Choppy Ride Ahead of U.S.
Markets Print for 29 September 2020 · by Diego Tremiterra
- Election years have historically brought positive return to markets, and since 1944 we only had two election years that were not positive… 2000 (Dot-com Crash) and 2008 (GFC).
- Market participants care about the US elections, the level of fiscal support from governments around the world (unclear in the US, whilst Europe has it covered until 2021) and about the strength of COVID’s second wave.
- Given the strong market performance throughout summer, the political uncertainties ahead, and the risks of the current short gamma positioning of many market participants, we believe that risk is skewed to the downside and that volatility is likely to pick up in the near term.
The narrative right now is quite simple: market participants care about the US elections, the level of fiscal and monetary support from governments (more unclear in the US than in Europe) and the progress of COVID (more of a wild card in case the situation gets fully out of control again).
I believe that we have downside risk into year-end given the strong market performance throughout summer, the uncertainties of the next few months given COVID and the US elections, the increased share of trading volumes of non-professional investors and the fact that the market is really short gamma. That being said, I also think that a scenario of extreme weakness is likely to be met by further stimulus, which will be taken positively by markets. Thus the only thing I am fairly confident about, beyond the fact that the 1961 Ferrari 250 GT SWB California Spider is the most beautiful car ever designed, is that until year-end we’re likely to have a choppy ride (volatility will increase), especially as the risks of the US election being contested increase.
On the political spectrum, the US election will be the most important event until year-end. Biden has a lead on Trump according to polls, but who knows what’s in store between now and November (*political nerd giggle*). This will be a very unusual election because of the candidates (Biden campaigns on dignity, perseverance and integrity, and Trump is Trump), because of the current political polarization within the US (and the increasing social cost of it) as well as due to the operational nature of the election during a pandemic (many votes will be casted through mail).
Source: The Economist
The main thing to remember is that both candidates are likely to be in favor of some sort of fiscal stimulus; what changes though is the timing of it and the scale. Democrats are incentivized to delay any kind of stimulus post-US election (they want Donald to look bad), and once in power they are likely to continue to monetize the budget to support the American people and find ways to decrease wealth inequality. Trump would likely benefit from having Americans receive helicopter money before they cast their vote, as a “friendly reminder” that in Donald We Trust. Short-termism aside though, we enjoyed the analysis that Juliette Declercq gave in an interview on the MacroVoices podcast with Erik Townsend:
“Trump is more friendly to corporate earnings. That’s potentially great for equities short-term but the lack of aggregate demand risks stopping the recovery right in its track, which will eventually be an issue for assets. Biden stands for social stability and redistribution. It would greatly benefit aggregate demand in the long run but potentially justify increased volatility in the short term on higher corporate taxes and increased regulations. The risk with Trump is a return to trade wars eventually, which would also include Europe and slow the USD slide, stopping the global recovery in the process. But this really is tomorrow’s story; he will avoid tariffs at a time when the economic recovery is so fragile. Conversely, Biden would lower the world’s geopolitical temperature and accelerate the recent cyclical recovery through further fiscal stimulus, further widening of the US trade deficit and a much weaker USD.”
Additionally, at Evergreen Gavekal, they’ve eloquently written down some thoughts around the election, all of which are worthy of your attention:
- Focus on how the different candidates will tackle the wealth gap, which is the “real elephant in the room for markets”. This could be done by increasing wealth taxes, increase antitrust regulations, or by more “benign tactics” such as an increase in the minimum wage or the creation of a Universal Basic Income (UBI).
- The potential risk of the elections result being contested is real, independently of the result, and that is likely to be negative for the markets.
- If a Biden’s election drives a market sell-off, it will likely be short-lived. A Trump election is likely to strengthen the USD even in the short term.
Another important variable is the replacement of the late Ruth Bader Ginsburg (RBG). She was one of the eight associate justices of the Supreme Court of the United States since 1993, and with the addition of the Chief Justice, they make up the highest court in the US. Why is that important? Because the Supreme Court has tilted more conservative in the last few years, and with the loss of one of its most liberal members, and the nomination of a another conservative (Amy Coney Barrett), the Supreme Court just became a 6:3 “conservative” institution, which might have a significant impact on US politics, especially amidst an election in which President Trump is saying that he’ll refuse the commit to a peaceful transfer of power, in which case the Supreme Court might be called into the equation (see Bush vs Gore, a five weeks process that drove the market down by 12%).
Source: The Economist
Politics in Europe are less heated until year-end, especially as countries like Germany, France and Spain have already extended some sort of fiscal support to their households well through 2021 and no major country has elections until year-end. Interestingly enough, the main British, Italian and French equity indexes are down more than 20% year-to-date, whilst the German DAX is down c.7%. This compares to a flat S&P and an almost +20% Nasdaq. Maybe the market really doesn’t care about politics after all…
More than calling the result of the election though, what we care more about is how the market might move around the elections. Historically, election years have, on average, delivered positive returns for markets. Interestingly though, since FDR’s victory in 1944, we can recall only two years in which market performance in election years was not positive: 2000 (Dot-com crash) and 2008 (GFC). This makes me less confident about 2020’s being a positive return year, as both years had similar non-sustainable built ups to the ones we have now.
Source: Real Investment Advice
Since the last markets print, we’ve seen one major change coming from The Fed, who said they’re now targeting an average inflation rate of 2%, with the key change here being the word “average”. This means that, when confronted with consistently low inflation, the Fed will allow inflation to run above its 2% target. The reasoning behind this change is straight-forward, and well explained by The Economist:
“The Fed initiated its strategic review in response to criticism of its performance during and after the global financial crisis of 2007-09. Like most rich-world central banks, the Fed orients its policy around an inflation-rate target. When inflation threatens to rise above 2%, the central bank typically adjusts policy (by raising interest rates, for example) to slow economic growth and prevent a further acceleration in price rises. Inflation that is too low, on the other hand, generally prompts actions to boost economic growth. This system seemed to perform well in the 1990s, when America enjoyed a stretch of rapid growth alongside low and stable inflation.
Since then, however, its shortcomings have become plain. In a world of falling real interest rates (ie, adjusted for inflation) a background rate of inflation of 2% is too low to prevent nominal interest rates from repeatedly falling to zero, at which point central banks can no longer rely on their favoured stimulative policy tool, an interest-rate cut. And too often, a focus on preventing inflation from rising above the target has led central banks to rein in economic expansions before the economy has clearly reached its capacity. The overall effect has been to depress employment and wage growth unnecessarily.”
In practical terms, the Fed is trying to increase inflation expectations. As the Fed allows for inflation to overshoot the 2% target (instead of raising rates as soon as inflation gets close to that level), it is expected that inflation will stabilize closer to or at the 2% target level, instead of stabilizing below that.
Source: Federal Reserve Bank of San Francisco
Since the beginning of COVID, inflation expectations have rebounded, decreasing the risk of deflation, something that we have written about in the past. That being said, we’re still far-away from being deflation-risk free, and once we account for the continued deflationary trend of velocity of money and industry specific dynamics that have structurally changed on the back of the pandemic, like the increasing share of e-commerce (tends to decrease inflationary pressures), then the Fed’s change in policy continues to make intuitive sense.
This all means that Real Rates (Nominal Rates – Inflation) are likely to continue negative for longer as inflation expectations are being given a further boost and nominal rates are unlikely to go anywhere in the near future. Given the strong inverse correlation between Real Rates and Gold (i.e. lower Real Rates lead to higher Gold), this should set up a positive macro backdrop for the bullion.
Whilst we had a lower dollar and stronger gold move between July and August, in the last month we had a partial reversal of that.
September and October are also months that have historically been weak for equities, and this year has so far followed that trend. That is not surprising, especially as the S&P had the strongest August performance since 1984 (+7%). Some of the generalized weakness in the markets could also be attributed to what seems to be a less accommodative Federal Reserve after they disclosed, on August 31, that they’ve only been buying $9mn a day of corporate bonds and bond ETFs, compared to $300mn a day earlier in the summer. Additionally, the Fed, at its September 16 meeting, did not boost asset purchases, disappointing those market participants who were hoping for further drivers of risk-on sentiment.
Broadly, beyond Tech and Gold, something that we’ve written about last month, I find it interesting trying to understand the long-term movements in the currency markets.
One of the most insightful reads I’ve found on the US Dollar, the global reserve currency, came from A.G. Bisset, with their analysis on the Dollar’s 15 years cycle.
Source: A.G. Bisset
In a nutshell, they believe that the US Dollar started a bearish cycle in January 2017 that on average lasts for 8 years, and that will lead the euro to rise to $1.7 by 2024 (currently it’s at $1.16). The key driver behind this move is the capital investment cycle of commodity prices. According to A.G. Bisset:
“As commodity and oil prices bottom and start to rise, as they did in 2016, commodity producers receive more dollars. Their terms-of-trade improve. They sell dollars to import goods and services from around the world. It adds downward pressure on the dollar in a feed-back loop that enhances the trends in the upward and downward phases of the cycle. As commodity prices rise, capital investments in oil production, mines, etc. accelerate. Projects take years to complete, but when done, supply is increased; commodity prices begin to fall and the dollar cycle reverses.”
Commodities are currently trading at incredibly cheap levels versus equities, and recent price action, shown below by the Bloomberg’s Commodity Index (ex-Energy) suggests that we might be beginning a new bullish cycle. If that is to be the case, then that would fit A.G. Bisset’s narrative quite well.
All of this doesn’t bode well for Europe, which has chronic deflationary problems which would only escalate by having a stronger currency.
The current market structure is quite narrow and has little depth (meaning fewer players making fewer transactions), something that Mike Green has been saying for a while now. Citadel has been quoted to be responsible for 25% of all US equity volume and one third of US options market volume.
I would argue that having only one institution handling so much volume might create, once again, a “too big to fail” scenario in which, if something turns south, taxpayers’ money will need to be used in order to rescue financial intermediaries and ensure the well-functioning of the market. What’s also not good news is that we’re currently seeing the greatest amount of equity options trading volumes on record, much of which has been driven by retail investors. Broadly, retail investors now make up 20% of US stock market activity (25% on peak days) compared to 10% in 2019, according to Joe Mecane, the head of execution services at Citadel Securities.
Source: Financial Times, The Economist
For the first time ever according to Goldman Sachs, the average daily volume of equity options traded was higher than that of the equity itself.
Source: Goldman Sachs
There has also been a massive discrepancy between call and put options activity, as highlighted by the WSJ chart:
Source: Wall Street Journal
Such an increase in call options activity by non-professional investors increases the volatility of the market.
Call options bought by retail traders are usually purchased “naked”, which forces options dealers to buy the underlying equity in order to hedge their short gamma position (they are sellers of call options). The more the price of the underlying stock rises, the more they have to buy the underlying to hedge their gamma exposure. Paradoxically, the more they have to hedge themselves, the more stock they need to buy, increasing demand for the underlying and driving its price even higher. But whilst a rising market forces dealers to buy in ever increasing quantities, the exact opposite happens in a market downturn. As noted by Bloomberg:
“If short gamma hedging lifted stocks, logically it should also be capable of exacerbating moves the other way. When shares fall, market makers are likely to unwind hedges at an increasing speed, spurring more losses. Examples of such events are common: Volkswagen AG shares in late 2008 or the spike in silver during 2011. Some even saw parallels in Tesla at the start of the year, though those moves look negligible compared with today’s.”
And ultimately, this is the reason why I am interested in seeing how this plays out until year-end. We have a market that is poised to move quickly to the downside, whilst any downward move might be followed by equally strong rallies given the (already proven) commitment of governments and central banks in promoting stability amidst the pandemic.
Whilst this last quarter didn’t provide the same fireworks show as Q2, this next quarter is setting up to be a grand finale. And if there’s one thing I’ve learned through the volatility of 2020, it’s that, humanity, through it all, can still find a way to produce greatness, and this generations greatness is most assuredly that of the fin-meme….