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Risk-Adjusted Return Monitor Summary & Views

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Risk-Adjusted Return Monitor Summary & Views a global macro investment newsletter by Neil Azous Morning Edition | October 12, 2018 Risk-Adjusted Return Monitor CROSS-ASSET FOREX FIXED INCOME EQUITIES COMMODITIES THEMATIC PAIRS India SENSEX EUR/CNY UK 5-Yr Gilt India SENSEX Soybean China Exposure EU Cyclicals vs Defensives Saudi Tadawul USD/TWD South Korea 10-Yr Saudi Tadawul Gold None EU Domestic vs EM Exposure * Highlights the largest overnight positive and negative risk-adjusted returns across 160+ market proxies Summary & Views Contents These Are Not The Droids You Are Looking For Summary & Views Top Observations . The Pedestrian View Tracking Portfolio . Our View – Mutual Funds Economic Data . Our View – Hedge Funds . Our View – Global Macro . Financial Conditions Tracking Portfolio Admin – Schedule Tracking Portfolio Twitter @sbstimestamp The next edition of Sight Beyond Sight will be delivered on Monday. Bloomberg MCRO <go> Any updates to the tracking portfolio will be sent via Twitter (@sbstimestamp) or Bloomberg (MCRO<go>). Links Subscribe Now! Newsroom View Archive Permissions/Reprints Connect Twitter @neilazous These Are Not The Droids You Are Looking For The Pedestrian View This is the 23rd correction greater than 5% in the S&P 500 Index (SPX) since the March 2009 low. The average correction is -9.3% and the median correction is -8.4%. The average VIX peak is 32.1 and median peak is 30.3. From the high-to-low, the S&P 500 fell 7.8%, and the VIX peaked at 28.84. Add in the drawdowns in other benchmarks – Russell 2000 Index (RTY) -11.29% and NASDAQ-100 Index (NDX) - 10.49% – and the dozens of intra-day indicators showing extremes, and it is easier to understand that the correction is largely complete. The next trade is a recovery. Our View We have a lot of sympathy for the pedestrian view except the recovery call. While we would not be surprised to see the benchmark indices up 1-2% today, that dead-cat bounce misses the bigger picture. Here is what we mean by that statement. Mutual Funds Put yourself in the seat of a mutual fund manager. Earnings season starts today. Why would a Portfolio Manager buy individual stocks in front of their earnings release? Considering the degree of weakness seen following a negative preannouncement for this quarter, their bias is to wait for confirmation that the company delivers on earnings, and the stock reacts positively. Otherwise, they risk purchasing the stock too early, which is the same thing as being wrong. Also, unlike February, where large buybacks were the catalyst that marked the bottom at the index level, buyers of stocks today do not get the tailwind of buybacks until later in October or early in November. Finally, the sell-off in risk assets began with FAANG and the momentum factor. Netflix, the "N" in FAANG, reports earnings on Tuesday, and will likely set the tone for tech earnings season. Last quarter, after missing on subscriber growth, NFLX fell 14% and has not recovered. The key point here is that buying back the momentum stocks or growth strategies that were sold in advance of NFLX earnings is premature. Hedge Funds Put yourself in the seat of a hedge fund manager. The best thing that could have happened to a long/short strategy is a market correction. Not only did it narrow their underperformance to the benchmark significantly, with the S&P 500 only up 2% YTD now, but there is also no anxiety over fourth quarter performance chasing. Last October, the S&P 500 was up significantly and on its way to having the highest Sharpe ratio in 50 years. The profile today is very different. This is a good thing because if anyone is playing for a V-shaped recovery and wanted to get out in front of that index move higher, S&P 500 call option spreads that have a payout ratio of more than 5 to 1 with implied volatility this elevated is non-existent. Said differently, the only true way to play for a slingshot bounce higher is to own stocks (i.e., “deltas”). Rareview Macro LLC | Soundview Plaza, 1266 E. Main Street, Suite 700R, Stamford, CT 06902 Page 2 Copyright © 2018 Rareview Macro LLC. All Rights Reserved. Also, the two “alpha” trades – small caps and Chinese internet stocks – for the fourth quarter are currently dead. No one is buying an IWM call option fly (i.e., 1x2x1) in case the Republicans win the House, and small caps recover the most. Nate Silver, at FiveThirtyEight, told you that is throw away money. Besides, every hedge fund is still suffering from Trump Derangement Syndrome (TDS) and believes there is no way Republicans can win in the House. Despite 20-40% underperformance to their US peer group, Chinese stocks are now contending with a different sentiment. In the last two weeks, the market has begun to shift to “China Cold War 2.0” from just a trade war. The 15 executive departments, or Cabinet, and the National Security Council are now waging some state of political hostility towards China, not just the Commerce Department. Global Macro Put yourself in the seat of a global macro manager. The correction in February was the recognition that the rest of the world (RoW) passed its peak growth rate, whereas the US was still accelerating. The question now is – with momentum and growth strategies faltering because investors are marking-to-market long duration technology stocks relative to a steeper yield curve and higher absolute level of real interest rates, is this the signal that US growth is also now past its peak? Either way, the ”strong US versus weak everywhere else” narrative is changing. It is too early to tell if that leads to relief in the RoW or the US will force the RoW even lower. Next, there are too many professionals looking to last February as a parallel for what happens next in stocks. The backdrop now is extremely different. Since February, the Fed has raised interest rates three times. The fixed income market is priced for another four hikes. The Fed has removed the forward guidance goal post of the neutral rate cap. The Fed’s balance sheet runoff (i.e., “QT) is now $50bn per month, up from $20bn. Except for the S&P 500 and NASDAQ-100 indices or a one-off index here or there, every asset globally, both risk and risk-free, is negative on the year. In fact, now, the US cash equivalent interest rate is higher than the S&P 500 YTD performance. Add in the breadth of weakness across asset classes and regions, how can someone label this still a bull market? There were no US mid-term elections, trade war (or China Cold War 2.0), or Italy problems at the time. Finally, the stock market has not dropped enough to test the “Fed put.” Based on what professionals heard over the last month, a sustained stock market correction is required to slow the Fed down or price in a pause. At best, this week’s events removed 30-40% of one hike next year. Said differently, fixed income barely batted an eye. Conclusion Like many, we are left asking if this correction is different, especially given the juncture of the Fed tightening cycle. One scenario that we are not ruling out is if the SPX drops 8-10% and just sits here for a while. Right now, there is no fourth quarter wall of worry that needs to be climbed. If you are looking to buy something, then buy crude oil on this pullback or gold priced in Mexico peso (XAU/MXN). At least the former has a stellar profile, and the latter has the two most extreme positioning across assets and is attempting to break out of a 10-week rectangle. Rareview Macro LLC | Soundview Plaza, 1266 E. Main Street, Suite 700R, Stamford, CT 06902 Page 3 Copyright © 2018 Rareview Macro LLC. All Rights Reserved. Update – US Financial Conditions Since the Fed recently removed the neutral rate cap as a yardstick, and the stock market has not fallen enough on a sustained basis to impact future interest rate hike probabilities, we fall back on US financial conditions. Below is a yield curve populated with USD denominated senior unsecured fixed-rate bonds issued by US companies with a rating of BBB+, BBB or BBB-. On aggregate, the BBB corporate yield is now higher on an absolute basis than the worst of the 2015-16 industrial recession and close to breaching the 2013 taper tantrum high level. We highlight this because corporate yields are the largest component of financial conditions. The Goldman Sachs US Financial Conditions Index (Bloomberg symbol: GSUSFCI), an index created by former NY Fed President William Dudley that is incorporated in the FOMC’s economic models, has retraced more than 61.8% of the easy financial conditions since the start of the Fed hiking cycle in December 2016. Here are the components of this index. (Source: Goldman Sachs). In this index, corporate spreads hold the second largest weight beyond 10yr US Treasury yields. Rareview Macro LLC | Soundview Plaza, 1266 E. Main Street, Suite 700R, Stamford, CT 06902 Page 4 Copyright © 2018 Rareview Macro LLC. All Rights Reserved. As the Federal Reserve continues to tighten financial conditions, either through interest rate hikes or running down their balance sheet (“QT”), it is worth keeping an eye on these metrics. Back to top] Rareview Macro LLC | Soundview Plaza, 1266 E. Main Street, Suite 700R, Stamford, CT 06902 Page 5 Copyright © 2018 Rareview Macro LLC. All Rights Reserved. Top Observations Money Flow . Fund Flows (Source: BAML, EPFR data) o Bond funds see “massive” outflows of $14bn, most since the first week of February.
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