"The breakdown in Sino-U.S. talks and the latest targeting of Chinese companies by the White House has economists at investment banks increasingly pessimistic about the long-term outlook. Goldman Sachs Group Inc., Nomura Holdings Inc., and JPMorgan Chase and Co. are among those pricing-in a greater chance of a protracted trade war. One China analyst sees both sides stuck in a cycle of 'fighting and talking' until 2035."
-- Bloomberg, May 23, 2019
"Some money managers are bracing for a potential resurgence in trade tensions after President Trump's meeting with Chinese President Xi Jinping this weekend...
"Strategies include a short on the Australian dollar and other currencies as well as bearish put options on the iShares China Large-Cap exchange-traded fund. Money managers including Russell Investments have pared their exposure to U.S. stocks, favoring more-attractively-valued shares of emerging-market companies...
"While money managers at UBS Asset Management expect a trade deal at some point over the next 12 months, the broad level of uncertainty has led them to take a more neutral investment stance that offers some protection."
-- The Wall Street Journal, June 28, 2019
All eyes were on the G-20 meeting in Osaka, Japan this weekend, with investors particularly focused on President Donald Trump and Chinese President Xi Jinping, as the U.S. and China remain locked in a trade war. While Treasury Secretary Steve Mnuchin expressed optimism about progress toward a deal, other U.S. officials, including President Trump, downplayed expectations.
And to get a sense of economists' views heading into these talks, and the actions on the part of some money managers ahead of this past weekend's meeting among world leaders (excerpted above), I get the sense that it will not be a major negative surprise if the U.S. and China do not come away with a deal. And, to some, it may not be a major surprise if talks cease again for a while. Some investment banks expect a protracted trade war that lasts years, implying it is highly unlikely that this past weekend was approached with the kind of widespread euphoria that sets up a major negative shock to the system if a deal or significant progress isn't made.
If anything, from an anecdotal perspective, the stage was set for a positive shock to the system if significant progress was made or a compromise struck at the G-20 meeting.
But the pessimism being expressed in the excerpts may not be as extreme as perceived. For example, the article in The Wall Street Journal discussed money managers playing bearish put options on the iShares Large-Cap China ETF (FXI - 42.77) ahead of the G-20 meeting. This was true, especially as Trump began threatening additional tariffs on China (and Mexico) and there were not yet scheduled trade talks with Beijing.
But with Xi and Trump confirming a meeting at the G-20, and Trump backing off on tariffs on Mexico, some of the pessimism we saw in May and June has been unwound. For example, in the second pane of the chart below is a 10-day, buy-to-open put/call volume ratio on the FXI. The higher the ratio, the more the pessimism. As you can see, the ratio is heading sharply lower from the late-May and mid-June highs. At the same time, it is still well above the February and March lows.
So, if you are following the short-term money bets, it is fair to say that short-term sentiment was fairly neutral heading into this past weekend, implying the risk and reward in the immediate days after the G-20 meeting is about equal.
"…since September, the SPX has become unstable when it ventures into the 2,950 area. This is obvious to anyone with a chart, and therefore might invite profit-taking or bring short sellers into the picture. A minor win for bulls, then, with the G-20 meeting set to begin at the end of this trading week, would be a bout of consolidation."
-- Monday Morning Outlook, June 24, 2019
Last week's action was not a major surprise, as the S&P 500 Index (SPX - 2,941.76) pulled back from resistance in the 2,950 area that has been in place since September 2018. This is also the area where the SPX was trading at the time of the last two Federal Open Market Committee (FOMC) meetings, in which the Fed kept rates steady, which has proven a short-term bullish trigger on most occasions since a rate-tightening campaign began in December 2015.
"Sophisticated investors are on edge about the health of the global economy and corporate profits.
"Pessimistic fund managers are rushing out of stocks and piling into cash and ultra-safe government bonds, according to a Bank of America Merrill Lynch survey published on Tuesday. They're also rapidly marking down their estimates of global growth and earnings...
"The biggest fear continues to be the trade war. Fifty-six percent of investors surveyed by Bank of America listed it as the top 'tail risk'...
"Equity allocations are now the lowest level since March 2009 -- the month the bear market in US stocks ended."
-- CNN Business, June 18, 2019
Growing doubts about the economy's ability to handle an extended trade war created a perception that the Fed needs to cut rates, and this is why the market failed to rally after the May 1 decision to hold rates steady, as there was no clear indication that the Fed was thinking about rate cuts. But the Fed has since come around to the market's thinking, which sparked a rally from last month's low. However, market participants still appeared wary of pushing the SPX above 2,950 ahead of this past weekend's trade talks, even with the prospect of the Fed becoming more accommodative if there are no signs of progress on the trade front.
Certainly, there is enough sideline money from money managers to make this happen, and this is echoed by retail investors, where there are still more bears than bulls in the American Association of Individual Investors (AAII) weekly survey. Additionally, despite June's equity rebound from May's weakness, the mid-June short interest report indicated that short interest on SPX component stocks increased 2% in the first half of the month, as shorting activity continues to increase (but is nowhere near an extreme).
It appears that signs of progress on the trade front, or a series of economic reports that suggest trade uncertainty is not weighing on the economy, is what investors are looking for to push the SPX through resistance in the 2,950 area.
And since some economists and fund managers are convinced that a protracted trade war is ahead and have raised cash already, perhaps a perceived negative outcome this weekend would have done little damage to the market, since the Fed has signaled it is ready to act if necessary. One area to watch as support is around 2,870, where the 40-day and 80-day moving averages are converging.
If trade talks are called off again, a volatility pop that accompanies equity market weakness is a risk, but I would not expect as big of a volatility pop on a percentage basis like we saw in April to May. This is because large speculators on Cboe Market Volatility Index (VIX - 15.08) futures are not in an extreme short position like they were in late April ahead of trade tensions flaring, stocks pulling back, and volatility (as measured by the VIX) doubling from intraday low to high from April into May.
In other words, while they are net short VIX futures, the unwinding potential is not as great. But then again, there was not "full" unwinding of the VIX futures short position in May, so I might be underestimating the magnitude of a volatility pop if it occurs.
Todd Salamone is Schaeffer's Senior V.P. of Research.
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