Performance Chase

By Doug Noland

Credit Bubble Bulletin

The Nasdaq Composite, Nasdaq 100, small cap Russell 2000, Value Line Arithmetic and the NYSE Arca Biotechnology were among U.S. indices trading to all-time highs during Wednesday’s session. In the real world, there is escalating risk of a destabilizing global trade war. The Shanghai Composite sank 4.4% this week to two-year lows. It was another week of instability for emerging market equities, bonds and currencies – especially in Asia.

Here at home, it’s difficult to envisage a more divided electorate or a more hostile political environment. Record securities and asset prices and such a sour social mood appear quite the extraordinary dichotomy. Yet I would argue that speculative financial market Bubbles, heightened global tensions and domestic social and political angst all have at their root cause decades of unsound “money” and Credit (an archaic notion, I fully appreciate).

“Inflation is always and everywhere a monetary phenomenon…”, Milton Friedman explained some 50 years ago. At the time, Dr. Friedman was contemplating goods and services inflation. Financial, monetary management and technological developments over recent decades ensured that asset inflation evolved into the much more destabilizing form of inflation. A Bubble collapse presented Dr. Bernanke the opportunity to test his academic theories, unleashing unprecedented monetary inflation specifically targeting securities markets. His policies spurred similar monetary inflation around the world that has continued for almost a full decade.

Cut short rates to zero, print “money,” buy bonds; force market yields lower; spur buying of risk assets and higher securities prices; orchestrate powerful wealth effects; households and businesses borrow and spend; the economy expands; inflation rises back to target – and all is good. Sure, there’s some risk that asset prices get ahead of the real economy. Not to worry. Central banks will ensure a steadily rising general price level – and inflating earnings and incomes – to catch up to elevated asset prices. All will be well.

All is not well. With such complexity in the world, central bankers should be disinclined from grand experiments. A decade of central bank rate manipulation, “money” printing and market intervention has ensured deep structural changes in the marketplace. Central bankers failed to appreciate the evolving nature of contemporary Inflation Dynamics. Over time, a potent inflationary bias took hold in asset prices, while for a variety of reasons disinflationary dynamics held sway in the pricing of many goods.

A decade of unprecedented global monetary stimulus has stoked speculative assets Bubbles, replete with history’s greatest redistribution of wealth. Central bankers now face acute market fragility, while governments face electorate enmity (along with other shaky governments). With U.S. stocks at or near record highs, my warning that free market Capitalism is today at great risk surely sounds ridiculous.

At this point, the key market issue goes far beyond securities valuation. Too many years of too much “money” chasing too few financial assets have imparted deep structural impairment. Or phrased differently, there has been too much “money” playing the game; too much liquidity and leverage aggressively playing a historic speculative Bubble has wrecked the game. Financial markets have become maladjusted and dysfunctional, although much remains unrecognizable to the naked eye.

Thursday from Zero Hedge: “This Is The Greatest Short-Squeeze In History.” The Goldman Sachs Most Short (50 highest short interest names above $1bn) is up 18.8% y-t-d. From May 3rd intraday lows, the GS Most Short has surged 20% – one of the past decade’s more spectacular squeezes. This squeeze saw Tesla, with 39 million shares short, spike almost 100 points.

The Retail Index (XRT) jumped 15% in about seven weeks. Ascena Retail Group (and Fossil) doubled in price. Signet Jewelers surged 55%, Rent-A-Center 55%, Carvana 54%, Wayfair 50%, Tripadvisor 50%, Express 50% and Conn’s 50%. Since the May 3rd trading reversal, Food Retail and Department Stores have been two of the strongest industry groups in the S&P500. Footlocker gained 32%, Carmax 28%, Kroger 24%, Macy’s 20%, Lowe’s 20% and Kohls 18%. Hanesbrands jumped 33%, Under Armour 35% and Ralph Lauren 22%. Twitter surged 48%, AMD 44%, Netflix 33% and Micron 23%.

Squeezes have been spectacular in the mid and small cap universe. Since May 3rd in the S&P Mid Cap 400, Chesapeake Energy, Mallinckrodt and Genworth Financial have all jumped more than 50%. Akorn, Five Below, Southwestern Energy, and Boston Beer gained more than a third. Short squeezes in the small cap space have been even more dramatic.

The speculative melt-up in segments of the U.S. marketplace is the antithesis of the faltering EM Bubble. This week saw indications of strengthening EM contagion. Ominously, the Chinese renminbi dropped 1.0% versus the dollar (offshore CNH down 1.15%), now having given up previous solid y-t-d gains. The Thai baht fell 1.5%, the Indonesian rupiah 1.1%, the Taiwanese dollar 1.0%, the South Korean won 0.9% and the Singapore dollar 0.6%. China’s small cap CSI 500 index sank 5.9% (down 17.5% y-t-d), and the growth/tech ChiNext index fell 5.6% (down 11.6%). The CSI 300/Telecommunications Services Index collapsed 15.7% (down 37.5%).

Elsewhere in Asia, major indexes were down 4.1% in Indonesia, 4.1% in Thailand, 3.8% in Malaysia, 6.2% in Philippines, 2.0% in South Korea, 1.0% in Taiwan, 3.3% in Vietnam and 4.3% in Pakistan. Hong Kong’s Hang Seng index sank 3.6%, and Singapore’s STI index fell 2.1%. Japan’s TOPIX dropped 2.5%. Winning distinction as the most likely prophetic indicator of the week, Japan’s TOPIX Bank Index sank 5.4% and Hong Kong’s Hang Seng Financials dropped 5.1%.

Indonesian 10-year (local currency) yields jumped 20 bps to a 15-month high 7.43%, and Philippine yields rose 12 bps to a seven-year high 6.31%. Financial conditions continue to tighten throughout EM, though there was some relief this week with rallies in the Argentine peso (4.6%) and Mexican peso (3.1%). The Turkish lira recovered 1.1% ahead of Sunday’s election. Notably absent from the EM currency rally list, Brazil’s real declined another 1.5% (down 12.6% y-t-d).

It was only back in January that EM was in full melt-up mode – a speculative blow-off right in the face of tightening global financial conditions. With a veritable flood of flows into the $5.0 TN global ETF complex ($100bn inflow in January!), EM was a major beneficiary (EM equities and bonds both saw record inflows in January). Recall that EM ETFs enjoyed record inflows in 2017, with the inundation continuing well into 2018. What’s more, EM flows benefitted from the U.S. market stumble in early February. Amazingly, EM ETFs were at the top of the ETF inflow leaderboard all the way into early May.

And a Friday afternoon headline from ETF.com: “Massive Weekly Inflows For Russell-Indexed ETFs.” And from ETF Trends, “Small-Cap ETFs Big Winners in U.S., China Trade War.” The iShares Russell 2000 ETF enjoyed its largest inflow since March. A Bloomberg headline: “Trade War Fears Spur Rotation From Industrials Into Small Caps.”

The culminating shot of “hot money” into EM earlier in the year – benefitting both from the U.S. market swoon and the drumbeat of “global synchronized economic boom” – set the stage for today’s trouble. So, it’s only fitting that cracks at the Periphery of the global Bubble would incite a surge of “hot money” into outperforming U.S. securities markets. At this point, global finance has regressed to one big game of Performance Chase.

Am I the only analyst that views the manic interest in U.S. small caps portentously? I have highlighted the concept of the “moneyness of risk assets” – central bank backstops having nurtured the misperception of safety and liquidity throughout the risk markets. Incredibly, as fissures materialize in the global Bubble, performance-chasing “hot money” now floods into the least liquid corner of the U.S. equities market.

The gargantuan ETF complex has been instrumental in perpetuating this dynamic, intermediating less liquid securities into perceived highly liquid ETF shares. This was the situation earlier in the year for emerging market securities, and it remains the case in U.S. markets. And as the global Bubble navigates a worst-case scenario, it’s only fitting that small caps lead the charge in U.S. equities and junk bonds outperform in fixed income. Over generations, market structures evolve and instruments change. Yet amazingly, through it all everyone seems compelled to get all ebullient and hunkered together at major market tops.

June 22 – Bloomberg (Shelly Hagan): “Corporate bond spreads jumped to the widest level in 16 months Friday as large deals flooded the U.S. market and rising trade tensions scared off some investors. Investment-grade bond spreads saw the biggest weekly increase since February as companies sold $43 billion of debt, including $31 billion from Bayer AG and Walmart Inc. alone. The market was also shaken by escalating trade tensions between the U.S. and its major partners… Corporate bond spreads have been widening since February, when they reached the tightest since before the financial crisis. Fewer foreign buyers, rate volatility and trade tensions are chipping away at investor confidence in the U.S. market, according to Thomas Murphy, a portfolio manager at Columbia Threadneedle… ‘A lot of people pushed into our market because of QE overseas. They can now go back to their home markets. Hedging costs have gone up dramatically,’ said Murphy…”

Global contagion and tightening financial conditions are making steady headway toward “Core” U.S. securities markets. The Trump administration is bluffing, aren’t they? Or is the era of Trump Tariffs and trade war retaliation soon upon us? It’s got to be the President playing hardball dealmaker with Beijing – right? Or could a momentous Washington crackdown on China be in the offing? Appearing increasingly vulnerable, China may emerge the cornered pit bull. It was another ominous week. China and Asian Contagion. Widening Italian spreads. But, then again, with a short squeeze in play and only a week or so until the end of a big performance quarter, why be bothered with global market instability or unfolding trade wars… These are deviant markets.

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Gary

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