The Week in Review. 22 Sep 2018

Last week was a significant week in the financial markets for many reasons.

To us, it flashed a Warning signal.

Bond jitters

In a very unusual occurrence last week, the Dow Jones Industrial Indexand the Dow Jones Transportation Indexfinally surpassed their January highs and recorded new all-time highswhile US 10-year bond yield finally broke out and closed above 3 %.

Higher bond yields are NOT GOODfor the elevated US bond and equity markets.

They are NOT good for global equity markets either as liquidity is being withdrawn.

The charts below show the importance of last week break-outs in bond yields and a potentially sharp move up in yields is sight with targets of 3.6 and 3.9 % on the US-10 year bonds.

We have been arguing for months that the most dangerous asset class of all was the US bond market and that bond investors, with their hands forced by the abnormal Quantitative Easing bond buying policies of the World Central banks have been ignoring the resurgence of inflation for too long.

Bond Yields are at abnormally low levels considering the stage of the cycle we are at.

Last week gave the first hint that the US Bond market seems to be waking up and starting to price-in the return of inflation.

A global bond market and interest rate re-rating may be at hand.

Jerome Powell’s speech on September 26th could mark an important milestone in that respect

Weak Internal Dynamics and loss of leadership

In another extremely rare occurrence, last week the Dow Jones rose +2.25 % while the NASDAQ closed down -0.25 %.

Both the Dow Industrials and Transports reached new highs. This is the first new high in the Industrials in months, following the previous breakout from Transports.

This is usually a BUY signal according to the Dow Theory. However, these signals have had a very mediocre track record at predicting the future course of the markets.

What is extremely rare and significant, however, is the fact that the leaders of the 2009-2018 bull market, technology and the FAANGS closed DOWN when the Dow was making a new High.

We have made the case for many months now that the leadership of technology was coming to an end and that the very heavy concentration of portfolios in very few stocks could trigger a sharp move a la1987 when the FAANGS would roll over.

Looking at the charts of the individual stocks and of the NASDAQ, there seems to be a roll-over in the making.

IF THAT ROLL-OVER CONFIRMS ITSELF, THEN THE NEW ALL TIME HIGH OF THE DOW JONES COULD PROVE TO BE SHORT-LIVED AND A SIGNIFICANT DOUBLE TOP WILL HAVE BEEN RECORDED.

Another worrying sign of weak internal dynamics was that The Dow Industrial jumped more than 2.25% to a 52- week high last week, and yet there were MORE securities trading down to a 52- week low than securities rising to a 52-week high on Thursday.

Going back to 1965, this has only happened in February 1980 – the Dow then dropped more than 15% over the next few months, in March-April 1999 during the final blow-off rally and finally December 1999 at the peak of the Dotcom bubble years.

Furthermore, there is a HISTORIC SPLIT in the US stock markets at the moment.

On Tuesday, an abnormally large number of securities on both the NYSE and Nasdaq exchanges hit either a new 52- week high or low.

Over the past 2 weeks, there has been an unprecedented cluster of these “split” signals, and every similar cluster preceded a bear market.

Option Traders are pricing in a Crash

As noted by the Chicago Board Options Exchange, the SKEW index has closed above 150 for four days in a row, the first time in history.

The SKEW index compares prices in put options versus call options, and the higher the index, the more traders are paying up for out- of-the-money puts.

That is a form of crash protection against a “black swan” event of suddenly rising volatility.

So, in spite of a market that’s enjoying a historic level of bullishness, options traders are pricing in a big event, raising concerns that “somebody knows something.”

The one Black Swan event we can foresee on the horizon, besides a crash in the US Bond market, is an all out conflict in the Middle East and Oil prices shooting up.

Today’s mass shooting in Iran during a military parade, the sharp fall of the Iranian Rial to 150’000, the drying up of Iranian Oil sales, the relentless attacks of the Israeli aviation on Iranian and Hezbollah military in Syria and the recent cut-off of funding of the Palestinian Authority by the USA all point to the reaching of a boiling point in the Middle East.

Could an all-out war take place in the Middle East before the US mid-term elections ?

Trade Wars

The week started with Donald Trump imposing 10 % tariffs – increasing to 25 % next January – on $ 200 Bln. of Chinese goods imported into the USA on top of the initial $60 Billion that have already come into effect.

The list was carefully crafted as to avoid hurting some of the American iconic companies such as Apple Inc. whose products components are mainly manufactured in China.

As we argued in our various posts, this round of tariffs will in fact hurt the American consumer much more than the Chinese exporters as the high added-value components cannot be sourced elsewhere easily and the tariffs will actually end-up in either US corporate margins or translate into higher prices for the US consumer.

Corporate America did warn Donald Trump not to go down that route, but he did not listen. His comments on Fox News whereby the long term gains for the USA to be expected from the Trade War with China far outweighed the short term pain where a clear acknowledgment that the immediate pain will be in the US rather than in China.

Contrary to expectations, China reacted by lowering import duties on a very large variety of products imported into China, positioning itself as the champion of free trade. They nevertheless imposed the planned retaliatory sanctions on $ 60 Bln. of US goods announced in August.

China’s calm attitude reflected the conclusions by the Chinese Government that the Chinese economy would not be secretly affected, that the November Mid-term elections would weaken Donald Trump’s political standing, that China had the mean to prevent a collapse in its financial markets and that a turn in US equities would actually considerably weaken Donald Trump in the upcoming elections.

A last turn of event took place on Friday when Donald Trump sanctioned the Chinese Minister of Defense and its procurement Director for having acquired weapons from Russia.

On Friday night, China cancelled the talks that were scheduled to take place this coming week in Washington and cancelled the trip of China’s Vice Time Minister Lui He and his delegation to the USA.

Asian Markets

Chinese and Japanese equities has theirbest week in months rising by 5 % on average.

A clear bottom is in place in China and a significant break-out took place in Japan as the Japanese Yen confirmed its break out from its long-term triangle.

In China, Equity indexes rose by 4 to 6 % on large volume as the Government intervened and hedge funds started covering their short positions.

China has clearly decided to prevent the US trade war to degenerate into a Chinese equity meltdown and the ultra-cheap valuations and massive short positions provided an excellent backdrop for a successful intervention.

It is not an accident if the FT50 China index was the strongest of all ( + 6.32 % ) and the Hong Kong Listed HSECI Index the least strong ( +4.27 % ) last week.

China’s “National Team”, the Government entered the field and lifted stocks decisively on Thursday, breaking the downtrend in place since January and laying the foundation of a very significant bottom.

Moreover, China passed a significant reform last week allowing the large pool of investment products as they are called there to invest in equities, something they were prevented from doing before that.

Another extremely significant event took place last week, even if it went largely unnoticed by global investors.

The Hong Kong Dollar had a brutal and unexpected sharp move up, an unprecedented occurence for this currency pegged to the US dollar since 1982.

We have argued for many months now that China’s way out of the Trade War would be to allow its currency to rise structurally.

The Hong Kong Dollar peg to the US dollar has always been a difficult issue for China and Hong kong itself as 95 % of Hong Kong’s economy is now dependent on mainland China while its monetary policy is dictated by the US Monetary policy through the peg.

We have been arguing for years now that, at a certain point in time, the HKD peg to the US dollar would have to be replaced by a peg to the Chinese CNY.

The US China Trade War may be exactly the catalyst China needed to make that switch happen.

A re-pegging of the HKD to the CNY would make the CNY much more used and traded in Hong Kong at a time where China is pushing hard to make its currency a widely used currency in international trade.

For the re-pegging to happen smoothly from a technical standpoint (a 1 to 1 peg) , the two currencies should trade on par, which means that either the Yuan depreciates from 6.8 to 7.8 – something that China has just confirmed it would not allow to happen – or the HKD must appreciate from 7.8 to 6.8.