Beach Please!

There was plenty of headline risk last week.

Markets are always a humbling experience.

Last week was fraught with a fear that the bull market train was going to careen off a cliff. Daily case counts across the world increased with several outbreaks, most notably in South Korea and China, spooking investors. News that the deadly respiratory virus had penetrated the west wing of the Whitehouse didn't help. Investors were also subject to a further deterioration in the US/China relationship after the Whitehouse had ordered some US pension funds to halt investments in Chinese companies. Economic data continued to break records, and not in a good way, while the Federal Reserve Chair delivered a decidedly dour outlook. What kept the train "on the rails" was likely technical factors from gamma hedging, which were acting as a shock absorber this week. Unfortunately, most of these options have now expired and will push dealers closer to the gamma flip zone. That sets us up for a fairly directional week riddled with event risk. It's important to note that despite monetary/fiscal policy delivering unprecedented support, markets have stabilized from a flattening of the COVID curve, which has given hope of a gradual reopening. Any unexpected changes in the evolution of the pandemic will put us right back where we were in March.

We're in uncharted territory.

In the US, New York, New Jersey, Connecticut, and Delaware all agreed to let beaches reopen for Memorial Day weekend, albeit at a limited capacity. We are at a critical juncture where, in the coming weeks, we will find out whether reopening the economy without proper testing will result in a surge in infections. As I've referenced in the COVID-19 explainer series, epidemic models indicate that a spike in cases will be almost an inevitability. However, models aren't necessarily a reflection of reality. In Georgia, where the reopening process has been underway for a few weeks, there appear to be some reassuring signs. However, states like Texas continuing to struggle with new cases. Of course, this isn't a US-centric issue. South Korea and China saw flare-ups last week, and it's important to note that the global daily case curve is not declining. The chart below shows the daily change in global cases. It is very difficult to see a world where reopening the economy doesn't result in a spike in infections given this backdrop.

The US/China squabble continues.

On Friday, the commerce department amended export rules to target Huawei acquisition of semiconductors. Huawei has been a bit of a sticking point between the two nations. During some of the darkest days of the 2019 trade war, the US moved to blacklist Huawei based on a national security threat. It seemed as though anything was a threat to national security at the time, with Germany automakers receiving similar heat (maybe President Trump just wanted to rid Fifth avenue of all Mercedes?). Regardless of the motivation, it appears Huawei has skirted some of the blacklist rules and has not been behaving like a "responsible global corporate citizen." That's according to Wilbur Ross, a man who wants to put a gas station on the moon. Ross' aspirations aside, what's concerning is that we appear to be turning over stones from 2019, which have severe ramifications for US/China relations. As I had mentioned in a previous post, none of this is to say the US administration isn't correct in punishing China. However, the timing of this escalation is inopportune and has costs. A tightening of financial conditions is the last thing anyone wants amid a global pandemic where hundreds of millions of people are unemployed globally.

Powell doesn't dabble in negative interest rates.

There was a parade of Fed officials marching in lockstep towards the conclusion that negative interest rates are not a viable policy tool in the US. Last week I highlighted that the Fed Funds Futures (FFFs) contracts had begun to price in negative interest rates for 2021. Well, despite Powell's best efforts to tell markets that a negative overnight rate was not on the table, the market continues to price in sub-zero rates. Although there's suspicion that technical factors are also at play, some market participants believe that the Fed will be forced below zero. The Fed's opposition to negative interest rates appears to be in stark contrast to the Reserve Bank of New Zealand, who announced last week that if they had the means, they would dip into negative interest rates. The Bank of England also appears to be on the same page as the RBNZ, with Chief Economist Andrew Haldane telling the Telegraph that the BoE is accelerating research on negative rates. Needless to say that monetary policy going forward is going to get funky. The Fed will likely be forced to introduce some form of yield curve control (pegging 10-year interest rates to a certain level) along with other policies.

Economic data continues to break records.

We're in for a wild ride.

With an additional 2.9 million Americans filling for unemployment insurance last week, the total number of Americans that have filed for unemployment since this whole pandemic began sits around 36 million. With figures like those, it's unsurprising that US manufacturing production declined the most in over a century. That is particularly astonishing given the data covers the 30s and 40s. Of course, the data isn't just dour stateside. Germany is now officially in a recession thanks to a downward revision in Q4 data. The German economy contracted 2.2 percent from the previous quarter and is the second-largest contraction since the Eurozone unification. Unsurprisingly, Eurozone manufacturing has also collapsed. If you're wondering how the UK is holding up, the answer is not well. The British economy contracted 2.2 percent from last year and, judging from the latest manufacturing prints; the UK is on track for a recession in Q2. Juxtaposing this egregious backdrop is China, who witnessed industrial production expand for the first time since the CoronaVirus outbreak began.

The economic recovery is all about letters.

The debate at the center of all economic commentary is the shape of the recovery; V, U, W, and L. You know things have gotten out of hand when the Onion is running an article about the recovery being an infinite mandelbrot shaped recovery (wtf?). The consensus view has been that the recovery would be a V-shaped, implying that once we begin to reopen, everything will go back to normal. Now, there are numerous issues with this view. As Deutsche Bank's Alec Kocic put it a few months ago, "when precarity becomes everyone's prospect, the consumers from a wider sector of the population withdraw and the rest of the economy gradually has to contract or shut down." The 16 percent plunge in US retail sales last week shows how consumers have tightened their belts. JC Penny filing for bankruptcy on Friday highlights how retail has been devastated by this virus and how there will be permanent damage from this pandemic. In many ways, this is a wake-up call. The interconnectedness of the economy allows for devastation in one sector to eventually make it's way to others. Once banks start to take losses on their loan books, they tighten their restrictions, and it becomes the survival of the fittest. Steve Hafner, CEO of Booking Holdings' Open Table and Kayak, told Bloomberg that nearly a quarter of all American restaurants wouldn't reopen after the crisis.

Will COVID-19 be inflationary or deflationary is the big question.

There was a stark contrast between the read on consumer price inflation (CPI) and survey data from the University of Michigan. Starting with CPI, US inflation decelerated the most since the financial crisis. The broader index points to a deflationary demand shock that overwhelms and supply-side price pressures. That's not say that prices at the grocery stores aren't on the rise, more so that prices on other items have more than offset those increases. What's raised a few eyebrows it the U-Michigan survey, which suggests that survey participants expect headline inflation to increase to 3 percent next year. The headlines surrounding meat shortages, rising prices at grocery stores, a damaged consume psyche, and the prospect of normalizing oil prices are all likely factors behind the spike. The idea that COVID-19 has changed the world as we know goes back to limited capacity in restaurants and even factories. The theory goes that companies will thus need to expand operations to produce the same amount of products they had in the past, which should be inherently inflationary. With that said, no one really knows how this will play out. I still side with the shock being more deflationary than inflationary.

Oil cranks out a third consecutive week of gains.

As was the case last week, oil investors had plenty of news to digest. A week ago, Saudi Arabia announced that it would likely need to tap the global market for around US$ 58 billion throughout 2020 to handle the deadly combo of COVID-19 and a self-induced oil collapse. That debt package is now paired with a US$ 27 billion in taxes, a move that is unpopular at best and can spiral into social unrest at worst. Saudi Aramco, the state-owned oil company, helped bolster sentiment by raising oil prices in specific refineries. The declining supply out of the US is a net positive for global oil prices (US oil rigs are at an 11-year low), and the gradual opening of economies is slowly reviving demand for oil. That's not to say that everything is clear from here, there's plenty of inside-baseball to be played. Nearly 30 crude oil tankers are set to make landfall in the US this month, raising questions of storage constraints just as inventories are starting to draw down inventories. That creates a precarious situation where we may see the June WTI contract price collapse as inventory space gets taken up. For context, last week, Cushing Oklahoma crude inventories had their first stock draw in weeks.

Markets have the potential to get more directional.

Policymaker aggression towards Amazon, Google, and Facebook is perilous.

As I highlighted a few weeks ago, the US equity index's composition is heavily weighted towards tech companies. The S&P500's top five companies (Facebook, Apple, Amazon, Microsoft, and Google (FAAMG)) account for roughly 20 percent of the broader index. This level of concentration is the highest it has been in nearly three decades. Going forward, the index will be inherently more susceptible to idiosyncratic risks (company-specific news). We had a taste of this a few weeks ago when Amazon and Apple both announced earnings. Worryingly, the recent announcement that the Justice Department is drafting an Antitrust suit against google could have a larger impact on markets than it would have in the past. When you consider that policymakers have generally been hostile towards big tech, further pressure on Google will likely spread to Amazon and Facebook. Additional pressure from the US administration on China won't bode well for Apple either. The bottom line is that Microsoft aside, the other four companies have some hurdles to contend with, which likely will have a sizeable impact on the broader index.

Money printer go brrrrrrr.

There is a myriad of headlines to get everyone excited. A vaccine developed by Moderna is showing promising potential to create some form of immunity for the new CoronaVirus. President Xi of China pledged US$ 2 billion to the World Health Organization to assist countries affected by COVID-19. Powell's remarks over the weekend that there was "no limit" to what the Fed could do under these circumstances is also proving constructive for riskier assets. A Bloomberg article suggests that Chinese demand for oil is climbing and will soon go back to levels seen before the country imposed lockdowns. All of this, assuming it continues, could prove to be very procyclical and result in a big unwind in the momentum trade (which has generally been long duration and short cyclical). Steepening of the yield curve driven by inflation and growth prospects rather than the increased supply from the Treasury could lead to a profound reversal under the hood in stocks. In terms of what to expect on the gamma front, we're sitting right at the flip zone. Any significant move higher will be met with resistance from market makers throughout the week. On the flip side, a move lower would be met with further selling. The chart below shows the market maker gamma model with a smooth line rather than bars.

Tiago Figueiredo