During a short stay in Shanghai a few weeks ago on unrelated business, we had an opportunity to witness the ground zero of the China market frenzy at its peak and its nascent plunge. Chinese retail investors make up 85% of the market, a far cry from the U.S. where retail investors own less than 30% of equities and make up less than 2% of NYSE trading volume for listed firms in 2009. Combined with the highest trading frequencies in the world and one of the lowest educational levels, describing China’s market as immature is an understatement.
The ongoing decline in the VIX starting last week (and still going) is the largest supernormal volatility collapse in VIX history. Over the past 2 years, we have been experiencing a quantifiable ‘outlier’ or ‘black swan’ decline in the VIX every 6 months as evaluated against history. We can only point to government intervention as the core reason. We firmly believe that this moral hazard produces a hidden leverage and “shadow market gamma” that at some point will result in a sustained volatility outlier event in the opposite direction.
Investors are too myopically focused on expectations of a steep rise in bond yields and on using central bank stimulus to pile back into riskier assets. There is too much complacency. We believe the upside potential for Treasuries prices for the balance of the year is once again being greatly underestimated. The long end should continue to perform well under various scenarios. If the Fed hikes in September or earlier, the back end should perform well. If the Fed breaks its implicit promise to hike rates in September, its credibility would be damaged: unless of course, it was due to a significant deterioration in the economic or political landscape. Either outcome would likely benefit long Treasury security prices.
Next week's key events and data, if we can look beyond Greece and China.
Markets are beginning to signal that policy makers are losing control. Many second-order-effects of the unprecedented and experimental global actions taken since the 2008 crisis are beginning to manifest. There are always causes and effects that develop; but they do so at different speeds. Many actions in recent years have prioritized 'benefits today' over 'consequences tomorrow'. 'Tomorrow' is approaching ever more quickly. There is no 'free lunch'.
After hiking the haircuts on Greek banks' ELA collateral, the ECB decided it was time to apprise the market of its "risk management" procedures. The result: an epic display of central banker hypocrisy.
When it comes to Greece, and Europe in general, "hope" continues to remain the driving strategy. As Bloomberg's Richard Breslow summarizes this morning, "if you were looking for a word to describe the general feeling of equity markets today, you might well pick hopeful. U.S. equity futures opened higher and have been up all day. European bourses opened cautiously higher as they await word, any word, from the European finance ministers or more importantly, Chancellor Merkel. Equity markets will continue to be very reactive to European headlines, but so far, no news has been taken as a reason for hope." Which incidentally, has been the general investment case for the past 6 years: "hope" that central banks know what they are doing.
Tumbling Futures Rebound After Varoufakis Resignation; Most China Stocks Drop Despite Massive InterventionSubmitted by Tyler Durden on 07/06/2015 06:52 -0400
More than even the unfolding "chaos theory" pandemonium in Greece, market watchers were even more focused on whether or not China and the PBOC will succeed in rescuing its market from what is now a crash that threatens social stability in the world's most populous nation. And, at the open it did. The problem is that as the trading session progressed, the initial 8% surge in stocks faded as every bout of buying was roundly sold into until every other index but the benchmark Shanghai Composite turned sharply red.
- N1 – Soft deal: The most unlikely scenario is that the euro-area partners offer a much softer programme to Greece.
- N2 – Default-and-stay: Moderately less unlikely is a scenario where Greece defaults but stays in the euro thanks to a direct recapitalisation of Greek banks by the euro-area partners, with the Greek government using only domestic resources for the country’s fiscal needs.
- N3 – New deal: The third scenario is one in which the rising economic and political cost of a closed banking system results in the Syriza government being replaced by a new government of national unity and a new deal with creditors being reached.
- N4 – Grexit: In our view, Grexit and Scenario N3 are the most likely – with about equal probabilities.
What investors will focus on in the week ahead
Cheap, easy credit has created moral hazard and nurtured magical thinking throughout the global economy.
Late Friday night a solid blow was struck for sound money, free markets and limited government by a most unlikely force. Namely, the hard core statist and crypto-Marxist prime minister of Greece, Alexis Tsipras. He has now set in motion a cascade of disruption that will shake the corrupt status quo to its very foundations.
"As this critical domino chain of local governments in China’s credit risk situation begins to wobble, there could be significant ramifications for broad financial market stability. Such a chain reaction seems to have begun."
Just as we warned earlier in the year, total uncertainty about the future of Greece has enabled a growing sense of moral hazard as "if the nation doesn't pay its debt, why should we" sweeps across the troubled nation. As Greeks' tax remittances to the government, which were almost non-existent to begin with, have ground to a halt, so The FT reports, so-called 'strategic defaults' have become a way of life among Greece's formerly affluent middle-class..."I still owe money on the car and motorboat I can’t afford to use. Even a holiday loan I’d forgotten about...I’m living with my mother looking for work and waiting for the bank to come up with another restructuring offer."
"Over the last couple of decades, we have been engaged in an enormous national experiment, taking impressionable and often ignorant teenagers and young adults and seeing just how much student loan debt they can handle.There is a practical question at hand for people who feel as if they are in over their heads: Is it ever a good idea to try to beat the system by openly defying it and refusing to repay the debt that you willingly took on?"