Last Friday was a very bloody day where the markets made a messy and confusing turn. Most importantly, the S&P 500 closed below my significant level of 4300.
Let’s take stock of what had happened. Firstly, the biggest winners for the year - the commodity stocks - turned into the biggest losers on Friday. In my previous report, I’d mentioned that the VIX was at a support trendline. That if anything, the VIX could rise (i.e. the markets could fall).
So what does the VIX do? If you are an options market maker and you think the risk of a sharp market decline is rising, then you will charge more to sell downside protection. i.e. your puts will cost more than the calls. It’s just like how an insurance company would charge a client more for home insurance in an area more prone to hurricanes and earthquakes. On Friday. the VIX rose sharply i.e. there was lot of hedging going on.
What’s the market really worried about? Is it the fear of more aggressive Fed rate hikes? The market has already reacted to that. Whatever the Fed does in the current interest rate cycle, they are going to trail inflation by a wide margin - fighting inflation solely is not their singular agenda.
Are the earnings an issue? About 20% of the S&P 500 companies’ results are out and about 80% of companies have beaten the street earnings estimates. The coming week should see the major FAANG results being deeply scrutinized.
One of the biggest concerns the markets may be having is the French election. The second voting takes place on Sunday evening. Though Macron is in the lead, a lot of uncertainty prevails if Le Pen makes a surprising victory. She is a hardcore nationalist running on the platform of regaining French sovereignty. Le Pen will surely be a threat to the Euro and can become a threat to the unity of the European Union. To put it bluntly, a Le Pen victory is what the Brexit vote was to the UK and what the Trump victory was to the US. Remember in both the above outcomes, the polls were showing something different.
Secondly, though it is not publicly spoken, there is a global currency war likely to develop. The Japanese Yen has weakened all of a sudden by 12% within a month. I cannot remember any time in the last decade that it has made such a sharp move in such a short time. Perceptions of interest rate movements are the major drivers of currency movements. But the Chinese Yuan is very important in my opinion. The value of the Yuan is completely controlled by the Chinese government. In the past four days, the Yuan has weakened by 3%. They probably are threatened by the Japanese Yen's weakness even though Japan is not that big of an export competitor vis-a-vis China.
We faced a similar situation in 2015 when China was sending signals that they will do a much bigger one-off devaluation and stocks fell by almost 10% in a few days. The Chinese however didn’t follow through.
So, we are going to have a very volatile week as markets open on Monday. But I am still holding on to the view that the markets should overcome this level of uncertainty for higher levels in the coming days.
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Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and multi-billion dollar portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office and a hedge fund. Currently, he is a co-founder of a new hedge fund where foreign citizens can invest in Indian growth stocks like Tanla operating in hyper-growth markets like CPaaS.