an over leveraged housing and credit market in 2008. So, yes, it's a possibility today, but currently the global economy is still worrying about deflation and disinflation. So to move from bad disinflation to bad inflation, the economy is surely first past through growth, which would actually have upside risks for assets as investors start to price in the growth that’s been pretty much absent for most of the last 10 years. What about an escalation in trade tension? Well, that's another favourite catalyst for a lot of people. And so far, this experience has been death by a thousand cuts, but it's not been a sudden correlation. Events in central banks have just about managed to keep up with the swings we've seen in sentiment. So, of course, tensions may reach a tipping point in which China acts more aggressively via a currency devaluation, but that would be the nuclear option, considering the discomfort it caused for China during the mini devaluation of 2015. And this is one of the reasons why it shouldn't be a core expectation, even though it is a clear risk. And in terms of the overall equity market, well, it's still only 12 months since the last 20 percent decline of the S&P 500 back in 2018. And it's rare to have back to back 20 percent declines that are separated by a new all time high. I think in the most recent examples was the 20 percent decline of the S&P in 1998, followed by New High and then the 2000 2001 dotcom bust. So although the market is long overdue, a short, sharp correction, it is not showing the signs that we've come to expect on the approach of a major market peak. But perhaps that's the issue. Today's markets have been deformed beyond all historical recognition, and the signalling this time could be totally unique. So we will need to be on alert in 2020, even though it's the beginning of the election year. There are clearly the risks there, even though at this point it's hard to say that a major market top is on the approach. 

    [00:08:35] In October 2019, Japan raised the national sales tax from 8 percent to 10 percent when they raised it from 5 percent to 8 percent in 2014, consumption took a hit and the benefits of Abenomics, which had been started a couple of years before, were quickly put into reverse. The economy again looks to be taking a significant hit this time round. Japan's household spending has collapsed again, just like it did in 2014. Month on month, retail sales have taken a bigger hit than in 2014, even though the actual size of the sales tax hike is slightly smaller. And the overall outlook for GDP is fairly negative because Japanese GDP is highly correlated to consumption patterns. And the hike in this tax comes at a time when global manufacturing in the economy was already weak. Japan was already exposed to the slowdown in global manufacturing and the ongoing retrenchment in China. Both imports and exports have been struggling even before the sales tax hike was introduced. Japanese industrial production growth, which had been hovering in negative territory anyway, is now accelerating to the downside. So I guess the big question here is what does this mean for Japanese policy? Of course, Japan has been at the forefront of global unorthodox monetary and fiscal policy. The Bank of Japan has been far more aggressive than either the ECB or the US Fed in printing money. But since a misstep in early 2016, which saw JGB yields collapse, this is the 10 year yield, the Bank of Japan has taken something of a back seat on the international stage. Inflation may start to pick up. It might be marginal, but there was an inflationary spike in 2014 when that sales tax was added to all the household bills. If the Bank of Japan is going to resort to printing more yen, then U.S. dollar/yen should again push back through the 110 level where there is this huge, huge resistance that has so far kept dollar yen in check. But interestingly, Japan is also one of the world's main global creditor nations. Its retail sector is a huge investor in overseas markets. They've been hunting for better returns than they can achieve at home where you've got a lot of these negative yields. So if there is a significant slowdown at home, then there is also a risk that the Japanese investors could start to repatriate capital. And so in this scenario, rather than seeing the yen weaken as the economy falters, actually the initial risk could be for a stronger yen. And this repatriation of capital could undermine some of the weaker spots in the global financial framework. In fact, Japanese investors may become forced sellers of illiquid overseas assets if the domestic economy takes a hit. And that could actually tighten global financial conditions. And as we've noticed in the previous section, there aren't many obvious catalysts for reversal in global risk assets. But repatriation by Japanese retail could have an unexpected knock on effect from this sales tax hike. So it's not a risk that many will have on their radar. And that's why it could be all the more surprising and shocking if it does materialize. So therefore, buying yen volatility or maybe just yen calls, which is US dollar puts out right, could be a decent way to hedge the surprising leftfield shock to the global system. 

    [00:12:09] Last week, the EU 28 member states said they were in favour of clearing houses having a larger internal capital buffer to cover against losses from defaulted trades. Now, although the clearing houses came to real prominence to settle trades within the big listed markets, since the 2008 financial crisis, regulators from around the world have already tried to put more interest rate, credit default and other swap products directly onto the clearing houses and away from being settled by the banks themselves. Funnily enough, this is pretty good for clearing houses and business has boomed. Volumes have skyrocketed, but also risks have been going up too. Each position requires the owner to put up a sum of capital called the initial margin. It's a bit of a safety buffer and then there's ongoing variation margin as the position develops with the market price changes. However, it's very rare for one member to have just a single position. Normally each member will have a vast array of positions and clearing houses will allow their members to offset or net off these positions. The risk models that are used effectively equate low volatility in the marketplace to low risk. However, low volatility also encourages investors to increase leverage so positions become bigger and margin requirements become smaller as volatility falls. It's a generalization, but you sort of get the picture. Now the assumption is that the long and short positions that are involved are generally offsetting i.e. the risk on one side is fairly similar to the other, and that's sort of true in normal market conditions. But anyone who is around 1998 will remember Long-Term Capital Management, a hedge fund that built up huge positions in similar assets on long and shorts in the expectation that these positions would converge. The problem was that we had the Asia crisis, which then became a Russian default, which then saw finally the S&P cracking in 1998, and when the market went into full risk off mode, it revealed a huge liquidity mismatch. And these positions effectively wiped out the fund and caused problems for the market. Well, today, we don't have a single fund with huge offsetting positions, but we have a whole market framework in which these positions are being netted off and therefore with huge potential liquidity and duration risks. But this also means that therefore the clearing houses will demand more capital from their customers and this is going to push up the cost of capital. It may even mean that many of these positions have to be liquidated. And worst of all is that until the clearing houses actually have the increased capital buffers, there is a huge gap risk in the market. Listed positions today are bigger than they've ever been. But if one counterparty experiences a shock leading to a failure, it could set off a chain reaction of defaults and that would be like LTC M squared.