The stock market had a minor move lower on Tuesday in the first day back from the Labor Day weekend. This is the start of the weakest month of the year. For some reason, the North Korean threat is now being considered an issue again even though the market ignored the missile launch by trading with little volatility on Friday. It’s a questionable tactic to always blame any weakness on North Korea. It’s even more questionable to claim this is a big crash, just for clicks on articles; a 0.75% selloff isn’t a big deal, no matter what the circumstances are. I consider the selloff to partially be driven by hurricane Irma which is one of the strongest storms ever recorded and is setting its sights on Florida. When you combine the impacts of Harvey and Irma, a big chunk of the country will be at a standstill in September. With the government put in a position where it should act, the fact that it is polarized makes matters worse. FEMA is currently almost out of money, so the Congress will need to make changes for the government to help out in Florida.
To be clear, the chart below of the hurricane forecast only implies the eye will stay within that cone 60%-70% of the time. However, the market works off of probabilities, so it will start to price in economic weakness now. A Florida and potentially Gulf Coast storm means a large portion of the south will be in rebuilding mode. This will take out a big portion of consumer spending and cause jobless claims to spike like they did during hurricane Katrina. Home Depot stock has seen moderate improvements because of hurricane Harvey. If you’ve done some extra research into the storm, buying Home Depot makes sense. It can also be used as a good hedge against the storm if it does severe damage. The great part about this hedge is Home Depot stock won’t crash if Irma goes out to sea.
The worry about any shock to the financial system is what could occur in the market as a result. Specifically, the short volatility trade has become more popular than ever. If all these trades unwind at once, there could be a liquidity crunch. Problems with liquidity are why markets fall very sharply. Most sane people wouldn’t sell stocks when the market is down 40%. The reason they do so is because they’re in the position where if they lose any more money their fund could close or they are already seeing redemptions. The chart below does a great job of showing how much speculation has gone into the short volatility trade. At this point, none of the other bubbles have reached the size of the increase the short volatility trade has reached. The total increase is already larger than any other bubble besides bitcoin. Technically, calling bitcoin a bubble is immature, but it has had extreme speculation.
As we know, the central banks have had a hand in making the market act as if it doesn’t have a pulse. It seems as if I’ve been talking about the unwind for a while, but nothing has happened yet. The chart below does a great job of explaining the current situation. The Fed has been static, while the ECB and the BOJ have been increasing their balance sheets. The Bloomberg chart has the BOJ increasing their balance sheet in the next two years. Instead of the SNB acting as a proxy for the Fed if the economy goes south, the BOJ can do so. It is much larger than the SNB and would be more effective. I’m expecting the ECB to slow its purchases in 2018 and stop them sometime in late 2018 or 2019. This change will tell us how much the lack of volatility is being caused by global QE. Clearly, the economy is relatively strong and S&P 500 firms have record earnings which are good for stocks. However, there have been periods with much stronger GDP growth and record earnings, yet they had higher volatility. This current streak of 10 months without a 3% selloff is in the 99th percentile while GDP growth and earnings growth are not there.
The chart below does a great job of using monetary policy to contextualize the 10-year bond market and the global manufacturing PMI. As you can see, the background colored bars show when there is a global monetary policy in place which is dovish. Notice how there is almost no white space from 2009 to 2017 as either the ECB or the Fed had a QE program going most of the time. The period where the Fed tapered QE3 right before the ECB started its QE program led to a decline in the 10-year yield and the global manufacturing PMI. The question is if the next round of tapering, where the Fed’s balance sheet shrinks, causes another weakening trend. The other notable trend in the chart is the bifurcation between the global manufacturing and the 10-year bond. This can be explained by the relative economic weakness in America compared to the emerging markets which have rebounded. The U.S. stock market is also relatively weak compared to other markets especially when you look at the Russell 2000 which is only up 3.13% year to date.
Conclusion
The stock market had a minor blip lower on Tuesday as the worst month of the year began. I think hurricane Harvey and Irma will pack a 1-2 punch to the gut of the economy. The stock market won’t selloff hard when weak data comes out because investors know it will be temporary. However, it’s still not a positive to see very weak reports. To be clear, this is a catalyst for economic weakness and spiking government deficits, but not one for a recession. These weak reports will make it tough to judge the initial effects of the Fed’s unwind which will start in a few weeks. The Bank of Japan and the SNB are about to be on their own with QE as the ECB announces its tapering in October.
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