Fog of Trade War

After a weak close on Wednesday, a weak open on Thursday got enough stock traders to capitulate to form a short term bottom.  A clean break below SPX 2700 caused enough fear to keep the put call ratios high throughout the day yesterday.  It has now been 13 trading days since the peak of the rally on June 13, the day Jerome Powell gushed about the economy.  I have noticed in the past that many of these selloffs last 5, 13, and 22 days.  

The trade war fears are a bunch of hype, of course.  Hyperbole is never in short supply these days, where tweets move markets 15 SPX points in minutes.  Even if the tariffs get implemented, a $50B tax on imported goods is nothing compared to the fiscal stimulus that is coming down the pipe this year and next.  But like always, the markets tend to overreact to every headline because in the background, the Fed is slowly tightening and choking off the liquidity that this market needs to keep going higher.  This tightening makes it hard for stocks to shrug off very minor news and keeps the market range bound.  What matters is the monetary tightening, not some hyped up trade war, which hasn't even started, and probably will be a nothing burger if it does get started.  

But money is run by managers with short term thinking, without long term and deep analytical skills that you would find among those in other more technical fields.  Money managers are wrapped up in their own little fog of "trade war".  The fog is keeping their visibility low, and make them unable to see beyond the headlines into what really matters: the tightening.  

I expect a rally next week heading into the Trump China tariff date on July 6th.  I am sure Trump will do something to back off his tough talk on trade, because the market has been feeling the heat.  His report card is the stock market.  The Fed put strike price is much lower than the Trump put strike price, as Powell seems content to let the market sink or swim on its own.  

Any rallies should struggle to break through 2800 strong resistance, but we could have a false breakout above that level if Trump really throws in the towel and tries to pump up the market by delaying or canceling the $50B in tariffs.  

Trump Backs Off

Not that the market was very worried, but Trump's tweets and threats about more tariffs on China did get the market's attention.  There is a feeling among the traders now that Trump will walk back whatever threats and tough talk he spews out, especially if the markets are going down.  This is what happened again, as this morning's tweet from Trump as he feels the heat from markets and from politicians who probably have been getting an earful of demands by corporate lobbyists to shut this trade war down, fast.  

Once again, the market has bounced back from the pullback, but this doesn't feel like a V bottom that will keep going and make higher highs.  It feels more like a move that goes back to retest previous resistance around SPX 2780-2800.  Perhaps by next week, as a new quarter usually brings in investment flows into stocks.  The put volume never got extreme this week, and we are still in the stock buyback blackout period, so I don't expect a flood of money coming into to chase any rallies.  

Most of the leading economic indicators have peaked or flattened out, so expect the economy to slow down later this year and into 2019.  

China is peeling out a page from its 2015 playbook to fight the downturn in its economy.  China only resorts to yuan devaluation when it is backed into a corner.  And right now, the best way for them to relieve pressure on the economy is to print money and devalue the yuan.  There will be no deleveraging.  They are stuck just like the US and Japan into a world of continual monetary backstops, due to the size of the debt and lack of growth.  

What is even more painful for China this time around is that crude oil is strengthening, not weakening like it did in 2015.  Inflation makes their devaluation strategy that much more painful, as importers will be hit on both ends, a weaker yuan and higher commodity prices in dollar terms.  

Strong rally today, I am just waiting for a bigger extension higher to short, probably in early July.  Don't like the risk/reward of buying dips at these levels.  

China Priming the Pump

Does anyone actually believe when things get hairy that central banks will just let it play out?  You have a little slowdown in China and the PBOC is already on their 3rd RRR cut.  I am sure the authorities at the top are urging banks to lend to stop the slowdown.  Never forget one thing:  central banks are turtles and patient when the economy is booming.  they are impatient and micro managers when the economy slows down.  There is an asymmetric response to a cyclical economy, which leads to long up cycles and short but violent down cycles.  

It isn't trade wars that is causing the Chinese slowdown.  It was the PBOC trying to keep up with the Fed in the tightening cycle, and realizing that China's economy is much more sensitive to monetary policy than the US.  The Chinese have built up such a huge debt pile, much of it nonperforming and junk, that any increase in interest rates causes immediate weakness in the economy.  The Chinese government has done a masterful job of keeping the USDCNY exchange rate stable despite all the money printing they have done to keep the financial system intact.  It has taken a draconian approach to capital outflows, essentially making it impossible for any significant sums of hard currency to be taken out of China.  And no, the yuan is not a hard currency.  It is about as soft as Charmin when it comes to currencies.  The dual currency system of internal CNY and external CNH has been used to keep inflating the debt bubble in China, forestalling any financial crisis, while keeping the supply of CNH limited in order to keep the yuan looking strong to the rest of the world.  That way, China can maintain its purchasing power when buying commodities overseas, and give the appearance of the yuan as a legitimate currency for foreigners to exchange their dollars for.  

Anyway, only in a tightly controlled economy can such huge financial distortions and incessant can kicking last for so long, without any serious repercussions.  Yet.  It will happen, because eventually the Chinese will lose faith in the value of their currency, much like Turkey, Argentina, and Brazil.  Sure, those other countries don't have the command economies and government capable of neutering the masses.  But the Chinese government will eventually realize that the costs of keeping the time bomb from blowing up outweigh the cost of the sharp, short term pain from a one time massive hurricane to clear out the debt overhang.  

As the global economy slowly heads towards recession, the US looks stronger and stronger by comparison.  The money flows go from Europe/Japan/emerging markets towards the US.  That helps to keep US stocks fairly immune to the global weakness.  But it doesn't make the fundamentals in the US any better.  With a stronger dollar coming from these money flows, the large caps suffer as much of their earnings come from overseas.  Eventually, the fundamental realities will hit the S&P 500 and bring it down like the rest of the world.  Trade wars and tariffs are not going to be the trigger.  What is the trigger is global economy ex US going back to its natural rate of growth, and perhaps overshoot lower.  

All the tax cuts and government spending bill has caused is taken investment money dedicated to corporate/mortgage fixed income/loans and shifted it to T-bills and T-notes.  The result is an increase in corporate bond spreads, which is unusual when the economy is in an up cycle.  There is less liquidity sloshing around in the investment world, leaving financial markets more vulnerable when investors want to sell in mass.  The corporate stock buyback window is now closed for the next several weeks, so the stock market is on its own.  It could get ugly if investors decide to de risk after putting on a lot of risk over the past 2 months.  

I missed the short on this down move, but based on all the trade war headlines, when that fades away, there should be a rally just around the corner which should provide a decent risk/reward short entry in early July.  

Complacent but Without Bullish Conviction

The public is trying to get wise to the game.  They now know that dips on "bad news" are to be bought, not sold.  That is what has led to intraday gains after gap down opens on Friday, Monday, and Tuesday.  Mostly because of trade war headlines.  I will have to side with the CNBC Fast Money crowd on this one, which isn't common.  These tariffs are a big nothing burger.  As I have stated all along, politicians are bought and paid for by big corporations.  They don't want these tariffs, which means they won't stick, no matter how many tweets that Trump lets loose.  Even if they do get passed, they will get repealed at the first sign of economic weakness, which means they will be repealed quickly. 

What I disagree with the CNBC crowd is that this is a good risk reward market for longs.  We've already being rallying for over 2 months, close to 2800 resistance, and the low put/call ratios and the general complacency that you can see all around.  Even if investors are not wildly bullish, they are still fully invested, but without a lot of conviction.  Those are the best situations to get short, as those type of investors will be quick to push the eject button at any sign of serious trouble. 

The US government has consistently shown is an intolerance for economic pain.  Unlike EU governments, which are limited in their fiscal stimulus because of budget deficit constraints, the US government can spend and does spend like drunken sailors.  That is what is keeping the expansion going so long, even with higher interest rates and weakening emerging markets and European growth.  Trillion dollar budget deficits is a heck of a stimulus to the economy, even if it is going mostly towards those that don't need it, which are US corporations.

That is why you continue to see a divergence between equity market performance between the US and Europe/Japan.  Despite a stronger dollar, the SPX has outperformed the Eurostoxx and Nikkei.  And the gap between emerging markets and US equity valuations is getting obscene, which tells you how bad China is doing.  China basically determines the fate of the emerging markets.  And the PBOC is already getting panicky, which means there is no serious desire to deleverage. They didn't follow the US rate hike, as many expected, and now a RRR cut is just around the corner, after they did one several weeks ago.  And that is even before property prices have started going down. 

Don't buy the view that Xi Jinping wants to deleverage the economy.  He wants to deleverage only if the economy isn't negatively affected by it.  He will not deleverage and allow China's economy to weaken for long.  And there is no way China's economy can withstand any meaningful reduction in debt. 

I have read some of Steve Keen's work, an unorthodox economist, one of the few who actually understands how the economy works, which is rare.  Most economists are useless.  The economies that are the biggest ticking time bombs, based on credit growth rates and private debt/GDP ratios are the following:  China, Canada, Australia, Korea, Sweden, and Norway.  Those just happen to currently be some of the weaker economies globally. 

I view these trade war headlines as kind of a fog of war.  They serve as a distraction, a mask for what really matters:  overlevered global economies with aging populations, too much inequality, and not enough monetary dry powder.  The next downturn will be interesting to watch, as the global central banks are basically down to the weapon of  last resort:  mass buying of equities.  Unlike what many think, central banks cannot do helipcopter money without the federal government complicit in the action, as the government will be the distributor of helicopter money, the drug dealer, so to speak,  while the central bank will be the drug maker.  The rise of populism will only encourage helicopter money, to keep the masses satisfied by giving them tax cuts, rebate checks (ala George W Bush), and other handouts.  All while blowing up the budget deficit, the excess Treasuries that result which will be taken care of by Fed QE. 

We are entering the topping phase of this move, as S&P 2800 acts as strong resistance.  There was a juicy short at 2784 in after hours which I was considering hitting but thought I could get slightly higher prices to short in regular trading hours.  Europe didn't cooperate.  So I wait, and getting eager to put on a short before the bus heads downhill.  That should happen any day now. 

Hawkish Powell Dovish Draghi

Jerome Powell is drinking the kool aid.  Unlike the March meeting, he literally was foaming at the mouth about the US economy, about as excited as you will see a central banker in front a crowd.  It is almost as if ordered by Trump, gushing about the economy and jobs and to keep the bond vigilantes at bay, stating that inflation remains moderate.

I will admit that Powell was given a raw deal, being handed the keys to a late cycle economy with the Fed funds rate at 1.25-1.50%.  It was Bernanke and Yellen who nurtured this bubble, with their needless QEs, taper delays, rate hike delays, and turtle like speed in raising rates.  Bernanke should have been the one who should have started the rate hiking cycle, not Yellen.  He was the clown who insisted on QE2 and QE3 when it was totally unnecessary.  QE3 and its taper effectively delayed rate hikes by 2 years.  QE3 was started in September 2012 and continued until December 2014, when the taper finally ended.  When it was clear that the US economy was growing strongly in 2013 post fiscal cliff, he should have put in the first rate hike in the second half of that year. 2014 should have had at least 4 rate hikes.

The bond market was having a taper tantrum for a reason in 2013.  It realized that there was nobody keeping the insane clown posse of speculators under control.  Bernanke was the chief clown himself.  Only an imminent QE by the ECB was able to keep bond yields in check.

Yellen was almost as bad as Bernanke, which is saying a lot.  She instituted a painfully slow QE taper as the SPX kept making new highs and the US economy was at its strongest (2014) over the past 10 years.  And then in 2015, when interest rates should have been hiked immediately after the taper was over, she waited till the final days of 2015 to put in a token rate hike to try to maintain its last remaining ounce of credibility, which was mostly frittered away by Bernanke's bubble blowing ways.  So when 2016 slowdown happened, the Fed couldn't do anything, because the Fed funds rate was 25 -50 bps, when it should have been 225-250 bps.  In that case, the Fed probably could have cut rates a few times and probably would have resulted in a stronger economy in 2016.  Only after the S&P made an all time high AND Trump got elected with promises for huge tax cuts, did Yellen finally do another rate hike.  It took an almost perfectly placid uptrending stock market in 2017 to get her to do 3 rate hikes that year.  Just really bad.

So yeah, Powell is better than both of them, by a mile, but its too little too late.  Bernanke and Yellen basically took a page out of Greenspan, doing an even worse job of delaying rate hikes for way too long, and set up this scenario where Powell will be blamed for the next bear market in stocks because they got too high and overvalued under Bernanke and Yellen.

Here is what is going on in the big picture.  The US economy is clearly in the late cycle phase, and much of the fiscal stimulus is being negated by higher interest rates and a slowing Europe and emerging markets.  Stocks are grinding higher on animal spirits and stock buybacks coming from repatriation, not better fundamentals.  In the meantime, there are plenty of signs that Europe is back to its old, moribund economy, and China's financial system is being held together with duct tape handed out by the PBOC.

Draghi senses that Europe's growth has peaked and had to throw the European markets a dove bone with a 1 year promise of no rate hikes with his QE taper ending in December.  He wants a lower euro, and he needs a lower euro.  He got the job done today with his forward rate guidance.  But he just used up one of his bullets that he may need when Europe is in even worse shape.  He really can't do any more rate cuts because rates are already deeply negative, and because of a shortage of Bunds, he can't go back to QE unless he changes the capital key rules for bond purchases.  That leaves just the nuclear option of buying European equities, which will probably only be brought out when Europe is about to enter recession.

We are getting a BTFD gap up off a dovish Draghi, even though the US multinationals will have to deal with a stronger dollar because of it.  Its been a strong uptrend over the last 6 weeks, so its probably not going to end immediately, but Powell's hawkishness will probably keep a ceiling on the SPX around 2800.  A hawkish Powell only strengthens my conviction that the SPX will drop in the coming months.  He seems intent on hiking until something really bad happens, which makes the probability of something bad happening much higher.  Have my hand on the sell SPX trigger, ready to pull any day now, but trying to be patient so I don't short early.

Grind into Fed and ECB

So here we go again, per usual.  The grind higher, as investors sell volatility and get complacent.  That is why you can't short early in the SPX, because it will go up slowly with no pullbacks and cause gradual, continuous pain.  Its better to be a little bit late to avoid the misery, even at a less optimal price point.  I haven't done much with SPX over the past couple of weeks, it just isn't worth it for a bearish trader at this juncture.  The re-risking off the deep dips in February and April is mostly complete.  Perhaps there is a bit more of a rally after the Fed and possibly a false breakout above 2800.  That would be a point to leg into a short, adding more when the rally stalls out and starts getting choppier. 

As quickly as the Italy headlines rocked the Treasury market (less so the equity index) higher, it has faded and all of a sudden, Italy has issued a EU compliant budget.  The PIIGS have been neutered and are walking zombies at this point.  Bad enough to cause populism, not bad enough to leave the euro.  The European economy is moribund, what happened with the bump up in GDP growth to 2.7% was Europe's version of running hot.  That is as good as it gets over there, with the EU budget mandates eliminating any possibility of a big fiscal stimulus, and monetary stimulus is maxed out with QE and negative rates.  At this point, only a helicopter drop by Draghi with an FU towards the Germans will get the EU towards higher growth rates. 

The German Bund has sniffed this out well ahead of any Italian headlines, because it peaked out at 0.80% in February, and the yield has been going lower ever since.  The next global slowdown will be the final nail in the coffin for the EU, as it officially enters Japanese zombie economic status. 

But it could actually be worse in the EU over the next decade than it was in Japan.  At least Japan could use fiscal stimulus to somewhat offset the slower domestic growth rates.  The EU with their budget rules, all but binds member states to strict guidelines on budget deficits, eliminating that form of stimulus.  That leaves monetary policy as the only form of stimulus, and it is mostly maxed out, unless the ECB starts buying up European stocks, which is very unlikely with the next ECB president likely to be German. 

Today we have the FOMC meeting and tomorrow the ECB.  With stocks grinding higher, but with CPI numbers contained, I expect the Fed to come out with the status quo, similar to March, and not lean dovish or hawkish.  It probably will not live up to the hype of a press conference meeting.  Powell seems to be a market follower, not a leader, so I don't expect him to rock the boat today.  Getting the Fed to this point of raising 25 bps every 3 months hasn't been easy, so I don't expect them to tamper with market consensus which is still leaning towards 3 hikes this year, not 4. 

The ECB is stuck between a rock and a hard place.  They want to end their QE program, but the economy is stalling out so they will try to do it as gently as possible.  I don't expect any tape bombs from Draghi, the European economy just isn't strong enough and Italy and Deutsche Bank will keep them from being hawkish. 

Once the dust settles this week, I expect the SPX to be a little bit higher and bond yields to be a little bit lower.  But over the summer, it should be a different story, as emerging markets and Europe are a canary in the coal mine for slower global growth.  I will get positioned for a move lower, probably late June/early July is the time period for looking short SPX. 

Submerging Markets

Slowly dropping like flies.  A few weeks ago it was Turkey, now Brazil.  There were many gurus who touted emerging markets earlier this year because they were cheap historically compared to developed markets, especially US.  Now they are even cheaper.  There is no guarantee that past performance is repeated in the future.  There is no law that past valuations should be maintained in the future.  The linchpin for all this weakness is China.  When China slows down, its a domino effect that slows down the other emerging markets.  It is not really a dollar story, because the dollar was much stronger in late 2016 and China and the other emerging market economies were stronger than they are now.  You can't blame the Fed for this one.  You can blame China for not taking control of their debt bubble sooner and instead have built up a monster that needs more and more debt just to keep financial stability.  

In the meantime, until yesterday, the US markets didn't care, as the FOMO trade is back on and VIX is back under 12.  With the ECB signaling that they want to end QE this year, that is going to allow the Fed to tighten a bit more than before because the dollar will weaken with ECB being marginally more hawkish.  The monetary tightening in the US and the reluctance to ease more in the other developed economies will keep a lid on any equity exuberance over the coming months.  We have reached a level where the risk/reward for a short on the S&P is now very favorable.  Anything near 2780 can risk up to 2830 for a target of 2600.  That is 50 point risk for 180 point gain.  

I would like to wait for the FOMC meeting to pass by before putting on the shorts.  It could be the final hurdle that the bulls clear before they go all in.  They are almost there, it will just take a few more days.  

Bulls Slowly Getting On Board

Last week was a slight detour on the grind higher, as the Italy headlines are mostly forgotten ex-Europe.  It is easy to panic on scary Italian political headlines, as the fear of Italy leaving the EU can stir up asset managers to de-risk, despite the extremely low probabilities.  As long as PIIGS citizens fear losing money on their assets in the case of a EU exit, they will be against leaving.  In the UK, there was not that kind of fear because whether the UK is in the EU or not, they don't use the euro, effectively keeping them out of the EU financial system.  That is a huge difference between leaving a political union which they really weren't a participant in and a monetary union.  Anyway, Italy, Spain, or any of the other weaker EU economies still fear the consequences of being left out of the EU and thus their threats at the technocrats in Brussels are not taken seriously. 

Another worry from last week was Deutsche Bank, as its credit rating was downgraded and its stock continues to go lower.  I don't pretend to know the deep fundamentals of Deutsche Bank, but it seems like a profitability problem rather than a solvency or liquidity problem.  They have a huge amount of assets in Europe and if they all get marked down by huge amounts, sure they will be in trouble, but a 100 bps move higher in European peripheral sovereign yields is not going to do it.  It would take a deep recession, in which case, DB won't be the only bank going down.  The weakness in DB does show that Europe's economy is still mediocre, and that QE didn't really help the European banks that much.

The S&P keeps grinding higher, making new highs after last week's bad news shakeout.  We had Italy, DB, and tariffs.  This is the kind of resilient price action on bad news that gets bulls excited, but I would argue that the news wasn't as bad as it seemed.  It has been 2 months since the early April lows, and the SPX still can't get close to 2800.  The fuel coming from short covering and fund managers putting back on long positions after a scary bottom are long gone.  Now the US market has to rise on its own natural strength, as global markets are not going to help.  Neither is the Fed.  With Europe's economy looking like it has peaked, the US markets will have to deal with a dollar that is unlikely to weaken much in the near term.  A stronger dollar, 10 yr interest rates near 3.00%, and weak global growth is not going to get the job done for the bulls.  I expect a dovish Fed next week, because the dollar has strengthened, and that should be good enough for a last gasp stock rally in the US.  But after that, you have the black out period for corporate stock buybacks which will reduce demand for several weeks.  So I am looking at a potential short around late June, and anything between SPX 2750-2800 should be a good entry.  Until then, I will let the bulls try to grind this market higher.