Track Research hosted its mid-year idea dinner with an illustrious group of traders, analysts and portfolio managers.This dinner identified a list of 5 negatives for markets and yet ended with many leaving upbeat on the second half with a bit more risk appetite seemingly spurred by the food and wine.There were moments of boisterous bullishness as betting over deserts proved, along with almost abject despair as many saw the decline of Western democracies as inevitable. The role of the USD and the calendar to the mood was also part of the puzzle of where to put risk in 3Q.

The US did have half-dollar coins early in its history – and perhaps that early money and how it was used for explosive growth into the next century is an example of where markets are in 2018. Of course, the role of tariffs and trade back then was just as important and maybe the cautionary side tale of the new Trump economy. 

June Price Action:

Many will be happy to see June go. Price action across most markets has been choppy, volatile, and filled with more fear than greed and yet the drop in mood hasn’t been completely reflected in price. We saw an early rally up in S&P500 fade to near flat at the end of the month. The S&P500 is up about 2% on the year – not horrible given the 1Q theatrics but hardly inspiring.  Emerging Markets have notably suffered from ARS, TRY, BRL and ZAR – bleeding into a contagion with the MSCI EM off 6.5% and the currency index off 2.6%. Turkey led the pain trade this month with the snap election working out but certainty in politics doesn’t mean sustainability.  

The late spring surge led to a stultifying start to summer with the focus on global trade war fears rising – starting with China going into a equity bear market as the Shanghai Composite falls 10% so far on the month, 23% from its peak, CNY off over 3% - with Germany’s DAX down 3.4% on the month, EUR down off 1.5% as focus on Autos and Deutsche Bank dominates. US shares are mostly up though DJIA is off 0.7% while the NASDAQ is up 0.90%.   The VIX is holding 16.70% up about 1.5% from May, still below the 20% fear mark and near the long-term average.

Commodities are another story and one that puts the OPEC increased production agreement at odds with the price, as WTI jumps over 9% back over $72 while Brent is flat. Other commodities reflect trade fears with Corn off 12%, Soybeans down over 15%. Perhaps most confusing for many in a time of rising uncertainty is gold which is off nearly 4% despite fiat currency doubt.

For rates, there was a dramatic turn down despite the FOMC hiking another 25bps and spelling out another 2 for 2018 and more for 2019. 10Y Rates touched 3% twice in the month and then rolled over on risk-off moods at month-end to trade below 2.80% but we seem set to close near the 2.85% levels. German Bunds were much the same as the ECB taper talk but forward guidance on rates had 10Y Bunds over 0.5% 3 times only to see a test below 0.3% at the end of the month. The question to ask is whether trade war concerns are overpriced and growth/inflation underpriced into 2H 2019.

June Idea Market Themes:

• Trump Trade policy uncertainty hitting confidence vs. US growth in 2Q
• FOMC rate hikes vs. EM USD funding squeeze,
• Recession risks and yield curve vs. term-premium and BOJ/ECB QE
• China growth slowdown vs. PBOC reaction function – weaker CNY, softer rates
• Market liquidity and technology vs. Volker Rule easing and the end of LIBOR
• Populist politics – more spending, less immigrants vs. Push for broader EU reforms
• Brexit and PM May politics vs. BOE rate threats, loss of London as financial center
• Crisis alpha – is there a hedge to present market state vs. global QE, negative rates and liquidity traps

The Wall of Worry List:  The dinner listed out 5 key themes that investors need to climb over. This was the heart of the conversation, as to how to see beyond this list. Many argued that comparisons to 1987 were just wrong and that they were frequently cited by bears over the last 10 years only to be shown wrong. Others noted that tight monetary, easy fiscal = USD higher. Global savings are going to the US at the expense of the rest of the world. Throw in $ repatriation thanks to the tax reform and trade concerns and you have a USD squeeze that destabilizes EM and other markets. Ultimately, the room saw the risks and rewards into 2H2018 as balanced.

1. The end of easy money – FOMC normalizing rates, ECB tapering QE – both lead to less global risk taking as it’s the opposite of QE3 where policy tried to drive up risk taking.The view was that the ECB, Norges Bank, BOE, BOC and Riksbank – all wanted to move to tighter policy in 2018. Against this was the argument that divergence in policy was going to continue longer and make up for the Fed rate hikes.This led to a sidebar discussion of the term premium in the US 10Y and how many see that as consequence of policy divergence.
2. USD drives EM volatility – the higher US rates were seen as a key support for the USD and that left little room for emerging markets.One participant highlighted the RBI Governor’s push back against FOMC Powell’s argument that US policy isn’t driving cash outflows in EM, but the $14 trillion in EM corporate borrowing means higher US rates force deleveraging. The trouble in emerging markets was discussed as starting out as idiosyncratic but now reaching contagion like levels.
3. Politics – The role of Trump policies driving volatility and a new world order from WTO to NATO starts with populist politics driving his agenda.Similarly, many saw Italy facing a similar new populist government leading to more EU disagreements.The Merkel troubles over immigration highlight this point. The debate over politics led to comparisons with China/Russia where autocracy was seen as winning for now.Stakes over the present trade situation were seen as high.
4. Liquidity in Markets – the rise of financial regulation post 2008 mixed with more technology leading to faster electronic markets made many at the dinner fear more flash crashes leading to systemic risks.The role of LIBOR was discussed at length and the argument was made that the $350trn of paper using LIBOR will be at risk well ahead of the January 2022 headline. The problem of replacing LIBOR was seen as driving regulatory arbitrage and hurting liquidity already with the US/UK versions of official rates being an example.How FX markets deal with the implicit lack of credit clarity was also discussed.
5. Cycle of the Economy – Some argued that higher oil, the FOMC raising rates was indicative of a later stage economy.Others made the point that the US was far from there with profit margins still very strong, inventories low, overall wage inflation modest – all point to middle stage of cycle.The other point made about the market was that even as profits in companies peak, the stock market continues to go up.One study found that the average gain in the S&P500 was over 25% from peak earnings.

Offsetting the wall of worry from the list above was US growth, expectations that trade war fears were overblown and lead to better global deals with lower tariffs and that the rest of the world would continue to keep rates easy.Whether US growth was going to continue to be as robust as 2Q – estimated at 4% or higher by most at the dinner – was the key debate.Many expressed fears that the key was both business and consumer confidence.The role of the media in being negative mixed with the political noise of the mid-terms and the ongoing trade war rhetoric driving down optimism. 

The biggest obstacle to the market rallying from here is how global trade disputes plays out.The global order was seen as being upturned by US President Trump and other populist politicians. How the present China/US skirmish plays out was seen as difficult – with many seeing it getting worse before it gets better. Fear was high that the market expects a deal when Trump seems unclear on what he actually wants. The consensus was that Trump was using trade as a negotiation tool but the debate in his cabinet between the free traders and the unfair trades was seen continuing. The President didn’t take the quick win on when China offered $70bn in trade deals – making clear he wants something larger and is clearly going to push harder. China was seen as winning the first set of talks and publicity, with its interest in US LNG seen as important in setting up a new world order.

As for the implications of this, many saw the fear of contagion in EM as the first wave. Some argued that oil was the differentiation – with India and Korea most at risk in Asia while others saw C/A deficits as still the most troubling with South Africa, Turkey as the front line of trouble in EM.  Oil was clearly not enough to help MYR, RUB and IDR pain trades making it clear that oil isn’t the only driver here.  The role of IMF and World Bank in solving problems from trade contagion was put into doubt. 

The higher risk aversion in 2018 was seen as something here to stay.  Some argued that volatility in equities was higher this year due to rates, others to geopolitics, many saw the bruises from 2008 still not forgotten.As for this risk aversion remaining into 2018 2H the role of the FOMC balance sheet roll-off and shrinkage left some concerned about mortgages and household leverage. The ability for the FOMC to stop its balance sheet reduction as a tool was discussed. The balancing act of capital spending against the fear of the US mid-terms and a Democratic Sweep was also discussed.  

Best Trades:The trades were more upbeat for risk than the dinner in May but this wasn’t uniform.

1. Short JPY, Long USD.The US rate differentials and the modest hopes for a more positive risk-environment drive this trade logic with 110 to 120 test seen.
2. Short ETH and BTC vs. long RIP and other newer coins.The role of bitcoin as an anchor to value was put into doubt with fear that more investigations will hit both brokers and new business wrapped around BTC and ETH.
3. Short Gold. Perhaps it was the room’s bullish risk tilt or the talk of the USD going up further, but this trade was seen as having more momentum with $1235 key for $1150 retest.
4. Short EUR, long USD. While this trade worked well from 1.23 to 1.15, the argument was made that we could see 1.16 to 1.08 again with US rates, EU politics continuing to drive.
5. Long volatility (VIX).This was a bit counter to bullish mood on equities but the fear gauge was linked to weaker financials and fears that it would continue with yield curve flattening. 14% to 20% return was seen in 3M.
6. Short Financials.This was a debated trade with some seeing a rally back in the next 2 months but over the longer term 12months or more, lower thanks to LIBOR issues and other issues like the rate curve.
7. Long Nikkei and short JPY.The hedged long Japan asset trade has not done much but was seen as working better in 2H2018.
8. Long Nifty50.This wasn’t hedged like the Japan trade.INR weakness in 2Q was seen as overdone.

Worst Fears: Trade and US politics were highlights again.

1. Trump goes full protectionist with China, Europe and NAFTA leading to retaliation and global trade war.
2. In crypto currencies, Tether infects BTC and drives price below $2000
3. No US midterm election majority – a 49.9-50.1% split in Congress.
4. US Supreme Court nomination leads to larger disruption in politics and policy.
5. Negative news globally leads to an erosion of confidence in markets and economy.
6. Libor replacement costs and regulation lead to further lack of financial innovation hurting economic productivity and growth globally.