The Big Conversation
Episode 73: Is now the time for a stock market hedge?
This week we look at the ongoing surge in commodity prices and the massive miss in the employment data. Are these both going to have an impact on earnings and increase the risks for the stock market? Some investors have been looking for cheap hedges to protect against any sudden air pockets. In this week’s Chatter, Refinitiv's Saida Litosh outlines the demand for gold from retail, who are investing in physical gold such as jewelry, whilst institutions have been liquidating ETF positions as they flip into reflation trades.
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Last week when we looked at whether inflation is out of control, we focused on the commodity sector and copper in particular. Since then, copper has broken to a new all- time high, adding further fuel to the fire. But we also saw one of the worst misses on record for the non-farm payrolls. Now on the surface, this looked like a weak report, although April's effect was probably exaggerated. But it really indicates the ongoing dislocations that the economy is trying to recover from. Perhaps even more remarkable was how initially the market reacted to this news, brushing it off on the assumption that central banks will just step in. Since then however, tech stocks have stumbled amid a pullback in retail activity and rising fears of inflation. This week's Big Conversation will look at mounting pressures for corporates and consumers, and how this could constrain the Fed's policy response.
So that US payrolls number looked like a shocker, gaining 266,000 jobs versus expectations of around a million for a huge miss. It's unlikely that job demand was a problem, though. The recently released JOLTS job opening index has just reached a record high in excess of eight million people, matched by a new high in the 'jobs hard to fill' section of the NFIB Small Business Survey. The payrolls data could have been impacted by issues with data collection and seasonality. The events of last year continued to distort many data releases. But if that's the case, then the miss of this month will get averaged out over time. Another candidate for the miss is a problem with labor supply. Many commentators argue that the benefits of wage support schemes have discouraged workers from looking for jobs. But the sharp drop in numbers receiving benefits argues against that. There is however, evidence that many potential employees have been sidetracked by gains made in the equity market and other risk assets. The recent pullback in tech names may now have closed some of that opportunity. There may also have been a skills mismatch between the old and the new economy, where technology has either replaced jobs or requires new training. The participation rate of 25 to 54 year olds is still below the initial bounce out of last year's lows. A lack of childcare has also slowed down the ability for some parents to take work. The lack of labor supply and robust demand has shown up in average hourly earnings, which rose naught point seven percent against an expectation that they'd be unchanged. Therefore, although the non-farm's headline was weak, there are signs that companies are starting to pay up in order to secure jobs. So far higher wages have not yet had a big impact on the U.S. Employment Cost Index, which remains below pre-pandemic levels. Unlike in 2019, when there was no inflation despite an almost full labor force, today we have a huge amount of slack, but rising wages. The risk is that wages rise but potentially employees are permanently left behind and require continued income support because of these structural shifts. Biden has said that support will be removed from people who turn down job opportunities, but that's easy to say than monitor. Perhaps the declining retail interest in the equity market will encourage people back to work. Or it could be that as people return to work, engagement with stock markets has started to decline. Option volumes have fallen, suggesting some disengagement from the year's early fervor. Refinitiv's Most Shorted Index, which had been outperforming the S&P500 over the last six months, has now given back a good part of that relative run. This may, however, simply reflect a wider shift toward the crypto market where even Bitcoin appears to be experiencing outflows into various other coins, whilst Ethereum is generating more and more of the headlines. Policymakers may be happy to see the removal of froth from stocks, but they're showing little interest in the huge gains in commodities which they consider to be transitory. The powerful macro story that has helped copper break the all-time highs should bring in new momentum players. But it's now very overbought on the Relative Strength Index and traders will be looking for a retest of that breakout level amid this bout of rising uncertainty for risk. If we look at the copper/gold ratio, the risks for bond yields are to the upside, but the market may also be concerned about stagflation. If input costs are rising faster than economic growth, then margins and growth will come under pressure. Many CEOs are handing higher prices on to consumers. Copper's rise has been well flagged, but it's also been joined by some spectacular moves in other commodities. China's iron ore futures have made a new all time high as global demand starts to pick up while supply remains constrained. Equally spectacular are gains in many agricultural commodities. Corn is closing in on the all-time highs of the last decade. The speed of the move is the largest year on year change, apart from the surge at the beginning of the 1970s. But that was off a far lower base. When agricultural commodity prices surged 10 years ago it was an element in the Arab Spring uprisings. Today, many struggling lower income U.S. and European consumers will also be impacted if those higher food prices persist. And yet, despite all these surges in commodities and upward pressure on many measures of inflation, there remains little interest from commercial banks to lend. Commercial bank lending year on year has gone negative. Some of this weakness is the base effect from last year, but we can't dismiss this while still claiming the relevance of the upward base effects in commodities. For inflation to really take hold on a permanent basis, it needs more than supply chain bottlenecks. It needs the creation of money by commercial banks and not just the one-off transfer of money from the state to those household saving accounts. Furthermore, if consumers and corporates borrow to put money into financial assets, then there will be no inflation outside of asset price inflation. We therefore currently have a very unusual landscape in which inflation is everywhere, but one of the biggest drivers of long-term inflation is nowhere. Banks could start lending at any time, but that would also require a willing on the part of consumers and corporates. So where does this leave markets? The reaction to the huge payrolls miss was very, very short lived. Yields soon stabilized and the S&P500 celebrated with a new all time high. But many of the tech darlings are still struggling with inflation, even though bond yields remain subdued. As long as yields are well-behaved, risk assets should be able to withstand higher levels of inflation. U.S. bond yields peaked at the end of March, which was the end of the Japanese financial year, having been sellers of bonds year-to-date until that point. Within the stock market, however, rotations are continuing and this could have a detrimental effect if retail are caught on the wrong side. The ratio of the Nasdaq versus the S&P500 is breaking down, and many of the high-octane tech names are off over 50 percent from this year's peak. The stability in nominal bond yields and a fresh high for inflation expectations mean that real yields have rolled over. Five year real yields have made a new low. Falling real yields are supportive of gold prices, and it's no surprise that gold has bounced back with this decline in real yields. And the gold chart is forming a cup and handle formation, which would suggest significant upside if the 2000 dollar level was broken again. The implied volatility of gold has dropped back to 14, and apart from a brief period a few years ago, this is the bottom end of the long-term range and this is close to fair value. Call options maybe an attractive way to play for a breakout in gold beyond that 2000 dollar level. In the equity market, days like Monday May the 10th are extremely rare where the Nasdaq took a beating, but the Dow Jones Industrial was almost unchanged. Nearly all prior observations of similar underperformance are aound the dotcom peak of 2000. 44 percent of S&P500 shares made a new 52 week high, according to Sentiment Trader. Whilst Tesla is testing the medium term uptrend. On a closing basis, the 38 percent retracement of the rally since March 2020 is a key support level around 580. It's been almost impossible to play the broad market for the downside because pullbacks have been very few and far between, and they quickly reverse. Implied volatility is unattractive when compared to historical volatility. And many institutions and hedge funds have taken a view that there's no point in buying tail hedges because each time we get a significant correction, the Fed comes riding to the rescue. But that doesn't mean that their reaction will always be the same. Although they think that inflation is transient, they will be very wary of fueling it further just to protect the froth in the stock market. Now a classic macro hedge fund strategy to play for a very sharp and sudden correction, is selling a one by two put spread for aroud zero cost. Now, the thinking behind these structures is that the market mainly grinds higher, but when it does reverse, those corrections will be sudden air pockets with significant downside. An example of this structure would be, for instance, selling a 90 percent put in June and buying two of the 83 percent puts for around zero cost. If the market crashes beyond 83 percent of current levels, they would effectively be long one put at the 83 percent level at expiry. And at expiry is absolutely key here for the payout. Now clearly there are risks in selling that first out of the money put, but the point of these structures is to hedge against a much steeper drop for only a small outlay just in case this is the one where the Fed is caught napping. Hedge fund leverage, which Goldman Sachs reports has reached a new record, could exacerbate these gyrations. Investors will look at different strikes and expiries on these one by two structures, but in environments like this, they are generally looking for low cost hedges that don't burn capital. Any position with a short strike though, obviously needs careful managing. But the risks are that short term inflation continues to impact earnings, which could discourage employers from hiring, which could in turn make consumers cautious about spending those savings. Current labor availability or lack of it, could be a limiting factor on the speed of economic reopening. Input inflation in this case, denoted by the ISM Prices Paid Index, has not always coincided with a significant high in the S&P, but many of the significant highs have been accompanied by a spike in prices paid, such as 2000 2008, a less impressive pullback in 2011 and then 2018. Today's assumption is that central banks will always have our backs, but some investors have been looking at gold again, as well as low cost market hedges, just in case inflation limits the tools at the Fed's disposal.
As discussed earlier, this is an environment in which real yields have been pulling back, allowing gold to rally. I spoke with Refinitiv's Saida Litosh about the gold trends in Q1 2021 and the outlook for the rest of the year.
Gold is one of last year's star performers within the commodity complex as the combination of fiscal policy and high inflation expectations helped to drive it to a new all time high. Since the end of last year however, its performances sagged when investors started switching their attention towards reflation assets. Saida Litosh explains some of the demand dynamics affecting gold in Q1 of this year.
In Q1 we saw a rebound in physical gold demand, which was up by 25 percent year-on-year. And this was driven by gains in jewelry demand and retail investment. Jewelry demand, which roughly accounts for a half of global gold demand was probably one of the worst, if not the worst hit segments by the pandemic last year. Demand from this sector recovered by over 40 percent in Q1. and this was to a large extent driven by a recovery in key Asian markets, including India and China, where demand revived from the lockdown hit Q1 2020 as the economies continued to reemerge from the pandemic helped by the festival period and also lower gold prices in local currencies.
Now looking at retail investment, which is investment demand for bars and coins. Demand rebounded by over 40 percent in Q1, it was driven mainly by a resurgence in demand in Asia as economies continued to reemerge from the pandemic and recover from lookdown. There was also an element of opportunistic buying as lower gold prices in many local currencies was seen as a good opportunity or a good timing to reenter the gold market, especially given the expectations about the price outlook. In addition to that, retail investor demand in the Western world remained quite strong in Q1, and this was driven by ongoing concerns around economic uncertainty, currency stability and growing inflationary pressures given massive stimulus measures introduced by central banks and national governments to pull economies out of the deep economic recession caused by the pandemic. In a sharp contrast to that, we witnessed a shift in investor sentiment towards gold among the professional investor community, which pretty much started towards the end of last year and sort of accelerated since the beginning of this year. This was evidenced by liquidations from ETF investors who reduced their global holdings by over 170 tons in the first three months. Just to put this into perspective, gold ETFs witnessed a record level of net inflows of around 900 tons over the course of last year. Q1 selling represents the second consecutive quarter of net outflows, with net selling of 75 tons reported in Q4 2020. This compares to net inflows of over 300 tons witnessed in Q1 last year and also represents the largest net quarterly outflows since Q4 2013. Another sort of weak story here is official sector buying. Central banks gold purchases were estimated at around 81 tons in Q1, which was down by more than a third year-on-year. And this is driven by a sharp increase in gross sales led by countries such as Turkey and the Philippines, but also a year-on-year reduction in gross purchases.
Retail investors have been buying into recent weakness, especially in Asia, but institutional investors were unwinding because of the improved outlook of growth and anticipation for higher bond yields.
So on the one hand, we have a strong rebound in retail investment demand. And this was largely driven by a post-pandemic recovery, particularly in Asia, as economies continue to reemerge from the pandemic. As a result, we saw a strong year-on-year increase compared to Q1 2020 levels when many economies were affected by lockdown. Another key driver here was lower gold prices in many local currencies, which boosted gold purchases, especially given that many were still expecting gold prices to move higher later in the year. So on the other hand, we just talked about an acceleration in selling from ETF investors reported in the first three months. This was largely a reflection of a shift in investor sentiment towards gold since the beginning of the year, with gold being pressured by a firmer dollar, rising U.S. Treasury yields and growing optimism around economic recovery supported by stimulus measures and ongoing rollouts of vaccination programs. As for central banks, a year-on-year decline in net purchases, was largely a reflection of a sharp increase in gross sales, which was partly driven by growing pressures to raise capital in order to mitigate the economic damage caused by the pandemic.
The divergence in gold demand looks like it's set to continue through 2021, although the macro backdrop will probably remain broadly supportive for precious metals.
We expect retail investment demand to remain strong this year and to deliver a strong year-on- year increase, with gold remaining a robust portfolio diversifier, particularly in light of ongoing economic uncertainty, negative interest rates and unprecedented stimulus measures introduced by central banks and governments around the globe. As for ETFs, we are likely to see a sharp drop in net inflows this year compared to a record level witnessed in 2020. We have already seen an acceleration in selling in the first three months and further liquidation is very much possible in the coming months, particularly if we continue to see positive economic data supporting a faster than expected economic recovery and a further rise in treasury yields. Overall, we expect a year-on-year decline in central bank purchases this year. But despite a year-on-year drop, central bank purchases will remain an important source of global gold demand. Demand is likely to be supported by the overall macroeconomic environment and the factors I have previously mentioned. Also anticipated stimulus measures to revive the global economy will continue to support a strong case for central banks, especially in emerging economies, to diversify their international reserves away from the dollar towards gold.
Different investors have approached the gold market in extremely different ways, with retail demand picking up just when institutional investors started to take profits. Overall, the outlook for yields and real yields in particular remains key. Gold rises when real yields fall. The US five-year real yield has just made a new all-time low, inflation could easily spike in coming months, and the gold price could be explosive if it breaks those previous highs again.