Cash is king: Buy volatility and buy liquidity
From Andy Lees at UBS:
The pace and depth of decline in the US surprise index over the last 3 months is the fastest on record (chart 1), worse even than Q4 2008 although only very marginally worse. The index has fallen from 97.5 on the 4th March to -117.20 on the 3rd June, ie a 214.7 point fall in 91 days or a fall of 2.36 points per day. By comparison in 2008 it fell from a high of 73.6 on the 4th September to a low of -140.60 on the 5th December, a fall of 214.2 in a period of 92 days or 2.33 points per day.
The rate of deterioration in data, relative to consensus expectations, has never been worse since Bloomberg records began in 2003. The Latin American surprise index is now -31.8 which other than a temporary dip on 3rd January this year to -39 is the lowest since May 2009, the Japanese index is -28.8 and whilst APAC is still positive at +11.70 it is clearly rolling over (chart 2), making lower lows and is seemingly on the edge of a precipice. Europe is the only economy seemingly holding up, however the surprise differential vs the US is now towards an extreme, making some sort of correction highly likely and as the German trade data showed today, it is starting to lose momentum.
Again, we are in a mid-cycle slowdown not dissimilar to the ones we experienced in 1995 or 2005. I am remarkably sanguine about the ability of policy makers to induce a cyclical recovery via fiscal and monetary stimulus. And, of course things don’t move in a straight line – not on the way up and not on the way down. See my comments from “Back to the global imbalances norm”.
Here’s the thing though; the difference is policy and the macro backdrop of accumulated debt and deleveraging.
As Andy says:
Mainstream US Republicans are now starting to think a temporary US debt default may be an acceptable price to pay for getting a proper restructuring of the deficit to a sustainable position. QE2, which on an annualised basis was equivalent to 69% of the last 12 months budget deficit is about to expire and Fed governors have said that the QE3 put is significantly below present levels, requiring a serious fall in growth and unemployment expectations to trigger. In other words risks are starting to converge and there is no protection out there from the central bank. Even China’s hands are also tied by the bad debt on local authorities hands, which until it is brushed under the carpet over the next few months, will limit its ability to initiate another stimulus package without raising alarm bells. The ECB is raising rates rather than cutting them and it is becoming increasingly likely that a Greek default (whether classified as that or not) is imminent.
Now I don’t see QE2 as having had an appreciable affect on the real economy. After all, US growth has decreased every quarter since QE2 began. And now we are at stall speed. But QE2 was good for asset prices – and that is important in a world of high private sector debt. With the QE2 trade off the table and QE3 not happening anytime soon, bond yields are falling and equities are looking vulnerable (as predicted). And that could have negative consequences for balance sheets, especially bank balance sheets.
Political pressures to remove fiscal and monetary stimulus are too much to bear. It is remarkable that the US has resisted as long as it has. But an attempt at fiscal consolidation is coming – and that will make an economy at stall speed vulnerable, potentially turning what is a mid-cycle slowdown into something worse. As for quantitative easing, I said the following in March:
the Fed will not want to make a hasty exit from QE2. I think they will see it out through June and then pause. My sense from the totality of Fed communications – from both hawks and doves – is that they will stick to their original timetable and then pause. At that point they have to decide whether to mop up the excess reserves. If the economy is OK, they will start to sell Treasuries. If the economy is too fragile they will simply do nothing and wait. If the economy really sucks, the QE3 speculation can begin. The timetable depends entirely on the economy, of course. And Bernanke has said so. Bottom line: we are a long way away from either QE3 or raising rates. Over the near term, it’s a question of what to do after QE2 is over.
This is negative for equities. And that means curtailing risk, raising cash and buying volatility. Andy writes:
The VIX is towards the lows of the 2008 to present range, seemingly ignoring this mounting risk and not yet responding to the fact that the largest seller of volatility, the Fed, is stopping its underwriting programme and is rolling down the strike of any future put, leaving the market long with the exit door being shut. Buy volatility, and buy liquidity; for the moment cash must be king.