Performance Chase

Doug Nolan

The Nasdaq Composite, Nasdaq 100, small cap Russell 2000, Value Line Arithmetic and the NYSE Arca Biotechnology were among U.S. indices trading to all-time highs during Wednesday's session. In the real world, there is escalating risk of a destabilizing global trade war. The Shanghai Composite sank 4.4% this week to two-year lows. It was another week of instability for emerging market equities, bonds and currencies - especially in Asia.

Here at home, it's difficult to envisage a more divided electorate or a more hostile political environment. Record securities and asset prices and such a sour social mood appear quite the extraordinary dichotomy. Yet I would argue that speculative financial market Bubbles, heightened global tensions and domestic social and political angst all have at their root cause decades of unsound "money" and Credit (an archaic notion, I fully appreciate).

"Inflation is always and everywhere a monetary phenomenon…", Milton Friedman explained some 50 years ago. At the time, Dr. Friedman was contemplating goods and services inflation. Financial, monetary management and technological developments over recent decades ensured that asset inflation evolved into the much more destabilizing form of inflation. A Bubble collapse presented Dr. Bernanke the opportunity to test his academic theories, unleashing unprecedented monetary inflation specifically targeting securities markets. His policies spurred similar monetary inflation around the world that has continued for almost a full decade.

Cut short rates to zero, print "money," buy bonds; force market yields lower; spur buying of risk assets and higher securities prices; orchestrate powerful wealth effects; households and businesses borrow and spend; the economy expands; inflation rises back to target - and all is good. Sure, there's some risk that asset prices get ahead of the real economy. Not to worry. Central banks will ensure a steadily rising general price level - and inflating earnings - to catch up to elevated asset prices. All will be well.

All is not well. With such complexity in the world, central bankers should be disinclined from grand experiments. A decade of central bank rate manipulation, "money" printing and market intervention has ensured deep structural changes in the marketplace. Central bankers failed to appreciate the evolving nature of contemporary Inflation Dynamics. Over time, a potent inflationary bias took hold in asset prices, while for a variety of reasons disinflationary dynamics held sway in the pricing of many goods.  
A decade of unprecedented global monetary stimulus has stoked speculative assets Bubbles, replete with history's greatest redistribution of wealth. Central bankers now face acute market fragility, while governments face electorate hostility (along with other shaky governments). With U.S. stocks at or near record highs, my warning that free market Capitalism is today at great risk surely sounds ridiculous.

At this point, the key market issue goes far beyond securities valuation. Too many years of too much "money" chasing too few financial assets have imparted deep structural impairment. Or phrased differently, there has been too much "money" playing the game; too much liquidity and leverage aggressively playing a historic speculative Bubble has wrecked the game. Financial markets have become maladjusted and dysfunctional, although much remains unrecognizable to the naked eye.

Thursday from Zero Hedge: "This Is The Greatest Short-Squeeze In History." The Goldman Sachs Most Short (50 highest short interest names above $1bn) is up 18.8% y-t-d. From May 3rd intraday lows, the GS Most Short has surged 20% - one of the more spectacular squeezes over the past decade. This squeeze saw Tesla, with 39 million shares short, spike almost 100 points.

The Retail Index (XRT) jumped 15% in about seven weeks. Ascena Retail Group (and Fossil) doubled in price. Signet Jewelers surged 55%, Rent-A-Center 55%, Carvana 54%, Wayfair 50%, Tripadvisor 50%, Express 50% and Conn's 50%. Since the May 3rd trading reversal, Food Retail and Department Stores have been two of the strongest industry groups in the S&P500. Footlocker gained 32%, Carmax 28%, Kroger 24%, Macy's 20%, Lowe's 20% and Kohls 18%. Hanesbrands jumped 33%, Under Armour 35% and Ralph Lauren 22%. Twitter surged 48%, AMD 44%, Netflix 33% and Micron 23%.

Squeezes have been spectacular in the mid and small cap universe. Since May 3rd in the S&P Mid Cap 400, Chesapeake Energy, Mallinckrodt and Genworth Financial have all jumped more than 50%. Akorn, Five Below, Southwestern Energy, and Boston Beer gained more than a third. Short squeezes in the small cap space have been even more dramatic.

The speculative melt-up in segments of the U.S. marketplace is the antithesis of the faltering EM Bubble. This week saw indications of strengthening EM contagion. Ominously, the Chinese renminbi dropped 1.0% versus the dollar (offshore CNH down 1.15%), now having given up previous y-t-d gains. The Thai baht fell 1.5%, the Indonesian rupiah 1.1%, the Taiwanese dollar 1.0%, the South Korean won 0.9% and the Singapore dollar 0.6%. China's small cap CSI 500 index sank 5.9% (down 17.5% y-t-d), and the growth/tech ChiNext index fell 5.6% (down 11.6%). The CSI 300/Telecommunications Services Index collapsed 15.7% (down 37.5%).

Elsewhere in Asia, major indexes were down 4.1% in Indonesia, 4.1% in Thailand, 3.8% in Malaysia, 6.2% in Philippines, 2.0% in South Korea, 1.0% in Taiwan, 3.3% in Vietnam and 4.3% in Pakistan. Hong Kong's Hang Seng index sank 3.6%, and Singapore's STI index fell 2.1%. Japan's TOPIX dropped 2.5%. Winning distinction as the most likely prophetic indicator of the week, Japan's TOPIX Bank Index sank 5.4% and Hong Kong's Hang Seng Financials dropped 5.1%.

Indonesian 10-year (local currency) yields jumped 20 bps to a 15-month high 7.43%, and Philippine yields rose 12 bps to a seven-year high 6.31%. Financial conditions continue to tighten throughout EM, though there was some relief this week with rallies in the Argentine peso (4.6%) and Mexican peso (3.1%). The Turkish lira recovered 1.1% ahead of Sunday's election. Notably absent from the EM currency rally list, Brazil's real declined another 1.5% (down 12.6% y-t-d).

It was only back in January that EM was in full melt-up mode - a speculative blow-off right in the face of tightening global financial conditions. With a veritable flood of flows into the $5.0 TN global ETF complex ($100bn inflows in January!), EM was a major beneficiary (EM equities and bonds both saw record inflows in January). Recall that EM ETFs enjoyed record inflows in 2017, with the inundation continuing well into 2018. EM flows benefitted from the U.S. market stumble in early February. Amazingly, EM ETFs were at the top of the ETF inflow leaderboard all the way into early May.

And a Friday afternoon headline from "Massive Weekly Inflows For Russell-Indexed ETFs." And from ETF Trends, "Small-Cap ETFs Big Winners in U.S., China Trade War." The iShares Russell 2000 ETF enjoyed its largest inflow since March. A Bloomberg headline: "Trade War Fears Spur Rotation From Industrials Into Small Caps."

The culminating shot of "hot money" into EM earlier in the year - benefitting both from the U.S. market swoon and the drumbeat of "global synchronized economic boom" - set the stage for today's trouble. So, it's only fitting that cracks at the Periphery of the global Bubble would incite a surge of "hot money" into outperforming U.S. securities markets. At this point, global finance has regressed to one big game of Performance Chase.

Am I the only analyst that views the manic interest in U.S. small caps portentously? I have highlighted the concept of the "moneyness of risk assets" - central bank backstops having nurtured the misperception of safety and liquidity throughout the risk markets. Incredibly, as fissures materialize in the global Bubble, performance-chasing "hot money" now floods into the least liquid corner of the U.S. equities market.

The gargantuan ETF complex has been instrumental in perpetuating this dynamic, intermediating less liquid securities into perceived highly liquid ETF shares. This was the situation earlier in the year for emerging market securities, and it remains the case in U.S. markets. And as the global Bubble navigates a worst-case scenario, it's only fitting that small caps lead the charge in U.S. equities and junk bonds outperform in fixed income. Over generations, market structures evolve and instruments change. Yet amazingly, through it all everyone seems compelled to get all ebullient and hunkered together at major market tops.

June 22 - Bloomberg (Shelly Hagan): "Corporate bond spreads jumped to the widest level in 16 months Friday as large deals flooded the U.S. market and rising trade tensions scared off some investors. Investment-grade bond spreads saw the biggest weekly increase since February as companies sold $43 billion of debt, including $31 billion from Bayer AG and Walmart Inc. alone.
The market was also shaken by escalating trade tensions between the U.S. and its major partners… Corporate bond spreads have been widening since February, when they reached the tightest since before the financial crisis. Fewer foreign buyers, rate volatility and trade tensions are chipping away at investor confidence in the U.S. market, according to Thomas Murphy, a portfolio manager at Columbia Threadneedle… 'A lot of people pushed into our market because of QE overseas. They can now go back to their home markets. Hedging costs have gone up dramatically,' said Murphy…"

Global contagion and tightening financial conditions are making steady headway toward "Core" U.S. securities markets. The Trump administration is bluffing, aren't they? Or is the era of Trump Tariffs and trade war retaliation soon upon us? It's got to be the President playing hardball dealmaker with Beijing - right? Or could a momentous Washington crackdown on China be in the offing? Appearing increasingly vulnerable, China may emerge the cornered pit bull. It was another ominous week. China and Asian Contagion. Widening Italian spreads. But, then again, with a short squeeze in play and only a week or so until the end of a big performance quarter, why be bothered with global market instability or unfolding trade wars… These are deviant markets.

Forecasts of the impact of a US-China trade war fool markets

Economic models ignore that some industries and regions will be hit more than others

Megan Greene

With Donald Trump poised to deliver on his presidential campaign promises to protect American industries with tariffs, the question is: what does this mean for the world economy?

If you plug the actual and anticipated actions of the US into most models, there is an almost imperceptible annual shift in gross domestic product growth in the US, Chinese and global economies. Despite the sound and fury, the steel and aluminium tariffs, $50bn of tariffs on Chinese goods imported by the US and $50bn tariffs on US goods imported by China add up, based on the models, to the economic equivalent of a mosquito bite.

The impact of a trade war is greatest on the countries directly involved in the tariffs and tends to be felt early on. In this case, the models point to an average of one- to two-tenths of a percentage point drag on growth per year for the US and China over a five-year period.

The brunt of the pain is felt in the first two years, and after five years it is virtually undetectable. This remains true even if the additional $100bn of tariffs on Chinese imports that Mr Trump once threatened are included. The results are similar for most forecasts of the impact of a collapse of the North American Free Trade Agreement on US, Canadian and Mexican GDP (though Mexico would be worse off than the other two).

In the event of a trade war, the models suggest a benign — boring, even — global growth picture. The US would still grow well above its potential GDP growth over the next two years because of fiscal stimulus measures from tax cuts and deficit spending.

China’s GDP growth would still decelerate gradually over the next five years. The EU would see its GDP growth converge with its lower potential GDP over the medium-term. Emerging markets would suffer marginally in the short term because of a stronger dollar.

All this is annoying but not a game changer. These predictions, and Mr Trump’s reputation for backtracking on his bluster, help explain Wall Street’s reaction. The S&P 500 is up almost 4 per cent since the administration began talking up trade wars in March.

However, the models largely ignore that the effects of a trade war would hit some industries and regions harder than others. This will become even more of an issue if President Trump follows through on threats to impose 25 per cent tariffs on imported automobiles. The Canadian, Mexican and German auto industries would suffer significantly, even if the overall impact is muted.

These benign predictions are probably flawed in other ways. First, most models are not granular enough to reflect the disruption in global supply chains that would result from tariffs.

These are likely to provide the biggest drag on growth from the tension over trade. Some car parts cross the Mexican, Canadian and US borders several times before they end up in a finished vehicle. If Nafta collapses, would carmakers raise prices, absorb additional tariffs or find ways to procure all of their parts in one country?

Second, it is difficult to model the impact of trade-related uncertainty on business sentiment.

The stalled Nafta negotiations are starting to affect Canada through lost or deferred business investment.

The trade wars could quickly extend into areas that are even harder to quantify. When the US first threatened an additional $100bn in tariffs on Chinese imports, it became clear that China could not respond in kind; it simply does not import enough US goods. But it could hit back by creating more bureaucratic hurdles for US companies operating in China, and interfering with licensing. The impact of such steps would be hard to measure in economic forecasts.

Finally, the Trump administration’s approach has led to the country’s isolation on the global stage, as highlighted by its refusal to sign the G7 communiqué over the weekend. The economic implications of that are impossible to specify.

A cardinal rule in economics says that, while tariffs create winners and losers in any economy, the latter outweigh the former. The gap is known as “deadweight losses”.

Even though econometric models suggest a trade war will not significantly cut global growth, there is a real danger that investors are underestimating the impact of those deadweight losses, and a world with vastly different rules.

The writer is global chief economist at Manulife Asset Management

The Conundrum Of The US DOLLAR

This was the weekend update I provided to members of The Market Pinball Wizard a week ago, which will explain my perspective on the DXY and gold:

I am going to do a larger degree overview of the DXY, since I have not done one in while, and I have been getting a number of questions about it of late. So, if you are following along, please take a look at the attached monthly chart, as I go through the progression of where I think we are in the larger degree time frames.

Back in 2011, we correctly saw the impending multi-year rally developing in the DXY, whereas most others were looking for the dollar to crash. In fact, our target was 103.53, the 1.618 extension from the 73 region, which we exceeded by 29 cents before the market turned back down. And, to put this market call into context, many of you may remember the certainty within the market that the dollar was going to crash due to all the QE thrown at it. Yet, the exact opposite occurred, which clearly surprised most of the market . . . well . . . at least those who were not reading our analysis.

Initially, I had expected the turn down in the DXY from 103.53 to be a 4th wave, which would hold support at the 91.70 region, the 1.00 extension and common target for a 4th wave.

However, when we exceeded that support to the downside, we then overlapped into what I was initially counting as wave 1 off the 2008 lows (now labeled as an a-wave), which then invalidated the standard impulsive structure I was tracking since that time. This caused me to re-assess the entire structure since 2008, which has me viewing the larger structure now as a corrective rally into 103.82.

But, as we know, corrective structures are much more variable than impulsive structures. They take many unexpected twists and turns as they eventually head to their targets. In our case, I still think that target is much lower, and potentially in the 80 region next. Yet, the question is what path will the market take to get down to the 80 region next.

While there are several ways to count the micro structure on the smaller degree time frames, I think the monthly chart does suggest we are approaching not only trend line resistance, but also larger degree Fibonacci resistance. But, until we actually break down below the low struck this past week at 93.19, it is certainly possible that the DXY may attempt to extend as high as the 98/99 region before we set up for an appreciable turn down.

So, I will be looking for clues in the coming week as to whether we are indeed going to see an extension in this 5th wave, as presented in yellow on the 21 minute chart, or indications that the market has begun an impulsive decline to the 80 región.

Now, I know there are some that are still viewing this larger degree monthly chart as more immediately bullish. And, to do that, you would have to assume that the high we struck at 103.82 was actually the b-wave of wave (4) so that you do not have the overlap I mentioned before which would cause an invalidation of the larger degree impulsive structure. However, to do so would suggest striking Fibonacci levels for wave degrees in a manner in which I have rarely seen occur. Moreover, it would suggest proportions between the various waves which also rarely occur. While it is certainly possible and I am keeping that potential in the back of my mind should it increase in probability, I don’t think it to be highly probable at this point in time based upon historic patterns I have tracked through my experience with Fibonacci Pinball.

Lastly, I want to make one more important point about the dollar, and that is in relation to the metals market. Most believe that if you know how the dollar is going to trade, you know how the metals will trade. They assume it will be in lockstep in an inverse relationship. I see that as complete poppycock, and want to show you an example of why I feel as I do.

If you simply glimpse at the monthly chart of the DXY I have presented with this inverse relationship in mind, you would have to assume that the large rally we have seen in the metals began when the DXY topped out at 103.82 and dropped precipitously to 88.25. And, you would clearly be wrong.

Rather, I have highlighted the segment of the DXY movement wherein we experienced one of the strongest rallies the metals have ever seen. Is that really where you would expect it in relation to the DXY action? In fact, you probably cannot find a more innocuous segment of market action within which you would expect the metals to see one of its strongest rallies in many, many years. Moreover, the DXY was not even moving down the whole time when the metals were seeing their major rally.

So, I would like to reiterate a point I have made many times. You MUST analyze each chart on its own. Moreover, if your analysis methodology is unable to accurately predict the movement of a particular chart (the great majority of the time) without needing to look at another market for guidance, I suggest you find yourself another methodology. You see, correlations come and go, and unless you are able identify the point at which the seeming correlation will break, you are only setting yourself up for a potentially bad trade for which you will not likely understand the reason you took a large loss. And, more often than not, it happens at a major inflection point for markets.

Lastly, I want to remind you that, as we were coming into 2016, our analysis was pointing to an upcoming period of time wherein many old “correlations” would likely break down, as many of the charts we were following were looking for major trend changes. In fact, among our predictions for early 2016 was an expectation for a rally in commodities, metals, US equities, bonds and emerging markets all coinciding. So, not only were we able to identify the trend changes in each of the markets, we were able to even identify when the supposed “correlations” that many were following would break down. Yet, notice how no one really discussed this break down in correlations. In fact, it took a year until many in the market began to identify what we warned about a year earlier: Morgan Stanley: "We Haven't Seen A Shift This Severe In Over A Decade"

But, can you imagine the amount of losses created in the accounts owned by those expecting those correlations to continue to hold? Not only did they not have the tools to understand what was happening, most continued to hold their losing positions because they were not able to recognize that what they were relying upon no longer worked.

I hope I made my point. Enjoy the rest of the weekend.


The Trade War’s First Casualties

Investors are likely to get hit before the U.S. and Chinese economies feel the pain, meaning the trade feud could escalate

By Justin Lahart

Soybean near-month futures

Source: FactSet

With their escalating trade feud showing little evidence of hurting their economies, the U.S. and China aren’t close to backing down. Investors may get squeezed between the two giants before one of them cracks.

The U.S. has already put tariffs on steel and aluminum and will add a 25% tariff on $50 billion in Chinese imports starting next month. China is matching the U.S. tariff for tariff. These actions have sent U.S. steel prices higher and U.S. soybean prices lower. But the broader economic effects so far appear negligible.

That could change soon. The administration is set to announce restrictions on Chinese investments in the U.S. next week, and Mr. Trump has threatened to retaliate against China’s retaliation and put tariffs on more godos

The administration thinks that China has more to lose in this dispute, since China runs a big trade surplus with the U.S. The real issue isn’t who has more to lose, but how long each side can bear the pain. This is where it could get dangerous for investors. Worries about what could come next weighed heavily on shares of companies that depend on China for business, such as Caterpillar and Boeing , last week.
The next round of tariffs against China, if it comes, will likely hit consumer goods. As a result, it won’t affect just Chinese producers, but also U.S. retailers (if they absorb the cost increases) or U.S. consumers (if the price increases get passed on). This is particularly true for the many goods dominated by Chinese production, such as cellphones and footwear, where the ability to find other sources is limited. A lot of those China-made goods are produced by U.S. multinationals, so they, and their investors, will share in the pain.

China could also make things difficult for U.S. multinationals by stepping up regulations against them or encouraging Chinese consumers to avoid their products. And it has ways to blunt the impact of U.S. trade actions, such as supporting affected Chinese exporters and lowering the value of its currency.

China’s leaders may not back down until there are serious economic or social consequences from the trade fight. The government has the ability to control the Chinese stock market, and leaders don’t have to worry about elections. The White House does have to pay attention to the stock market, since sharp declines inevitably stoke economic fears. And it has midterm elections coming up.

Until one of those tripwires gets hit, the trade fight could get more pitched, leaving investors to absorb the blows. It could be an interesting summer.

The Asia-Pacific Gender-Parity Imperative

Oliver Tonby , Anu Madgavkar

Japanese Prime Minister Shinzo Abe poses with members of his cabinet

SINGAPORE/MUMBAI – Gender equality offers a sizeable economic opportunity for any country. A government that hopes to achieve strong growth without tapping into women’s full potential is essentially fighting with one hand tied behind its back.

In fact, new research from the McKinsey Global Institute (MGI) finds that Asia-Pacific economies could boost their collective GDP by $4.5 trillion per year by 2025, just by accelerating progress toward gender equality. That would be the equivalent of adding an economy the combined size of Germany and Austria every year. The opportunity is especially large for India, where GDP would grow by as much as 18%.

Gender equality contributes to growth in three ways. According to MGI, 58% of the gains in the Asia-Pacific region would come from raising the female-to-male ratio of labor-force participation, 17% from increasing women’s work hours, and the remaining 25% from having more women working in higher-productivity sectors.

But equality at work goes hand in hand with gender equality in society. While there have been notable advances in girls’ education and health, women across the region remain subject to traditional attitudes that define their primary role as being in the home. As a result, women often lack access to the financing needed to start or expand a business, and to the training needed for the modern labor market.

To be sure, tackling gender inequality is a complex, long-term challenge that requires broad social engagement. But there are five areas in the Asia-Pacific region where governments, companies, and non-governmental organizations could start to make meaningful progress.

The first is women’s participation in higher-quality jobs. While women currently account for half of the region’s population, they contribute just 36% of its GDP. But GDP does not account for the unpaid work that they do in the home, which could conservatively be valued at an additional $3.7 trillion of economic output.

Globally, the value of women’s unpaid work performed is three times higher than that of men, whereas in the Asia-Pacific region, it is four times higher. In some cases, the time that women spend on such tasks may be a personal choice. But true equality of opportunity eludes too many women who want to earn money outside the home.

This problem can be addressed in a number of ways, starting with more flexible workplace policies, affordable childcare, and expanded skills training, particularly in STEM fields (science, technology, engineering, and mathematics). Moreover, in countries such as India and Indonesia, investment in infrastructure and transportation can reap dividends by connecting more women to productive work opportunities.

A second priority is to address women’s underrepresentation in business leadership circles. Globally, there are fewer than 40 women for every 100 men in leadership positions (including in politics), and in the Asia-Pacific region, that figure falls to around 25. Though the share of women sitting on company boards across the region did double between 2011 and 2016, from 6% to 13%, it remains far too small.

Breaking the Asia-Pacific region’s glass ceiling will require dismantling several barriers, including cultural expectations that women should prioritize childcare over their careers, a lack of suitable or affordable childcare, unconscious bias in the workplace, and a scarcity of role models and sponsors. But, most critically, too few companies in the region offer flexible working options.

A third priority is to improve women’s access to digital technology, which can open countless economic (and social) doors – including into finance. In fact, women have already begun to thrive in some of the region’s burgeoning digital industries. In Indonesia’s largest online marketplace, women-owned businesses account for 35% of total revenues. And in China, women found 55% of new Internet businesses.

Building on these successes will require more training for women in the use of digital technologies. In Asia’s booming Internet market, digital technologies could be a double-edged sword: If the gender gap is not closed, women will be left on the sidelines of the technology-driven revolution sweeping the region.

A fourth priority is to change social attitudes about gender roles. The traditional view that women belong in the home is arguably the largest barrier to women’s advancement in both society and the workplace.

The World Values Survey’s findings on this issue between 2010 and 2014 are revealing. Across the Asia-Pacific region, 44% of respondents said that men make better leaders than women. And 70% of Indian respondents – compared to just 21% of Australian respondents – agreed with the statement: “When a mother works for pay, the children suffer.” Leaders in government, business, the media, and individual communities need to work together to change such views.

The final priority is to pursue more regional collaboration to achieve gender equality. Public and private initiatives tend to work best when they are tailored to specific communities and countries. But regional partnerships that are established around shared goals could give national and local efforts more momentum.

For example, Asia-Pacific countries could come together to provide more financing for gender-equality initiatives, and to encourage more gender-based investment and budgeting. And, more broadly, governments could do more to share knowledge about which approaches work best.

The Asia-Pacific region is home to some of the world’s fastest-growing and most innovative economies. It is forging an exciting new future, and assuming an ever-greater global role. Yet women are not playing an equal part in this drama, as many leaders have come to realize. Now is the time to accelerate progress toward gender parity, and to women’s power to deliver growth and improve social wellbeing.

Oliver Tonby is McKinsey & Company’s managing partner in Southeast Asia and the co-leader of the firm’s All-In initiative, which develops and shares innovative work practices that promote gender inclusivity and women’s leadership.

Anu Madgavkar is a McKinsey Global Institute partner.