In a testament to the sprawling confusion that has erupted in the aftermath of the recent market swoon (and correction), the past 2 days have seen a veritable cornucopia of rhetorical question by an analyst community that has few answers but a lot of unknowns.
Just yesterday we discussed a new report by Bank of America’s derivative strategists, asking “what if a new bear market has begun.” This morning, it’s Bloomberg macro commentator Richard Breslow who notes that the $64 trillion question asked around trading desks everywhere today is “do you think we will look back on this period and realize this was the turning point.“
While Breslow does not give an answer, he shares a list of items that traders need to consider when deciding what to do next: the things investors and traders will have to keep an eye on include i) central banks and what they do next; ii) soaring LIBOR and the collapse in FX-hedged TSY yields; iii) Geopolitical risk, and how to hedge it; iv) positioning and crowded trades and v) the impact of regulation on markets.
Adding all of this together leads to another word, “change”, something that traders of this generation may have forgotten how to adapt to in a time when central banks used to eliminate all downside risks. Is this time different?
Breslow’s full note below:
Embrace Change as a Strategy, Not Just a Tactic
The first question I was asked this morning after, “Did you remember your umbrella?” was, “Do you think we will look back on this period and realize this was the turning point?” It’s an interesting question. I was initially tempted to reply that time will tell, but upon further reflection decided to avoid getting whacked with said umbrella and give some thought to what was being asked.
Usually when people ask this sort of thing they are simply wondering whether it’s time to fade a trend. It’s a roundabout way of asking what to do. In this case, however, its implications are so much greater than merely some tradable moment. We are really asking has the world changed. And the speculation about that causes so much emotion that it’s hard to even have the discussion. Especially in a world where even the most adamantly felt conviction trades have life cycles subject to alteration based on a couple days of price action.
Was it only a couple of weeks ago that we were writing about money flowing back into hedge funds as investors are betting on a strong 2018 performance? To be fair, this is partially in a response to concerns that real-money managers may struggle. They’ve broadly hinted at this themselves. But for hedge funds to outperform they will need to put the “hedge” concept back into hedge fund. And that is something they have been punished for attempting since the beginning of the quantitative easing experiment. How they do during this roiling period will be a defining moment for the industry.
- One thing that you need to resolve in your own mind is just how reliable are the assurances that central bank rate and balance-sheet normalization will go smoothly. “Smoothly” is a poorly chosen euphemism for “without any pain”. The answer is that it’s unlikely, which is not to say it may or may not go OK or doesn’t have to be done even if it gets a little rocky. Cue the discussion of reaction functions and ignore any claims that central banks are apolitical.
- Short rates are going up. Libor is higher for the 36th day in a row. And you can be sure this is playing havoc with a broad subsection of quantitative models. Crowding out hasn’t even started in any meaningful way. And all of the Fed’s friends are itching to talk about when they can talk about getting started.
- Another biggie to consider is whether geopolitics will once again begin to have lasting impacts on markets. The answer to that is brinkmanship in a deeply unhappy world is a dangerous even if calculated policy where one side thinks it’s a tactic and it looks like strategy to everyone else. Especially when you get more than one superpower involved. How do you handicap this? With hedges. Not by thinking you can be all-in or out as the news ebbs and flows.
- Another change to consider is that during QE it didn’t really matter when you got in on a trade. Rising tides and all that. “Crowded” just meant having congenial company. In a higher-volatility, less wealth- effect driven world it’s become far more important to be as early or alone as possible. This is going to require fortitude that may be hard for many to summon.
- Lastly, for this short list, consider that regulation can be a dirty word for some and a saving grace to others. Some is by choice and some by necessity. Events in the large cap tech world could have long-term ramifications that change all sorts of attitudes and policies. And these may or may not be industry specific.
People, especially investors, are often highly averse to change. look around and ask yourself whether some change might not be a good thing indeed. You just need to prepare for it.
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