Calm Waters, Europe vs US

It has been a calm, sleepy market in SPX for the past 2 weeks.  The VIX is getting pummeled, as the realized vol is just too low to allow the VIX to stay above 15.  There is a bit of a sticker shock effect for market participants when they see the VIX in the 13s even though the SPX is not in a bull trend, but options traders aren't stupid.  They will not keep paying a fat premium for IV when realized vol is so low. The much hyped September seasonal weakness has occurred, but not in the way that many expected.  Its been a very controlled drip lower, since the start of the month.  Its mostly sideways, yet from watching CNBC and Bloomberg, I sense that the fast money crowd is looking for a down move in the coming weeks.  We got an oddly high put/call ratio yesterday even though the market didn't go anywhere.  Perhaps they are loading up on puts before the big Sep. opex on Friday.  They are definitely not bullish here. 

One thing that has been noticeable is European weakness. European indices have  been underperforming the US indices for awhile now.  There is a very simple reason that separates the US and Europe.  Its not demographics or the economic system.  They aren't that different.  Its fiscal policy.  Europe is governed under rules and stipulations determined by the EU in Brussels.  They have a big say in what kind of fiscal policy that the member states can run.  In particular, there is a limit to the budget deficits as a percent of GDP that are allowed.  Before 2020, their rules were strictly followed and this kept a lid on fiscal policy for most of Europe.  After 2020, the rules were relaxed because of extraordinary circumstances but that wasn't meant to be a permanent relaxation of rules, just a temporary one.  In particular, Italy took full advantage and ran up huge fiscal budget deficits to stimulate its economy, making it much stronger than most of the other member states.   And Italy has horrible demographics and a huge debt to GDP ratio, making them spend way more than other EU countries on interest expense rather than actual government spending.  That shows you the power of fiscal.  But rules are rules. EU budget rules hang like a dark cloud over the European economy, and has kept the member states from going full bore on fiscal stimulus. 

In the financial markets, fiscal policy is very underrated, and monetary policy is very overrated.  That is a result of decades of fiscal policy which didn't stray too far from normal, with low single digit budget deficits as a percent of GDP.  Fiscal policy used to be a near constant, with only small stimulus packages during a recession, and with no  bold spending plans over the past few decades.  That's changed since 2020.  With more populism, and politicians as well as most voters no longer caring about deficits and the national debt, sovereign governments are much more willing to spend without taxing more.  In fact, they are spending more and taxing less.  More spending + tax cuts/subsidies = bigger deficits = stronger economies.  But there is no free lunch when the government spends more money.  

The more money that the government spends, even when its not financed with the money printer (QE), the more demand that is pumped into the economy that would otherwise not be there.  Sure, that money now has to come from investors instead of from the central banks, but those investors can use those government bonds that they purchased as repo collateral to invest in stocks and other bonds like its cash.  So net net, the government spends more money and economy gets stronger, and investors can continue to buy riskier financial assets, even though they have to buy more government debt as its issued.  

There is a reason why the bond market is so weak.  The current fiscal policy, in the US anyway, is being run as if the economy was in a deep recession, with budget deficits of 8% of GDP with near full employment and fairly strong GDP growth.  Its hard to have a recession under those conditions, even after 525 bps of rate hikes.  US fiscal policy is ridiculously inflationary.  The bond market hates it.  The stock market likes it, because it boosts corporate profits, even with much higher borrowing costs.  

When big corporations and homeowners are already well financed with long term debt, their net interest expense will remain low even with yields exploding higher, because they locked in low rates in 2020 and 2021.  It makes them less sensitive to bond yields, and Fed policy.  It seems like the macro pundits are more worried about higher rates than the borrowers who actually are involved.  

So the country (US) that has the most long term fixed interest rate debt and is the least sensitive to monetary policy is running the most expansive fiscal policy.  While the ECB is trying to follow the Fed because of short term inflation pressures which are much more likely to subside than in the US because their governments aren't going hog wild with spending, and because their homeowners are on more variable interest rate debt, which is much more tied to current monetary policy.  

While the CPI in the US is much lower than in Europe, that's not going to last.  The CPI in the US is already bottoming, and going back up, while in Europe, they will continue to go lower as the EU inflation leading indicators are all pointing down.  Add on top of that the trend of European industrial production moving offshore, and you are looking at a big divergence between European and US inflation in 2024.  The Eurostoxx is sniffing out the weakness in Europe, as Europe, which was leading for the first quarter of 2023, is badly lagging the US in Q2 and Q3.  It doesn't help the case that the ECB remains stubbornly hawkish, thinking they can copycat Fed policy, and get the same economic results.  Lagarde has outsourced EU monetary policy to Powell, who has much more room to be hawkish than Lagarde, but it seems like Lagarde is trying to outhawk him.  It should lead to a very weak European economy in 2024, which will seep a bit into the US, but not much.  The US government always figures out a way to prime the pump with more stimmies out of the blue, so the US should remain resilient for the next several months.  Bottom line, for the next 6 months, US stocks > European stocks, and European bonds > US bonds.  

There hasn't been much to do.  There is no reason to press any positions here.  If I had to choose a trade right now, it would be to buy bonds, just from a purely tactical view.  It would be for a short term trade, not a long term holding.  My preferred trade is to wait for a dip to buy SPX and NDX.  Perhaps after you get past September triple witching opex, you can start to see a bit of a downdraft to buy into.  There is a potential government shutdown at the end of September, and the restart of student loan payments on October 1 which could act as bear catalysts.  Take a look at the underperformance of the Eurostoxx and Russell 2000 vs. SPX over the past month.  The divergences are building for another move lower in the coming weeks, although I am not playing it. 

SPX vs Russell 2000

SPX vs Eurostoxx 50

Its not a time to force trades, wait for the market to come to your levels.  Less is more here.