January 2021 Macro Markets Post

 Recap

Hi all, and thank you for tuning into the January update from MacroSquawk. First looking back to the November update. A lot of the views written about at the time had come to fruition. From that writing we saw continued weakness in dollars, and a major rally in cyclical commodities which was the highlight of the last post. The challenges were an underestimation of the robustness of the rally in cyclical stocks, which was a massive outperformer to the rest of the equity market. We have also seen what's presumably a fundamental shift in the macro with the Georgia elections that has shifted the interest rate and monetary policy outlook.

Macro Thesis

In a rare moment in the history of this blog, it seems looking forward into 1Q21 and 2Q21, we are entering into a more tepid outlook for risk assets where sentiment can, and might actually, roll over more easily. Most of the street is pricing in the possibility for record gains in the real economy. However, this view ignores the rising political, monetary, and health risks from the virus that might create roadblocks for risk assets across the world which have already started to be priced in less-followed parts of the market.

The first and most obvious risk is the poorly planned rollout of the vaccine which is leading to higher rates of inefficacy, along with the news strains of the virus. In an astounding, but perhaps not unexpected turn of events through the covid saga, governments across the world are systematically failing in vaccine distribution. This comes from disputes over who gets the vaccine first, how much of the vaccine to distribute, and to possibly delay taking the second dose which can lead to lower rates of inoculation. This is combined with the fact that there is no evidence that the vaccines work after 1 year which further compounds the vaccine risks. The other risk here is that there are two different strains of the virus from South Africa and Britain that have mutated and are not yet shown to be effectively fought by the current medication.

The obvious rebuttal to this argument is that governments across the world have ushered into a "new age" of fiscal dominance via MMT-like policies which promise to mitigate any fallout. This might be true - depending on your persuasion it might even be laudatory. However, its effects are starting to reverberate across interest rate markets and eventually across the whole world. The recent Georgia elections have handed this argument massive credibility as 10 year yields have broken solidly above 1%. What's more is that the Federal Reserve has even publicly stated that they are not yet worried about the level. This might indicate that there is much more room to run on the rates trade as YCC and other forward guidance might be mostly or completely off the table for now. This, along with Biden's doubling down on his message of, "a large price to pay," and his unmitigated ability to act might compound the worries of even the most complacent doves. That on its own should be a worry to stock bulls as earnings risk premia are likely to compress from here.

The worry about inflation might also be well-placed given that the global real economy does not seem able to perform without stimulus. We already see a slowing down of activity in China as they have gone from bear steepening to bull steepening on 10s30s. This might be due to the fact that manufacturing, though still growing, has slowed down since the initial reopening. This was evidenced by the December manufacturing PMIs. The challenge with this is that China tends to lead the world in activity and this might reverberate around the rest of the world in due course. This would leave the United States as the most likely to keep global growth going. However even here we see that the real economy is not performing. This is evidenced by the recent NFP numbers which have missed the mark, along with labor force participation grinding lower. This means that the outlook for growth in the United States in the first half of this year might be totally dependent on stimulus and vaccine news, both of which have risks of their own. This is evidenced through the US credit markets that are already starting to price in financial stresses (chart below). Therefore it might mean that stimulus will only delay the inevitable. 

For these reasons it makes sense to start building a portfolio that is hedged for the possibility for downside coming into the end of the end of the quarter and into mid-year. This is because while the risks might be rising, it will be difficult to time them and would be a stroke of folly to fully put on the trade after the trade right now. For these reasons the major theme of this post is a potential reversal in dollars after months of one-way action. This is along with a continuation in the rally of cyclical commodities, though in a more cautious way given the nature of aggregate demand. Caution must be used in the equity markets; this is because the rally in cyclicals might be a month or two away from some kind of top. While the short bonds trade might seem enticing, it might be best to find other expressions for it. This is because experience has shown that the Federal Reserve as an institution jumps in too quickly in the beginning of cycles to raise rates. This might happen even in spite of their new AIT framework given institutional inertia. 

Here we see IG credit in the 15 year and above maturity bucket sharply selling off. What's interesting is that since the second half of last year, this has been a reliable leading indicator by almost a month of what will happen to general risk sentiment. This along with the fact that the Federal Reserve has stopped its purchases of corporate bonds at the end of 2020 might pose risks to the outlook for corporates that can feed into the stock market.

Here we also see Chinese yields have broken through important resistance levels and have started a new downtrend. Typically, Chinese yields tend to lead rates across the world. Along with the slowing down in Chinese manufacturing, this might also pose risks as we get into 1Q21 and come into midyear. 

Summary of macro thesis

• Increasing risks to the outlook coming into the middle of the year. These are: policy inefficacy in vaccine rollout, mutant strains of the virus, and misuse of vaccine doses which delay immunization
• Massive fiscal stimulus might only delay the inevitable pricing in of a globally weak/weakening real economy, while at the same time adding inflationary stresses. Thought must also be given to how stimulus might make today's employment crisis a structural issue by keeping labor force participation lower for longer. This might lead to a political necessity for continued stimulus.
• This political necessity might at some point this year meet with the demands of economic logic in that the Federal Reserve might be forced to raise rates before they plan to. Whispers are out about this topic though more information must be gleaned later this year
• As a result one might position themselves to capture the remainder of this rally in risk, while preparing for the next trade

Long Dollars - USDMXN, USDBRL, USDKRW, USDZAR, USDJPY 

As stated in the thesis, the major view for this post is betting on a possible shift in the one-way action in dollars over the past six months. The versatility of this position in multiple market environments makes it an attractive trade that deserves to be a larger position in a portfolio. For example, if we continue to see rising yields, in accordance with a bull market, it's possible dollars might rally. In this environment we would see capitals flood back to the United States after an ample dose of fiscal stimulus that shifts growth premium in the US' favor. This was a pattern that was seen across the world last year (example CAD and EUR). This would be a situation in which EM equities and commodities are likely to continue rallying, along with EM Rates selling off (which is what we have already seen since the end of last year). However if the worst is realized, it's likely that we would see a flood back to the US and into Treasury bonds. Therefore in most situations this trade seems to work. Where this doesn't work is if the market continues to price in the debasement of dollars given massive fiscal stimulus.

In response to the above-stated risk, it might make sense to play for a potential reversal given that the DXY is currently at the important 90 level. It's also the case that a lot of the above-mentioned pairs are likely to have their basic balance of payments come out of line given the rise in oil prices given that they are net importers of oil. ZAR has already started pricing in that story. BRL might be coming undone given the possibility of more stimulus that the country may not be able to afford. USDJPY is moving mechanically with rising yields in the United States. MXN might also come undone given that it has in recent years become a net oil importer. Perhaps the only thing saving it is its still higher than average carry. However whenever that fails there could possibly be a large reaction to the other side. Along with rising yields in the United States, it might make sense to play for a reversal with very high risk/rewards. 

Above we see a chart of DXY. Here we see that it is at the important 90 level where there is a possibility for a reversal given that it has acted as a major level since the beginning of this decade. Along with the shifting fundamentals led by interest rates, this might make for a good spot to try and fade the one-way action in dollars for the past six months. 

Here we see the chart of USDBRL in a possible bullish pennant that has been developing since the summer of last year which can possibly break given a reversal in dollars. What makes this a fundamentally interesting trade is that it was the worst performing currency last year given a weaker aggregate demand function. The other thing that makes this interesting is the fact that they plan on doing fiscal stimulus sometime this year which is something that they are less likely to be able to handle compared to the United States.

Here we see a chart of USDKRW right along the years long support. Along with the fact that dollars might rally here, KRW also seems vulnerable given that they are about to go into lockdown once more which would weigh on their capital account. It's also the case that they are heavily dependent on their current account via exports. This is heavily dependent on the global real economy which at the moment seems weak outside of the possibility for stimulus. 

Here we see the chart of USDMXN sitting right at 20. This is interesting because outside of the carry, there are few reasons to be long MXN. This is because over the past few years they have become net importers of oil. They have also gone through a downturn in activity, which has been reflected through their underperforming equity markets relative to the rest of EM. This can possibly lead to a shift in their capital account in spite of higher carry. 

Here we see a chart of USDZAR holding its years long support. What's interesting is that USDZAR has been an early mover based on the weakening balance of payments that might hit the rest of the above-mentioned currencies. As a result, ZAR might act as the bellwether for the EMFX short. 

Here we see the chart of USDJPY breaking out of the downtrend it's been holding for almost a year. This would be a pure expression of the widening rate differential as a result of stimulus in the US. 

Commodities - Long WTI and Silver, short Lumber 

This basket of commodities allows for an accurate expression of the state of the global economy. On the one hand, we are in the midst of a decline in activity. This was more than evidenced by last month's housing data which unexpectedly turned down. As lumber is the primary input in homes, its price action is likely to be a function of that downturn. Technically it also seems to be offering a good setup to play for a much more pronounced selloff as we enter into a seasonal lull period for home buying as well as the downturn in the macroeconomy. 

On the other hand it might make sense to be long oil and silver because they offer exposure to the various paths that inflation might take throughout the year without having to trade against the Fed's bias via rates. Say for example we enter a period of gangbusters growth due to stimulus. In this situation, it's likely that oil will continue rallying from here. This is because the shale response is likely to be muted given their decimation last year leading to needing higher prices to bring production online; this is along with the delayed response time between price rises and production. In this situation it is also likely that silver would rally. Much has been made about the recent 10% selloff. However it's possible that this was a knee-jerk reaction to a rise in real yields. We might be best served looking at the history of the 2008 - 2011 recovery, where silver moved in line with other cyclical commodities in a rising rate environment. Technically, silver also looks to have maintained its rally and might be poised to break to new highs over the next few months. In the opposite situation where there is high inflation and no growth, silver would be an obvious outperformer due to its inflation hedging properties. In this situation oil is also likely to go up, but may not be the outperforming commodity that it has been recently. 

The other value in being long silver is the fact that you can circumvent the need to be short bonds and take the risk of playing against the Federal Reserve - a game that has in the experience of history been a fool's errand. This is because, as stated above, you can have a view on inflation as well as growth at the same time. 

Here we see the weekly chart of WTI. If it is the case that this reflationary scenario is to play out, oil is the first place that it is likely to show up. Oil was recommended in the last blog as well and has since broken through the initial targets. As a result the new target is 60, which has been an important level over the past several years. 

While at the same time that we might have an increase in inflation which can be played with oil, it's also the case that consumption is coming down due to a weakening labor market and rising case counts. This has started to be priced into the housing market data which unexpectedly shifted down last month. This is also what's showing up in the lumber market as it's the major input in homes. We also see that it has put in a head and shoulders which makes it an attractive short. 

I also think that silver is an attractive trade at these levels. This is because along with the other two commodities trades, silver allows for a well-rounded exposure to the possible paths of inflation and growth. If we have a high inflation and high growth environment, it's likely that silver will rally that situation. This would be akin to the move seen from 2008 - 2010 where cyclical commodities and precious metals rallied in a rising rate environment. In this situation it might be an underperformer, which is why the commodities portfolio owns oil as well. However if we see high inflation with growth that doesn't keep up, silver would be outperformer. Technically we also see that it has completed a pullback to the top of inverse head and shoulders. 

Equities - Long cyclicals (Russel and EMs), Short tech via QQQ riskies

As stated above, we seem to be in a precarious environment for global equities. On the one hand markets are pricing in a massive recovery in demand and higher expectations for inflation leading to rising rates. On the other we have a weak economy which continues to pose more than skin-deep risks along with said rising rates. As a result, it might make sense to buy clean and dirty energy stocks in the United States, along with EM equities such as in China which has recently broken out of a major long-term level. At the same time you can hedge downside risk being short tech via riskies. The benefit of this is that being long equities along with the rest of the portfolio allows you to play the fiscal stimulus trade. At the same being short tech allows you to prepare for the possibility of a selloff due to higher real yields along with the dollar position.

Here we see a chart of the Russell 2000 making new all time highs. Given that it is the highest performing index since the reflation trade started, and the reflation trade is likely to continue for now, this might be how to play the rally in risk as opposed to tech given rising yields. 

Here we see the chart of the Shanghai Shenzen index. If this rally in EM and cyclical stocks is to continue, it's likely that Chinese stocks will continue to rally. We see here that they have broken through the 5000 level that they have been holding for the past few months now. With this level cleared it's possible that the 2007 highs might be broken soon.

Thank you for reading. Any feedback and suggestions on how to improve are greatly appreciated. I am a recent at NYU Stern graduate with a major in Finance and Philosophy and interested in the Financial Services Industry. I can be contacted at snd314@stern.nyu.edu