Beware markets exhibiting low volatility and complacency. As markets rise steadily, investors with profits can protect their profits by buying put options. They tend to do this at key technical levels on broad market indices. Option counterparties do two things. They either act as middlemen, selling puts to investors seeking protection and buying puts from investors who seek to earn a premium and gain some positive delta exposure to the market. The net delta or exposure that they cannot match up, they need to hedge by trading in the underlying instruments that the options refer to.

Consider when the investor community is net long protection, or net long puts on the market. A long put position is one of positive gamma, or convexity. Option counterparties are therefore net short gamma or convexity. Their hedging strategy involves selling the underlying market when it falls and buying the underlying market when it rises. To further illustrate this, note that if the market is net long puts, the option hedgers must be net short puts. A short put is a long stock and a short call. A short call is hedged by buying at higher levels and selling at lower levels. The expected trading loss is the option premium.

 

Thus, if a market has been rising steadily and investors have been sufficiently careful to lock in some of their profits with put protection, it creates net gamma at important levels in the market. The gamma at these levels simply implies that the market cannot settle at these levels, they either rise above it or they fall below it but they cannot linger for long at those levels. It looks like 2050 was such a level on the S&P, as was 2000. And there are other important levels. As the market rose, investors would have bought protection at 1850. As we get to those levels, the gamma will cause the market to either rebound sharply, or fall sharply, but is unlikely to loiter at that level.

What will the Fed do?

 

The Fed might raise rates in September because:

• It wants to reset a policy tool.

• It honestly thinks that inflation is a future risk and that the labour market is sufficiently healthy.

• It has signaled to the market that it wants to raise rates and if it doesn’t the current market volatility will get worse.

• If it postpones a rate hike to December things might look worse and if it doesn’t raise rates this year, the market reaction might be even more severe.

 

The Fed might postpone a rate hike because:

• There is no sign of inflation anywhere.

• Even the labour market strength is hardly excessive.

• USD strength may be exacerbated and this is already hurting profits.

• Markets have already tightened credit and liquidity conditions on behalf of the Fed.

• Recent equity market weakness around the globe may cause a negative wealth effect.

 

If the Fed stays in September, it might have to move in December because:

• If it doesn’t it will be a signal of a weak economy which would spook markets further and could end up tightening liquidity conditions.

• It would have a pretty hard time managing expectations. If it didn’t hike this year it would have to prepare the markets well before December and guide the market toward an early 2016 move.

 

Conclusions:

• If the Fed moves in September it will be raising rates into a slowing global economy, if not a slowing US economy. The US economy is likely still stable but is not overheating and an early rate hike will slow it down. The impact on the short end of the treasury curve will be quite direct, as one would expect, but the impact on the long end might be to suppress it. The curve is more likely to flatten. The impact on the USD would be negative. A rate decision in September would take away the expectations supporting the USD since the next rate hike would probably skip a couple of meetings and be no more than 25 basis points. USD weakness would put pressure on European and Japanese equities via the EUR and JPY as funding currencies.

• If the Fed doesn’t move in September it will be under pressure to move in December. Delaying into 2016 may be taken as a sign of weakness which could increase volatility and likely depress equity and credit markets. The impact of a delay to December will be positive for USD as it keeps the prospect of a rate hike on the table. The impact on European and Japanese equity markets is likely to be positive through the EUR and JPY as funding currencies.

• Looking at general conditions the Fed may have to delay liftoff indefinitely and only raise rates when data suggests it is suitable to do so. This will likely introduce short term volatility into treasuries and credit markets and weaken the dollar in the short term but keep it on a firm footing over the long term. The dollar will probably only weaken after a rate hike and not before.

 

If you sold in May and went away you’d have been back in July, re-established positions and got your throat slit in August. The S&P and broad equity market benchmarks have lost some 10% in a week, most of it in a couple of days, Europe has done slight worse, down some 12%, and China, apparent epicenter of the troubles is down a fifth, yes, 20% in the last week. Emerging markets have lost some 28% since April in a steady decline. In this time, US, European and Japanese equity markets ground steadily higher, until last week. And then they played catch up. Is this then an emerging market phenomenon unfolding before us? The Lat Am equity markets have been falling steadily since last August (2014). They have lost 50% since then, and 30% since April 2015. Emerging markets as a group are not the catalyst. Was it just China? China equities peaked in mid-June then fell precipitously while western markets chugged along unfazed. It could have been China’s signal that it would no longer support its equity markets but would allow western style market forces for price discovery that broke the camel’s back.

What about credit markets which investors have been fretting over for the past year or two, worrying about market liquidity and the risk of higher interest rates? The US high yield market is down 5.4% since its April high, its European counterparts are down 2.3%. The leveraged loan market is down 1.3% from its April high. Emerging market bonds are generally off their April highs by some 4.3%. Treasuries have rallied, even the US variety where a potential interest rate hike looms.

On August 11, the PBOC introduced market forces into the determination of its CNY reference rate, which resulted in a 2% devaluation. Emerging market currencies which were already weak from weak commodity markets fell further while the relative strength of the USD to EM currencies reduced the probability of a September rate hike thus bolstering JPY and EUR. But the lags in currency movements to the PBOC’s announcement was measured in days, not minutes or seconds as is usual for FX markets.

Commodity prices have been weak since early 2011 with an acceleration to the downside in oil beginning in mid-2014. Commodity prices seem to have correlated well with emerging market equities and currencies.

No smoking gun. Sometimes markets move because of a confluence of events and technical price patterns. Could economic fundamentals be driving markets? The US economy is stable and growing at a very steady if slightly tepid rate. Europe is in a cyclical recovery even if it is a structurally flawed region; Europe is simply not an optimal currency region. Greece is out of the limelight, despite having found no lasting solution; it may once again serve as a focus sometime down the road. China’s economic weakness is a known fact, perhaps the degree of the slowdown has been underestimated. The PBOC’s relaxing of the currency reference rate mechanism could be seen as a competitive devaluation strategy signaling greater problems in China. But China has the economic and financial resources to manage any kind of liquidity crisis. In any case, given the semi closed structure of China’s markets, there should not be and has not been contagion at the financial market level. There will likely be economic consequences of slowing Chinese growth. The Chinese stock market phenomenon is remarkable in the lack of contagion to its credit markets, both USD and RMB. The Chinese high yield market has seen a 3% retracement in the last couple of weeks which is well within the volatility tolerances of this market. At the fundamental level, corporate China has been borrowing against equity to invest in equity markets, a clearly unhealthy practice.

So we cannot explain what happened apart from blaming technicals and jumpy investors. So far so normal. It will not deter us from making predictions about the how the various economies and markets will evolve.

Let us look for excuses to sell the markets.

Central bank policy has created a number of problems. The US Fed is apparently at the point of raising interest rates, and some time down the line, reducing the size of its balance sheet. The Bank of England is similarly advanced in the cycle. The ECB is only in month 6 of an 18 month QE program. The Bank of Japan is in the middle of an interminable QQE program. The PBOC has been in expansionary mode since mid-2014 although it hasn’t yet started to directly buy assets, it is a pretty sizeable repo counterparty.

The Fed is in a difficult position having very early on telegraphed its intentions to raise interest rates. It counted on a long runway to manage expectations and soften the blow of raising interest rates from 0.25%. A long runway has its advantages but is also vulnerable to changing conditions. The US economy is stable but there is no sign of above target inflation and one could argue quite easily is far from being in need of higher interest rates. If the Fed raised interest rates now it would certainly slow an economy only showing tepid growth. In the meantime, expectations of higher interest rates and a resurgent manufacturing sector have boosted the USD and tightened financial conditions. The recent equity market volatility is also tightening financial conditions for the Fed, making a rate hike less justifiable. Having so early on signaled its intentions to raise rates, however, the Fed now risks investors interpreting prevarication as a sign of a weakness, which could lead to wider credit spreads, weaker equity markets and thus tighter financial conditions. Over and above the question of interest rates there is the Fed’s expanded balance sheet which needs to be shrunk at some point, hopefully in an orderly manner. The question of how to shrink a balance sheet gently is a question which will be asked of all the world’s central banks at some stage or other.

The rally since 2011 has been driven re-rating, not so much by earnings growth. Re-rating has been driven by falling interest rates, falling cost of debt to fund buybacks. US equities are unlikely to face falling earnings but they may face a gradual de-rating. Even if earnings grow at 2X GDP growth, the range is 5-7%. A de-rating from 16.5 to 14.5 would still lead to a lower market level. European equities are cheaper than US equities but they show the same trading pattern, that is, much of the returns have come from a re-rating. That said, earnings growth in Europe is expected to be quite robust at c.18%. Also, the ECB is not quite as late in the cycle as the US Fed. The risk of de-rating is not as great.

So much is dependent on central bank policy. The widespread use of QE has led to a disconnect between fundamentals and asset prices to the extent that it is difficult to estimate asset prices in the absence of QE. The recent volatility in the US equity market is an interesting case in point. While other economies have their problems, the US economy is sufficiently robust, at least according to the Fed in the past months, for lift higher interest rates. And yet, the stock market was in free fall for three whole days, losing some 10% of value. As discussed, there are no credible single catalysts for this volatility. Perhaps it is the difficulty in valuing US assets under QE and the fact that interest rates may be raised at a time when the Fed is no longer expanding its balance sheet, and may in fact shrink its balance sheet a year from the first rate hike, that is responsible for this volatility.

The fact that the Fed Funds effective rate is 15 bps and not 25 bps is reason enough not to raise rates. Central banks should refrain from moving rates about as they see fit. For one, their understanding of the economy is no better than anyone else’s. How can one make interest rate policy amid this much ignorance? For another, they tinker with the most important price of all, the price of money, which anchors all other relative prices.

Market interest rates, are telling us something already. Let them be our guide. The market is being distorted by Fed OMO and rate prognostications. The market doesn’t need to watch a Fed that is watching the economy. If the market focuses on the economy, the Fed can be absolved from that responsibility and go where all central banks should go absent crisis. The scrapheap.

On a more topical and practical note, the Fed has backed itself into a corner. If it raises rates, it does so into a US economy that isn’t exactly firing on all 8 cylinders. You don’t raise rates when inflation is this conspicuously absent, when you clutch at straws to find strength in labour markets. It is clear that the Fed wants to raise rates, is looking for an excuse to raise rates, because it telegraphed its intentions too soon, based on data that is now stale. If the Fed doesn’t raise rates, given current sentiment, the market will take it as a sign of weakness and asset values will tumble further. Since the Fed has been revealed to be supporting asset markets, it won’t do that. If it does raise rates, it will allay the market’s fears but it will slow the real economy. It will have to go very slowly indeed into the next rate hike. And it will have to provide more liquidity support to the market. It couldn’t possibly do a QE4, so a backdoor QE like the ECB’s LTRO may be one idea. But if it did do that, then the effective rate would not rise substantially to the target rate and the Fed risks losing the little credibility it has left.

So we have this situation where the Fed is damned if it does and damned if it doesn’t. In other words, the Fed is simply damned.

Discretion is the better part of valor. I began the year still bullish on China domestic equity markets. The thesis was founded on a number of factors.

1. Low inflation and slowing but still positive growth had led the PBOC to significantly expansionary policy. This policy was widespread including

   1. Cutting the RRR.

   2. Cutting interest rates.

   3. Various open market operations to increase liquidity and cut real borrowing costs across the board including short and medium term lending facilities, pledged supplementary lending and a local government debt swap which manufactured qualifying collateral for cheap repo.

2. Valuations on Shanghai Composite and H Shares were not demanding, at 15X and 8X respectively coming into the year.

But we outstayed our welcome, missing a number of things.

1. The level of retail margin trading was apparent and we saw that. What was less apparent was the level of corporate share financing whereby corporates used their equity as collateral for loans.

2. Corporate borrowing to invest in the stock market instead of operating assets. This created a feedback loop whereby falling prices triggered LTV covenants and thus margin calls on corporate investors.

And we revised our outlook for a number of reasons.

1. Corporate investments in the stock market implied A) company management not seeing investment opportunities in their core competencies, B) corporate balance sheets were more volatile than represented and therefore of poorer quality.

2. Given the signals from corporates’ investment patterns, we have a less optimistic view of Chinese corporate earnings prospects. Indeed the economy appears to be slowing faster than we expected. Despite the fact that our investment thesis relied on a slowing economy, it relied on a moderate decline. The current decline appears to be more serious.

We expect that the Chinese equity markets will trade in a range.

1. We expect the Chinese government will not tolerate much weaker equity markets as this will threaten the solvency of corporate China. Hence there is an implicit support, a sort of PBOC put. We think the strike may be around 3500-3700 if we use the Shanghai Comp as a guide.

2. We expect the Chinese government will not tolerate strong equity markets either. The 18 month bull market in Chinese equities was not driven by earnings growth but by a massive liquidity operation of the PBOC resulting in multiple rerating. This encourage leveraged, speculative activity which destabilized the market. China values stability and will likely to allow the market to rise too quickly. We think there is a sort of PBOC call, with a strike somewhere between 4300-4500.

What about structural reform?

1. We think that the structural reform in China will continue. We do not see the anti-corruption campaign and the emphasis on rule of law and the constitution as cosmetic but rather as a genuine effort to create a socially and politically durable regime. We think that to not do so is to present an existential threat to the Party in the face of a growing middle class and greater information mobility.

2. Economic reform goes hand in hand with political reform. As the government is moving towards rule of law, it is pushing its economy to rule of market. The intervention in the equity markets during the recent volatility is no more interventionist than the Fed, or the ECB during the credit crisis of 2008. The recent turbulence surrounding the new RMB rate determination is also, when examined closely, a move towards more market price discovery, but was unfortunately miscommunicated, and misunderstood, as a competitive devaluation.

What are the long term prospects?

1. China continues to grow in size and importance. Even at 6% GDP growth, China will add more nominal output than the US economy growing at 3%.

1. China’s to do list includes the following

   1. Rule of Law.

   2. Rule of Market.

   3. Rebalance the economy.

   4. Hold society together.

Holding society together is the most important agenda item as it gives the Party legitimacy and thus a raison d’etre. Rule of Law is simply a means to this end. Corruption needs to be addressed in order to present a fair and even playing field in a country where inequality has been rising even as the country has become richer. Rule of Law is also important in presenting the government as an impartial and disinterested arbiter. Most importantly, laws and principles are far more durable than persons or parties. By embracing the constitution instead of subordinating it as in the past, the Party gains legitimacy and longevity.

Rule of market is necessary to integrate China into the global economy even more. When China was simply a factory, integration is not important. The relationship between China and the rest of the world was sufficiently simple that it could be controlled through closed channels. If China rebalances its economy successfully, it will no longer be just a factory to the world but will be a source of capital as much as a destination, a source of intellectual property creation as much as a consumer of it, an importer as much as an exporter. Only an open economy guided by market forces, even if with some soft direction, can facilitate China’s future intended relationship with the rest of the world.

In the long term, investing in China will be more like investing in the US. Today we buy US business and companies, not USA. In future, we will also be able to buy Chinese businesses and companies and not just China beta.