Daily Brief For August 1, 2022

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Fundamental

Today, we add to our narrative updates with respect to the Inflation Reduction Act, China crises, implications of earnings growth that’s down below the surface, the Federal Reserve’s pivot from forward guidance, how uncertainties boost risk premia, and geopolitics. Then, in the coming days, we’ll hone in on measuring the impact.

Let’s get into it.

Inflation Reduction Act Disinflationary

The bill, which reforms the tax code, cuts health-care costs, and helps with climate change, per Noah Smith’s letter, is disinflationary.

The reason being? 

It works to shrink the deficit by $288 billion, over a decade. Additionally, though government investments are “inflationary in the short-term, and deflationary in the medium term,” embedded tax hikes “should more than cancel out the short-term inflationary piece.”

China Crisis Contained

Next, is the crisis in China. 

After Evergrande fears “peaked in September, … people stopped paying their mortgages,” in protest, per Marc Rubinstein’s Net Interest letter. 

Why is this problematic?

Typically, purchasers place “down payments into developer’s escrow accounts some 18-24 months before taking delivery of their home which are then topped up via mortgage loans.”

Though these funds would “cover the remaining cost of construction,” developers mismanaged and, “when the market turned – and traditional credit channels turned off their supply of new credit – many developers ran out of funds to complete projects.”

Despite “unfinished residential projects across China representing only 1.7% of total outstanding mortgage loans, … [they’re] a lot riskier,” now. Homes are a big chunk of household wealth and damage to this area of the market has major implications.

For context, home prices are to China what stock markets are to the Federal Reserve and peripheral bond spreads are to the European Central Bank.

Notwithstanding, despite “excessive leverage, regulatory arbitrage, and irresponsible risk-taking, … [China] banks are able to pursue a borrower’s other assets if they default on their mortgage, … [so] strategic defaults are less likely.”

Here Comes The Earnings De-rate?

As well explained in last Friday’s morning letter, essentially, the 2022 decline was mainly about higher inflation and interest rates. 

“The second half will be about earnings,” Blockworks puts well. Here’s why.

Despite, “S&P 500 earnings [] on track to rise by a robust 9.4% in aggregate,” per statements by Deutsche Bank AG’s (NYSE: DB) Binky Chadha, growth “is down sharply below the surface.”

If the massive increase in energy earnings, the return to profitability for pandemic-impacted businesses, and the drag on banks from loan loss provisioning are excluded, the “earnings adjusted for seasonality are on track to fall sharply by -4.5% quarter-on-quarter, one of the steepest declines.” 

This is among the factors prompting the likes of Meta Platforms Inc (NASDAQ: META) and Amazon Inc (NASDAQ: AMZN) to trim resources like labor.

Uncertainties Boost Risk Premia

Alfonso Peccatiello, in his letter The Macro Compass, explains that the Federal Reserve ditching forward guidance gave “markets the green light to freely design their probability distributions across all asset classes, without any anchor.”

This explains the big rally in risk assets like equities.

Notwithstanding, the Fed no longer being on autopilot promotes uncertainty and higher volatility in bonds, which is an “enemy for risk assets,” over longer time horizons.

“While ditching forward guidance might be the right monetary policy strategy, … when there is no anchor for bond markets, implied volatility will have a hard time coming down. And a higher volatility in one of the biggest, most liquid markets in the world generally requires higher (not lower) risk premia everywhere else.”

This does more to support our recent positioning analyses and the case for an “untethering” in equity implied volatility, “one of the most supportive things into the decline,” per statements by Kai Volatility’s Cem Karsan.

Tensions Flare, Elsewhere

While, on one hand, the pressures from the Russia and Ukraine conflict are beginning to ebb as the first ship carrying Ukrainian grains left for Lebanon, tensions elsewhere are flaring.

To be specific, news regarding the unrest in the Balkans, between Kosovo and Serbia, hit the wire, yesterday. Per Washington Post coverage, “Ethnic Serbs in northern municipalities of Kosovo bordering Serbia blocked roads and skirmished with police on the eve of the implementation of a law requiring them to replace their license plates with Kosovo plates.”

Per Newsweek coverage, in response, a NATO mission called KFOR would “take whatever measures are necessary to keep a safe and secure environment in Kosovo at all times, in line with its U.N. mandate.”

Adding, “Observers fear Moscow might see an opportunity in the current tensions between the two countries to push the U.S. and the NATO mission out of Kosovo.”

This is as a Chinese invasion of Taiwan may come sooner than expected, Axios reports.

Technical

As of 6:30 AM ET, Monday’s regular session (9:30 AM – 4:00 PM ET), in the S&P 500, is likely to open in the middle part of a negatively skewed overnight inventory, inside of prior-range and -value, suggesting a limited potential for immediate directional opportunity.

In the best case, the S&P 500 trades higher.

Any activity above the $4,107.00 VPOC puts into play the $4,149.00 VPOC. Initiative trade beyond the VPOCs could reach as high as the $4,164.25 RTH High and $4,189.25 LVNode, or higher.

In the worst case, the S&P 500 trades lower.

Any activity below the $4,107.00 VPOC puts into play the $4,073.00 VPOC. Initiative trade beyond the $4,073.00 VPOC could reach as low as the $4,040.75 and $4,015.25 HVNodes, or lower.

Click here to load today’s key levels into the web-based TradingView charting platform. Note that all levels are derived using the 65-minute timeframe. New links are produced, daily.

Definitions

Volume Areas: A structurally sound market will build on areas of high volume (HVNodes). Should the market trend for long periods of time, it will lack sound structure, identified as low volume areas (LVNodes). LVNodes denote directional conviction and ought to offer support on any test. 

If participants were to auction and find acceptance into areas of prior low volume (LVNodes), then future discovery ought to be volatile and quick as participants look to HVNodes for favorable entry or exit.

POCs: POCs are valuable as they denote areas where two-sided trade was most prevalent in a prior day session. Participants will respond to future tests of value as they offer favorable entry and exit.

MCPOCs: POCs are valuable as they denote areas where two-sided trade was most prevalent over numerous day sessions. Participants will respond to future tests of value as they offer favorable entry and exit.

Volume-Weighted Average Prices (VWAPs): A metric highly regarded by chief investment officers, among other participants, for quality of trade. Additionally, liquidity algorithms are benchmarked and programmed to buy and sell around VWAPs.

About

After years of self-education, strategy development, mentorship, and trial-and-error, Renato Leonard Capelj began trading full-time and founded Physik Invest to detail his methods, research, and performance in the markets.

Capelj also develops insights around impactful options market dynamics at SpotGamma and is a Benzinga reporter.

Some of his works include conversations with ARK Invest’s Catherine Wood, investors Kevin O’Leary and John Chambers, FTX’s Sam Bankman-Fried, ex-Bridgewater Associate Andy Constan, Kai Volatility’s Cem Karsan, The Ambrus Group’s Kris Sidial, among many others.

Disclaimer

In no way should the materials herein be construed as advice. Derivatives carry a substantial risk of loss. All content is for informational purposes only.