When A Walk To The Park Isn't A Walk In The Park

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About: SPDR S&P 500 Trust ETF (SPY), EEM, VWO, VOO, HYG, SH, UUP, SDS, IVV, SSO, LQD, SPXU, UPRO, SPXL, RSP, SPXS, IEMG, EDC, VFINX, SCHE, EDZ, EMF, EPS, MSF, ADRE, EEV, EUM, EET, GMF, SPEM, EEMA, BXUB, SPLX, SPUU, EEME, XSOE, DBEM, FEM, BXUC, HEEM, SFLA, SPDN, SPXE, EWEM, ROAM, SPXT, ESGE, EDBI, EMLB, FLQE, KEMP, PPLC, SPXV, EMSA, RYARX, SPXN, KLEM, RFEM, DMRL, RVRS, USMC, EMEM, MFEM, PPEM
by: The Heisenberg
Summary

For U.S. equity investors, the road to new record highs has become considerably more arduous since the halcyon days of January.

While there are a number of tailwinds, there are also a series of dynamics that have served to make your trek a halting, unpleasant affair over the last several months.

Here's a trip across markets that documents those headwinds and tailwinds and this one comes complete with one of my signature vignettes.

It's Sunday morning as I write this and there for about 15 minutes, I had designs on cramming my woefully out of date MacBook Air into my trusty Alleretour Messenger 34 (which has been subjected to an obscene amount of abuse considering its pedigree) and trudging the two-ish miles to a brand new park local officials decided to install next to one of the only public beaches on the island.

I like parks and I wish all the beaches here were free for visitors because even during tourist season, this place isn't exactly Miami. That is, it's not like there are more people than beach space (even in July and August), so it's not entirely clear whether charging people for access is even profitable, let alone necessary or desirable.

Anyway, my only qualm with this new installation (which amusingly features one of those fountains that kids can run around in despite the fact that there are almost never any small children here) is that it's right next to one of my favorite local seafood shops which is itself hidden in the back of a grocery store (I'd tell you the name of the grocery store chain, but that might be one hint too many).

This grocery store is a real throwback. Walking in there is like a time warp. I'd say it satisfies my desire to feel nostalgic for something, but that wouldn't be quite accurate because I'm literally not old enough to be nostalgic for a time when this place would have been considered some semblance of modern.

My overriding concern is that the decision to install this park is the first step towards modernizing everything in the cul-de-sac where it's located. If that ends up being the case, well then you can kiss my beloved Andy Griffith-style grocery store goodbye. Today was going to be a reconnaissance mission, of sorts.

Then it got hot. And the morning breeze that, just an hour ago, was wafting across the back deck and carrying both the steam on my coffee and the smoke off my morning cigar out to sea, has given way to a balmy, humid quagmire that pretty much rules out walking anywhere comfortably.

As long-time readers know, there are always market parallels in my vignettes. Sometimes I start writing and the market connections reveal themselves to my digital pen as I go and other times I know exactly what the parallel will be when I start writing. "The Truman Show" and the classic "Sharon Is Now Bullish" are examples of the latter process and so is this piece.

Headed into February, U.S. equities (SPY) were all set for a comfortable walk to a destination defined simply as "higher highs," presumably with the breeze at their backs, where the breeze was massive retail inflows, fiscal stimulus and somewhere between $650 billion and $800 billion in projected buybacks. Recall this anecdote from Barclays' Q2 outlook, which reads like a requiem for euphoria:

In the last week of January, as equities went on yet another run, a client who had been waiting to buy the dip called us with an exasperated query. What, he asked, could possibly go wrong given strong global growth, non-existent inflation pressures, and a spanking new US tax cut? Sure, markets seemed too complacent, but there didn’t seem to be a plausible catalyst to shake that equanimity, especially given how calmly investors had reacted to event after event in recent years. How, he wondered, does one buy the dip if stocks only keep rising?

But you know what they say about "the best-laid plans."

No sooner had markets regained their footing after the February VaR shock than regulatory concerns cast a pall over tech and no sooner had those concerns abated than trade tensions mounted and emerging markets (EEM) began to crack under pressure from a resurgent dollar (UUP) and an unapologetic Fed.

The end result: a sweaty, slow-motion trudge higher for stocks, reminiscent of what would have befallen my ill-fated, two-mile Sunday jaunt.

There's a sense in which Trump's trade bombast is actually a helpful speed bump for a market and a U.S. economy that might otherwise spin out of control. In keeping with the analogy, a little headwind isn't necessarily a bad thing if you might otherwise be inclined to overexerting yourself. Consider this amusing excerpt from a note penned by JPMorgan’s David Kelly last Monday:

A number of years ago, I worked for a Swedish asset management firm and this occasionally required me to journey to Stockholm. On these visits, I was generally impressed by the good humor and intelligence of my Swedish colleagues. I was surprised, however, by two things: The quantity of alcohol they could drink at night and the amount of strong coffee they could subsequently consume the next day.

For the most part, they carried it off without incident. However, it was a fine balance and could easily have tipped either way. In addition, a policy of over-indulgence in both stimulants and sedatives probably carried with it certain unpleasant side effects.

The U.S. economy finds itself in a similarly oddly balanced position today with a strongly stimulative fiscal policy being softened by the dampening impact of trade uncertainty.

To the extent you're inclined to take a bigger picture view of things and eschew the myopic pursuit of the fabled "blow-off top" in favor a view that prefers a slower grind higher that perhaps keeps the Fed at bay, well then the type of trade tension that was on full display this weekend at the G-7 is actually a helpful thing.

But for most of you, I'd imagine you'd be just fine if U.S. equities broke free and sprinted to new records at a breakneck pace reminiscent of the January run.

Well, that doesn't look like it's in the cards. The path ahead for equities looks like it will be a hot, halting, unpleasant affair, replete with requisite breathers and water breaks, similar to what we've seen since February.

Given all of the myriad reasons why investors might be inclined to adopt a cautious approach, you might wonder how it is that stocks have held up as well as they have. Last month, after all, was the best May for equities since 2009.

Well, JPMorgan's Marko Kolanovic predicted just that on May 1 and his rationale was based on sticking with his contention that the systematic crowd hadn't yet re-risked after the February volatility shock. I detailed his latest note (dated June 6) earlier this week here, but for our purposes, the following excerpts will probably suffice:

Our view is that the re-risking is likely to continue during the summer as volatility stays contained and investors increase equity positions. Volatility is likely to be contained due to summer seasonality, dealers’ long convexity positions, and lower correlations after a large spike in Q1. Investors’ exposure to equities is still relatively low. Systematic strategies de-risked on account of the high realized volatility in Q1 and discretionary investors de-risked on account of various macro fear narratives.

Focusing on the equity exposure of systematic investors, we look at volatility targeting. When volatility goes up (such as in February and March) these investors sell equities, and when volatility goes down they buy. An important question is which volatility measure is being used to time the market. 43% of volatility targeters use relatively fast signals (shorter than 3 months), 24% use 3M-6M signals, and 33% use signals slower than 6M. Faster signals were already prompting some re-risking in May and June (e.g., 2M volatility recently declined by half, but is still twice the January level), and this will continue during the summer with the addition of slower signals that will also start to re-risk.

That's a tailwind. So is this:

(Goldman)

And while systematic re-risking, buybacks and record earnings are all "stimulants" (to quote the above-mentioned David Kelly), trade tensions and other geopolitical concerns are sedatives.

If it seems like just a little over a week ago when Italian bonds were no-bid and Italian equities were diving in sympathy, that's because it was - just a little over a week ago, that is.

The funny thing is, if you go back and read my articles about that for this platform, there are still (as of yesterday) people making comments about how quickly that problem went away. Clearly, those people have not looked at the charts, because Italian equities just had a week that was worse than the previous week are now down five weeks in a row:

(Heisenberg)

How about the BTP-bund spread and Italian yields? Well, they're moving (back) in the wrong direction too:

(Heisenberg)

And don't even ask about CDS and € financial spreads:

(Heisenberg)

All of that just as the ECB has made it clear that next week is indeed in play when it comes to announcing when asset purchases will be wound down. Here's Barclays, from a note out over the weekend:

Markets anticipate an end of QE this year and EUR rates have re-priced almost entirely to “pre-Italy” levels (Figure 2) and assign about an 80% likelihood of a 10bp depo rate hike by June 2019. We expect the ECB to wait and announce an end of QE this year at the July meeting as it assesses recent downside data surprises.

Whether or not the ECB pushes the APP (asset purchase program) forward guidance tweak to next month, the point here is that thanks in no small part to hawkish rhetoric from officials last week, the rates market has completely faded the initial response to the Italian drama. That chart shows that any hope of the ECB leaning decisively more dovish in light of events in Rome was rapidly priced back out. That, even as Italian assets have largely erased the recovery they staged when new elections were averted.

Then there's the Fed, which will almost certainly hike this week, piling still more pressure on emerging markets. That's obviously the key event in the week ahead and if you're interested in exploring the hike in the EM context, you can read the lengthy piece I wrote on Saturday.

From the perspective of U.S. equities, consider that as financial conditions tighten (i.e., as the Fed continues to hike and assuming the dollar remains buoyant and yields continue to rise), weak balance sheet stocks are likely to come under pressure. Have a look at how the relative performance of stocks with strong balance sheets has become completely detached from leverage in the U.S.:

(Goldman)

That's the product of accommodative policy (i.e., QE, ZIRP and NIRP) compelling investors to reward recklessness and punish balance sheet discipline and it's starting to reverse in 2018. Remember, financial conditions continued to loosen even as the Fed hiked due to, among other things, the dollar's weakness in 2017 and 10Y yields' refusal to rise until Q4 of last year. Now, "tightening" actually means "tightening" and it isn't at all clear that over-leveraged U.S. corporates are prepared for that.

Interestingly (and this is important), U.S. credit is saying something different. The following chart shows how strong balance sheet stocks began to outperform weak balance sheet stocks starting early last year as investors began to (prematurely as it turned out) worry that financial conditions would eventually start to tighten as the Fed proceeded apace. But the following chart also shows a complete disconnect with that trend in credit (i.e., IG/HY compression):

(Goldman)

Part of that is technical (supply/demand), but part of it is the extent to which investment grade (LQD) has actually become more risky in some respects than high yield (HYG).

I've talked about this a ton in the context of the "hierarchy of vulnerability," a concept outlined by Deutsche Bank's Aleksandar Kocic following the February turmoil. Simply put, low rates have kept the cycle from turning in credit while QE and the global hunt for yield have served to artificially suppress HY spreads. Meanwhile, IG has become synonymous with macro-systemic risk thanks in no small part to the duration story. Here's Kocic explaining this:

While this is atypical in general, the dispersion is consistent with the recent stylized facts whereby IG has been behaving like duration and linked to systemic risk while HY, which has considerably lower duration (and has in the last years had low default history) has been straddled between duration and equity, leaning more towards the later.

Now, you're seeing a pretty notable disconnect between IG and U.S. equities. Have a look at this:

(Goldman)

So that's the performance of the stocks corresponding to CDX.IG 30 constituents and the performance of selling protection (12x hedge ratio) on the index. What you want to note there is that not only is credit underperforming equities, the two are moving in opposite directions (i.e., stocks rallying, credit selling off).

The key point Goldman makes in the note that chart is from (and this is the parallel to Italy), is that the same disconnect is true in Europe (i.e., selling protection on Main is underperforming European equities), but at least the direction is right. That is, European stocks are also selling off (Stoxx 600 down three weeks in a row), just not as much as € IG. In the U.S., the signals are completely different.

(Goldman)

It's not just that credit is disconnected from equities, it's also disconnected from other markets. As the above-mentioned Kocic writes in a note dated Friday, "there is a bifurcation across different risk premia [with] credit leading the way by resetting wider [and] other markets seemingly pricing the recent developments as transient."

You can see the disconnect between IG and HY mentioned above (i.e., IG widening out more relative to HY) in this chart:

(Deutsche Bank)

But moving beyond the IG/HY compression story, the broader point is that credit is disconnected not only from equities, but also from curve risk premium and FX volatility. Here's IG versus the CVIX, for instance:

(Deutsche Bank)

Here's Kocic explaining that, for the time being, the disconnect betrays a lack of consensus with regard to whether the Italian situation (and whatever else might be pushing credit wider) is transient or something more enduring:

This is partly a function of the current distribution of risks and their interaction with flows. As long as it remains non-systemic, European weakness is seen as supportive and in general stabilizing for the US long end. A consensus on that issue is still not clearly legible from the market pricing.

Implicit here is the notion that as long as central bank forward guidance remains predictable and consistent with market expectations, and as long as risk-off flows are supportive of the U.S. long end, rates volatility can remain anchored. Similarly, as long as the simmering trade tensions don't morph into an outright trade war, FX volatility can remain subdued. Credit, meanwhile, may remain wider compared to the regime that existed in 2017, and that bifurcation underscores my characterization of the current environment as a halting, arduous trudge higher for average investors' risk asset of choice: stocks.

There are two ways this can resolve itself and they're not mutually exclusive as the first will likely lead naturally to the second.

Equities' slow, sweaty push higher could come to a complete standstill and eventually morph into a situation where stocks simply give up and retreat in the event any of the various risk narratives (e.g., Italy and emerging markets) show signs of becoming systemic.

In that scenario, the Fed will likely be forced to pause, prompting the market to take out some of the additional hikes or even start to price in future rate cuts. That could potentially remove the headwinds by alleviating the pressure on emerging markets, reducing the chances of a bond unwind/credit shock and ultimately underwriting the viability of the carry trade and the short volatility trade in all its various manifestations.

At that point, stocks would be free to resume their trek higher unimpeded, with the buyback wind at their back.

Most of my readers here claim to be invested in U.S. stocks. If that's accurate, well then I wish you the best of luck in your journey in what has become a rather balmy, unpleasant environment relative to January.

As for me, I'm staying home.

Figuratively and literally.

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.