Executive Summary

This year has unarguably been one of extremes. Extreme pessimism and almost sociopathic optimism. Traders, investors, corporate hedgers, financial authorities alike have been alternately unnerved, terrified, relieved and ecstatic.

In our opinion there are numerous indicators which signal danger to financial market actors who are currently oblivious to the risks that are growing more acute with each passing week.

Positive sentiment towards equities is practically at unprecedented levels. Valuations are at positive extremes which largely ignore the significant economics risks, which persist in the wake of the economic fallout from Covid-19. Let us be clear. There is little to no chance that we will experience a ‘V’-shaped recovery.

Dollar weakness has been a thematic since mid-March. The belief that this will be a perpetual condition is merely lazy extrapolation. By the same token Euro strength and the sentiment accompanying it is also at an extreme.

Given the raft of insoluble risks facing the Eurozone, chronic economic weakness, unsustainable debt for the Club Med countries, increasingly partisan and fascist politics we do not detect a strong case for further and extended strength.

Our note sets out a number of arguments for why we believe that the markets are setting themselves up for a fall of significant proportions in the next 3 months.

Elevated volatility will be the order of the day. As South Africans, we are used to encountering flashing red lights at disabled traffic intersections. Contrary to local popular belief a flashing red does not mean speed up and hope for the best.

It is time to consider your positions, exit strategies and hedging alternatives. We believe that we are going to be tested, so it is best to be prepared.

A Case in point

 

Red Lights are flashing – “Canis canem edit”

The Federal Reserve in the United States and its peer central banks around the world are blowing bubbles. Despite their denial that a bubble cannot be detected before it bursts we are of the absolute opinion that market bubbles are obvious all over the globe.

The most obvious is the tech-laden Nasdaq and the mega-cap stocks, such as, Apple, Amazon, Facebook, Google and Tesla.

The chart below illustrates the lengths to which the Fed and the ECB are going to inflating their Balance Sheets in order to provide cost-free to the global economy.

Although it is in neither of their respective mandates to goose up the equity markets, (their mandates specifically refer to full employment and price stability) their repeated mention of equity market performance is proof positive that they are failing on all other fronts.

As side issue market commentators have made comment on recent Dollar weakness. Their assertion is that the Fed is judged to be more ‘dovish’ than the ECB. That could not be further from the truth as the ECB are already below the ‘lower bound’ of zero interest rates that Jerome Powell was mumbling about at Jackson Hole.

Many Central Bankers are proving to inveterate incompetent liars. They have run out of ammunition and out of ideas.

The chart below illustrates this principle perfectly. The Fed’s intention when pumping up their Balance Sheet, USD 7 trillion and counting is that the commercial banks will take advantage of further available lending capacity.

The evidence points to exactly the opposite. As the Fed has repeatedly increased its Balance Sheet over the last decade, in aggregate the banks have chosen to leave that additional lending capacity on deposit with the Fed.

Even though the banks are only receiving 0.25% on those deposit funds, they have collectively made the judgement that not enough has been done to justify a far riskier asset portfolio. This is the very essence of collective Central Bank failure over the last decade.

Additional liquidity has been applied most recognisably in the inflation which has taken hold of the equity markets repeatedly over the last decade, but most significantly in the last 6 months.

 

Bond Markets don’t believe a word


A comment from the Financial Times stated that 10-Year and 30-Year yields are surging in response the Jackson Hole statements from Jerome Powell. They should know better!

The bond market is doing nothing of the sort as there has been no significant moves since early May.

If the market judged that the Federal Reserve was going to be successful anytime soon in reflating the economy then rates would surely be rising.

 

Credit Markets shows trust has limits

Credit spreads, particularly BBB & AAA have slowed their compression. When credit spreads compress it implies that the market is becoming more comfortable with the credit risk posed by lower rated credit entities.

In contrast to equities, credit is still pricing more risk than was the case prior to last February. This is particularly true of the BBB cohort, but tranches continue to be more circumspect than the equity market.

Equity Markets in Bubble

            Case-Shiller CAPE (Expensive on the basis of 140 years of data)

As we write this note the equity markets (S&P500) are currently experiencing their worst shellacking in a single day since June 11, which saw a 6.00% sell-off from top to close. The top today was 3584 and is now at 3440, a loss of 4.10%.

Prices appear to be overestimating earnings – no doubt the Federal Reserve are happy. They may not be so pleased with themselves by the end of the year.


A possible explanation for the VIX decoupling from the SP500 market (usually the two are strongly and negatively correlated) is that retail market purchasing of single stock and index call options have overwhelmed the conventional practice of fund managers who sell call options as markets move higher.

This has placed a bid under the market which in other circumstances are typically well offered.

Added to this there has been substantial buying of SP500 index put options as market professionals seek to protect their portfolios.


The VIX Index measures the 30-day expected volatility of the S&P 500 Index. The components of the VIX Index are at- and out-of-the-money put and call options with more than 23 days and less than 37 days to a Friday SPX expiration date. The VIX Index is intended to provide an instantaneous measure of how much the market expects the S&P 500 Index will fluctuate in the 30 days from the time of each tick of the VIX Index.

CBOE® Volatility Index Calculation Methodology


If market actors are both out the money calls and puts with equal facility the usual relationship between the VIX and the SP500 index breaks down.

The imminent risk posed by this behaviour is that there are no natural buyers in the market. Everyone is long! In the light of today’s events the VIX has surged to 31.60% – a level last seen in mid-July. 

Currencies

We remain bearish on the Rand, despite many calls for the currency to be priced at much stronger levels by the end of 2020. There are many reasons why we are bearish the Rand, but the major ones are as follows.

Government finances are an unmitigated disaster. The market both local and foreign have largely run out of patience and confidence that the government has the will or wherewithal to significantly make the necessary changes. Debt-to-GDP is anticipated to reach 85.00% by 2022.

Since the middle of March a large cohort of ‘risk-on’ assets have made significant runs to the topside. These include equities, mega-tech in particular, Gold, Silver, EUR, AUD, GBP and to a more limited extent that is true of Crude Oil and Credit products.

At the same time the Rand, and for that matter other emerging market currencies have not made any recoveries that engender confidence for the future should a risk-off situation occur.

The Turkish Lira is pitiful. Most of the reasons for its recent collapse are self-inflicted wounds caused by increasingly authoritarian and irrational decision-making.

The Brazilian Real is exposed to significant internal political discord.

The Rand is vulnerable to both domestic politics & international investment indifference.

The red lights are flashing. We believe the time is now to examine all investment and trade positioning.