Market Thinking

making sense of the narrative


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Traders are trying to see if the dollar will break to the downside. On balance it still looks like it might, but no clear trend yet. Interesting to see that after a spike, both Euro and Sterling have corrected back to previous support levels. Things look a bit clearer in the commodity complex, especially oil, which seems to have resumed an upward trend quicker than many,  indeed most, had expected. Gold too remains in perhaps the clearest bull trend of all of them, along with TIPS, the index links bond ETF, both of which are looking positively correlated at the moment, suggesting the growing conversations about inflation are having an impact. Over coming weeks, talk will be of the shape of the recovery and the US Election; some will let their wishes for the latter shape their ‘forecasts’ of the former. As ever, investors need to step back from the politics.

Major economies are starting to come out of lockdown and talk is of the shape of recovery. – L, U or V. We continue to believe that we will see all three, but in different sectors of the economy. The Gig economy for example may find quite a sharp V shape as pent up demand moves quickly to consume those sorts of personal services, while the more traditional high street may see more of a U shape, as online shopping has, in many cases, filled the void. The L meanwhile will be coming to businesses that already had ‘pre-existing conditions’ and in particular too much debt as well as to those who were under-employed and will now find themselves unemployed.

Western economies are largely emerging from lockdown, although as predicted by many, the UK government is finding it harder to come out of lockdown than to go in, not least down to the success of its own hyperbole. This week, the UK government is lowering its alert system from 4 to 3, even though according to its own definitions that ought to have happened even before the UK went into lockdown and in reality it should probably already be at 2. The elusive R rate in every part of the country is now below a level that the Germans, for example, deem safe, but as noted, the Precautionary Principle has become so dominant that politicians are more concerned about being blamed for a single death from Covid than for any of the costs of lockdown.

Emerging market economies however are still struggling and Fitch note that 22 sovereigns pertaining to $7.4tn of issuance have been downgraded and a further 31 are on negative outlook, confirming our view that EM debt, not supported by the US Fed, is trading too rich compared with US corporates. Taking advantage of this environment, top rated US corporates have already issued over $1tn this year, more than for the whole of last year. Not all US corporates of course, we also noticed that around 30 issuers responsible for about $300bn of US corporate debt have been downgraded to BB+ this year. This is becoming an increasingly Bi-Polar world as the strong get stronger.

Meanwhile, in the US, it is becoming increasingly difficult to disentangle facts from political opinion and political activism from other behaviour. Everything is now starting to focus on the November Election and the behaviours observed by the Never Trumpers over the last four years are becoming ever more intense. We use the expression Never Trumpers because it is bi-partisan, not only Democrats, but many Republicans as well, including of course former allies such as Steve Bannon and John Bolton, the latter of whom had a book came out this week joining a long list of ‘bring down Trump’ memoirs published over the last three years. However, for all the excitement, it’s difficult to see how it will really change anybody’s opinion one way or the other. The Economist has started publishing a sophisticated prediction model combining the economic data with the opinion polls, the economics having more weight at the start of the campaign, giving way to polls closer to the actual Election. Currently they have Biden to win, but the difficulty (as with everything) is that while the Covid-19 related economic data looks unequivocally bad, it is questionable whether the incumbent will be  ‘blamed’ in the manner of previous recessions. 

Generally though, when the Political and Media class froth and fume, investors have been well served by stepping aside and acting only when one side or other becomes particularly over-excited and then acting by being contrarian.

It also raises the issue about the other, important, opinion polls for shorter term traders, the Economic Surprise Indices (ESIs) and the Purchasing Managers Indices (PMIs). In particular the PMIs are diffusion indices (as we are constantly saying) and essentially reflect the opinion poll answers from purchasing managers to a series of questions which boil down to “are things better than last month?” The mantra from the copy/paste brigade is that “below 50 is a recession” when in fact it is not – it is about direction not absolute levels. Below 50 could be slowing from 9% GDP growth to 7% (as happened in China in the past), while above 50 could be – and likely is going to be – an acceleration from -10% to flat. Similarly with the ESIs. Citi runs ESIs for most countries which again are effectively opinion polls. Economists ‘predict’ high frequency economic indicators and the surprise index is the extent to which they beat or miss.

Currently, the US Economic Surprise index is at its highest level ever. Which probably tells us more about the economist forecasts than the economy.

This of course follows the (second) lowest reading ever at the beginning of April – the lowest being November 2008. Traders have followed the indicators quite closely and in the near term they have tended to follow Soros/Popper’s theory of reflexivity – money is ‘bet’ on them and thus they become important. That having been said, they look like they work better as indicators in broadly stable markets; this last move the index lagged the market by a month, making its use for traders purely academic.

In fact the indicators look like they started to go a bit ‘rogue’ in the second half of 2017 and again in 2018 and even though they were still being closely followed by some macro traders going into this year, they look to have lost any predictive ability they might have once had for equities. To us, this is a classic case of taking a sound theory from financial markets – the signalling embedded in corporate earnings momentum – and applying it erroneously to economic data. To explain, when a company raises guidance from 10 cents of earnings per share to 11 cents, the probability of a subsequent raise to 12 cents is higher than a revision back down to 10 cents. In the terminology it is ‘serial correlation in earnings’ or earnings momentum and it embodies a degree of ‘insider’ information. By contrast, there is no Finance Director guiding the economist as to where they should pitch their forecast for the high frequency data and the reality is that the forecast is essentially ‘trend’ plus or minus 1 standard deviation. As such, the ‘surprises’ tend to be somewhat mean reverting and of little long term value.

Commodities correcting back

Commodities are usually, but not always, about simple supply and demand. More important, they are leveraged markets that tend to be dominated by speculative traders riding on the back of underlying operational hedging. As such. the Covid-19 shock to demand came just as the oil markets were squeezing higher in anticipation of a supply shock from Iran in the wake of repercussions from the US  targeted assassination of a senior Iranian general in January. This rush to cover positions caused an exaggerated U-turn from leveraged long to leveraged short. Generally, though commodities are self correcting, a fall in prices produces a fall in production and vice versa, acting as a form of automatic stabiliser. As they used to say, the best cure for $100 oil is…$100 oil. As such we watch indicators such as the Baker Hughes Rig Count index to see the supply response and indicators such as the Baltic Dirty Index, which measures the day rates for Oil tankers – prices rise when there is a lack of end user demand relative to supply as tankers are used for storage when existing facilities are full. 

Consistent with the theory, the Covid-19 hit to global demand produced a drop in oil prices, and a drop in the rig count. It also produced a glut of oil in storage and a spike in the Baltic Dirty Index. Now it is all reversing, Rig counts are going down, the Baker Hughes index is at 189, the lowest level since 2005, while the Baltic dirty is at a 5 year low around 500, a third the levels of a few months ago. Meanwhile Oil prices are going up, crude heading over $40 again.

The chart is indexed to January =100 and we can se that rig count is down to 27, while tanker rates are at 32, oil, meanwhile, is at an index level of 63 having also been down as low as 27.

Chart 1. Rig counts and storage prices down, Oil prices rising.

Source Bloomberg


Geo-politics remains a key medium term risk and thus the renewed tension between India and China is certainly something to keep an eye on. While often presented as an expansionist policy, we would instead regard One Belt One Road and the moves in the South China Sea as being strategic defence by China. It’s key strategic weakness is the need to import Oil and Gas via the ‘choke point’ of the malacca straits and this is the main imperative behind the Pakistan Economic Corridor as well as the pipeline through Mynamar.

As with much in the region, the history of the disputed area is long and complex, but briefly, it was last August that the Modi government unilaterally revoked parts of the constitution that guaranteed the autonomous status of the Jammu and Kashmir region which is currently majority muslim. The dispute with Pakistan is centred around the area which is also containing the headwaters of the main river in Pakistan – the Indus. Indeed, many of the disputes in the region are over the water supplies and the assorted Hydro Power projects. Recently, alarm bells began ringing in Beijing and Islamabad when the Indian Army started building infrastructure on the so called Actual Line of Control (ALC) between the autonomous region and the China held section to the east known as Askai Chin. Meanwhile Indian Ministers started announcing that the whole region – including the western parts currently owned by Pakistan – Pakistan Owned Kasmir (POK) as well as Aksai Chin China – rightly belonged to India. Geo-Politically this is crucial for China. The POK is the only area where Pakistan shares a border with China and the Askai Chin region is a vital link between Tibet and Xinjiang. As such any attempt at re-unifying Kashmir would both block the Pakistan Economic Corridor as well as Chinese influence over Tibet.

Finally and to absolutely nobody’s surprise, the attempt by the UK government IT wizards to develop their own track and trace app for Covid-19 has ended in failure. Doubtless ‘lessons will be learned’ as they always are, but perhaps a more serious question ought to be why bother with this in the first place? Aside from the obvious attractions to those of a certain controlling disposition, what is the actual point? The medics and statisticians are now telling us that more than 80% of those with Covid and at risk of transmitting it suffer from no symptoms, so is it really a constant testing regime they have in mind? While not believing that this started as a conspiracy (as some on the fringes do) we should not be so naive as not to think that many different actors are trying to use the current situation to suit their advantage. We will look at some of this in more detail in the next Wednesday Wonderings. (WWW)

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