Warning: market setback risk at highest since pandemic outbreak.

Warning: market setback risk at highest since pandemic outbreak.

Macro 8 minutes to read
John Hardy

Head of FX Strategy

Summary:  From bubble stocks to commodities and now possibly the broader market, post-pandemic market developments have been peaking and rolling over in serial fashion since Q1 of this year. The event that set off the mounting risk of a more severe and broader market correction was the beginning of the Fed tightening cycle in June, with the FOMC minutes last night adding to the sense that the Fed feels it has done more than enough and is ready to close the window on QE excess.


This market is set up for a potentially very significant correction (baseline of 10-20% given the magnitude of the recent draw-up) in the coming weeks as the post-pandemic policy cycle is coming to an end, likely bringing with it the prospect for a semi-stagflationary environment that will render ineffective both the fiscal and monetary policy stimulus that so profoundly stimulated the economy – and even more so markets – in the wake of the covid pandemic. In this article, we look at:

  • Why the point of danger has been reached as the Fed is finally taking away the punchbowl that was so crucial in pumping up global markets, from equities, to credit and possibly even treasuries.
  • Evidence that parts of this market and the market narrative that has developed in the wake of last year’s pandemic outbreak are already falling apart in serial fashion
  • Why the risk is that both monetary and fiscal stimulus will have limited impact from here
  • Ways for traders to mitigate risks to their portfolios, especially those heavily geared long growth- and momentum equities.

Sure, we could be very wrong, or very early, but we think it is worth giving these points some serious thought at this point in the cycle, when the pandemic stimulus has peaked in its impact on the real economy and as the economy and markets will theoretically need to stand on their own two legs, now that the central banks are set to withdraw support.

It’s not just about the Fed, it’s also about “the beef”.

In a brilliant old advertising campaign from the 1980’s, US burger chain Wendy’s came up with the slogan “where’s the beef” to differentiate itself from competitors, touting its thicker, juicier beef patties relative to the stingy competition. In the policy response to the global Covid pandemic, the really significant new policy “beef” was the enormous fiscal stimulus that was unique in scale relative to anything outside of wartime or perhaps the Great Depression. The intention was for the stimulus to offset the correctly anticipated enormous drop in the demand side of the economy as the pandemic saw millions losing their jobs and hunkering down under a massive cloud of uncertainty.

Fast forward to today and we see the unanticipated consequences: soaring demand for consumer goods and chaos in supply chains as companies were caught off guard by the magnitude of the demand and didn’t have the means to increase production due to poor forecasting, new inefficiencies caused by virus testing and quarantining and the unavailability of workers due to shutdowns from the outbreak itself. At the margin, some workers may have been slow to look for work again as they prefer to stay on unexpectedly generous benefits as long as possible.

In the background, central banks did their part in slashing rates to zero and have kept right on purchasing assets at a furious pace to ensure maximum accommodation until some pre-pandemic norm has been achieved. But their efforts are not the “beef” of fiscal stimulus and they are finally recognizing that their activities are not only not really supporting the recovery at this phase, but could have aggravated the alarming acceleration of inflation in places (housing market), as well as the glut of liquidity that has unnecessarily over-stimulated asset prices, particularly in housing.

EM central banks have been the first to respond to the inflationary outcomes with rate hikes. Among developed markets, Canada’s and New Zealand’s central bank tapered asset purchases in recent months and New Zealand and Norway are expected to be the first to hike rates later this year. The Fed has dragged its heels in finally shifting to a less accommodative stance. But the mid-June FOMC meeting finally marked a turning point as Fed forecasts brought the anticipated date of the first interest rate hike forward as inflation forecasts were raised. More recently, the minutes of the July meeting and speeches from a number of Fed officials indicate an increasing urgency to slow and eventually stop the over-generous pace of QE. As we lurch toward Q4, asset markets will increasingly scream for the Fed to refill the emptying punchbowl, while as we discuss below, the real economy will wake up with a stimulus hangover and ask “Where is the (fiscal) beef?”.

Markets have started rolling over even before the Fed is set to pull out

Here are a few charts offering evidence that the most speculative corners of this amazing market rise began peaking out and rolling over already months ago. The process began even before the last blast of fiscal excess in the Biden stimulus check in March was dropped into an already rapidly recovering economy. Since then, we have seen important asset classes and individual proxies rolling over in serial fashion as noted below.

The Saxo Bubble Stock portfolio
The Saxo quantitative team put together a basket of tens of global, potential bubble stocks as defined by a number of quantitative metrics, ironically around the time that these stocks turned out to have peaked in February. That peak came about two weeks after the bubble stock poster child, Tesla, peaked in late January, as did a number of so-called “meme stocks”. Elsewhere, the Russell 2000 small cap index peaked in March and is challenging its 200-day moving average as of this writing. (Important: note the Log format on the price axis).

Source: Bloomberg and Saxo Group

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?

Source: Bloomberg

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.

Source: Saxo Group

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!?

Source: Bloomberg

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.

Source: Saxo Group

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.

Source: Saxo Group and Microsoft Excel

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.

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