Market Thinking

making sense of the narrative

Bull markets and Bullet Trains..

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After a weak September, Equity markets have recovered in the last few weeks as buy on the dips seems to have kicked back in (as well as some momentum chasing or buy on the rips) for a strong looking seasonal effect in the fourth quarter. While we are used to prices in capital markets being inflationary thanks to QE, we now have prices for real assets running hot thanks to (bad) policies on Covid and Carbon and the risk of that temporary inflation being imbedded by further bad policies on administered wages. The UK seems particularly at risk on the latter, while the US mask mandate seems to be creating labour shortages and increased union tensions. Ultimately relative domestic inflation translates into relative exchange rates, which is maybe why the exporters – China and Russia – are seeing their currencies at 12 month highs. That this makes their products even more expensive in local currency terms only compounds the problem. Meanwhile the yield curve is flattening rapidly as traders get spooked by a possible flip in monetary policy and bond volatility spikes up, making it likely another tricky month for the quants.

As October closes out at an almost 5% gain for the MSCI world equity index, we have largely unwound the September sell off to leave the last two months perhaps best described as having moved ‘aggressivly sideways’. Long Bonds too, have followed a similar trajectory – much as they have done for the last six months in fact – and this positive correlation tends to suggest that markets are more about leverage and liquidity than any of the ‘fundamentals’ that we are supposed to be looking at. Indeed far from being more sensitive to worries about inflation than short dated bonds, they have rallied suggesting they were seeing panicked short covering from spread traders. The spread between 30 year yields and 5 year yields has come in 40bp in the last 3 months, mainly as the short end yields have spiked higher (see chart) . For investors and asset allocators rather than traders, long bonds are nevertheless still down on the year to date, with only high yield and index linked showing a positive return, making it a tough year in general for bond funds and anyone running balanced strategies.

In terms of market mechanics, we are also watching the volatility in the bond markets, where the MOVE index of Bond implied volatility has been trending higher. This once again raises the prospect of the minimum volatility quant funds whipping markets around for reasons not associated with inflation or other fundamentals. The general rally in equities might also simply be a function of being oversold and a general lack of follow through on a number of (negative) popular narratives as well as some ‘buying the dips’ in the now characteristic ‘melt up’ scenario.

Sharp Moves in Bond spreads and spiking volatility.

Source Bloomberg, Market Thinking

The ‘China is going to collapse’ narrative is probably the most obvious one that has failed to follow through. Largely fueled by a broad misunderstanding of the economic importance of the default at Evergrande, as well as the pain from the hit to the China ADR space in August and September, an aggressively anti-China sentiment was building among western market commentators during September, but which has failed to translate into weaker share prices this month. While the Evergrande stock itself languishes at its lows, the more significant (from an investment point of view) Chinese ADRs have rallied. AliBaba is up almost 15% in October so far, while Tencent also bounced over 10% higher.

Another part of the ‘Everything China’ story is the Australian Dollar, which rallied around 4% so far in October, along with commodities generally, as the markets also reverted to reflation not stagflation as a central theme and a recognition that China was not going to stop building houses due to Evergrande. The offshore Rmb meanwhile, far from crashing (as widely predicted by some high profile Hedge Funds) actually ground almost 1% higher against the $ and the Euro and is now up around 2% against the $ and over 7% versus the Euro year to date. The Ruble also hit a 12 month high, along with Gazprom as high energy prices continued to help producers.

Another indicator of ‘risk on’ might be the resurgence of Bitcoin, or indeed the massive ‘pop’ in the share price of Tesla, both of which happened in October. In the case of Tesla, this looks like an extended case of some of the market mechanics we have been talking about for a while now – a huge number of short term call options were traded in the stock ( a typical sign of aggressive RobinHood type day-trader activity) and this has essentially put in place what is known as a Gamma Squeeze. In effect, the market maker selling the call options needs to buy a position in the underlying stock depending on how far in or out of the money the option is in order to hedge their book. However, if the stock squeezes sharply higher they will likely be forced to buy more stock to hedge , forcing it higher still in a self reinforcing circle and producing the sort of spike we have just seen. Of course, once the cost of call options is at a level where no-one is buying and/or the options expire, then the spike can unwind as quickly as it came. Something similar happened in August 2020 causing the stock to almost double, and then again in November 2020. Both times the stock reversed sharply, before consolidating and then moving higher. It will be interesting to see which, if any, of these patterns repeats this time.

While markets seem more confident, the risks from ‘bad policy’ remain however. Once again for example, the UK medical establishment is demanding restrictions on the wider economy and other measures such as working from home and facemasks to ‘prevent the NHS from being overwhelmed’. Fortunately, so far these are being resisted and people are starting to ask why they haven’t spent some of the last two years increasing capacity if that is really the problem. There is also the fact that, by testing so much, the UK has one of the highest ‘case’ levels in Europe – but not cases per test – and, perhaps most importantly, the median age of those testing positive is 27, which the CDC tell us has a case Fatality rate of around 0.02%. There are of course other, more rhetorical, questions, some of which are probably worthy of a T shirt.

why do the protected need to be protected from the unprotected by forcing the unprotected to use the protection that didn’t protect the protected in the first place?

Rhetorical question from online anonymous

Zero Covid errors being compounded by government interference in the price of labour, risking wage price spirals.

One thing that is being under-reported is the impact that forced vaccine mandates are having in the US, with labour shortages as ‘refusniks’ are either sacked or walk out of front line jobs. Most of these, by definition, are among the ‘key workers’ who have not been working from home over the last two years and this is fueling tensions already building in the labour markets. In the UK too, a degree of economic illiteracy around subjects such as the minimum wage risks bad economic outcomes; politicians appear to believe that they are ‘giving people more money’ without recognising that it has to come from somewhere. Small business will either raise prices or cut labour or both. The lessons from Southern Europe, where high social costs for labour have essentially the same effect, means that there is large unemployment co-existing with a lack of supply of labour at a price at which the market will clear. Australia recently had a similar (failed) experiment in making themselves a ‘high wage economy’ by simply setting minimum wages too high. Small businesses, particular in hospitality, either closed because they couldn’t afford staff, or tried to push through price rises and lost out to the ‘takeaway’ culture.

Talking of takeaways, one company reporting sharply rising costs, especially labour, is McDonalds who are accordingly putting up prices. By the logic of the Economist Big Mac index, the relative inflation in McDonalds in the US versus elsewhere should drive the ‘real’ exchange rate. In other words, the higher inflation in the US should mean a weaker $ against countries with lower price increases. Given the inputs are relatively ‘global’, the difference therefore is wages. In effect, the net result from countries such as the UK and the US to become high wage (in fact high cost) economies will ultimately translate to weaker currencies (and higher costs of imports).

SCO more important than COP.

Finally, on a positive note and largely unnoticed in the west amid all the marketing noise around ESG Glastonbury, the One Belt One Road Initiative delivered the first high speed bullet train connection between Kunming in Western China and landlocked Laos. The railway is expected to reduce transport costs by 30-40% as well as open up the country for investment and Tourism. As soon as China itself opens up that is. While the west indulges in the, surprisingly Soviet sounding, Conference Of the Parties (number 26) and complains about China not attending, China gets on with building Eurasian infrastructure. There is a good deal of western projection about the supposed debt entrapment of OBOR, but it is as nothing compared to the predation of the Washington Consensus (WC) policies of the last 50 years. The reality is that the soft power tactic of building transportation and other infrastructure that also serves China mercantile interests is far more attractive to emerging markets than the WC alternative and is consolidating China’s influence in the region as well as enhancing # the power bloc of the Shanghai Cooperation Organisation. In effect, the COP is talking while the SCO is doing. Meanwhile, as the US military talks of imminent threats and demands its allies buy weapons from the Military Industrial complex ‘to preserve freedom’, China is building railways across the region. Bullet trains rather than bullets.

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