Observations by David Robertson, 8/19/22
As we coast in to the end of the summer, news flow is slowing down, trading volumes are slowing down, and it is exactly the kind of nice, quiet environment central bankers like to have before their big get-together in Jackson Hole at the end of August. As always, let me know if you have questions or comments at firstname.lastname@example.org.
It was a fairly uneventful week with much of the attention placed on the release of minutes from the FOMC meeting three weeks ago. Adam Neumann was back in the news and meme stocks continued to do well, but the action was fairly isolated. In short, it was a pretty boring week for markets.
A good chunk of commentary has been focused on how long the summer rally might last. To that point, one relevant date is today, August 19th, because it is an options expiration date. As the graph by SpotGamma below shows, a large volume of calls roll off today.
This matters quite a bit partly because options volume has become so big and partly because dealer positioning for those options can dictate the rhythm of trading. As a result, “opex” dates often mark changes in market tenor.
Twitter Spies, Cash Tornadoes, and Silicon Sanctions ($)
A San Francisco jury has found Ahmad Abouammo guilty of spying for the Saudi government by routinely using his position at Twitter to collect and then share information associated with accounts that criticized the kingdom and its senior leaders, reports the Wall Street Journal.
The three men were able to access and share the personal information of more than 6,000 Twitter accounts in 2015. When confronted by Twitter leadership, Alzabarah—also a Saudi citizen—fled the United States, as did Almutairi, leaving Abouammo on his own. The FBI has issued arrest warrants for both men.
But one thing should be very clear, this isn’t just about people’s emails and phone numbers being improperly shared—this data was being collected so that critics of the regime could be spied on, intimidated, or disappeared like Khashoggi.
OK, so I will admit that I have not trusted major technology or social media platforms from the early days. I will also admit that my radar is up since Salman Rushdie was viciously attacked at what was supposed to be a nice, quiet literary affair - and almost no media is talking about it. But this report from Klon Kitchen came across to me as something considerably less like innocent hijinks and rather more as a deeply concerning vector of personal security.
It is one thing that companies don’t do enough to protect personal information and law enforcement doesn’t do enough to come down hard when obvious lapses present themselves. It’s another thing to so easily allow employees to access that information and allow it to be used for nefarious purposes. Regardless, this incident certainly reframes the potential of social media in a much darker light.
Beijing is tanking the domestic economy — and helping the world ($)
But China’s internal troubles have an upside: lower demand for imported metals, energy, food and capital goods is alleviating inflationary pressures in the rest of the world. For the first time in decades, the country’s enormous trade surplus is a boon for workers elsewhere.
The result is extra supply for the rest of the world. Iron ore, metallurgical coal and copper are essential materials for making construction steel, household appliances and electrical wiring. Before the recent downturn, China consumed about two-thirds of the world’s iron ore and metallurgical coal and about 40 per cent of the copper. Lower demand means lower prices.
For many years the exceptional yearly growth in China was reason enough to get positive on commodities and construction equipment and plenty of other things. Not only was the country consuming large portions of global supply, it never seemed to stop growing.
Until now, that is. Economic numbers coming in from China continue to indicate weakness. Just like it was hard to overstate the impact of China on global markets on the way up, so too is it having a big effect on the way down. As Matt Klein puts it, “China’s domestic weakness is crushing demand for goods from the rest of the world.”
In general, this is quite helpful for the rest of the world. A much lower trajectory of demand in China is making constrained supply conditions for many products and commodities much more sustainable than they otherwise would have been. Of course, the other side of the coin is judging the supply/demand balance of many commodities has become much more difficult because it is dependent on Chinese policy. Suffice it to say, China remains an extremely important variable in the global equation.
Case in point: It looks like China has been building oil inventory which has kept prices of oil elevated. If China’s steady-state level of oil consumption is lower than its recent level of imports, it is fair to expect those imports to slow down - which would lower global demand for oil.
The question for the fall is which will have the bigger effect on global supply/demand balance - China reducing it’s demand or the eventual end of SPR releases from the US that artificially boost supply?
It is very hard for me to not see the SPR releases as a baldly political initiative designed to lower gas prices ahead of midterms. Insofar as that is the case, prices could rise a lot after the ploy is over. However, China is the 800 pound gorilla of commodity markets and if it slows down, which looks likely, it will be felt. This promises to be an interesting ongoing drama with the potential for big moves in either direction.
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Reverse Engineering QT
Many folks are unimpressed with the effect QT [quantitative tightening] has had on the FED’s BS [balance sheet] thus far. Some are accusing the FED of lying about conducting it altogether. Others accusing it of being too slow. Universally though, these folks don’t seem to understand its mechanics. This post seeks to explain them and demonstrate that the FED is executing QT as it said it would.
Plus, since the bulk of the MBS [mortgage backed securities] purchases takes 1-2 months to settle. There is a significant lag. As a result, almost all the MBS adding to the SOMAH in June and July was actually purchased prior to the start of QT. But that is all passed now so MBS BS reductions should reflect 17.5b in August. But do note that there will be a similar lag for when QT ramps to a 35b cap, will just reflect a 17.5b drop in September and October as the MBS purchased in July-Aug settles.
This piece is fairly technical but addresses an important issue and contains an important insight. The issue regards the QT program which the Fed started in June. I have tried to be clear that I believe this will be a far more important driver of markets than Fed funds rate increases. The reason is the reduction of the Fed’s balance sheet will reduce liquidity. Lower liquidity will force the sale of assets like stocks and bonds in order to purchase new issuance of bonds. This will drive prices lower.
Despite the incredibly important ramifications, investors seem nonplussed by this threat. Partly this is due to lags in implementation which have deferred the full force of consequences. Partly too, investors are extremely skeptical the Fed will actually act in a way that threatens stocks and bond prices. As a result, the attitude seems to be QT is a nothing-burger.
Underestimating QT is a mistake. As John Comiskey highlights in this piece, balance sheet reduction will become much more apparent over time. As it does, so too will belief in the Fed’s mission to reduce liquidity become apparent - and that will not be good for asset prices.
The Marginal Buyer
Treasury buybacks would be a powerful tool that could ease potential disruptions arising from quantitative tightening. The Treasury hinted in their latest refunding minutes of potential buybacks, which is when Treasury issues new debt to repurchase old debt. Buybacks can be used to boost Treasury market liquidity, but more importantly also allow Treasury to rapidly modify its debt profile. By issuing bills to purchase coupons, Treasury could strengthen the market in the face of rising issuance and potentially structural inflation. An increase in bill issuance would also facilitate a smooth QT by moving liquidity out of the RRP and into the banking sector.
This is a classic story of good news and bad news. So, the good news is the Fed is finally starting to reduce its balance sheet that has ballooned from QE in response to the GFC and the pandemic. The bad news is that is extremely hard to do without creating a “taper tantrum” or some other “problem” than can cause the market to seize up.
The good news is monetary authorities are on the case by scoping out a buyback program that could “improve market liquidity” for less liquid Treasuries and also strengthen liquidity in the banking sector. The bad news is the capacity of the program is limited. Essentially it only modifies the way the fuse burns on the debt bomb; it doesn’t stop the fuse from burning nor does it eliminate the bomb.
One major takeaway from this discussion is it reduces the chances that some kind of market breakage will cause the Fed to quickly and decisively switch from tightening to easing, at least in the near term. As a result, buybacks can buy the Fed some time, but they can’t solve the underlying problem.
Finally, with the release of the FOMC meeting notes on Wednesday, Wang offered his assessment in the tweet below. He thinks the Fed might be getting cold feet with its tightening program. If so, that would bring into play Bob Prince’s scenario of a Fed toggling back and forth between growth and inflation that I mentioned just last week.
The Structural Drivers of Investment Returns
The declining rate of U.S. structural growth reflects a progressive slowing in trend productivity driven by decades of weak net domestic investment as a share of GDP, coupled with progressive slowing in U.S. population growth, amplified by a demographic shift as aging baby boomers exit the labor force.
That pattern [of a steeper slope of the relationships between valuations and returns since 1995] [sic] actually a “tell.” It’s not the relationship between valuations and returns that has shifted up in parallel. Rather, it reflects a sequence of bubbles since 1995 that front-load returns, and then resolve with negative returns, as usual.
I don’t like to belabor these points because after a while people just tune them out, but they are really important points. First, all three of the key drivers of stock returns are trending downward. At the same time, valuations are exceptionally high. The net result, according to John Hussman, is an expectation the S&P 500 will “lose an average of about -2.9% annually over the coming 12-year period.” This is meaningful - and still ignored by a lot of investors.
Second, the pattern since 1995 has been for stock returns to be front-loaded. This means there are smaller windows to buy stocks at reasonable prices. As a result, it is harder for younger investors to reap the same kind of benefits from investing.
The Passive-Ownership Share Is Double What You Think It Is
We find that strict end-of-day indexers held 37.8% of the US stock market in 2020. There are two important takeaways from our analysis. The first is quantitative. Our 37.8% estimate is more than double the widely accepted previous value of 15%, which represents the combined holdings of all index funds. What’s more, 37.8% is a lower bound. The true passive-ownership share for the US stock market must be higher. All this implies that index inclusion is the single most important consideration when modeling portfolio holdings.
The second important takeaway is methodological. The rise of passive investing has been one of the most talked about developments in financial markets. There is now an entire theoretical literature which aims to understand the consequences for price informativeness and investor welfare. We think it is noteworthy that, when calibrated to the data, none of these models recognized that the assumed values for the US passive-ownership share were off by a factor of two. The size of this blind spot poses a real problem for anyone trying to use these models to make policy decisions.
This is an academic paper so be forewarned, but it comes with some important insights about the market. For one, by analyzing trading activity around index changes, it finds that passive share is more than twice the proportion assumed based on reported index AUM. This is a point Mike Green has been making for some time.
In short, there is a lot more money being managed passively than previously thought (by many at least). In fact, even this is probably a low estimate as the methodology focused on trading activity on the day changes were made to indexes, even though a number of passive funds have more latitude on the timing of such trades.
A couple of important consequences arise from such concentrated index investing. One is it calls into question much of the research that has been conducted on financial markets the last ten to twenty years. The reason is that research assumed lower amounts of passive share. All those conclusions must be reassessed.
Another consequence is market prices have become much less informative. Since index inclusion is by far the most important factor for a stock’s valuation, fundamental factors take a back seat.
Implications for investment strategy
I have talked about the consequences of the proliferation of passive investing many times in the past so that isn’t particularly new. However, the research above does highlight why there hasn’t been more and broader concern about passive investing: Because the penetration level of passive has been significantly understated, so too has its consequences.
This is going to cause problems for a lot of investors. As the teeth of the Fed’s QT program really begin to sink in, there will be ongoing pressure to sell stocks. This ongoing pressure will cause prices to decline and in doing so, significantly challenge the (mis)perception that passive investing is safe. In short, it is a great time to consider more active strategies that can sidestep many of the upcoming landmines.
Another implication of the current market environment regards the need to re-think risk management. If you believe, as I do, that the Fed is essentially implementing a “controlled demolition” of the market, then it is important to understand the “control” as well as the “demolition” part of the proposition.
Clearly demolition means stocks need to go down (as a means of easing inflationary pressures). The control part, however, implies the need to avoid any breakages. Part of the way to do that is to allow the decline to play out slowly. Another part of the way is to allow for pauses along the way so investors can digest the changes. That gives investors time to react and to adapt to changing conditions.
Unfortunately, it also means that many common strategies to protect against downside, such as buying puts, become less useful because they are time-dependent. The longer the time period for which protection is needed, the more expensive the insurance. As a result, a slow decline is more expensive to protect against than a fast one, though also less destabilizing to the economic environment.
In sum, the baseline expectation is for a long, slow decline in stocks, punctuated by occasional rallies, that is likely to make it hard for both bulls and bears to benefit meaningfully. Insofar as this is correct, it implies lowering expectations for stocks and bonds - and also searching for alternative means of returns.
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