Tuesday, May 22, 2007
Which of these things is not like the others:
a) Uber-bid oil and gasoline prices at record highs
b) Rising global interest rates
c) A VIX that won’t go down
d) Equities across the globe at or near their highs
OK, now let’s play again. Which of the following just doesn’t belong:
a) Double-digit broad money growth in many economies
b) Defensive positioning
c) Central banks just now starting to buy stocks
d) Near-record global growth
e) An historically favourable environment for corporate profits
f) Upside profit surprises
g) Macro Man’s bearish equity tilt in his alpha portfolio
This is the conundrum that Macro Man, and he suspects more than a few others, currently faces. He feels that equities are currently overdone and due for a correction, particularly when faced with the triple whammy of rising energy prices, rising interest rates, and unfavourable seasonality.
By the same token, he currently feels woefully underinvested, courtesy of the short SPM7 call position in the alpha portfolio. IMM specs are leaning the same way; a diffusion index of all non-commercial positions in the big and e-mini S&P futures reveals a net short position.
Moreover, we are currently living in a tremendous environment for stocks. Globalization has meant that multinational companies are able to reduce (labour) costs like never before, albeit with a concomitant rise in commodity prices. Tax regimes in both West and East are generally favourable, at least for the time being. Global growth is not only extraordinarily strong, it’s also extraordinarily broad-based.
And perhaps most importantly, the hegemonic actors in financial markets these days, FX reserve managers, are only now starting to have a bite at the stock market cherry. As Bretton Woods II starts fraying at the edges, it’s becoming clear that the returns on low-duration fixed income reserve portfolios ain’t gonna cut it.
China’s decision to create a separate investment vehicle and take a stake in Blackstone is by now well-known. But consider also that Taiwan, with a not-insubstantial $266 billion in reserves, is also setting up a sovereign wealth fund. Eventually, even Japan may follow suit. And look out for Russia as well. Vlad Putin said yesterday that oil revenues should go into the domestic equity market (presumably at the expense of FX reserves or the Stabilization Fund, which is tantamount to the same thing.) Even Norway, which has been doing the sovereign wealth thing longer than most, is feeling pressure to perform. Q1 returns for the oil fund were 1.5%- not exactly eye-popping. It surely isn’t a coincidence that the decision to raise the equity allocation of the fund was taken at the same time that returns from more traditional ‘reserve assets’ has been flagging.
Add it all up, and Macro Man is left between a rock and a hard place. He expects a correction to ensue (another Chinese export, perhaps?), but wants to use it to take off his alpha shorts and increase equity length. Positioning indicators suggest he is not alone. Could it be that the real ‘pain trade’ in equities is a continued grind higher? It may well be.
At the same time, he remains of the belief that the tactical headwinds for equity performance have strengthened considerably in recent weeks. He’s though long and hard about this, and arrived at the decision that buying volatility is the way to go. Again, the divergence of the VIX from the SPX suggests that he isn’t alone here. Macro Man needs upside deltas in the event of a continued grind higher, but wants to make hay if the much anticipated correction does finally ensue.
He will therefore buy 100 SPM7 1495 puts at the opening, and buys 500 July DAX 8000 calls at 55. Today’s ZEW confirms the German economy remains resilient against the VAT effect, higher rates, higher energy prices, and a strong euro.