A Pause that Refreshes…
Market movements in April might best be described as an apparent ‘reversal of the reversal’ as many of the winners of the inflation/reflation trade that began in October appeared to sell off while the ‘losers’ rallied. Most obviously, Bonds had a better month and while equities also did well, beneath the surface we saw momentum doing better than value, mega cap doing better than small cap, tech doing better than cyclicals and so on. The question for investors obviously has to be, was this just one step back after two steps forward? Or was it in fact the move from October that was the head fake? As the title suggests, we think it is more likely to be the former rather than the latter, largely as a function of what we refer to as ‘market mechanics’, a view we feel that is supported by all our various models and indicators as well as the macro views that we continue to hold. The main risks for May are some reversal of these mechanics as low volumes and increased volatility make markets ‘choppy’, but we would keep an eye on the opportunities presented by the longer term trend of reflation which remains very much intact.
Short Term Uncertainties
Our Market Thinking approach looks at the investment landscape through the eyes of three major protagonists; Short term traders, who are looking for absolute return and use leverage and narrative as their main tools, medium term asset allocators, who are largely risk averse, unleveraged and looking to protect relative return on the downside, and long-term investors, who are generally buyers of dips in bull markets and sellers of rallies in bear markets. The impetus to markets can come from any or all of them, sometimes they push in the same direction and sometimes they offset one another, but the essence of market thinking is to try and understand the balance of these dynamics to help with our own risk/return analysis.
It takes two three to make a market….plus the mechanics
As part of this we have evolved a concept known as Market Mechanics, recognising the role of the other participants in markets – notably the banks and the dealers as well as certain types of quant traders that can influence shorter term movements.
Thus, as we discussed last month, the options expiry in March tends to be the big time for Asset Allocators to put on their positions for the year and, directional bets aside, generally speaking this will involve selling call options to collect premium and buying put options for downside protection, which is consistent with their medium term risk reward profile. Without straying too far into the world of ‘the Greeks’ and derivative trading, what this tends to mean is that the dealers and market makers who facilitate these trades are, by definition, on the other side, and their subsequent risk management involves unwinding that risk. They are, in the terminology ‘long Gamma’ ( look at the answers given on this link for some explanation of some of these trading strategies). However, for simplicity, in practical terms what this means is that the dealers who are long gamma are acting to buy on weakness and to sell into strength (to offset the theta if you really want to know!) and thus as a result act as a dampener or shock absorber on markets generally.
Chart 1. April saw ‘market mechanics’ bring down realised volatility
We can see this from the chart of S&P500 implied volatility (similar to the Vix and best thought of as the price of put options) and actual realised volatility – shown here in orange. Note that the actual 60 day volatility has been steadily falling and is now back to the levels seen pre-covid and that historic ‘vol’ is now below implied vol. This is a more ‘normal’, long Gamma market, where dealers are acting to stabilise markets and helps explain the benign environment in April. By contrast, when the dealers are short Gamma, as can happen periodically, it means that they buy rallies and sell dips instead, exaggerating rather than dampening the market moves. Obviously a so called ‘Gamma Flip’, when they go from long to short gamma is the sort of shift in market conditions we need to monitor carefully for broader portfolio risk management. On that issue, a recent article in the FT discusses a Fund known as The Gamma Hammer which is currently making a lot of money betting on stable markets catches our interest. When we read of the success of this type of ‘picking up Nickels in front of a Steam Roller’ strategy, reminiscent of the LTCM strategies back in 1998, we take it as a sign of increasing market fragility, not strength.
As dealers and Option traders hedge their books, volatility is falling and triggering Quant funds to buy index futures..
This brings us to the second, relatively obscure, influence on markets, the Quant funds. A lot of capital is tied up in funds that seek to, inter alia, minimise volatility or otherwise asset allocate systematically through futures and thus, in one example, if equity volatility drops they will buy equity Index futures. By definition, those futures are like market cap weighted tracker funds and thus it means we will see a disproportionate flow to tech and mega cap rather than to cyclicals and small cap. Thus lower volatility can mean market cap weighted indices move higher and appear to be telling us something about the underlying fundamentals, when in fact they are doing nothing of the sort.
As far as Bonds are concerned, they too tend to reflect trading moves based on volatility and the fall in Bond volatility in April will likely have been a factor in the stabilisation of bond markets. Of course these things can be relatively self fulfilling – in the short term at least. Meanwhile, we should not overlook the fact that the Bond markets are largely financial structures involving huge leverage and are thus far more focussed on structure and what the Fed says about the price and stability of their cost of borrowing (their raw materials) than about inflation or any of the so called fundamentals that the narrative machine tells us are important.
All of this therefore gives an appearance of a return to the old winners and losers, but far from a being a fundamental assessment it is pure market mechanics.
Medium Term Risks
Sell in May? – Watch Volatility
The old adage of Sell in May and Go Away originated in the Commodity Markets when most of the trading activity had been already put on and volumes fell sharply, increasing volatility. With China and other parts of Asia closed next week, as well as rolling holidays throughout Europe, the same is true of equity markets. This is probably more important than normal this year in the light of the ‘set-up’ we received in April. Remember that we believe a large part of the strength of Equity Market in April was a function of risk parity and other Quants buying into falling volatility in relatively low volume markets, causing an updraft. It is therefore undoubtedly something of a risk that these moves could easily reverse if volatility picks up again.
Because many of the macro commentators start from the world of Bonds, to them the latest price moves suggest that the Bond markets – which they never tire of telling is where the ‘smart money is’ – are calling for no inflation. However, we believe that the market mechanics described above help explain why the bond as well as aspects of the equity market seem to be ‘selling’ the inflation story while the commodity markets appear to be buying it. For us, the message from the Commodities markets is ‘cleaner’ and thus more accurate. “Dr Copper, the metal with a PhD in economics” – as they used to say – suggest still very much a reflationary, pro-cyclical, environment. Also, other cyclicals commodities like timber and grains hit new highs during April, while Oil is moving back towards the March highs again. Meanwhile, macro data on industrial production, prices paid, supply/demand imbalance and many more all suggest pressure to the upside. The chart below shows the broad CRY Commodities index, which is a weighted index of commodity futures components. We can see from this that the sell-off due to the ‘induced coma’ that the global economy was put into was cleared out by the end of last year and that 2021 looks to have been a resumption of that longer term trend reversal that began last October.
Chart 2: Commodities breaking higher
Fundamentals are however telling us that reflation is real
Moreover, as the following chart (from Goldman Sachs via Zero Hedge) illustrates, most of the commodity index is currently in a state of ‘backwardation’, see here for more explanation, but from a macro perspective we can think of it as meaning near term demand is exceeding supply such that the price to buy for next month delivery is higher than for three months time. The recovery is creating a supply/demand imbalance and prices are adjusting higher.
Chart 3. Commodity Complex suggesting demand recovering faster than supply – inflation results.
Further anecdotal evidence on inflation came at the weekend from Warren Buffet who in his annual address to Berkshire Hathaway shareholders noted that his input prices were rising but that there was no problem in passing them on. Thus, in addition to watching Commodities themselves, we would be looking for a flip back to the previous factor and sector behaviours during May and regard April as a buy on the dip opportunity.
Similarly with the US$. Having rallied in March, the trade weighted index for the $ – ticker DXY – dropped again in April, consistent with the inflation rather than the deflation narrative. Geo-politically we would add that while it bounced against the Ruble and the Turkish Lira, it continues to weaken against the Euro and of course the Chinese Yuan.
Longer Term Trends
The key message from all of this is, that while the market mechanics around volatility and delta hedging has acted to lower volatility and bring in quant buying of both equities and bonds, the implied message about growth and inflation has not reversed from the new trend established in q4 2020. The regime shift from Quantitative Easing and everything being some form of financialisation/carry trade to one of government intervention and almost boundless levels of borrowing and spending is only just getting underway. As governments rather than central banks or financial institutions expand their balance sheets, the balance of too much money chasing too few goods will spill over into real world prices and volumes rather than just in asset prices. As such this is more than just a bounce back for the economy from the clinically induced coma of Covid, it represents a structural shift in pricing power and profitability.
Inflation/reflation is a function of higher demand and/or lower supply. Thanks to government we have both. As well as stimulating an already growing economy, the involvement of government in capital allocation, either directly or by facilitation of the whole ESG ‘industry’ is also likely to have some unforeseen(?) consequences on supply, especially in energy. Tesla now has a market cap higher than the entire Oil and Gas energy complex for example. As the old saying goes, you can ignore economics, but it won’t ignore you and the reality is that electric cars may be the future, but they are not the here and now. Investment in oil E&P will pick up again, perhaps not in shale, but certainly elsewhere. As such it is worth keeping an eye on some of the oil service companies for instance who were major beneficiaries of the previous commodity super-cycle. Having languished for four or five years, many doubled from the lows in November and while they look to be seeing some profit taking during April, they certainly look interesting as an Equity ‘play’ on the prospect of supply/demand driven higher oil prices.
Another commodity facing pricing pressure due to both increased demand and supply shortages and which may have longer term impacts is computer chips. At a time when working from home has significantly boosted demand for products, there has recently been something of a ‘perfect storm’ on the supply side. Droughts in Taiwan (chips need a lot of water in production), storms in Texas hitting energy output and thus shutting down production and of course the ship getting stuck in the Suez canal triggering a backing up of supply chains generally. Meanwhile, ongoing geo-political tension between US and China, much of which focuses around Taiwan, is only going to intensify the need to ‘de-globalise’ supply of computer chips. However this also threatens to de-globalise demand. While the US seeks to limit access to the machinery to make the most advanced Chipsets, it risks local, Asian, suppliers taking the Asian consumer markets away from US exporters of less sophisticated chips. Meanwhile, global manufacturers such as autos are caught in the middle, with some having to limit production due to shortages.
