October 17, 2022 | Allio’s Chief Investment Officer, Raymond Micaletti, on the geopolitical turbulence impacting the markets, leptokurtosis, near-term market direction, and more.
This week we’ll take a quick look at some topics of interest:
At an industry conference this week, JPMorgan CEO, Jamie Dimon, said to a small group of listeners (closed to the press), “The President of the United States needs to stand up and say we may not meet our 2050 climate objectives because this is a f****** war”—alluding to the global standoff between the West and everyone else (most notably energy producers) over the incompatibility of Western sovereign debt levels and the price of energy.
This followed on the heels of the U.S. government taking action against China’s semiconductor industry on October 7—telling U.S. citizens who work in the industry to resign or face losing their U.S. citizenship. (The purpose being to deprive China of the technical know-how to advance its chipmaking capabilities.) According to reports, mass resignations have ensued and various Twitter threads have gone into detail about how this has devastated the Chinese chip industry overnight.
Throw in OPEC+’s recent decision to cut oil production (spurning American entreaties to wait until after the midterms) and it’s clear we’re in an economic cold war against Russia, China, Saudi Arabia, et al. This cold war may cause inflation to be structural rather than cyclical (our base case given our belief we’re in a secular bear market driven by high inflation).
For example, the Chinese chip action will cause supply shortages; reshoring American chipmaking (and other industries) will lead to higher labor costs; European countries are subsidizing consumers’ energy bills; higher interest rates choke off investment in new energy capacity; OPEC+’s antagonism will artificially prop up energy prices (as will the replenishment of our strategic petroleum reserve), which will flow through to all finished goods. And so on….
Thus, we run the very real risk of Federal Reserve rate hikes breaking markets without getting any commensurate relief from inflation. The aforementioned cold war also raises the probability that the Fed is not merely fighting inflation but has been weaponized by the U.S. government as a participant in the fight.
Consequently, the likelihood of any type of pivot, pause, or softening of rhetoric may have gone out the window.
While that’s a bleak outlook, there may be a positive way to frame our current environment. We’ll delve into that alternative framing later in this letter.
In the span of 24 hours in the middle of the week, Treasury Secretary Janet Yellen went from saying she thought Treasury markets were functioning just fine to saying she was concerned by Treasury market illiquidity.
In the same vein, FOMC member Lael Brainard said “The Federal Reserve is acutely aware that unexpected interest rate or currency movements may interact with financial vulnerabilities.”
Bloomberg reported that Fed officials faced a barrage of complaints at this week’s IMF meeting from foreign finance ministers angry about the damage wrought by the strong dollar.
MarketWatch reported that the publisher of the Bear Traps Report said that the consensus among 600 institutional investors from 23 countries that partake in the site’s forums is that “things are breaking” and the Federal Reserve will have to make a policy change “fairly soon.”
In contrast, most other Fed speakers continued the hawkish onslaught.
In the UK, Liz Truss fired her finance minister and abandoned her tax cut plans, reinforcing James Carville’s wish to be reincarnated as the (all-powerful) bond market.
In our view there are three considerations that may lead to a temporary respite in the Fed’s overt hawkishness.
The first is that the Fed may realize the more hawkish it is in the short term, the less likely it will be able to raise rates to its stated target—because markets will almost certainly break first, forcing them to relent. Thus, the Fed may want to see equities and bonds higher (temporarily) so it won’t have to pause or pivot prematurely.
Second, we are a few weeks away from a midterm election. The Fed may not want to be seen as crashing markets into the election and influencing its outcome. Brainard’s call for data dependency this week and her nod to market fragility (and Yellen’s comment about U.S. treasury liquidity) may be tells.
Third, the Fed will go into a two-week blackout period leading up to the FOMC meeting on November 2. Will the Fed want to leave the market teetering on the abyss and left to its own devices for two weeks without being able to jawbone it into stability if things start breaking?
For those reasons, we think it’s plausible we may see some easing of the rhetoric in the next week.
In late 2021, the volatility trader, Cem Karsan, tweeted about the fat-tailed-ness (“leptokurtosis”) of our current market environment, stating that we should get used to seeing phrases such as “the biggest ever,” “the most ever,” and “the worst ever,” because markets will likely move beyond what we tend to think of as reasonable.
It was a prescient tweet in light of the following:
The worst ever January return.
The worst ever first-half return.
The worst ever performance of the 60/40 portfolio.
Since WWII no market that had retraced 50% or more of its greater-than-20% drawdown had violated its bear market low—until this year.
Only three times before had the market had four consecutive weeks where it closed 4% off its intra-week high. This past week—the fifth week—the market closed 3.5% off its intra-week high, breaking the streak but still finishing lower. The other three times saw 10% returns in the fifth week.
Five of the seven trading days leading up to the June low saw more than 90% of stocks down on the day—the first time that has ever happened in data going back to 1928.
The 10-year yield has increased for 11 straight weeks. That has happened only one time before—the 11 weeks leading up to February 2, 1973. The market proceeded to lose 40% over the next 21 months.
In Karsan’s view, much of this leptokurtosis can be attributed to speculative options traders. When the market was rallying in 2021, they were buying calls (but not hedging them). This meant that options dealers were short calls and had to buy more equities as markets moved higher—spiraling them upward.
Now, speculative options traders have bought more puts than during the 2008 Great Financial Crisis (normalized for the size of the equity market). This means that as markets fall, options dealers (who are short puts) have to sell more equities to hedge themselves—spiraling equities downward.
Thus, contrary to the notion that the market can’t fall because everyone is positioned for it to do so, the market can fall—just as it rose relentlessly during the notorious “gamma squeezes” in 2021 that drove mega-cap and next-generation tech stocks to obscene valuations (e.g., NVDA at 40x sales).
Keep this options-hedging dynamic in mind the next time you hear of some superlative market event.
A Different Framing of our Current Situation?
Market strategist Russell Napier sees the world in much the same way we do—caught in a secular bear market driven by structurally higher inflation.
Rather than seeing this as a doom loop, however, Napier believes the global economy will be supported by a capex boom. He believes central banks will be forced to accept 4%-6% inflation but that nominal growth will come in at 6%-8%. The massive debt loads of developed-market sovereigns will be inflated away (he believes 4%-6% inflation is not too high that it would cause social unrest).
He also believes power will shift from central banks to sovereign governments. His argument is that banks are still lending despite a potential recession on the horizon and the reason they are still lending (to corporates) is that states have guaranteed the loans. In his view, as long as banks lend, nominal growth will remain strong.
A capex boom (with 8% nominal growth) would support earnings and potentially support stocks, even if inflation depresses multiples.
We should get some insight this earnings season as to whether this capex boom has begun or, if it hasn’t, when it might begin.
Near-Term Market Direction
Nothing would surprise us in terms of near-term market direction. A continued equity market selloff would mesh with global bond market fragility, volatility, and illiquidity, especially with not-yet-attractive equity valuations.
Likewise, another attempt at a rally would not be outlandish either given:
The bullish divergence in price (making new lows) vs. number of stocks making new lows (not making new highs)
The bullish divergence between price (making new lows) and various oscillator readings (not making new lows)
The Nasdaq 100 is at the bottom of a falling wedge and may test higher within the wedge
The S&P 500 is tenaciously holding its 200-week moving average
Earnings have been revised lower and now present a fairly low hurdle for stocks to generate upside surprises (though guidance will likely be more important)
The potential for the “capex boom” narrative to diffuse into markets
The upcoming midterm elections that will provide those with a megaphone (politicians, Fed speakers, financial media) the incentive to support the market
This week is options expiration week and that often means some wacky cross-asset price moves. Let’s see what happens.