PAUL KRAKE - During turmoil, some things matter, and others don’t

Here is what is going to matter to markets over the next couple of weeks.

During turmoil, some things matter, and others don’t

(The following is an excerpt from a brief note we sent to clients on October 11)

The world is never as simple as the answer to a single question but when I look at the mess that is the carnage in financial assets over the course of the last week, one can make the argument that in the near term, you can boil it down to list of things that will be relevant and things that don’t.

Here is what is going to matter to markets over the next couple of weeks. I have ranked these in order of timing rather than importance:

US CPI

The most immediate hill to climb. Any number above expectations and risk parity strategies get slammed i.e. stocks and bond prices go down aggressively in unison. Any spike in bond yields back above 3.25% and you will have a repeat of Wednesday’s price action in the Unites States that will spread to the rest of the globe.

Trump bashing the Federal Reserve

This is important and will not be taken positively. Imagine if Turkish prime Minister Erdogan said what President Trump said yesterday. The Lira would have gone into free fall. One of President Trump’s “victories” over the last 20 months has been equity market performance and if this turns ahead of the mid-term elections, Mr. Trump’s “crazy” rhetoric towards the Fed will only grow. While this will be nothing more than talk, you know that a liberal journalist is working on the article titled “Will Trump fire Chairman Powell” or “Is the Fed’s independence under threat?”. This sort of commentary will be alarmist, unrealistic, and will be so widely read that will affect sentiment and lead to lower equity prices”.

As an aside, there is next to zero chance of President trump firing Chairman Powell, although he certainly has the power to do so.

Earnings

They always matter and while we know that Q3 produced bumper profits for corporate America, it will be the guidance that will hold the key. While, trade tensions will be the excuse du jour for ratchetting down expectations, Q4 earnings will continue to be buoyed by the expansionist fiscal policies of the US administration. Comments about higher capital cost will be taken negatively but broadly speaking, profit growth and forward guidance won’t be a problem for US assets until Q4 announcements in January.

Positioning

Are we just getting rid of late summer froth or is it something more? For this, Apple is key. From the start of August, the world’s largest company rallied some 23% to its all-time high last week. Retracing the majority of those gains is not inconceivable.

Calming words from the Fed

I have never been a believer that the Fed tries to micro-manage equity prices. That said, a few choice words from Chairman Powell or others, would be taken positively and an incentive for short covering. This time around it will be more difficult as every journalist question to every single Fed member will revolve around the comments of President Trump. The governors will ignore the comments by the President as there is no upside in trying to defend the institution from the upcoming twitter tirades that seem inevitable. The Fed will focus on liquidity and financial stability and comments like these are generally taken well by skittish markets.

Republican poll numbers deteriorate

Signs in the polling that weak markets are hurting Republican chances in the mid-terms. Unlikely but must be watched. If they occur, they probably won’t become a headline for at least a week and frankly, markets would have to go considerably lower for this to be a true agenda item for partisan voters.

A further widening of Italian spreads

I have discussed this at length in recent weeks and there’s no need to rehash this. Italian spreads are judge, jury and executioner where it comes to European political risk

RMB trades above 7.00

Unlikely but by far the biggest threat to financial assets

Here is what will not matter - Valuations

While the US earnings season or should I say, the guidance of US companies, will be the ultimate determinant of whether the next 5% in equities around the globe is up or down, valuation is never a reason for markets to bottom. Markets trough when shorts start to cover and are then forced to cover as prices rise. My assessment is that while there are some speculative short positions out there in the hedge fund community, they are not substantial. Valuations do not alter the prevailing momentum of broader equity markets.

Taylor Swift

Don’t be greedy! Cover, or roll your index puts over the next 24 hours.

One observation I have witness time and time again is the inability of long volatility funds or owners of puts, to monetize positions when gains are produced via a violent correction. Please do not make this mistake again. Profit and loss on portfolios are driven by price, not timing and therefore determine a level where you would like to take profit and execute at this level. Do not try and time a bottom based on “proprietary” momentum indicators or whatever speculative tools people used to pick turning points. This is impossible, so pick a level and stick to it. If prices go lower, then there is some opportunity cost. If it doesn’t get there, well it was never meant to and respond accordingly. Remember, making money being short or via the buying of puts is the single most difficult investment strategy out there. Don’t be greedy. If you remain bearish, roll down your strikes but you must sell deep OTM puts against the core short to mitigate the spike in volatility.

The thematic model portfolio is aggressively short the SPX, Nikkei, and FTSE in both linear and options form. Based on last nights close, we will cover 25% of each position down 1% so the model portfolio will be flat equities in the event that equity markets fall 4% from closing prices.

We will keep our emerging market hedges on for the time being.

Also, tactically, I plan to sell some US 10-year bonds against my Brexit inspired UK 10-year gilt position should US 10-year yields trade back to 3.13%

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