Beware Of The VIX

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by: Douglas Adams

Summary

Markets blissfully continue to discount the growing political risk presented by Donald Trump's White House. Last week all four major exchanges put up simultaneous all-time highs, last done in 1995.

The VIX started the year at 12.85. Three other times in the history of the benchmark have been lower: 2007, 1994 and 1996.

Pew Research has Trump's approval rating at 39% - the lowest rating of any president in living memory at this early stage. The VIX closed at 11.49.

The economy continues to move promisingly forward. A barrel of Western Texas Intermediate crude in the second week of February 2015 all but languished at $39.81. So, too, did the economy. A year later, that price is $53.74/barrel - a gain of almost 34%. The economy has improved accordingly. The International Energy Agency (NASDAQ:IEA) reported a week ago Friday (February 10) that production from OPEC fell to 32.06 million b/d in January, a decline of about 1 million barrels compared with OPEC's October 2016 baseline. The decline is certainly one of the deepest in the history of OPEC with compliance estimated at about 90% for the month. Unsurprisingly, rising world oil prices have stirred a beehive of activity in the most cost effective fields in the US oil and gas playbook that dot the Permian Basin region of West Texas/New Mexico border region. The US has added 200 rigs through the week ending February 10 over the same period a year prior, according the Baker Hughes (BHI) data.

The good news keeps coming. After snapping a five-quarter drought in the 3rd quarter, corporate earnings are expected to weigh in at close to 5% for the 4th quarter, according to data from FactSet. Much of this growth comes from the upward pressure on prices throughout the supply chain, resulting from rising world oil prices as the energy sector exerts more of a positive than negative influence on growth and earnings in the greater economy.

With the increase in oil prices, headline CPI inflation has crept back into the picture, up 0.6% in January and 2.5% on January 2015 - the highest post since March 2012. The increase was driven mainly by energy costs that rose 4% for the month and 10.8% on the year. Excluding food and energy, core CPI inflation rose 0.3% for the month and 2.3% on the year. Market-based indicators of headline inflation over the course of a 10-year period hit 2.85% through Friday's market close (February 17). In real terms, however, inflation remains negative out seven years on the yield curve.

The January jobs report outperformed consensus reports, creating 227,000 jobs throughout the economy. The January post was higher than the average annual monthly job creation of the past two years. Unemployment insurance claims at 239,000 for the week ending the 11th of February, which is the lowest post since the week ending the 16th of June 1973.

While wage growth remains modest at 2.48% year-over-year in January, consumer spending and confidence levels remain robust. Retail spending rose 0.4% overall and 5.6% on January 2016. Gasoline consumption drove much of the increase for the month posting a 2.3% rise over December and a 14.2% gain over January 2016. Consumer confidence fell slightly in January to a reading of 111.8, down slightly from a high of 113.3 in December that dated back to August of 2001, according to data from the Conference Board.

The VIX, however, remains curiously quiescent. The last time the VIX began a year lower than a reading of 12.85 was in 2007 with a post of 12.04. Housing prices had peaked in April of 2006 across the 20 metropolitan areas covered by the S&P Case-Shiller Home Price Index, beginning a relentless month-over-month slide that would not be completed until February of 2012. Of course, December 2007 would mark the beginning of the Great Recession of 2007, the deepest recession since the 1930s. The two other times in the VIX's history that the benchmark started a year below a reading of 12.85 was in 1994 at 12.57 and again in 1996 at 12.19. Both of these instances were related. In December 1993, the Federal Funds rate was at 2.96%. By December of 1994 the Federal Funds rate through a series of unannounced increases during the course of the year settled at 5.45%. The yield on the 10-year Treasury note followed suit, soaring from 5.83% in December of 1993 to 7.84% by December 1994 for a move of 2.01 percentage points. The bond market experienced one of the worst bloodbaths in memory at the time. By way of comparison, the yield on the 10-year Treasury note went from a low of 1.366% in the first week of July 2016 to a high of 2.60% in the first week of December for a painful move of 1.24 percentage points. By January 1996, the Federal Funds rate has largely settled 5.56%, falling slightly to 5.29% by the end of the year. Meanwhile, the increases of 1994 in short-term rates had fed through the economy as the US Dollar Index went from a post of 89.99972 in early June of 1995 to a post of 96.9891 by December 1996. The relative strength of the dollar in world currency markets pummeled US exports while foreign imports took advantage of the dollar's strength causing the US trade deficit to swell.

The VIX's long-term average reading is about 20. For the past five or so, that average reading has dropped noticeably to 15. And since the Trump election, the average VIX reading has dropped even further to roughly 12. The fear here of course is market complacency. The VIX measures, though imperfectly, the balance of supply and demand for options on the S&P 500 - insurance policies against market slides for an equity portfolio. When the VIX is low, the signal here is there are plenty of investors selling such insurance policies and precious few investors assuming the opposite side of the trade. When so many investors are on the same side of a trade, an event that upsets market equilibrium can easily knock markets out of kilter - and quickly. That sense of complacency continues to be backstopped by monetary policy in Japan and Europe with both the BOJ and the ECB currently engaged in large-scale asset purchasing programs buying ¥80 billion and €80 billion per month of mostly government debt, respectively. Here in the US, while the Federal Reserve halted its asset purchase program in December 2014, the reinvestment of maturing bonds still provides copious levels of liquidity to the economy - a topic that will be at the heart of FOMC discussions as they debate the process and logistics of shrinking their outsized balance sheet.

Still, markets see Trump as much more of a factor in the economic growth equation over the medium term than the Federal Reserve, which also keeps market volatility measures at historical lows. The stock market continues to price in the Trump trade which has pushed exchange values to new all-time highs, with the Dow Jones, the S&P 500, the Nasdaq Composite and the Russell 2000 all sketching out four separate records in four consecutive trading sessions last week - a record in itself that dates back to June of 1995, according to FactSet data. The basis for much of this hope clings, rightfully, on the momentum created by ongoing, though modest, economic growth supported by strengthening underlying fundamentals. Yet, market expectations that the new administration will make good on tax cuts and business-friendly deregulation of the economy - all in the midst of one of the most turbulent first month of any presidential term in living memory - appear growingly unrealistic.

Political risk is running hot. The president has fired an acting attorney general, had one of his executive orders rescinded by judicial review, was forced to fire a national security advisor, lost a cabinet appointee and confirmed his education secretary with a first-time tie-breaking vote from his vice-president. Those cabinet nominees that have squeezed through the Congressional confirmation process to date have done so on razor-thin, politically charged, party-line votes. He continues to degrade the judicial system and is on a dangerously slippery slope with his own intelligence community. The dismissal of his NSA director begets even larger questions about the communications of a then private citizen, and perhaps others, with Russia in the December period - a direct violation of the 300-year old Logan Act (1799) - evoking the now famous Watergate question of how much the President-elect at the time knew and when. A stream of heated presidential social media blasts aimed at the intelligence community over the alleged leaks of classified materials around the case is a signal that the issue will continue to hang over the White House for the foreseeable future, reinforcing the all-too-familiar clang of a White House in disarray. Worryingly, bringing an end to the 24-day tenure of his NSA director was likely not due to the act itself (which could be a felony offense) or incompetence on the job, to which Mr. Trump's positive comments in the aftermath on both scores duly attest. Leaving his NSA director in place to ride out the storm proved to be too much of a personal affront to Mr. Trump's highly personalized style of leadership - red meat on which a hostile media could endlessly gorge. At the same time, questions regarding control over staffing and independence, likely an outgrowth of the affair, has culled the ranks of replacement candidates for the next NSA director, making the position all the more difficult to fill.

The president's hostility toward the media is already biblical. All of this has happened in the course of just one month - with theoretically 47 more to go. At this early stage, at least, the administration's base appears intact and his party controls Congress and with it the national agenda - at least for the time being. While markets see most of these issues as teething tantrums as they anxiously await policy details, this outsized dose of fiscal stimulus stands hostage not only to the countermands of the Federal Reserve but to the political reality of the mid-term electoral cycle that mathematically has Republicans defending proportionately more seats in both houses of congress. The more time spent untangling the nettles of governing dysfunction in the Trump White House is less time spent on rolling out a very expansive and highly controversial agenda that will most certainly cut along strict party lines under the best of political circumstances, with Democrats fully expected to employ every parliamentary delaying tactic on the books to thwart the effort over the course of the next two years. With the dismal start to the Trump administration to date, this lock on the legislative process could unravel in relatively short order as Richard Nixon - in his own battle with the judiciary, an unsupportive civil service bureaucracy and a hostile press - found out when his political base finally imploded and it became clear that impeachment in the House and conviction in the Senate would garner bipartisan support. To conclude that Mr. Trump's presidency could end prematurely given the events of the past month cannot be dismissed as the conjuring of rabid speculation. Universally, presidents' approval ratings with the public are at their peak in the first few months of their presidency. Pew Research polling data indicate the president has a 39% approval rating, the lowest reading of any president at such an early stage. This is key: it took six years into George W. Bush's presidency for his approval ratings to reach the low 40s. That year's mid-term elections in 2006 saw the Democrats pick up 30 House seats and become the majority party in both Houses of Congress. Across the country, Democrats won a majority of the governorships. Two years later, a young Democratic senator from Illinois captured the White House. Barack Obama's approval rating was similarly low just two years into his presidency at the mid-term elections of 2010. The Republicans came out of the contest with 63 seats in the House - the largest swing of House seats in the post-WWII era - erasing the Democratic gains of both 2006 and 2008. Still, Obama won big in 2012. The political problem for the Republicans is the probability of Mr. Trump's already low approval numbers dipping even further. Such an eventuality could not only threaten to dislodge the timetable for implementing the Republican agenda by the mid-term elections of 2018, but could cost them their majority status in both houses of congress - which would shut down their legislative options until at least 2020 or beyond.

Political risk is routinely assessed in the emerging market space - the higher the political risk, the higher the risk premium for both equities and debt. The fact the VIX has not even begun the process of pricing in the growing level of political risk here in the US is becoming all the harder to rationalize, let alone explain. Investors, worldwide, are being set up for a fall. We are now well past the stage where the current dysfunction in the White House brings to mind another electoral experiment with anti-establishment populism where a 38-year old political neophyte from Italy's Five Star Movement managed to capture the mayor's office in Rome in a highly fragmented popular vote. Eight months later, the experiment has turned almost surreal where dysfunction and political intrigue have morphed into an art form - this in a country that has seen 65 national governments in the post-WWII era.

Price inflation continues to migrate through the greater economy, a response to both rising energy prices as well as market expectations of fiscal stimulation. In her Humphrey-Hawkins testimony before the Senate Banking Committee last week, Janet Yellen pointed out that it is still too early to know what policy changes are in store for the economy from the fiscal side of the equation, let alone what the impact of such future policies would have on the greater economy. Fiscal initiatives have long lead-times from policy formulation to implementation to when the first shovel breaks the ground. While the Fed still has the luxury of time on its side, Yellen readily admitted that it would be unwise for the central bank to wait too long before putting a short-term rate increase cycle into place. The admission is as clear as a Fed chair gets to signaling an uptick in short-term rates is imminent. Markets clearly see things differently as they fervently price potential Trump policies into stock and bond valuations.

The battle of nerves between the administration and the Federal Reserve began with the surprise election results, spurred on measurably by the market's outsized reflation expectations for the economy that continue to be viewed as a slam-dunk in the Republican-controlled Congress. Investing in the US and around the world will revolve around these two variables for the foreseeable future: the Republican attempt at reflating the economy and the Fed's determination to hold the line on inflation in an economy that is largely at full employment. We will likely never see a photographic montage of Donald Trump taking Janet Yellen's hand in the same manner he did with a no-doubt surprised Theresa May while exiting a joint news conference during the prime minister's recent visit to Washington. For the market, the wild-card continues to be the fickle, unpredictable Donald Trump and his ability to deliver sweeping fiscal changes. If the music stops, Donald Rumsfeld's unknown scenario will lurch for every available seat. The VIX will soar and I pray investors will be able to keep apace.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.