“I don’t normally do requests, unless I’m asked to.”
-Richard Whiteley (redundancy expert)

Yesterday marked the 1 year anniversary for a landmark lesson in non-linear market dynamics.

The now storied vol-pacalypse of Feb 2018 was a veritable dystopian storm of networked and reflexive effects which saw a hawkish AHE print reanimate and amplify already percolating inflationary fears, serving to capsize the prevailing Goldilocks narrative and, consequently, conspired with The Machine and thereto latent market structure fragilities to catalyze the terminal unwind of the short vol trade and some of the largest point losses ever across equity benchmarks. 

Lessons learned?  Hopefully.

For the Panglossian posse, I suppose fully annualizing that 1st week of last February means the volatility numbers associated with the event now roll out the 1Y measurement window, providing a quantitative tailwind to systematic re-risking … or so the sirenic storytelling goes.

Back to the Global Macro Grind ……    

Happy Voliversary - z DxoSnF0UUAATN8o

So, with December’s cratering and January’s re-phoria, we’ve now had two contrastable market spasms in opposing directions to take (literal) stock of.

Analytical autopsies are rarely time ill-spent so let’s quickly conduct our own.       

For pre-text, and as backboard against which we can conceptually frame the macro factor dynamics, let’s distinguish between two distinct Growth and Performance Regimes. 

It’s a simplification but it doesn’t meaningfully dilute the conclusion:

  • Growth Accelerating regime:  Rates Up, Dollar Up, Stocks Up
  • Growth Slowing Regime:  Rates down, Dollar Down, Stocks Up. *Note that Stocks Up is largely predicated and contingent on a reactionary/dovish monetary policy pivot.   

Separate from the task of actually forecasting 2nd derivative inflections, the primary risk management exercise is in effectively traversing the market chop associated with the transition between those divergent regimes.

So what have we learned (or re-learned) in the latest instance:  

  1. You don’t know how long or how volatile the Transition will be so you can’t simply skip ahead and front-run the prospect of “stocks up” on.  An investing ‘strategy’ which also equates to simply always being long.  As we witnessed, buying the dip on the prospects of a Fed put optimizes to the point of nonexistence as the dip gets bought before the dip even really happens and, in the process, long vol carry gets crushed. This self-reinforcing volatility suppression cycle results in the cumulation of latent risk that works until it doesn’t (i.e. until the growth cycle inflects) and ultimately blows up in spectacular fashion.   
  2. If your model can front-run the inflection in the actual data, you can front-run both the market’s collective acknowledgement of it and the lagged reaction to it by the Fed.
  3. The Fed will respond directly to the slowing data or it will be forced to respond by the market which is likely to reflexively over-price in the growth inflection over the short-term. 
  4. So, you can’t simply and knowingly be long high growth/high beta/reflation into a negative growth inflection and the negative asymmetric probability for growth levered asset performance associated with the transition period. 
  5. What you’d like to be long is redundancy.  In other words, you want to be long what works both during the transition period as the market has the collective realization and begins to discount the growth inflection and what works if/when the Fed reaction function pivots in response to it. 
  6. For example:  what works if growth is slowing?  Bonds   … what works if growth slowing leads to the Fed going dovish and caving on the tightening cycle?  Bonds     …. What works (on a short lag) if the Fed stays hawkish into a slowdown and therefore craters both growth/inflation expectations … and is subsequently forced to pivot dovish anyway?  Bonds.   

Reality may not cut as cleanly as that scenario set above but you get the point.  Complex bio-physical pathways are a marvel of redundant systems.  Redundancy is a defining feature of evolution not a byproduct.  

If you want an investing process for the long-term, you can be like Buffet, take a bath and hope for an epiphany or you can model Mother Nature and get long redundancy.   For our purposes, long redundancy equates to being long exposures that work in Quad 4 and Quad 3 or, more preferably, that work in both. 

Mother Macro, meanwhile, remains generously redundant   … in Quad 4 data reporting terms. 

  • Brazil Composite PMI = 52.3 = sequential decline
  • U.S. Markit Services PMI = 54.2 = sequential decline
  • ISM Non-Manufacturing Index = 56.7 = sequential decline
  • Germany Construction PMI = 50.7 = sequential decline
  • German Factory Orders = -7% Y/Y = accelerating decline
  • Argentina Construction Activity = -20.5% Y/Y = accelerating decline

That isn’t a cherry-picked cross-section of global macro. Those are all the major releases of consequence over the last 24-hours. 

Oh, yeah ….. and the steady drumbeat of negative earnings revision trends into peak profit cycle comps domestically continues unabated with 1Q19 S&P500 earnings growth estimates having now turned negative at -0.9% Y/Y. 

Lastly, I want to quickly highlight this week’s 1Q19 Senior Loan officer Survey data.    

First, remember why we care.

In a financialized and credit driven economy like the U.S. credit trends and growth are inextricably linked.

Generally, credit growth is pro-cyclical as stronger-growth and rising spending drives income and employment higher which, in turn, drives consumption and confidence higher in a virtuous, self-reinforcing cycle.  Credit serves to amplify the cycle with credit expansion following pro-cyclically as loan demand and creditworthiness both increase alongside rising incomes and higher household net wealth. 

Of course, the converse is true as well:   As banks tighten standards and make it more difficult for Main Street and businesses to get credit, economic activity slows, which self-propagates lower loan activity as demand for credit suffers while credit worthiness deteriorates incrementally.  

The latest survey was, on net, not growth positive as C&I loan demand, CRE loan demand, Residential Construction loan demand and Auto and Other Consumer Loan demand all weakened in the latest quarter.  Moreover, underwriting standards were unchanged or tighter across all loan categories with CRE and Consumer Credit Card loans showing the largest tightening.   In terms of projections, banks reported expecting tighter standards, weaker demand, and worse loan performance across most loan categories over the NTM alongside an expected deterioration in collateral values

Loan book quality. 

As Josh Steiner, our head of Financials Research, summarily commented yesterday: 

  • Banks appear to have paused their prior efforts to relax C&I loan pricing and underwriting standards in response to increasing inter-bank competition and the growing presence of non-bank lenders. As global growth slows, with trade negotiations and a new Congress fueling heightened domestic uncertainty, restrained corporate CAPEX and M&A activity is driving weaker C&I loan demand.
  • Banks continue to exercise caution over particular loan categories, namely commercial real estate as underwriting standards continue to tighten. Moreover, on the consumer side, banks are exercising new caution in residential mortgage and non-mortgage household lending as they look beyond the latter innings of the current economic expansion and begin to form expectations for deteriorating household finances.

Unless we see a durable re-inflection in the growth cycle, the next few quarters are likely to see progressive caution and similar constriction in the collective credit box.   

In other words, the State of the (Global Macro) Union to start 2019 remains one of discrete Deceleration with an investing citizenry conditioned to the pervasive but vapid notion that policy driven asset price reflation isn’t subject to term limits.  

Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now: 

UST 10yr Yield 2.63-2.79% (bearish)
SPX 2 (bearish)
Utilities (XLU) 52.59-55.40 (bullish)
REITS (VNQ) 78.55-85.11 (bullish)
Industrials (XLI) 67.99-74.12 (bearish)
Housing (ITB) 31.61-34.88 (bullish)
DAX 11062-11447 (bearish)
VIX 15.11-21.43 (bullish)
USD 94.75-96.30 (bullish)
Oil (WTI) 51.66-55.71 (bearish)
Gold 1 (bullish)

Best of luck out there, 

Christian B. Drake
U.S. Macro Analyst

Happy Voliversary - CoD SLOS