Good Morning.. Not much of note from Asia with low volumes again and I think markets may be waiting for Powell tomorrow but Fed speakers yesterday, seemed to suggest he will walk back the recent dip into negative for longer dated FF rates. July FFs sit at -1 which is more or less where they closed Friday after a bounce. It will be interesting to see just how bad today’s US CPI is in front of this Powell statement. The NY Fed starts buying Corporate ETFs today (see below) which is another march down the same path as the BoJ and look where it got them. IF the markets ever feel the outcome of Fed policies will be the same poor result as the BoJ have seen, then look out. With the very unlikely event of a V-shaped recovery, I think the USD could still rise and that is bad news for the EM space (see below) which remains a huge concern of mine for multiple reasons. With this in mind I am pleased to say that I did not get taken out of the AUDJPY position and would recommend a short in Cable. I see the USD rising and the EU failing to get the UK to agree to an extension and trouble lies ahead. I remain bearish the EUR for many reasons highlighted here recently; but I think Cable may have some catching up to do. Stocks are going to have to wake up to the fact that a V-shaped recovery is off the table..

Keep the Faith..

Details 12/05/20

Fed speakers suggest negative rates may not be on their way: But central banks walk down the same dark path as the BoJ. The EM space a growing concern.

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Despite dreadful US data last Friday and FFs dipping below zero for a while on Friday, Fed speakers yesterday appeared less convinced than markets that negative rates will be a Fed policy adapted anytime soon. Both Bostic and Evans seemed to walk that idea back but I guess, to be sure, we need to wait and hear what Powell says tomorrow (not today as I mistakenly suggested yesterday). Of course, with the state of the US economy as it is, we cannot fully rule out the Fed shifting to NIRP but I think at the very least they will wait as a lot of what they have done is still funnelling down the pipe. But looking forward to a longer period of no recovery, I am sure it is something that will have to be discussed unless Powell suggests tomorrow that it is completely off the table which I very much doubt. (Powell is unlikely to rule out negative rates definitively as it makes strategic sense for the “prudent” Fed to keep all options on the table given that the cost/benefit analysis of implementing negative rates may change in the future, especially if there is a second infection wave later in the year). The longer this period of uncertainty and shocking data goes on, the more forward-looking markets will price in more from the Fed; including negative rates. The trouble is that most of what the Fed does is for market stability and not for the man on the street and the man on the street is in danger of not having a job to go back to for some time.

But it still seems that equity investors believe that all this is good for the big 5 tech firms which yet again supported stocks yesterday. But a new report from the University of Chicago found that pandemic-induced layoffs will result in permanent job losses, which shreds the Wall Street narrative of how many of these lost jobs will return once lockdowns are lifted. I agree with this and even those top 5 stocks will be impacted by lower margins and lower earnings. The reality has not yet dawned on just how bad things still are and are likely to be. I think bonds would be pricing more of this if not for the massive manipulation by the Fed but even that is dwindling as bond purchases are tapered. There seems to be some common view that more than 18 million of those jobs lost were considered temporary reductions and were likely to come back once restrictions were lifted quickly. Really? I guess it depends on what your take on temporary is; a month, a year? The issue here is that most cannot afford a few weeks without pay let alone months and the bridging funds from the government will not last much longer. Again, businesses will be slashing costs in an effort to hold onto margins and people are expensive; a lot of these jobs are gone for good; a tragedy of course but a grim reality. What this report suggests is that Wall Street’s optimism about a V-shaped recovery this year is wrong; and the recovery may not be seen until 2021 or beyond at best. Time for a reality check in my view.

This equity bounce has low volumes and a lot of money is still in MM funds but specs, CTA’s and funds are still buying US stocks in the face of what seems like a deep recession looming. According to the latest New York Fed survey of consumer expectations, virtually every metric having to do with one’s financial wellbeing – income, wealth, debt sustainability and earnings expectations – is dropping like a stone with expected earnings, income, and spending growth each hitting survey lows which is what one would expect in a depression let alone a slowdown. This is what the report threw up: The expected probability of losing one’s job jumped to an all-time high of 20.9% from 18.5% in April; the probability of missing a minimum debt payment over the next three months surged to 16.2% – a 7 year high – from 15.1%, while expected earnings growth tumbled to the lowest on record at 1.87%, down from 2.05% in April. Does that sound like a confident consumer to you? Nope; nor me and the hit to the consumer is a hit to the US economy; fact.

But here is the rub; while the above data may not have been surprising, what was shocking is what the central bank reported was the average consumer expectation for stock prices in the future: according to the NY Fed, the mean probability that US stock prices will be higher one year from now surged to 51.8% up from 47.7%, above 50% for the first time ever and the highest print on record. It seems they clearly believe the Fed can win this battle, I guess.

This is quite incredible and makes me wonder just how many unprofessional or retail investors are fully long up here! How can stocks be a recession hedge; is that how they see it?

Such optimism with all that lies before us is almost insane but shows just how omnipresent the Fed has become and have seemingly managed to turn bad economic news into good news for stocks. I take my hat off to them but honestly; can this absurdity last? It seems many do as they believe the Fed and other central banks, by throwing free money to the banks will help. Well, go ask the Japanese about how well that policy is going or the ECB for that matter. Money printing may continue but what happens if all that finds its way into the broader economy? If this kind of monetary and fiscal policy produced growth and inflation, then Japan would be the biggest economy on the planet and fighting inflation; guess what; it isn’t. There is a lot of hope from the unlocking of economies but very possibly that is where all the problems lie and the reality is laid bare for all to see. I am not saying we will not bounce from 25% unemployment or 20% hit to GDP; what I am saying is we will not recover as quickly and that will cost government and the central banks trillions of USDs they simply do not have and the economy will remain weak. In 2008 it was China that lead us out from the abyss but not this time.

Sovereign debt is about to become a problem as not all have the luxury of being the holders of the reserve currency. Household debt I discussed yesterday and there is corporate debt too to consider. Can everyone be bailed out? The gap between Wall St and Main St is depressingly wide and widening all the time and that gap could have social problems attached to it soon. Talking of contagion as this virus spreads, there is another one to consider. The EM space is starting to concern me as the sovereign default issue moves up the chain. Zambia, Ecuador and Rwanda have all announced in recent weeks that they are struggling to repay their debts. Lebanon has already kicked off its restructuring process, while Argentina, which was already battling its creditors even before the pandemic struck, appears to be heading for its ninth sovereign default since independence in 1816. Investors believe many other developing countries are not too far behind.

Chart showing that Covid-19 slams emerging market bonds. Rebased (May 9, 2019 = 100). Hard currency bond ETF against Local currency bond ETF

Just where will that stop, especially if the USD starts to rise further? Frontier nations debt burden has climbed from less than $1tn in 2005 to $3.2tn, according to the Institute of International Finance, equal to 114 per cent of gross domestic product for frontier markets but Emerging markets as a whole owe a total of $71tn! In the corporate world, Moody’s suggests that up to 13.7 per cent of all speculative-grade corporate bonds in emerging markets will sour in the year to March 2021. That high end of the estimate would narrowly exceed the 13.6 per cent default rate seen at the peak of the 2008 crisis.

Moody’s track record on this forecasting has been pretty good. Clearly, Retail and oil & gas are the areas of great concern but the NY Fed will start buying corporate debt ETFs later today. Blimey; things must be bad but it seems the central banks are happy to follow the Japanese template for dealing with a crisis but look where it got Japan; nowhere. If markets ever think the outcome from current Fed policies will be as pointless effective as the BoJ, then look out. That day may not be more than a few weeks away.

Meanwhile, the EU is heading down a dark path both economically and politically and I think the Eurosceptics are about to have their day. Last week the German Constitutional Court (GCC) ruled that it is superior to the European Court of Justice (ECJ), and that the ECB has three months to prove it is not exceeding its remit with its extraordinary monetary policy. Then the President of the EU Commission, von der Leyen threatened to sue Germany, stating the final word on EU law is always spoken by the ECJ. Guess which court ultimately hears the case? The ECJ of course. How is this going to play out if the GCC doesn’t back down? Very badly in the Eurozone periphery, to the benefit of Eurosceptics. How is it going to play out in Germany if the GCC is forced to back down? Badly in Germany, to the benefit of Eurosceptics. Given the ECJ won’t back down and the ECB has said it will ignore the GCC, and the GCC is not likely to blink either, we seem set for an institutional crisis over the scope and shape of the Eurozone financial market – albeit one that rumbles on rather than erupting immediately. EUR stayed offered all day again yesterday and I can see why and there is even chatter that other nations may decide to rule on ECB QE programmes (though chatter only so far).

A look at 1.0550 for EUR looks very possible to me (daily above).

It will be interesting to see how US CPI comes in today; a reading for April. The Fed does seem very reluctant to endorse negative rates as an option; but the market is concerned that they may have no choice in the future and this CPI, if a lot worse than expected could prompt another dip into negative for FFs. The BLS provided guidance this week on how the CPI would handle potential rental developments amid the COVID-19 pandemic. In the extreme, instances of rent forgiveness could result in “free” units entering the index, which, if large enough in scale would imply a substantial drag on CPI (where rents account for a 32% of the basket). So the Fed may need to increasingly lay out a convincing narrative as to how they’ll avoid it for markets to not price it in going forwards. Maybe equity investors are right by saying these data no longer matter as the economy was forced to close for a few weeks.

To be honest we are all guessing as most of this is unprecedented but all I am saying is it seems naïve to assume everything pops back to normal. I am not sure that is ever possible. I am pretty sure my take on the world has changed and I am sure it certainly has for all that are currently out of work and the experience will last some time. These unemployed are consumers after all. Right now, sentiment is battling with fundamentals but sentiment can shift quickly whereas fundamentals remain and take time to shift and I would not take my eyes off the damage being done in the EM space either. Could we see a 20% sell-off in stocks? Yes most certainly but for that, the top 5 need to wobble. I managed to stay in the AUDJPY trade but it was close. But I think the USD is going higher from what I see coming as the alternatives all look dreadful. I would recommend selling some Cable here at 1.2335 (add at 1.2415) with a stronger USD view and Britain prepared to refuse the call for an extension; the EU will have to get on with it. I see EUR lower but Cable may have some catching up to do.

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Strategy:

Macro:.

Short AUDJPY @ 69.25 added at 68.25 and Stop at 70.25 recent high.

Short GBPUSD @ 1.2335.. Add at 1.2415 Stop above 1. 2500

Brought to you by Maurice Pomery, Strategic Alpha Limited.

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