The trading of all asset classes in October was difficult. The plunge in global equities, the pain in bonds, the retreat of commodities and the ongoing rally of the USD against emerging markets and the EUR – all that forced a rethinking about what is a safe-haven.  The blame for uncertainty and risk-off moods came from the FOMC rate path projections, the Trump trade wars with China and ongoing with EU, the Italian budget battle with the EU, the UK talks on Brexit with the EU, the slowdown in 3Q growth in EU and Japan and China, the credit concerns in China and EM, the ECB ending QE, the BOJ thinking about policy shifts, the geopolitical problems from Iran sanctions, Saudi and the murder of journalist Khashoggi and the political shifts to the right from Germany to Brazil.

This list didn’t scare the October Track Idea dinner participants as much as depress it. The food and wine offered little comfort and the energy level of the room was the weakest seen for all of 2018, even February.  The group included portfolio managers, investors, research analysts and quants, gathered for a lively discussion of the markets with the first question being what is most important going forward, the second being what drives risk moods, and the third being a broad discussion of politics. 

What’s most important to markets going forward?

This was more a listing exercise than a debate as most in the room agreed on the factors but not the order or impact of them.  The list of issues was long and we spent much of the time trying to find something to add rather than to debunk the list.  The contrast to the September dinner was stark and the mood was less one of fear and more one of disappointment. Here is the list:

• Rates up.  The rise in global interest rates starting with the US was noted as the key factor for October and going forward.  The fear that rates would lead to a rethinking of equity values and squeeze out growth was the follow-up

• Central Banks. The role of central banks in removing liquidity as well as raising rates was also discussed. The ending of QE in the US was the key turning point for shifting volatility, changing investment strategies.  QE was a global event and so the US exit was less important than that of the ECB process and potentially even that of Japan.

• Forward Guidance. The tool now seen as one of the most powerful for central bankers was blamed for much of the present and future risks for policy.  The shift from promising lower for longer rates to policy normalization made the role of data puts the uncertainty on the central bank reaction function.

• US/China relations.  While many saw the trade war as central to present uncertainty, a large group also saw the relationship shifting into a cold war scenario. Everyone saw the risk of the US/China trade disputes extending well into 2019. A few expected a temporary deal that would likely fall apart later.  No one thought Trump or Xi would blink on the pressures each can put on each other – the US 25% on $250bn of goods vs. China shunning US bonds, limiting US key goods for production – neither solve the push for US IP protection and technology against China’s made in 2025 targets.

• Nationalism. There was a debate about which sort of nationalism mattered more – but most noted a sharp rise in right-leaning leaders from Italy to Brazil as chilling the global rules and pushing against the present world order.  Others noted anti-establishment parties as part of the off-shoot of political discontent – with the 5-star movement as the example.  The fear of more political shifts driving wider fractions in society followed along with the role that plays in destroying confidence.

• Politics.  The rise of extreme politics and the inability of many nations to find democratic consensus got the blame for hurting market confidence.  The slow erosion of government power leads to a broader problem for institutional credibility.  Many noted the role of politics in the US and the upcoming mid-term elections as a case in point for markets.  

• Oil/Middle East.  The ongoing cold war between Iran and Saudi was blamed for much of the present headlines. The murder of Washington Post journalist Khashoggi in the Saudi Embassy in Turkey becomes a problem for US and EU roles in this broader conflict. Oil also becomes the barometer for whether this risk matters. The role of the USD as a reserve currency for oil was also discussed with the China oil futures seen as an alternative to USD hegemony. 

• Passive Investing Dominance.  The role of passive investing since the great recession got some blame for the present equity/bond pain as many in the room saw the long-only, risk-parity and risk-factor trading models as vulnerable to active issues and driving larger washout trades.  The role of data mining and quant approaches to investing was also discussed with the view that much of the edge formerly found in information gathering was no longer present given the speed of collecting data and the push for e-trading across products.  Many saw today’s alpha turning into tomorrow’s beta products leading to further compressions in the financial industry.

Why are Risk-Assets lower?  While the listing out of factors driving markets seems to be the strategic reasoning for selling rather than buying, many wanted to discuss the tactical factors behind the October sell-off and think through whether this was a new trend or a buying opportunity. What showed up was a deeper dive into the details with fears about policy mistakes, inflation, global growth, mean reversion and deficit spending all coming out.

• Inflation.  The fear of an FOMC policy mistake rests on the rise of inflation surprising markets. There is no evidence of this yet but many saw US tariffs as beginning to matter. Also, connected to inflation worries was the pressure it puts on corporate profit margins and the effect it has on killing consumer demand. The rise of oil in 2018 was also mentioned in this discussion as it limits the ability for the ECB, FOMC and others to respond to present market volatility. 

• Global Growth. The ability for China to grow through the present tariffs was in doubt, but credit issues were also highlighted and some speculated that even with a trade deal, China growth would slow, adding to pressures on Emerging Markets.  US global facing companies were very much on the front-line of this discussion with CEO comments from 3Q earnings reports highlighted by the group. 

• Elections.  Beyond the US elections, many saw the pressure on Merkel and the EU in general as a problem for markets with the choice of the next ECB President and the EU shift in key leadership roles as a fear being reflected in prices.  More political upheavals were expected globally.  There was some discussion of Xi pressures in China and the inability for markets to correctly price this fact.

• Deficits.  The squeeze of global money by government borrowing was a rising problem aggravated by the FOMC balance sheet reduction and the upcoming QE end by the ECB.  The $400bn in 2018 may have been neutralized by the US tax reform and repatriation but that won’t work going forward.  Many saw the end of EU QE as a key factor flipping US term premium risks likely leading to higher US borrowing costs.  The level where rates mattered to stocks in 2019 was 4% - with that risk-free level seen as sufficient to pulling out excess investments in equities. The inflection point of peak earnings followed the calendar with tax cuts likely taking 10% or more from baseline 2019 earnings and with rate hikes adding to this view.

Why do politics matter?  Anyone that sees politics hurting markets now should have to answer to why they didn’t in 2016 and 2017.  The shock of Brexit and Trump didn’t hurt risk-assets then, so what is different this time?  The relationship of politics to overall confidence was discussed at length.  The rise of more extreme political views and splintering of electorates into identity politics was also mentioned.

• US and the Mid-Terms – most expected a tight result leading to gridlock in Washington. Polls suggest an edge to the democrats but the betting in the room was for a closer outcome with the Senate held by republicans and the House flipping to the democrats.  Effect on US government was negative with risk of impeachment proceedings derailing any hope for deficit controls or solutions for infrastructure spending.  Others pushed on the idea that only two issues have broad bi-partisan support – China and Infrastructure spending.  Countering this point for better roads, bridges and airports was the view that it was the regional disparities in such needs and the divisions of Red and Blue states leading to no real progress on either – particularly if this was paid for by a gasoline tax. As for the views for more on China, IP theft was a unifying theme while the trade war was less obvious Some thought the democrats would become like the republicans under Obama – the party of “no.”  Most agreed that this election would not end with a boost back in confidence but linger on as a problem for consumers and companies.

• Europe – The drop of support for Macron in France was highlighted as a problem for European shifts in policy and more proactive policy from the EU.  The demise of Merkel was also seen as causing more trouble for the EU as it tries to find a solution to the Italy budget challenges.  No one saw the ECB as able to do whatever it takes in 2019 as the replacement for Draghi was expected to be far less supportive of the periphery. 

Best Trades – This was less of a bearish list than in September, and that alone may give some hope for November performances across markets.  The list of trades had no strong commodity views which maybe something to consider as well. 

• Sell Bitcoin (BTC) with present $6350 target to $3500 and $2000 or even lower with $10,000 stop. View was that the shine is gone from the entire crypto currency world and that as rates rose globally, money would be pulled.

• Buy Argentina USD paper 2-3 years at 9%.  The pick-up in yield was viewed as good compared to the risks with the IMF $53bn backstop seen as sufficient. 

• Buy MXN and sell SGD (or more broadly buy LATAM FX basket and sell Asia FX basket).  This is a positive carry trade and one that sees the issue of trade wars helping Mexico and hurting Asia into 2019.  There was some push back on the commodity link and role of China in feeding back to Chile and other South American nations.

• Long S&P500 and long inflation bonds.  View was that October push was overdone for real rate rises and that it hurt equities more.  The anomalies of sector rotations in October was also discussed with Utilities vs. Consumer Discretionary as an example of the broader confusion over cyclicals and defensives.

• Trade S&P500 range – View was to buy at 2650 and sell at 2750 as long as real rates don’t rise and inflation remains in line.  This was the best short-term trade of the dinner but one that required some nimbleness to execute.

• Long calls for US curve steepening.  View was that 2-10Y curve was too flat and risk reward was for caps to pay out.  This trade also worked out but view was that it was going to continue for 2Q2019.

• Long US dollar index on clean break of 97 for 100 test.  The FOMC hike path was expected to continue to diverge against the rest of the world. This was the poorest performer of the dinner but view was that it would remain in uptrend for 1H2019.

Worst Fears – the lack of bigger geopolitical fears maybe telling and one that creeps back into the list in November. The two biggest fears were about Europe and China both getting worse.

• QE never ends.  The fear of a global liquidity trap remains in play.  ECB and BOJ being the two biggest fears.

• EU crisis. The Italy and Germany politics were seen as heading for a bigger conflict in 2019

• China blow up.  The fear was that China growth drops faster than the 2022-2025 expectation

• EM USD debt blow up.  The USD debt for foreigners both corporate and sovereign blowing up further was the fear.

• Rising real rates.  The sharp uptick in October real rates extending through 1Q2019 was the fear.

• Trump intervenes in the USD.  Fear was that Trump pushes against the Fed and China and sells USD without G7 support.

Conclusions:  This was a bleary-eyed group.  The discussions lacked the usual passion and debate as there was a beaten down consensus that markets were oversold but little will to fight against the mood.  The list of trades suggested showed the logic of trading against the tide but not much else.  Many left the dinner and had more of a confessional relief than an inspired urge to trade.  This highlights the present environment more than the future one where many saw issues coming to a tipping point – like politics and trade fears.