Updated Views on Macro and Markets

Updated Views on Macro and Markets

There are some market participants that see the weakness in Cyclicals and Emerging Markets as a buying opportunity. On the other hand, others are getting more concerned about the economic outlook, especially when the fiscal spending declines in October. When I analyze the economic indicators and market leadership, I continue to agree with the later.

In this post I discuss:

  • Global Manufacturing and Market Leadership
  • Update on China and Credit Spreads
  • Demand and Supply for Oil
  • Warning Signs for Volatility

Countertrend rallies, like we saw in July, can test the resolve of even the most confident investors. However, knowing that trades never go in straight line is why position sizing is so important when constructing a portfolio. Correct sizing should help you to stay with the long term trend, which in this case, are positions that outperform in a slowing global economy.

Global Manufacturing

Globally, the Manufacturing data continues to decline.

Source: Markit, JPM

More specifically, we have seen a sudden drop in Europe’s Manufacturing data…

…and in Japan.

However, as we saw in Brazil this past month, these moves rarely move in a straight line.

When looking at ISM Manufacturing, we continue to see the headline number and New Orders decline.

ISM Manufacturing (white), ISM New Orders (yellow)

Source: Bloomberg

Looking forward to the August numbers, we should expect to see another decline in the ISM data, as shown by @Not_Jim_Cramer.

Finally, equities are confirming the peak in manufacturing data and economic growth, as the market continues to transition towards more stable companies, industries, and sectors…

ISM (white), SOX (Semiconductors) Index vs Health Care (yellow)

Source: Bloomberg

ISM (white), Industrials vs Staples (yellow)

Source: Bloomberg

ISM (white), Financials vs Utilities (yellow)

Source: Bloomberg

…and to the most stable global economy, the US, which is seeing significant outperformance year to date.

Percentage Change YTD vs S&P 500: Europe (White), Emerging Markets (Purple), Brazil (Yellow)

Source: Bloomberg

Update on China

Focusing on China’s economy instead of the trade headlines, the Chinese government has been generating quite a bit of positive news lately. This is making some investors think that a rebound for China and Emerging Markets is in the cards. A recent example of this is from Reuters:

China almost quadrupled the value of fixed-asset investment projects approved in July from the previous month as Beijing looks to accelerate infrastructure spending to stabilize the cooling economy.


However, when you look at China’s M1 data, we see a completely different viewpoint than the narrative.

China M1 Money Supply Y/Y: 1ma (blue), 3ma (red), 6ma (green), 12ma (yellow)

Source: Bloomberg

The reason why the growth rate of M1 is declining despite the increase in infrastructure projects being approved is because of the decline in Shadow Banking Financing.  This was discussed in more detail in May (https://wp.me/p9vaFZ-5f).

China Shadow Banking Financing Y/Y (white), China’s 5yr Yield (yellow)

Source: Bloomberg

With China’s M1 still declining, demand of products and materials should continue to slow. In other words, the recent increase in Export data from China’s major trading partners shouldn’t be viewed as the beginning of a new trend.

China’s M1, 12ma Y/Y (black, 6 month lead), Exports Y/Y, 3ma: Australia (blue), Brazil (green), South Korea (red)

Source: Bloomberg

As Chinese demand continues to decline, we should expect the currencies of those countries to further depreciate against the USD as well.

China’s M1 12ma, Y/Y (black, 6 month lead), AUD/USD (blue), USD/BRL (green, inversed), EUR/USD (red)

Source: Bloomberg

Finally, the decline in demand and trade from China is part of the reason why we’ve seen European High Yield Spreads and Emerging Markets Spreads increase since the start of the year while the US Spreads have remained subdued.

Option Adjusted Spreads (OAS): US HY (white), US IG (red), Europe HY (yellow), Emerging Markets (green)

Source: Bloomberg

This helps explain why the US has outperformed the rest of the world, and in my opinion, will continue to until China changes from managing an economic slowdown to trying to stimulate growth in their economy.

Demand and Supply for Oil

Historically, at the end of an economic cycle we see oil prices increase significantly, which puts excess stress on consumers and businesses. If we are nearing the end of the economic cycle, the current outlook for oil would indicate that this time would be different, which makes me question the potential for a recession in 2020 since I tend to believe that history rhymes.

First, China is the marginal buyer of oil and we continue to see their demand slowing. This should be expected since the Chinese government is trying to manage, not stimulate, their economy as it slows. As usual, the 6 month average gives a better view of the trend compared to the more noisy monthly data point.

Source: Bloomberg

Turning to the Supply and Demand picture, we see the growth of Supply outpacing the growth of Demand on a Y/Y, 6 month average (6ma).

Oil Demand 6ma, Y/Y (blue), Oil Supply 6ma, Y/Y (red)

Source: Bloomberg

As mentioned a few months ago, the ratio of Total Demand/Total Supply on a 6ma continues to lead inflection points in WTI by ~6 months. It is important to note that this correlation broke down from 2001 – 2005 as China was building their massive cities.

Oil (blue), Oil Demand/Oil Supply: Monthly (red), 6ma (black)

Source: Bloomberg

We also see the ratio of Total Demand/Total Supply continuing to lead the EUR/USD by ~3 months.

EUR/USD (blue), Oil Demand/Oil Supply: Monthly (red), 6ma (black)

Source: Bloomberg

Finally, confirming the current decline of Oil is the Oil & Gas Exploration and Production Index underperforming the S&P 500 once more. Overall, the group has been under pressure as margins are getting squeezed. A decline in the price of Oil definitely doesn’t help improve that situation.

Oil (white), S&P Oil & Gas Exploration and Production Index vs S&P 500 (yellow)

Source: Bloomberg

It is important to mention that the news flow, or narrative, is very supportive of the price of Oil due to Venezuela production issues, Iran sanctions starting in November, and the potential inability of producers to expand production enough to keep up with the global demand.

While the narrative could end up being correct, as it could in China, the outlook portrayed by the Demand/Supply ratio shows that investing in Oil and Oil related companies means investing against the fundamental trend at this time.

Volatility Warning Signs

As mentioned in previous posts, Volatility spikes when we see ISM Manufacturing peak or trough. What we saw in at the beginning of the year was no different but the size of the spike was substantially larger compared to previous periods of ISM peaks.

We tend to see the number of shares traded in the market (i.e. volume) increase as ISM declines and vise versa. Additionally, we see Volatility trend in a similar pattern as volume, as shown by the arrows in the chart below.

A key point to understand with Volatility is that in order to see a sustainable increase you need to have ISM declining and the 90 day average volume increasing. Currently, we have ISM declining and Volatility trending higher but volume is declining. In this scenario, when we see short term spikes of Volatility, they should result in only small quick declines in the S&P, like we saw the week of August 13th– 17th. A large drawdown in the S&P becomes more likely when the 90 day average of volume begins to increase, like we saw six months ago.

Top Panel: ISM Manufacturing (red, inversed), Total Market Volume: 45 day average (blue), 90 day average (yellow)
Bottom Panel: Generic 2ndmonth Volatility Futures Contract (green)

Source: Bloomberg

I’ve previously described the importance of tracking the Volatility Spreads (https://wp.me/p9vaFZ-3z). Since that post, we continue to see the S&P 500 move with the difference of the 2ndand 1stmonth Volatility Futures contract, as seen below. As stated in that post, when the spread moves below 0.60 the risk of a market decline increases and a move below 0.0 tends to coincide with a large market decline.

S&P 500 (yellow), 2ndMonth – 1stMonth Volatility Futures Contract (white)

Source: Bloomberg

Breaking down this statement into something more meaningful, only 23% of the weekly data points of the Volatility Spread since May 2009 are below 0.50. Furthermore, of that 23% we see a distribution of:

  • 0.5 to 0.1 -> 12.8%
  • 0.1 to -0.1 -> 5.8%
  • -0.1 and below -> 3.8%

In other words, over the past 10 years, it is rare for the Volatility Spread to get below 0.5 and especially below 0. However, each of these occurrences are associated with market declines, thus the importance of tracking the Volatility Spread.

Weekly Chart: 2ndMonth – 1stMonth Volatility Futures Contract (Up weeks: green, Down weeks: red), Distribution of Data Points on Left Side

Source: Bloomberg

Finally, we are seeing the correlation of the S&P and Volatility Spread currently ranked in the top 15% over the past 10 years.  Overall, tracking the Volatility Spread and watching the 90 day average of volume becomes an important part of risk management with ISM Manufacturing declining and Volatility trending higher.

Top Panel: S&P 500 (orange), 2ndMonth – 1stMonth Volatility Futures Contract (white)
Bottom Panel: Correlation of Top Panel with Distributions on Left Side

Source: Bloomberg


As discussed in the various section of this post, the growth rate of the global economy continues to decline. Therefore, maintaining an allocation tilted towards a stronger USD and counter cyclicals will be a benefit to the performance of your portfolio. At some point, reducing exposure to US equities will be advised, but not yet.


  • Overweight (or long) the USD
  • Underweight (or short) Emerging Market currencies


  • Overweight (or long) long dated maturing US debt
  • Underweight (or short) Emerging Market debt


  • Overweight (or long) S&P 500
  • Underweight (or short) Emerging Markets
  • Overweight (or long) US defensive sectors and industries
  • Underweight (or short) US cyclical sectors and industries