The question investors must face
Is what type of risk to embrace
Are we in a movie
Where things turn out groovy?
Or are stocks about to retrace?

The risk narrative is having a harder time these days as previous rules of engagement seem to have changed. For instance, historically, when risk was ‘off’, stock prices fell, government bond markets rallied, although credit spreads would widen, the dollar and the yen, and to an extent the Swiss franc, would all out perform the rest of the currency world and gold would outperform the rest of the commodity complex. Risk on would see the opposite movement in all these markets. Trading any product successfully mostly required one to understand the narrative and then respond mechanically. Those were the days!

Lately, the risk narrative has been in flux, as a combination of massive central bank interference across most markets and evolving views on the nature of the global geopolitical framework have called into question many of the previous market assumptions.

The adjustments have been greatest within the bond markets as global debt issuance has exploded higher ever since the GFC in 2009, taking an even sharper turn up in the wake of Covid-19. Of course, central banks have been so heavily involved in the market via QE purchases that it is no longer clear what the bond market is describing. Classical economics explained that countries that issued excessive debt ultimately saw their interest rates rise and their currencies devalue amidst an inflationary spike. However, it seems that theory must be discarded because the empirical evidence has shown that massive government debt issuance has resulted in low inflation and relative currency stability for most nations.

The MMT crowd will explain this is the natural response and should be expected because government spending is an unalloyed good that can be expanded indefinitely with nary a consequence. Meanwhile, the Austrians are hyperventilating over the idea that the ongoing expansion of both government spending and debt issuance will result in a debt deflation and anemic growth for as long as that debt remains a weight on the economy.

These days, the distortion in the bond markets has rendered them unrecognizable to investors with any longevity. Central banks are actively buying not only their own government debt, but corporate debt (IG and junk) and municipal debt. Thus, credit spreads have been compressed to record low levels despite the fact that the current economic situation is one of a cataclysmic collapse in activity. Bankruptcies are growing, but debt continues to be sought by investors worldwide. At some point, this final dichotomy will reconcile itself, but for now, central banks rule the roost.

Equity markets have taken a slightly different tack; when things are positive, buy the FANGMAT group of stocks before anything else, although other purchases are allowed. But when it is time to be concerned because the economic story is in question, simply buy FANGMAT and don’t touch any other stocks. If you remove those seven stocks from the indices, the result is that the S&P and NASDAQ have done virtually nothing since the crash in March, and US markets have actually underperformed their European brethren. Of course, those stocks are in the indices, so cannot be ignored, but the question that must be asked is, based on their current valuation of >$6.8 trillion, are they really worth more than the GDP of Germany and the UK combined? While yesterday saw a modest sell-off in the US, which has continued overnight (Hang Seng -2.2%, Shanghai -3.9%, DAX -1.5%, CAC -1.3%) the fact remains stock markets continue to price in a V-shaped recovery and nothing less. And since stock markets tend to drive the overall narrative, if that story changes, beware the movement elsewhere.

It should be noted that yesterday’s Initial Claims data, printing at 1.41M, the first rise in the data point since March, bodes ill for the idea that growth is going to quickly return to pre-Covid levels. And given the uncertainty over how long that recovery will take, stocks may soon be telling us a different story. Just stay alert.

While idioms tell us what’s bold
Is brass, we must all now behold
The barbarous relic
Whose rise seems angelic
Of course, I’m referring to gold!

Turning to precious metals as risk indicators, price action in both gold and silver indicates a great deal of underlying concern in the current market framework. Gold, as you cannot have missed, is fast approaching $1900/oz and its record high level of $1921 is in sight. Silver, while still well below its all-time highs of $49.80/oz, has rallied more than 24% in July, and is gaining more and more adherents. The key unknown is whether this is due to an impending fear of economic calamity, or simply the fact that real interest rates have turned negative throughout the G10 nations and so the cost of owning gold is de minimis.

For the conspiracy theorists, the concern is that ongoing central bank money printing is going to ultimately debase the value of all currencies, so while they may remain relatively stable in the FX markets, their value in purchasing real goods will greatly diminish. In other words, inflation, that the central banks so fervently desire, will reveal itself as a much greater threat than currently imagined by most. Here, too, the geopolitics comes into play, as there is growing concern that the current tit-for-tat squabbles between the US and China will escalate into a more dangerous situation, one where shots are fired in anger, at which times gold is seen as the ultimate safe haven. Personally, I do not believe the US-China situation deteriorates into a hot war as while both presidents need to show they are strong and tough against their rivals, thus the rhetoric and diplomatic squabbles, neither can afford a war.

And finally, to the FX market, where the dollar has clearly lost its luster as the ultimate safe haven, a title it held as recently as two month’s ago. While today’s movement is relatively benign across all currencies, what we have seen this month is a dollar declining against the entire G10 bloc and the bulk of the EMG bloc as well, with several currencies (CLP +7.0%, HUF +5.4%, SEK +5.2%) showing impressive gains. If we think back to the narrative heading into the July 4th holiday, it was focused on the upcoming payroll release and the recent FOMC meeting which had everyone buying into the risk-on narrative. That came from the fact that the payroll data was MUCH better than expected and the Fed made clear they were going to stand ready to continue to add liquidity to markets forever, if they deemed it necessary. Back then, the euro was trading just above 1.12, and its future path seemed uncertain to most. But now, here we are just three weeks later, and the euro has been rising steadily despite the fact that concerns continue to grow over the growth narrative.

Is the euro becoming the new haven currency of last resort? That seems a bit premature, although the EU’s recent agreement to issue mutual debt and inaugurate a more fulsome EU-wide fiscal policy will be an important part of that story in the future. But for now, it seems that there is an almost willful blindness on the part of the investor community as they pay lip service to worries about the recovery’s shape but continue to find succor in (previous) risk-on assets.

While the dollar today is mixed with limited movement in any currency, there is no doubt the FX narrative is evolving toward ‘the dollar has much further to fall between the political chaos and the still positive view of the economy’s future. But remember this, while the dollar has traded to its weakest point in about two years, it is far away from any level that could be considered weak. Current momentum is against the dollar, and if the euro were to trade to resistance between 1.17-1.18, it would not be surprising, but already the pace of its decline has been ebbing, so I do not expect a collapse of any sort, rather a further gradual decline seems the best bet for now.

Good luck, good weekend and stay safe
Adf