US stocks logged their biggest three-day gain in months through Thursday, thanks in no small part to the monetization of hedges and profit-taking on long vol. trades.
But if you're searching for evidence of lingering trade jitters, look no further than the following visual.
On the top is Deere (DE), which is on track for its worst month since 2011. On Friday, the company cut its outlook citing uncertainty around "export-market access and near-term demand for commodities". In other words, the company cited trade concerns. In the bottom pane is the SOX (SOXX), which is headed for its second-worst month since May of 2012. In addition to generalized trade concerns, semis suffered a veritable bodyblow on Wednesday evening, when the Trump administration moved to blackball Huawei.
The Huawei story is huge. Ask anyone who knows anything about the situation and they'll tell you the decision to squeeze the company is one of the more momentous foreign policy decisions of Donald Trump's entire presidency. I put together a collection of quotables from experts and analysts here, but for our purposes, it's enough to note that the crackdown on one of Beijing's crown jewels may be enough to derail the trade talks permanently (or at least for the foreseeable future). That's not speculation. Over the past 48 hours, an already aggressive state media campaign in China kicked into high gear, including a shrill commentary from Taoran, which characterized the Huawei decision as a "little trick" aimed at "disrupting the atmosphere."
In addition to jeopardizing the trade talks and throwing Huawei into an existential crisis, the move has far-reaching implications for a variety of names. Consider this excerpt from a Goldman note dated Friday, for instance:
Huawei is an important customer for several Semi and IT Supply Chain companies. Within our coverage, companies with Huawei exposure include Micron (13% of revenue in the last 6 months per its 10-Q filing), QRVO (8% of FY18 revenue per its 10-K filing), SWKS (10% of FY17 revenue per its 10-K filing and we estimate 5-10% in FY18), XLNX, Flex, MACOM, Marvell, ON, WD, Seagate, Microchip, AVGO, ADI, TXN, NXPI and KEYS.
Again, this is a big deal at every level.
In an effort to blunt the impact of ongoing escalations with China, the Trump administration said Friday that a decision on auto tariffs will be delayed. Subsequently, Bloomberg confirmed that metals tariffs on Canada and Mexico will be lifted.
The problem, though, is that it's by no means clear those mitigating maneuvers are predicated on anything other than concerns about the market implications of a multi-front trade war. That's not nothin' (so to speak), but it's not ideal either. That is, what markets want to see is evidence that the US side is inclined towards addressing America's grievances with negotiated settlements, because negotiated settlements are inherently preferable to tariffs.
Instead, some traders are getting the impression that "countercyclical protectionism" is in full effect when it comes to China. As JPMorgan's Marko Kolanovic wrote Thursday, "the market moving higher generally leads to a hardened stance and more confrontational tone, and the market moving lower generally leads to either verbal or actual progress towards trade resolution."
It's possible (indeed, it's likely) that the conciliatory stance vis-à-vis Europe, Japan, Canada and Mexico is just an effort to blunt the market impact of the China tension - an attempt to have the cake and eat it too, as it were.
There's nothing inherently wrong with this approach if you believe (as many people do) that the administration's stance on trade has merit. But setting aside normative concerns, there is no question that the indeterminacy around trade is conducive to volatility in markets. For now, that volatility is concentrated in the yuan, which remains the outlier in the vol. space. Here's a snapshot of cross-asset vol. indexed to the first of the year:
You'll also note that rates vol. (the blue line) has ticked back up lately, nearly to local highs hit late in March during the "growth scare". This is something I touched on in a Wednesday post for this platform. Apparently, some commenters didn't understand the significance, but the point was to say that there's probably still some positioning overhang from March, which means that when you get growth jitters (stemming in this case from the renewal of the trade war and, on Wednesday, lackluster data out of China and the US), the concurrent rally in bonds can squeeze those positions, leading to hedging/convexity flows that then exacerbate the rates rally. As bonds surge, market participants who don't know what to look for in terms of footprints, mistake manic rates moves for acute growth concerns. That can then spill over into risk sentiment.
Again, some of the comments on that article indicated that at least a handful of readers thought I was employing "jargon" for the sake of jargon, but what I would note is that on Wednesday evening, Bloomberg ran a piece that documented the same dynamic. To wit:
But beyond all the global threats, the interplay between mortgages and Treasuries is also key. As yields drop, mortgage investors need to hedge, intensifying the move... In March, a massive wave of convexity-related hedging accelerated a drop in yields that was already underfoot after the Fed surprised traders with a dovish tilt.
The point is, the reference to hedging dynamics and convexity flows and the allusion to what happened in late March when dozens upon dozens of articles were written about the rally in developed market bonds, wasn't some inside baseball, obscure reference. Rather, it's something anyone who fancies themselves a macro watcher needs to at least attempt to wrap their head around because it can, in some cases, help explain action in the rates space.
Speaking of the rates space, Fed cut bets are deeply entrenched, folks. The Eurodollar bid is being described as "perpetual" out there. Here's Nomura's Charlie McElligott (from a short Friday note):
The “perpetual bid” in ED$ continues again on the risk-off overnight, with the same belief that the negative implications from the Trade breakdown into the already perceived ‘end of cycle’ economy means the Fed is “asymmetrically dovish” in policy options from here—MUCH lower bar to EASE than to hike again this cycle. As such EDM9EDM0 back to pricing 46bps of Fed cuts between Jun19 and Jun20.
Incidentally, that means the pain trade is the bear flattener, for whatever that's worth to the rates traders among you.
Getting back to RMB, the onshore yuan fell through 6.90 on Friday, and mainland Chinese equities dove. The Shanghai Composite has now fallen for four consecutive weeks and, notably, it does not appear that the vaunted "national team" (China's real-life plunge protection unit) is defending 3,000 on the SHCOMP.
The Huawei broadside increases the chances that Beijing will take dramatic steps to shield the domestic economy from the trade war, and those steps could include further devaluation and the possible liquidation of some US Treasury holdings, especially if Beijing can couch that in terms of defending the currency against speculation.
You could just as easily argue the other side of the coin. That is, you could say that with tensions running high, and the world on edge, China will avoid a 7-handle on the yuan like the plague, because breaching that psychological level would risk capital flight and an outright market panic. I would push back on that. Beijing learned a lot from the 2015 devaluation. They know how to clamp down on capital flight, they have a mechanism for stabilizing the domestic equity market and, this time around, they have a plausible claim on being the "victim" (although that's clearly a debatable characterization). If China believes there's no path to reconciliation with the US, the incentive to avoid currency depreciation would be diminished.
Additionally, Beijing isn't even close to exhausting its capacity to boost the domestic economy with stimulus. As Bloomberg reported on Thursday (and this was a great little pseudo-investigative piece), "central and local authorities in China have at least 25.1 trillion yuan ($3.65 trillion) unspent in their budgets this year."
Here's a useful scenario analysis from BofA that touches on all of the points mentioned above regarding China's decision calculus:
Circling back to equities, the week through May 15 was a total debacle on the flows front - I don't know how else to put it. Global equities saw $19.5 billion in outflows over the period. $8.1 billion came out of US equity funds.
That's just a continuation of the trend. As you can see, the four-week total for US equity funds is -$26.3 billion.
That contributed to the selloff, obviously, and as Marko Kolanovic wrote in the same Thursday note cited above, "an initial spike in volatility led to modest de-risking from volatility-driven investors [including] volatility targeting, HF platforms, dealers option hedging, etc." I've documented that every, single day over on my site and, whenever I've gotten the chance, on this platform.
Kolanovic went on to say that some of the systematic de-leveraging (and, one assumes, some of the profit-taking from asset managers, who came into the selloff sitting on a $123 billion net notional long), was offset by the corporate bid.
"The selling was to some extent countered by increased buyback activity in the aftermath of the Q1 earnings season (end of blackout) and as a result of the market decline (accelerated share repurchase programs)", Marko wrote.
That corporate dip-buying played out alongside profit-taking in long-vol. funds and strategies. Since May 5, some $750 million has come out of levered and unlevered long VIX products (combined), for instance. Those flows tamped down volatility/stabilized stocks (purple boxes below) short-circuiting the feedback loop that can develop between vol., low liquidity and systematic flows.
Think of the VIX as effectively "reverting" (yellow lines, bottom pane) now that the "Fed put" has been re-struck higher in the new year. Spikes are transitory and most traders seem to believe the so-called "Trump put" (i.e., the level on SPX at which the administration will soften its trade stance in order to shore up stocks) would activate much sooner than the Fed put. In other words, you've got layers of protection on the downside, one likely to be ~4% or so OTM, and the other ~10% (those correspond to Kolanovic's estimate of where the "Trump put" is and Deutsche Bank's take on where Powell would step in, respectively).
The problem going forward is that the China headlines aren't going anywhere. As noted above, Beijing's state media machine is working overtime, churning out "Op-Ed" after "Op-Ed", "commentary" after "commentary", virtually all of which suggest that we may have crossed the Rubicon when it comes to an amicable settlement. The Huawei move thrusts the plight of Meng Wanzhou back into the spotlight. Indeed, China formally arrested two detained Canadians this week, just hours after the US Commerce Department announced what is effectively a ban on Huawei.
It's not clear that anyone should take solace in the S&P's three-day rally (through Thursday). To be sure, positioning remains light, so there's certainly scope for re-leveraging and it couldn't get much worse on the fund flows side of things. Unless the market incurs serious damage (i.e., enough to trigger mechanical de-risking on par with some of last year's worst episodes), there's room for a constructive take, especially when you consider the figurative plunge protection provided by the corporate bid.
That said, you shouldn't kid yourself. This is all about China in the near-term and that situation is almost impossible to handicap. The Trump administration takes pride in being unpredictable - it's seen as an effective negotiating tactic. Well, suffice to say Beijing is unpredictable as well. We could just as easily get a shockingly weak yuan fix that throws everyone for a loop overnight as we could get signs of support for the currency and more incremental easing designed to shore up the domestic economy and, in the process, keep the global cycle from turning.
What I would say after this week, though, is that to the extent you were "constructive", you should at least temper your bullishness going forward.
I worry that the Trump administration has painted itself into a corner, wherein it will be impossible not to hit the remainder of Chinese goods with tariffs at some point. The Huawei escalation makes it far more difficult for Xi to make concessions without appearing weak domestically.
We'll probably muddle along for another week or two as Beijing takes the market's temperature and assesses whether or not some kind of deal that allows both sides to save face is possible. If that's not seen as realistic, don't be surprised if you wake up one day and feel like you're reliving August of 2015.
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.