You can’t handle the truth !
(this is the second and final part of Sunday's blotter. Please find thefirst part here)
The US Senate is an accident waiting to happen
While growth and profitability will continue to determine the next 5% plus or minus in US stocks, the aforementioned narratives will definitely play a roll with the US mid term elections likely to provide the potential for the largest surprises. Three factors to consider:
- President Trump’s poll numbers are again falling and the chance of a shock result in favor of the President are slim. Those of you that claim that Trump surprised in 2016 and will do it again miss some very fundamental points. Voter turnout in 2016 was historically low with Democrat voters, especially African American staying home in droves. Hilary Clinton was the number one reason for this and she isn’t on the ballot. Trump’s approval rating amongst College educated women and African American voters is at historic lows for any President and it will be them who cause a rout in November
- President Trump will be forced to pander to his base to get them to come out and vote en masse like they did in 2016. This is much more difficult in a mid-term election. The promotion of market unfriendly policies like additional Chinese tariffs are coming to inspire Trump supporters. The chances of him picking up new voters, despite a robust economy are low.
- The Senate only needs to swing by two seats to fall back into Democrat hands and while we should all appreciate how difficult this will be given the number of safe Republican seats that are up for re-election, that chances of a shock, somewhere are growing.
President Trump is correct in saying that we will all be poorer if he is impeached. Now, I am not saying the market is going to crash but, in the event that the Democrats take the Senate, the market will sell off 5% - 8% as the chance of impeachment proceedings grows. Now, it is important to note that the House of Representative Impeaches, but to remove a sitting President from office, you require a 2/3 majority in the Senate. The partisan nature of US politics would make this extremely difficult regardless if criminality is involved. Republicans abandoned Richard Nixon in 1974 but these were very different times.
Developed market equity volatility is simply far too low
All that said, the market appears oblivious to this risk which, to paraphrase President Trump, is not correctly pricing the chance that we are going to be poorer.
As such, US equity volatility between now and the end of the year is far to cheap given the array of global headwinds that are outlined above. With so many potential upheavals over the next few months, it is tough for me to see how MSCI World or US bonds remain so tightly constrained within trading ranges. While I appreciate the strong seasonality that exists in Q1, it is tough to see how we don’t see violent swings in asset prices in the event that a Hard Brexit is realized, Italian politics roils Europe, US / China trade relations deteriorate further, or Democrats take both the House and Senate and President Trump’s forecast come true.
Over the course of the next 3 weeks, the thematic model portfolio will buy ATM Puts on the SPX, FTSE and Nikkei and hedge them with long index exposures. This will be a pure volatility strategy and we will delta hedge regularly. We will spend 2% of capital on puts over that three-week period.
EM Volatility is at extraordinary levels versus G7. This chart is doing the rounds
To help to mitigate the cost of this, we will sell some volatility in EM currencies which have seen volatility skyrocket in recent weeks due to concerns in Turkey / Brazil etc. This chart has been doing the rounds and sums up perfectly the prevailing disconnect between EM and DM volatility.
(I stole this chart from Mohammod El Erian who borrowed it from BAML)
As I will outline below, EM volatility is at ridiculous levels especially if you consider that benign outlook for US rates that Chairman Powell outlined in Jackson Hole. If interest rate volatility will remain low, how does the USD keep rallying?
A dovish Chairman Powell or exactly what we knew?
Fed Chairman Powell’s speech at Jackson Hole was taken as dovish, but the reality is that the market is getting exactly what it expected. The Fed will raise rates in September, December and March and there is a solid likelihood that an additional 25bps in June will take the Fed Funds back to the range where the board of governors as a whole, believes the long-term equilibrium rate or neutral rate is; somewhere between 2.75% - 3.00%. The reality is that the hurdle rate for either the Fed to be more aggressive or to slow the pace of tightening from once a quarter are both very high and while the inflation and growth outlook maintain the current trajectory, the Fed and the market will remain in alignment.
To put this another way, how can interest rates be a negative shock to equity and credit markets if the Fed and the forward curve agree on the path of rate increases?
I say they can’t which is not only a positive for US assets but completely discredits the negativity towards EM which is drive by US rate fears and concerns over a stronger USD. Can the USD continue to rally if interest rate volatility continues to be this low?
As such, over the course of the two weeks, the thematic model portfolio will look to sell at basket of EM currency volatility versus G7. We will execute this in 50% of the size of the equity volatility strategy and this will go a long way towards reducing the cost of our equity options. We will come back with pricing and structure later this week.
The week before the US Labor Day holiday is always a slow one. Turkish market open again after an extended holiday and it is difficult to see how it doesn’t go poorly. Avoiding the negative carry over a week-long holiday was partly responsible for recent strength and expect speculators and desperate locals to send the Lira lower initially. Offshore liquidity will continue to be a problem.