Market Thinking

making sense of the narrative

A glass half empty week most likely

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As discussed in Friday Market Thinking, we would expect the professional traders to try and bounce the amateurs out of their newly acquired positions with a shift to a glass half empty stance this week. This is Standard Operating Procedure, the bad news previously overlooked gets moved centre stage, while the offsetting good news is moved to the background. The usual litany of perma-bears are handily brought into action – always happy to give a quote and trot out their statistics on Market Cap to GDP ratios or Cyclically Adjusted Price to Equity ratios. Meanwhile, talk of ‘A second wave” is already occurring in China and the inevitable spike in infections following the protests in the US will be picked up by a Main Stream Media primed for ‘bad news’ stories.

In some ways this is similar to the aftershocks of 9/11 or 2008; after a big sell-off, markets start to recover, get over-optimistic and then are hit with a dose of reality and sell off again. But this isn’t really about earnings and economics, it is about risk premium. While all the talk is on the high frequency economic data that traders love, markets start bouncing sideways of their own volition, slowly realising that the bubble wan’t built on over-optimism about the fundamentals, but rather on a one sided set of confirmation biases. Neither the positives or the negatives have got any worse, rather that the negatives that were being ignored no longer are. This is simply the mirror image of the final stage of the sell-off that saw all positive news ignored.

We can interpret this as uncertainty rising and conversations will thus turn away from V shaped recoveries to U shaped or even L shaped and those who believe that markets should track GDP forecasts and Covid deaths will switch back to their preferred indicators. The commentators will focus on the presumed economic and valuation triggers, when in fact much is about liquidity and the shifting of assets from weak hands to strong hands. As such, while the traders switch the narrative from boom to bust, from glass half full to glass half empty and then back again, the asset allocators start to accumulate assets. Two steps forward, one step back. Technically this will appears as a set of higher highs and higher lows in the relevant stocks, currencies, commodities and other asset classes. Oil appears to be making higher lows at the moment, while the dollar index just made a lower low than the previous December low, albeit still above the early March selloff. The sell-off move was particularly fast against the Euro so there may be something of a retrenchment, but both the Yen and the Swiss Franc look increasingly strong against the $ at the moment.

Speaking of Oil, it is perhaps worth mentioning that obscured behind all the other noise, was the fact that Iran managed to successfully export Oil to Venezuela, which is stranded with enormous amounts of heavy crude but no refineries (they are all in the US), while the US actually imported oil from Russia – from nothing in 2015 up to between 2.5% and 3% of total imports.

The biggest risk is our belief that we can eliminate risk without eliminating reward at the same time

However, we would stress that in our view, it is not about the virus – if indeed it ever was – it is about the economic consequences of the response to the virus and the overwhelming incorporation of the Precautionary Principle everywhere. The dramatic lockdowns – totally unthinkable even six months ago are the reductio ad absurdom of the Precautionary Principle that has come to dominate western society in the last two decades. The biggest risk is that we somehow think we can eliminate risk and yet not impact on returns. This applies as much to the real world as it has done in financial markets, where the application of process prevents proper risk management.

The concern has to be the mission creep on Covid, which in the west has morphed from preventing health services being overwhelmed to some variation on the Precautionary Principle that requires continued lockdown until all risk of re-infection has been eliminated. The (known) facts on Covid have changed, but the reaction to them in many cases is similar to that of a (bad) fund manager who has got it wrong – a refusal to cut the position and proceed in the light of the new information. J M Keynes is often quoted with the aphorism, “When the facts change, I change my mind. What do you do Sir?” – although according to writer John Kay, the actual remark is that “When my information changes, I change my conclusions” . Whatever, the sentiment is the same. We are still uncertain of the virus, but we can quantify the risks of remaining locked down. And this is not just in the west, the apparent second wave in China is currently only around 35 cases, while Hong Kong extended its draconian quarrantine law another three months over literally a handful of new infections.

This then is the big medium term risk to markets – heavily indebted, cash flow poor companies and countries, not underwritten by the US Federal Reserve struggling to deal with the economic shock of Covid lockdowns. It is worth bearing this in mind as we face a week of anxiety over a second wave, for the economic consequences of maintained lockdown as a sunk cost fallacy “we have come so far, we can’t risk turning back” are the real threat, especially in countries dependant on tourism and remittances. To take Indonesia as just one example. Critics are saying that the government is under-recording the fatalities and that they could be 2, 3 or even 4 times as high. However, given that the total is currently 1,801 deaths, out of a population of 275m, and that the annual death rate is 6.45 per thousand, or approximately 1.8m every year, or  4870 people every day, the draconian measures to lock down an economy in order to reduce that rate of approximately 1 in one thousand of ‘normal’ deaths to zero looks completely ridiculous unless you are in the curious belief system that it is possible to eliminate all risk without affecting return.

Finally, a link for readers who have yet to have read enough about Covid – if there are any. Dr Malcolm Kendrik has been writing some very interesting and useful things at his blog, including the piece linked here, which offers a very good summary of the current medical position on the virus.

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