"And I beheld, and heard the voice of one eagle flying through the midst of heaven,
saying with a loud voice: Woe, woe, woe to the inhabitants of the earth....
[Apocalypse (Revelation) 8:13]

Sunday, March 25, 2018

(ECONOMIC CRISIS) Morgan Stanley: “We Can Already See the Writing on the Wall”

(ECONOMIC CRISIS) Morgan Stanley: “We Can Already See the Writing on the Wall”

Last Sunday, just before the Facebook plunge opened the selling floodgates for tech stocks (as also previewed here last weekend in “FANG + Apple Now Account For A Quarter Of The Nasdaq, And Some Are Getting Worried“) and the broader market, Morgan Stanley warned that “something was different this year“, specifically pointing out that as a result of escalating trade tensions and a global economy that is rolling over, the market may be priced beyond perfection, and that “2018 earnings expectations may be too high“, which however was good news for vol-starved hedge funds (which just suffered their worst month since January 2016).

When considering what that means for markets, it feels less like ‘morning in America’ than ‘happy hour in America’. In that sense, we’re pushing back on the notion that US policy actions have meaningfully extended the market cycle, instead arguing that markets have already largely reflected, and are currently pricing in, the benefits they delivered. Hence, we see more volatility to navigate as we work through the other side of the policy agenda. In US equities, for example, tax benefits are clear in their scale, but their use is murky. The nearly 8% move in 2018e EPS following the passage of tax reform aligns with our US equity colleagues’ estimate for full potential earnings benefit for the S&P from tax reform (~7.6%), leading us to believe that estimates are baking in a full flow-through of tax reform.
Morgan Stanley doubled down on the bearishness the very next day, when on Monday its chief US equity strategist Mike Wilson said that it is likely that the highs for the year are now in, that “when we look at our internal data combined with industry flows and sentiment, we think there is a strong case that January was the melt-up, or at least the culmination of it“, that “peak sentiment/positioning is behind us” …

… even as profits – the primary driver behind the recent market rally – peak: “earnings expectations might need to come down if we start to see some evidence of lower margins since consensus forecasts assume no operating margin degradation. That is another reason why we think the S&P 500 makes its highs for the year.”
What does Morgan Stanley think now? Below we present the latest take from Michael Wilson, who released the following Sunday Start report ahead of this week’s trading, which appears set for more volatility if only on purely statistical grounds – as some have noted, since 1990 when the S&P has lost more than 1.5% on a Friday, Monday saw a lower low 97% of the time, or on 90 out of 93 occasions.
From Morgan Stanley’s Michael Wilson:
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Cruel to Be Kind
Just two short weeks ago, investors were celebrating the remarkably strong US jobs data with few signs of inflation. It was, in fact, the ideal combination for risk markets with many proclaiming “Goldilocks is alive and well!” Indeed, on the day of the release, the S&P 500 was up 1.74%–the biggest single day increase since the day after the US Presidential election in November 2016. Global markets celebrated too with every regional equity market rallying sharply that Friday or the following Monday for those that were closed when the data were released.
But, that excitement was quickly met with disappointing price action over the following days. There was no follow through—a classic sign that the good news had exhausted rather than uncovered new buyers. It also coincided with the top end our 2650-2800 trading range in which we have been suggesting the S&P 500 would be stuck until the next positive catalyst could arrive—1Q corporate earnings.
We also pointed out in our Weekly Warm-up on March 12th that the market wasn’t properly focused on two very visible risks over the coming weeks—The Fed’s March meeting and the potential escalation of trade tensions initiated with the US administration’s steel and aluminum tariffs. Fast forward to today, and the good news is that the market is now fixated on both—especially the higher risk for a potential escalation of trade tensions—and we have quickly fallen all the way back to the low end of our trading range.
Our nearly 30 years of experience often makes us wonder if markets are really designed to play with our emotions. At the same time, we can’t help but think that our firm’s 2018 outlook for a “Tricky Handoff” is playing out to a T. To recall, this was very different from our much more bullish view in 2017 and out of consensus at the time of publication. The reality is that many of the things we expected this year are happening—higher volatility across rates, FX and equity markets, tighter financial conditions, risk adjusted underperformance of credit relative to equities, contracting equity valuations in the US, narrower breadth, and a peak in economic leading indicators and data surprises.
We have yet to see some of the more inauspicious things we expect later this year—including a peak in operating margins and y/y EPS growth in the US and perhaps other regions as well. However, we can already see the writing on the wall and are highly confident this becomes obvious to the masses by the end of 3Q, or 4Q at the latest. This suggests more tough times for equity investors, but we doubt it will be that easy as market tops tend to be particularly exhausting.
In the near term, we think global equity markets will eventually settle down about the Fed’s slightly more hawkish path of tightening they signaled last week and the elevated risks of a broader trade dispute. Specifically, the dot plot is slightly steeper but not enough to upset the apple cart in the next few months/quarters. Our fixed income strategists have been highlighting rising funding costs—led by LIBOR—as a near term risk, but they also expect reduced supply in April and a subsequent fall in these rates. This should provide another positive catalyst along with corporate earnings.
As for the risk of a broader trade dispute, we think the odds here remain low as well. We note that so far, the size of the tariffs announced—25% on up to $50-60B—amounts to just $12-5-15B in actual tariffs. More importantly, Europe has been exempted much like the President exempted Canada and Mexico from the steel and aluminum tariffs a few weeks ago. This all suggests these shots across the bow are being used more as negotiating tactics. China’s response, so far, is tepid with tariffs affecting just $3B of traded goods with the US.
While I acknowledge most disputes are typically started unintentionally, I also believe the tail event will be over discounted in the near term relative to the actual near term impact on earnings and growth. In addition, these kinds of events do tend to ebb and flow and right now it’s ebbing sharply which means it’s getting priced; and just like markets top on good news, they bottom on bad. There is also significant valuation support at current prices so we stick to our guns that higher price highs for the year are still likely in 2Q/3Q for US equity markets as forward earnings move higher; but it should continue to narrow, we expect leadership to get more defensive and the S&P 500 should likely end the year not far from current levels as earnings growth expectations decelerate from the evolution of the business cycle, tougher comparisons and tighter financial conditions.

Deutsche: "We Are Entering An Environment Where Everything Wants To Sell Off"

The market responded with confusion to last week's Fed statement, which initially was interpreted as more dovish than expected in anticipating only 2 more rate hikes in 2018 sending the S&P spiking, only for a more hawkish narrative to gradually take over, facilitating last week's violent selloff, as the market focus shifted to the hawkish path of tightening signaled by the Fed dots. Even here though, the dot plot was slightly steeper but hardly enough to cause sleepless nights, even as Jay Powell repeated that the Fed will remain data dependent.
But perhaps the market was mostly taken aback by (lawyer) Powell's straight-to-the-point talking style, answering questions directly and efficiently, avoiding the coma-inducing verbal diarrhea that defined the press conferences of Janet Yellen (in fact, Powell's first presser set a record for shortest quarterly news conference by Fed chair), and generally eliminating much of the two-way confusion that markets had welcomed in the past, as it had provided a welcome buffer courtesy of Powell's predecessors saying so much fluff (and nothing of substance) that it paradoxically "justified" the market's every opinion (and resulted in such bizarre outcomes as record easy financial conditions amid several consecutive rate hikes).
What does the Fed's changing narrative mean? According to Deutsche Bank, two things.
First, in analyzing the market's response to the Fed statement, and especially the aggressive reaction in the rate vol space, Deutsche's resident semiotic and post-modernism analyst, Aleksandar Kocic - who has for the past year explained virtually every market move in the context of the bi-directional information pathway between the Fed and market, a trope he picked up by reading Lacan (the "mirror stage"), Derrida, Foucault and other pomos - who wrote that last week signaled a more hawkish Fed, "which suggests that monetary policy could become potentially disruptive for markets – after years for hyper-stimulative monetary policy, where everything used to rally, stimulus unwind is taking us into an environment where everything wants to sell off."
While it is hardly news that the Fed is now in balance sheet roll-off mode, if only until stocks tumble at which point the Fed will resume easing, Kocic warns that this hawkish shift "is now happening at accelerated pace and along the way creating new pattern of vulnerability across the markets."
It also leads to an important new question:
What is the hierarchy of vulnerability in this context -- which market sectors are going to be the more vulnerable than the others?
The practical, market implications of this "hawkish shift" narrative are a continuation of what we observed in the aftermath of the vol explosion in early February: a bifurcation of relative vol across asset classes. According to Kocic, the market still seems to see rates (and duration in general) "less vulnerable than equities." He explains furter:
This sentiment is reflected through enthusiasm for rates volatility, selling of the covered puts in credit, and equity/credit vol switches. The underlying logic of defensive credit trade is that scaling down on credit is taking place on the back of view of its gradual widening. Short credit vol overlay compensates for the loss of carry, but remains risky in case of violent widening. This is in tune with an implicit belief that further compression in credit is likely
to be limited and orderly
. The latter trade, financing equity vol with credit vol, is a complement of the credit view with high vulnerability of equities. Based on the last week’s finale, rising geopolitical risk and trade tariffs are only going to reinforce this hierarchy of vulnerability as well as provide support for bonds which, when coupled with a more hawkish Fed, could add more flattening bias.
Here it's also worth noting that another, parallel shift is taking place in terms of the market's response to newsflow from the political arena (of which Donald Trump has made sure there is plenty). As Deutsche Bank has repeatedly commented for the past year, markets have learned to discount the effects of political volatility "and growing political entropy." Ironically, noisy politics "was interpreted as an obstacle to ability to produce consensus and legislate changes." In other words, political uncertainty became synonymous with status quo and, as such, remained bearish for market volatility.  The paradox is that the more D.C. squabbled, and the more Trump got into hot water, the more traders and algos saw this as validation of the status quo.
And while, to a large extent this still remains the case, "with the escalation of political risks new modes of market vulnerability are emerging at the intersection of politics and policy," according to Kocic. Translated into English, this means that - as last week showed - outbursts from Trump are once again shaking markets, especially when it comes to the developing "trade war" narrative.
All this combined, pushes vol away from rates and into equities, and argues in favor of outperformance of equity vol over credit, "with a possibility that further escalation of political risk taking rates deeper into gamma bearish territory" as traders dump risky assets and buy such relative safe havens such as credit and duration (at least until China retaliates by announcing it will halt or sell TSYs).
Indicatively, we have already seen the onset of this pattern of repricing: this is shown in the two figures below, the first of which compares rates and credit vol...

... and the second looking at the repricing higher in equity vs credit vol.

So should one just enter into a "crash" pair trade, of selling rates vol and buying equity vol? Sure, just be careful for a potential whiplash in credit vol: as Kocic concedes, while in the near term, an aggressive/hawkish Fed is seen more disruptive for risk than for rates or credit, "that could change in the long run" especially if China, that holder of $1.3TN in TSYs decides to send a powerful message to Trump as to who is really calling the shots in the incipient trade war.
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There is a second "narrative" to emerge as a result of last week's hawkish FOMC: as Deutsche explains, "last week’s FOMC meeting can also be interpreted as an attempt of the Fed to take control of the process of rates market normalization. This is the alternative narrative." This particular narrative is one of substantial latent risks, as until now, the Fed was willing to let market's dictate the normalization process, even if it means a dual paradoxical outcome whereby the tightening after several rate hikes lead to higher risk, while yields rose in the context of an acute, and recessionary, curve flattening.
It is this nonsensical reaction to "normalization" that the Fed is hoping to "normalize" in turn, although in doing so it risks losing control of the entire process.
As Kocic notes, for more than seven years after 2008, bear steepeners and bull flatteners were dominant modes of the curve -- while short end hardly moved, back end articulated response to market shocks.
These two modes of curve response were effectively a referendum on success of stimulus. However, one should keep in mind that these two curve modes are highly unnatural. Normally, shocks arrive at the front end of the curve and, since rates are mean reverting, their effect attenuates with time making them less visible at the back end. This is why in normal times bull steepening and bear flattening represent dominant modes of the curve. In that context, bear steepeners and bull flatteners are a reflection of explosive rates dynamics (negative mean reversion) – front end shocks amplify with time. The explosive process does not present a problem as long as the front end is in a “sleeper” mode, but as soon as it starts moving – when rate hikes commence – the risk of the long end getting unhinged becomes a problem.
This "breathing" of the curve between Bear Flattening (BeF) and Bear Steepening (BeS) is shown schematically below:

It is this curve "breathing", which directly impacts downstream risk assets, that the Fed has been trying to control since the beginning of rate hikes."
As a consequence of this effort, "every violent bear steepener has been  encountered with an appropriate response of the short end of the curve causing a gradual flattener in such a way to shift the action closer to the front end. This is the “breather” mode of the curve. Effectively this was an attempt to recalibrate rates market and remove the risk of “exploding” back end. As a result, with time the bear steepening eruptions became less volatile and more limited arguing in favor of Fed’s success in their effort.
However, as a result of the changing narrative, and especially if indeed Powell wants to regain curve control over the recent resumption in flattening, the Fed risks jeopardizing its "credibility" of being able to control the curve.
In any case, according to Kocic, what this boils down to is that the Fed continues to supply convexity to the market, albeit in different form then before (rates range during QE or transparency and dialogue with the market in the first two years of rate hikes). It is in this shift that "the risks are being flexed."
In terms of market mechanics, this means that as monetary policy remains negatively convex to higher rates due to tail risk of the bond unwind trade, "the Fed’s supply of vol is effectively financed by increasing their negative convexity exposure."
In practical terms, this means that in a dramatic regime change, one which we hinted at in February when we first relayed the new Fed chair's stunning philosophical admission that "the Fed has a short volatility position", Powell now appears to be abandoning the problem of facing the tail risk by being behind the curve and is instead pushing rates higher themselves, or as Kocic summarizes, "instead of risking that markets raise rates" - a process which can quickly spiral out of control - "are taking control of that process."
This is where the biggest risk emerges:
And although locally vol could stabilize, stakes are getting higher with time and the question of whether the Fed would be able to successfully fine-tune its exit and take control of rates normalization without causing major disruption remains open.
However, a few more big, sharp drops in the S&P and there will be no question what the market thinks of the Fed's sharp regime change, and its chances of successful execution, especially if what Deutsche said earlier on, namely that "stimulus unwind is taking us into an environment where everything wants to sell off" remains the case.