Investors lack conviction and consequently risk exposure should be light until the macro fog clears.
Mr Macro concludes that the balance of evidence favours a sharp turn lower in risky assets.
Mr Macro has spent the past couple of days in Helsinki. The flight home was an opportunity to reflect on his 20 April missive proclaiming that now was time to prepare for despair. The operative scenario, a 75% probability, is that the risk rally is over. The alternative scenario is that after the recent pause another melt-up drives global equity indices toward the 200-day moving average benchmark before turning lower. Either way, the ingredients for a self-sustaining recovery in risk assets and the related V-shaped economic outcome are not in place. The recent choppy trade in a narrow range is testament to investor uncertainty and a lack of conviction. Positions will likely remain light until the macro fog clears. Here is a list of some of the important factors to consider:
Macro – Business survey data, consumer confidence, US housing, and Asian exports are all showing signs of bottoming. More generally, data continue to beat expectations. The negatives are that ISM is just 36.3, near the bottom of the 60-year range. Mr Macro thinks it quite possible that a new low is reached by June and eventually the all-time low of 29.4 set in 1980 is taken out. Why should not the worst recession since the Great Depression set the new standard for the weakest ISM reading of all time? The first indicator for a period of more negative macro news is the CESIUSD, the Citigroup economic data surprise index. Expectations are catching up with the improved outlook and it is likely to be more difficult to continue to achieve positive surprises. Call it negative.
Liquidity – Cash levels are still excessive relative to market capitalisation. Short interest is 4.23% of outstanding, high by historical standards. Since February the Fed has added $300bn to the balance sheet. On the negative side, State Street reported that US equity inflows are the highest in 12-years. Central bank reserves are shrinking. The forward looking Taylor Rule says that the US economy requires negative 7% rates by the end of the year, so each day monetary policy is becoming more restrictive. Call it neutral.
Valuation – The SP500 trades at 21 times 2009 earnings ($40), expensive against the long-run 16 times average. US housing is still expensive relative to rents. Rogoff showed that balance sheet recession bear markets for stocks and housing last 3.5 and 6 years respectively. In the fixed income space Europe peripheral spreads have narrowed significantly. Italy CDS is 82bp narrower from the 198 high. Money markets spreads like OIS-Libor and 3m6m basis swaps are back to trading at pre-Lehman levels. Meanwhile, central bank policy forwards are discounting a V-shape or hiking cycles to begin at the end of the year. Inflation is priced to normalize in line with higher commodity forwards which already look too optimistic given the collapse of global industrial production and trade. Call it negative.
Credit provision – Bank credit continues to shrink. The IMF says US banks need an injection of $500bn of new capital to return to 1990 levels of assets/shareholder equity capital ratios. For all the good intentions of TALF, PPIF, and PPIP, the securitized market remains stressed with ABS new issuance down 95% from peak levels. Call it negative.
Sentiment/Market internals – VIX, put/call ratios and % AAII bears are all warning of complacency. In the past few days, quality is outperforming high-beta names with poor underlying fundamentals. Some argue that this only means that the period of poor performance from quant strategies is finally coming to an end. Call it negative.
Intangibles – Banks know the stress test results and are now in a period of negotiation with the Fed/Treasury. Uncertainty is never a good thing for risky assets. The other major issue is the swine flu virus, something that was not on the radar a week ago, an unknown unknown. Now it is very much a known unknown. Investors are drawing comparisons with SARS and believe it is manageable and unlikely to morph into a pandemic. This may be right, and let us hope so, but the risk is all on the downside if this expectation proves inaccurate. Call it negative.
On balance the body of evidence points to a return to despair. How consensus is this view? It is hard to judge. Sure there are those who argue that flat is the new short or the more traditional view of “sell in May and go away”. It is possible that newly entered risk aversion trades get unwound in one final move towards the 200-day as even more cash sitting on the sidelines is deployed and short interest shrinks to more normal levels. Those holding this view also argue that there is no clear catalyst. Mr Macro concedes that is also the case – there is no smoking gun, just yet.
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