Political Correction

The recent defensive tone in many risk markets has taken many bullish investors by surprise. The signs that peak growth and inflation expectations started to arrive in Q2, just as the fourth wave of Covid infections started to be felt. Remember the widely touted lumber trade. It's now down a quick 75%. Although there is unlikely to be a return to mass economic shutdowns in the U.S. or most of the G20 nations, the effect on growth is still a driver for the current shift away from the cyclical/value trades that are now, one by one, shuddering to a halt. Copper broke down this morning after the strike-threat rally of last week. Oil is slowly retracing its' rally to the major supply zone near $70. The reopening trades are quickly closing again.

Most importantly, longer-dated maturities in all the major bond markets retraced 50% of the move since last October's lows (chart). A trip to the 38.2% Fibonacci level near 1% is possible should equities substantially correct.

U.S. 10 Yr Yield

There will be no shortages of 'excuses' for this surprising slowdown. The ending of 'Stimmy Cheques" is an obvious one as governments worldwide take the training wheels off their economies and set them free. The supply chain chaos created by the sudden stop in global production last year is still hampering inventory availability. China is sputtering in a self-inflicted slowdown, and the Delta variant is causing continued economic hesitation, as witnessed in the recent sharp drawdowns in Airline and Travel stocks. My Scottish golf trip slated for next month has been postponed for the third time since we started planning it in late 2019.

Secular forces are also back at work. Demographic deceleration and burdensome debt levels will be with us for at least another decade. Like the Covid virus, they are an unseen menace to bond vigilantes and other bond bears. The 'Death of 60/40' that was postulated earlier this year seems overblown. Rebalancing is now firmly back in charge, underpinning demand for bonds from pension and endowment funds flush with equity paper gains. The upshot of this reality is that bond prices will remain stubbornly resistant to short-term inflation data and supply fears. Peak U.S. Treasury issuance has already come and gone, putting another nail in the coffin of the consensus call for a 2% bond yield. Those forecasts suddenly look hyperbolical in the face of a strong rally in fixed income.

Vaccine hesitancy stemming from an anti-science, almost tribal place, is needlessly hampering the path to full economic recovery. Politicians are dancing around the issue and a patchwork of private and public vaccine passport systems that has resulted in a patchwork approach and an inconsistent reopening framework.

I am old enough to remember being inoculated from polio and smallpox. Our parents were saved from the threat of tuberculosis by vaccines. Nobody claimed 'right to personal freedom' back them. Those successful vaccine campaigns resulted in a collective freedom that was far more important and beneficial.

This is supremely frustrating to the vast majority of people who just want to get on with life and are being held up by the tinfoil hat crowd. It seems political correctness' over personal freedom has won out over vision and leadership. The disproportionate effects on the less fortunate, uneducated among us is a needless social cost that could have been avoided by a mandatory decree. I take no comfort in this Social Darwinism. Ignorance is combat-able if we only had more political will.

But here we sit, waiting on the sidelines due to the twin risks of negative economic surprise (July Retail Sales whiffed today) and impending reversal of QE . The Fed will soon feel comfortable enough to take their foot off the gas, and risk assets smell it coming. The Utility and Staples sectors shave started to take market leadership this week. Perversely, the potential removal of this stimulus has generated a bid to bonds, as it is seen as dampening inflationary fears. That isn't a recipe for a sustained cyclical bull market. It seems like the sidelines are a good place for players of higher beta stocks for the near future.

Perhaps a half-time pause that refreshes will lead to a resumption of better action in the Fall. There is a risk of a correction - one that is partially political in nature - and next week's Jackson Hole conference on monetary policy could be a negative catalyst for just such an event.

Risk Model: 2/5 - Risk Off

The Model agrees with the sideline call here. Copper/Gold sell-signal is confirming the economic deceleration now after a tepid summer rally based on strike-induced supply fears in Peru and Chile. Although the XIU has decelerated causing the RSI to enter a comfort zone, it has just recently been overbought and a quick trip below the lower bound (45) would seem to be in order. A more substantial 10-15% correction is long overdue, but the Model won't see it coming unless it is accompanied by a spike in the VXV. The chart to watch is below. A Five-month base has formed in this indicator and an abrupt break to the upside could trigger a tradeable knee-jerk stock pull-back. This would be a perfect scenario to re-enter the cyclical/value trade for a move higher into year-end on hopes for a 2022 re-acceleration.

3 Month VIX