Nowadays, it seems like markets will never fall again and I’m reminded of Irving Fisher’s infamous remark that “Stock prices seem to have reached a permanently high plateau”, just prior to the onset of the Great Depression. The reason for bringing this up is not because I expect another Great Depression, but to not forget that even the greatest can get it spectacularly wrong.
Actually I do not even expect a period similar to the GFC, which seemed like the market consensus until a few months ago. I continue to think while everyone seems obsessed with the left tail, that the right tail is more likely. Thus higher inflation followed by stagflation seems like the most probable outcome, in my view. I know, similar arguments were put forward in 2008 but the “inflationistas” have been put to shame by subsequent developments.
However this time it is different!
Seriously, I think the conditions are different and the fiscal measures taken this time are much larger and the probability of exceptional monetary and fiscal becoming permanent is very high. Let’s not forget that the boy who cried wolf was not wrong just early and the wolf showed up in the end. Despite what some say wrong and early are not the same unless you are in the habit of executing every idea instantly.
In any case, I’ve digressed and the main subject I wanted to flag was the potential for a decent correction in the short term, say in the next days. I have the following thoughts:
The option gamma position of dealers, (which support the S&P 500 index from time to time, but can also put pressure depending on where strikes are clustered) declined significantly after the index option maturity last Friday. This may have reduced the support of the S&P 500 index from this dynamic.
The second wave (Covid-19), is getting more serious on a global scale. Markets have not paid much attention to the second wave so far but their reaction to the Apple store closure news on Friday was telling and may be an indication that markets will become more sensitive to these kind of news flow.
The tense political climate in the US is likely to become even tenser as the elections approach.
The FED’s balance sheet fell by nearly $ 74 billion a week, ending June 16. This was due the decline in repo and other central banks and swaps, which is not a sign of decline in liquidity in itself, but the growth in the balance sheet has stalled and the composition of growth is becoming less asset inflation friendly but potentially more consumer price inflation friendly.
The national security law that China announced on the weekend for Hong Kong contains very heavy articles and may cause an increase in tensions between the USA and China.
The blackout period when the US companies are temporarily forbidden to buy back their own shares is approaching.
In the second quarter, the much stronger performance of US equities compared to bonds could create asset reallocation flows at this coming quarter end to bonds at the expense of equities. This would be like the mirror image of what we have seen at end 1Q.
Murat Berk
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