Longview on Friday

Below is a round-up of Longview related views/research & trade ideas – the intention is to publish this most Fridays, updating key themes and highlighting key pieces of (often contrarian) research. Feedback, as always, is appreciated. Equally just ‘unsubscribe’ at the bottom if you don’t want to receive the email.

Equities: What Just Happened?

The S&P500 closed yesterday approximately 200 points below its record closing high from 20^th September, having fallen by 6.7% in the last 6 trading sessions. With many investors/commentators blindsided by the move, there’s been a scramble to explain what’s caused it. The FT (amongst others) have highlighted the ‘worries over rising interest rates’; other market commentators have pointed to: “Trade wars, rising interest rates and slowing growth” (source: FT LINK ); while others are pointing to ‘rotation’, an ‘earnings/inflation warning from PPG’, and a ‘technical breakdown’ (e.g. see HERE). In reality, though, this is post price rationalisation and whilst we would agree with part of that rationalisation (i.e. especially the rising interest rates part), the US equity market sold off for 3 key reasons:

1. The back-up in bond yields (sell off in bond prices) preceded the break in the equity market by approximately one month. This was a similar pattern to that observed in December 2017 into late January 2018 (see FIG 1). Rising bond yields naturally pressure equities and the liquidity environment in general;

2. In a manner similar (in many ways) to 2015, the US equity market has been building towards a major SELL-off in recent months. That’s most obvious from the behaviour of a wide variety of breadth models – with the market’s advance narrowing. Other market timing models have also been behaving in an unusual manner, with the correlations between those models & the market breaking down as they did ahead of prior major SELL-offs in 2015, 2011 and other ‘global macro shock’ years (for full detail/analysis, see 5^th September 2018, Tactical Equity Asset Allocation, No. 176: “US/Global Equity Market SELL-off Increasingly Likely” – available HERE);

3. Key risk appetite models generated a SELL-off warning in early October. Our SELL-off indicator, for example, crossed its key +20 threshold Friday last week (FIG 2). This model has a reasonably good hit rate and its signals are often timely. The generation of a signal highlights excessive risk seeking behaviour in global financial markets over the prior 1 – 2 months. That excessive risk seeking behaviour included, for example: The US making new highs up to late September; other global equities rallying from oversold positions; some commodities rallying hard (especially OIL); and bonds selling off. All of those factors contributed to the BUILD-up in the SELL-off indicator. Other risk appetite models generated the same message: Our combined medium term risk appetite gauges (i.e. medium term RAG1 + RAG2) generated a SELL signal on 2^nd October (see FIG 3).

In many ways, therefore, this pullback reflects the ebbing and flowing of the natural cycle of risk appetite in financial markets, combined with the liquidity challenges of a tightening US Federal Reserve. The key question, therefore, is: What’s next?

FIG 1: US equity & bond prices (S&P500 and 30 year bond futures)

FIG 2: Longview SELL-off indicator vs. S&P500

FIG 3: Longview combined medium term RAG1 + RAG2 vs. S&P500

Equities: After that, what’s next?

Most SELL-offs tend to evolve in a ‘three wave’ pattern (and occasionally a ‘five wave’): That is an initial wave of SELLing (i.e. wave 1), followed by a wave 2 relief rally (typically retracing a significant portion of the wave 1 losses) and then a fresh wave (3) of selling to new lows. Occasionally, and especially when aided by central bank policy/pronouncements, the SELL-off can simply be a one wave affair (e.g. as in Sept/Oct 2014). Normally, though, it evolves into three waves. Given the resoluteness of the Fed to continue its tightening policy, we’d view this current pullback as likely to take 1 – 3 months to complete (NB the local high was 20^th September) and involve at least three waves. As such the key question is: When does the wave 2 relief rally start?

Our models are typically useful tools for judging the start of the wave 2 relief rally (i.e. to within a handful of trading sessions). Those models, especially the short & medium term models (when combined) are, as of the past 24 hours, generating BUY/strong BUY signals. The combined short & medium term risk appetite scoring system is a case in point: As of the close yesterday, it reached strong BUY (FIG 4). The Colvin model is generating a similar message (FIG 5), whilst the steepness of the volatility curve (a gauge of the levels of fear in markets) is notably inverted (although not as notable as during the SELL-off at the start of the year – FIG 6). All of these models, therefore, support our central expectation that a wave two relief rally has either just commenced (i.e. today/overnight) or is likely to commence over the next few trading sessions.

FIG 4: Longview combined short & medium term ‘risk appetite’ scoring system vs. S&P500

FIG 5: Colvin model (global over-extendedness indicator) vs. S&P500 

FIG 6: Steepness of US equity volatility curve vs. S&P500

One of the Most Important Foreign Policy Speeches……

Missed amongst all the dramatic price action in markets, 10 days ago US VP Mike Pence delivered what is arguably one of the most important foreign policy speeches from a member of the core White House team for several years (perhaps since Bush’s post 9/11 foreign policy speech). The link to the speech is HERE*. At its heart it raised the level of hawkish rhetoric towards China and illustrated that the administration doesn’t just view its problems with China as simply one of trade and intellectual property but that tariffs are part of a much wider strategy of containment of China.

“America had hoped that economic liberalization would bring China into greater partnership with us and with the world. Instead, China has chosen economic aggression, which has in turn emboldened its growing military……

…..Nor….has Beijing moved toward greater freedom for its people. For a time, Beijing inched toward greater liberty and respect for human rights, but in recent years, it has taken a sharp U-turn toward control and oppression.”

For more analysis on the approach of Trump towards China, see our April, 2018 blog: “Trump – the Historical Logic behind Tariffs”; as well as Longview Letter no 106, 16^th January 2017: “When a Rising Power Challenges the Incumbent, a.k.a. (Trump’s) ‘Fronting up’ to China” – available HERE.

*many thanks to J.P. in Oz for flagging it up

UK macro outlook: The Economy Beyond Brexit

With rumours swirling the British media, today and yesterday, that the UK government is close to agreeing a deal with the EU re: Brexit, it’s a key moment for assessing the strength, and substance, of UK growth ‘beyond Brexit’. In our global macro research this week, we outline how the UK’s cyclical strength peaked in 2014 and has been weakening since then. We also outline where the UK’s economic vulnerabilities lie and how the economy is likely to evolve once it moves beyond the influence of the Brexit negotiations. The thrust of the research is neatly summarised by a quote taken from the recent Nationwide survey of British spending habits:

“The pressure on household budgets in Q2 2018 has reached a high point, with essential spend up six per cent year on year to £1,510 per month – which equates to 80% of monthly income based on the average UK salary”.

Source: Nationwide Building Society Spending Report, August 2018

For full analysis see Global Macro Report, 10^th October 2018: “UK: The Economy Beyond Brexit” – available HERE

Have a great weekend.

Kind regards,

Longview

Longview research recently published

This week:

Commodity Fundamentals report No 86, 11^th October 2018:

“OIL: US bottlenecks easing, Iranian sanctions impact overblown       

a.k.a. SELL oil (near term)” – available HERE

Macro Trade Recommendation No. 93, 11th October 2018  

“Start BUILDing LONG Bond Positions” – available HERE

Global Macro Report, 10th October 2018:

“UK: The Economy Beyond Brexit” – available HERE

Weekly Market Positioning Update, 8^th October 2018:

"Sharp rise in yen SHORTs"

Last week:

Longview on Friday, 5th October 2018:

"Bonds: The Blow off Top" – available HERE

Tactical Equity Asset Allocation No. 177, 3rd October 2018:

"Move OW Bonds a.k.a. Remain cautious towards risk assets" – available HERE

Weekly Market Positioning Update, 1^st October 2018:

"Bounce in 'Risk-on' Positioning"