September turned out to be true to type, increased risk aversion in and around the triple witching mid month led to a spike in the price of put options (expressed as a higher VIX) and a modest amount of downward pressure on markets as the delta hedging by the market makers induced some further selling from systematic min vol funds. The dollar moved higher as leverage was unwound and confidence in general was sapped by the recognitions that the world economy was going to suffer from ‘Long Economic Covid’ – the dislocation of the just-in-time global supply chains that had taken years to assemble. Short term supply constraints are producing price pressures as commodities, particularly in the energy space, spike higher, spooking bond markets as well as equities.
Traders have woven a bearish narrative about a harsh wind from China as demand for raw materials collapses following Evergrande and government regulations/actions (Education, ADRs, Crypto) wipe out whole sectors and markets. With the exception of the attack on Crypto, we feel that this is a mis-reading of events, but recognise that the nervous holders of cyclical stocks and other China plays are being tempted to take profits after a very profitable 12 months (the cyclical rally began last October).
RIsk aversion remains elevated as investors raise cash and wait for the winds to subside and we note in particular that many of the new economy thematics are running into a lot of profit taking and a possible regime change from buy-on-the-dips bull market to sell-the-rallies bear market. Longer term investors should be looking to benefit from short term profit taking in areas like global trade and ‘all things China’ while also thinking of some of the big disruptions beneath the surface that have been obscured by Covid and other factors. Many are long term solutions like Nuclear Power and blockchain enabled stable coins (for transaction not speculation) that represent significant competition to ‘Green labelled products in ESG’ and transaction based financial services respectively.
Short Term Uncertainties – sentiment worsening
The AAII Bull Index of Investor Sentiment has been falling over the summer from its elevated levels back in April such that it has almost halved, while the equivalent Bear Index has been rising, meaning that the spread (lower chart) has once again flipped into negative territory. The Chart shows the last 3 years and while we would concede that it is is more of a thermometer than a barometer, indeed, markets often lead sentiment, it is nevertheless interesting in a number of ways. First that sentiment swings are usually quite short duration on the downside – although 2020 was an understandable exception – and second that there is an element of Autumn blues over the last few years probably giving some ‘muscle memory’ to markets. Generally we find that when the market sentiment flips from Bull to Bear or vice versa, the narrative adjusts to meet demand and that we need to wait until that becomes ‘consensus’ before it turns again. Thus it is key to remember that there are always two sides to every story.
Chart 1. Bull minus Bear Sentiment.
As expected, increased risk aversion triggered by asset allocators metaphorically (or literally) returning from the beach caused some typical September weakness and an accompanying shift in the narrative to ‘explain’ things. The biggest moves were in energy markets, with not only Oil but also Gas breaking higher – the latter helped by failures of both predictions and planning. The weather turned out to be colder than predicted, while European governments largely put in place insufficient gas reserves and/or tried to time the market – the UK being the worst. This wasn’t helped by China suffering assorted weather related energy outages – droughts in Hydro regions and floods elsewhere.
Meanwhile, the engineered collapse of Evergrande (gradually, then suddenly), despite being entirely predictable for a long time, nevertheless gave the traders another thread to weave into their bear story. The fact that so many western investors appear to desperately want not only Evergrande, but also the whole China economy to collapse has added momentum to the narrative and we once again see widespread repeating of many of the old mis-understandings about how China functions as an economy. These (emotionally) distressed sellers need to be cleared out however, before the cyclical profit taking/selling can finish.
Chart 2. Vix spikes, destabilising markets and risk parity models
Elsewhere, and actually more importantly, we also had market technicals to deal with. A quarterly ‘triple or quadruple witching’ set of options expiries can often produce a rocky month, with March and September tending to be the most volatile of ‘withchings’. The low level of Vix implied volatility Index going into expiry translates broadly into cheap put options and triggered some hedging, the unwinding of which by market makers then involves some selling of the underlying stocks. Usually this is self correcting as stock prices move down a little, deterring further selling and allowing the Delta One books to rebalance and he market makers to be in a position of selling rallies and buying dips. Sometimes, however, this system gets a little derailed by the Quant Funds who follow ‘risk parity’ models as a spike in volatility leads them to follow through on selling (regardless of price) which can destabilise the system and flip the market makers from stabilising to de-stabilising.
There was some evidence of this happening last month and certainly the risk parity index had a bad month (chart courtesy of ZeroHedge). Not so much as to fully destabilise, but certainly enough to provide the motive power to support the turn in sentiment narrative.
Risk Parity Index had a bad month
Quant Selling of Equities does not tell us about the economy, nor indeed would similar Quant Selling of Bonds tell us about inflation. However, what we do know is that the appropriate narrative will appear to suit the market movement and that this will tend to have some longevity if others then capitulate. At some point, the distressed sellers will be finished and if the fundamentals are unchanged (as is often, but not always, the case) then they can reassert themselves.
Meanwhile, our own risk signals suggest continued risk aversion as the Factor risk scores remain medium – all level 3, while the majority of the growth Thematics are now at level 5, meaning we have been raising cash throughout the month from what might be regarded as ‘longer duration’ assets.
Medium Term Risks
As ever, the risk to markets is less from the economy than from policy makers. The just in time global supply chain was disrupted first by lockdowns and subsequently by the reintroduction of borders that has left global logistics heavily disrupted. We have seen over the summer how this has introduced bottlenecks in things like shipping prices, while the reduction in free movement of cheap labour or cheaper goods has resulted in sharp price increases for goods and services. This is all likely temporary as it is a supply problem, not a demand problem. The risk is, however, that central banks see inflation as a justification for raising interest rates and crush demand without resolving supply
The Risk is Central Banks apply the wrong solution to a supply situation and crush demand instead
This would be the road to stagflation, caused by policy error.
While stagflation fears are likely overblown, we note that, while the risk measures on global factors (Momentum, Value, Size, Min Vol and Quality) are all on level 3 (medium) five out of the seven Global Thematics (Digitalisation, EM Consumer, Clean Energy, HealthCare Innovation and Gold) are currently on risk level 5 – so no exposure.
Disrupted Global Supply chains will be repaired, but in the meantime the Supply/Demand imbalance is offering a classic cyclical rotation as pricing power shifts to those in control of the bottleneck. On the obverse, those facing supply constraints will have to adjust their volumes or their margin expectations downwards. Or both. However, selling commodity producers on weak China PPI numbers and stagflation worries is a short term trade not a medium term asset allocation. The need for housing has not been altered by the fact that one of the suppliers (Evergrande) is in trouble. This is a financing issue not a lack of demand one.
The Cold War against China has clearly moved to the next stage of rhetoric. No longer referring to “Communist China’ in every sentence as Mike Pompeo did to make it an ideological issue, or demanding reparations for ‘The China Flu’ as Trump dd, instead Wall Street has shifted its stance, with a number of prominent US investors declaring the country ‘uninvestable’ and even demanding that the US government prevent any inward investment by US citizens. This was triggered by the hit to the Chinese Education stocks at the end of July spreading out to the China ADRs more generally and topped up by a number of pro-consumer (rather than anti-profit) measures aimed at some China tech sectors seeking to create and exploit monopolies. The meme has been fuelled by the Evergrande collapse last month, as mentioned earlier, which is cited as ‘evidence that the Chinese economy itself is about to collapse’, triggering something of a run for the exit last month on ‘all things China’. The fact that the evidence for this is the same mis-application of a US economic template over a Chinese economic system makes us confident that their assertions are wrong, but we need to not interrupt them while they are making this mistake (pace Napoleon).
However, despite the change of President, the militaristic Cold War Rhetoric hasn’t altered, indeed if anything it looks to be intensifying in October, with the west happy to distract voters from the economy at home with sabre rattling in the South China Sea.The escalation of the dispute between the US and China over the west’s freedom of Navigation rights to sail the Taiwan Strait has been going on for several years now, but with exercises stepping up from annually to monthly as well as around China’s National Day, it seems that there is an agenda of provocation not dissimilar to the annual exercises on Russia’s borders. These wargames may keep budgets high, but they also keep risk premia elevated.
Long Term Trends
In recent months we have been discussing the emergence of long term solutions to short and medium term problems, in particular the (re)-emergence of Nuclear Power as the answer to baseload issues surrounding ‘unreliables’. The US, China and India are all developing Nuclear power, most interestingly molten salt reactors which means that there is a risk that the real stranded assets are the inefficient clean energy ‘assets’, especially those that are in reality little more than Green accounting ‘teaching to the test’, like Biomass.
Toll-Keeper at the wrong gate.
Central Bank DIgital Currencies are another very important long term solution that is emerging from Covid, along with the more general bio-security state. As interest rates languish at ultra low levels, monetary policy no longer has any power to stimulate the economy, but can easily crush it – doubling rates to ‘only 2%’ would devastate cash flows for the household sector in many countries. The idea of a CBDC that could be targeted is thus appealing for many policy makers and there are various forms of semi hidden trial going on at the moment, In Hong Kong for example, Residents can register for electronic ‘Consumption Credits’ which can be added to an electronic account – usually the Octopus smart card used for travel and other basics. However, they come in stages and you have to spend the first amount (only in Hong Kong obviously) before being ‘topped up’. There are obvious, dystopian, concerns about such a system (one should always design a system on the basis that at some point bad actors will run it) and it may not come to pass, except perhaps in Mainland China where the surveillance state with its Social Credit system is already quite advanced, but it is certainly one reason why various central banks are cracking down on Crypto currencies.
The notion of stable coins, backed by the state is more likely than a fully formed policy instrument however, and that is where the Blockchain finally comes of age as a disruptor. A ‘BritCoin’ on a smart ledger that can be used for purchasing all manner of goods and services cuts out most of the profits in transactional banking – especially FX. It also disrupts the lucrative custody and clearing businesses that form the bedrock of a lot of bank profits. To the extent that Banks have just become toll collectors, the risk is that the Central Banks, in their desire to control the economy actually build a Blockchain bypass.
To Conclude
There are two sides to every investment trading narrative and when one becomes completely consensus then most likely it is due a reversal. However, investors need to stand to one side while the traders swing around; buying the dip when traders are still building their bear narrative risks Keynes’ dictum that markets can be irrational longer than you can remain solvent. Better to be patient and wait for the last distressed seller and the balance of the narrative to begin to turn. The negative growth narrative around Covid was at its peak a year ago, just as the cyclical and value stocks began a powerful run that peaked around April – just as it too became consensus. Now a stagflation narrative has taken hold and is triggering profit taking that is supporting a circular narrative that the stagflation view is correct. This is deemed as being further ‘supported’ by forced selling of some China plays such as the Tech ADRs spreading to profit taking in all the commodity and other input plays and thus being spun as a ‘China Collapsing’ narrative. This too will pass, and while we should not try to be too clever in our timing, we should also always be careful not to believe that the market is necessarily ‘telling us’ anything. There is a risk that policy error induces a stagflation, but that would be where there are rules based and dogmatic central banks who threaten to choke off demand to solve a supply issue. We hope common sense will prevail, as too with the sabre rattling in the South China Sea, where there are also definitely two sides to the story.
