Warning: market setback risk at highest since pandemic outbreak.

US treasury yields: the 10-year US Treasury Yield benchmark
After rising from major lows in the summer of last year, US treasury yields peaked already at the tail-end of Q1 and have declined steeply since then, in part possibly as the Fed’s and other central banks’ QE has drowned the market in liquidity, leaving no place to stuff excess reserves save for into treasuries. Some blame for the low yields is down to central bank excesses, therefore, but shouldn’t yields have risen more determinedly if we were expecting a strong economy in real terms?

Doctor copper
Copper has long been considered an excellent proxy for global growth, and given the added focus on the copper-intensity of the “green transformation”, one might have expected copper to continue flying higher as we stumble, delta variant or not, toward the pandemic exit. But something is amiss here for that notion, as copper peaked out in May and has stumbled badly in recent days, interacting with its 200-day moving average as of this writing. And another often cyclical commodity, crude oil, peaked in early July and has recently broken lower – with perhaps more specific link there to concerns about the delta variant of Covid.

The strong US dollar wrecking ball
The USD is the most important global currency as it is the global currency and a higher US dollar represents a tightening of liquidity on the global economy. This week, a number of currencies crossed to new lows versus the US dollar, including the big EURUSD, which traded below 1.1700 for the first time since late 2020. And a broader USD measure like the Bloomberg USD index is poised at key levels as the chart below shows. This is even before the Fed has decided to slow asset purchases and has been forced to lend out more than a trillion of what it has bought! Imagine if the Fed were even remotely tight. The key point here is that USD strength is toxic and will eventually force the Fed to slow or halt any plans to consider normalizing policy – at least relative to other central banks and/or to inflation (i.e. real interest rates) – sooner rather than later – in Q4? Not until Q!?

AUDJPY – an FX proxy for nearly all things pro-cyclical
AUDJPY has served as a great proxy for both risk sentiment, China, and commodities as well as for the Australian economy itself, which is very much leveraged to the world’s most important growth engine China anyway. The JPY is important as a proxy, to some degree, for the above, but also for Japanese capital flows as the legendary Japanese savers scour the world for yield in good times and bring funds back home as the level of concern rises. The AUDJPY has broken down badly this week, as have many other JPY crosses.

Saxo Global Risk Indicator
While not a market like any of the above, our Saxo Global Risk Indicator, one based on a number of market- and financial stability risk factors from credit to market volatility, has declined this week and is close to the lows for the year, having peaked out in February together. The indicator represents a rate of change more than it does a “level” but we’ll watch for the risk that this indicator slides into negative in the coming days as a further sign that risk conditions are deteriorating further.

Fiscal beef: is it all it is cracked up to be to begin with?

Another factor besides Fed withdrawal that will drive the risk for a market slide is the near term risk is for a rapid deceleration in economic growth. The chief driver is stark math of the post-pandemic fiscal cliff that is worst of all for the US – where there are no prospects for anything resembling the scale of handouts we saw in 2020 and early 2021 – the impact of which are fading fast. But at the same time we are unlikely to see inflation fall back into the comfort zone that the Fed is assuming it will as the jobs market proves uncomfortably slow to normalize. This will then bring the ugly reality of the next policy cycle: not only will ineffective monetary policy remain ineffective in stimulating the real economy, but fiscal policy will largely fail to do so as well. That’s because as long as the fiscal stimulus “beef” continues to be an approach of unproductive cash drops onto the economy, unproductive social spending (in economic output terms, not social justice terms) and investment in less productive, lower-intensity green infrastructure, stimulus dollars will feed straight into inflation. Real GDP growth, in other words, will prove anemic or worse. Sure, investors may have to chase the implications of where the stimulus is aimed, but the overall “beef” won’t bring economic health without a focus on productivity. Nuclear fission energy bridge to nuclear fusion anyone?

Ways to reduce exposure for those generally long this market.

For anyone sharing the concerns expressed above, the question immediately arises: what to do? Below are a few ideas for inspiration, not recommendations, as every investor has differing investment horizons and needs. But the general idea is that the market risks being complacent on the risk of the first significant broad drawdown in risk sentiment post-pandemic outbreak. This may require prudence for a time and a reduction of leverage, especially in the most crowded, most popular investments like US megacaps stocks.

• For longer term and general inspiration, consider an all-weather, 100-year portfolio, as discussed by our Steen Jakobsen (Note that Chapter 8 discusses the portfolio principles).
• Besides simply a partial reduction of exposure to the market, some may consider

• Options hedges (long puts) in the S&P 500 and/or the Nasdaq 100 futures, which are very liquid markets. The tough part here is choosing strike prices and expiry dates
• Hedging the market using a volatility ETF like the VIXM (ProShares VIX Mid-Term volatility ETF). The reason for using the mid-curve as opposed to products more sensitive to spot volatility is that it “costs less“ in terms of negative carry to hold the position, even if it is potentially less reactive tactically to moves in volatility.

The intention here isn’t to run under a rock and hide forever, but to preserve capital and the flexibility of taking risk when the market is at a better vantage point for realizing long term gains, which is harder to do when/if leveraged all the way down in a market drawdown event.