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As Most Global Equity Markets Are Underwater, Watch Central Bank Policy

07/11/2018 2:46 pm EST

Focus: ETFS

Landon Whaley

Editor, Gravitational Edge

The iShares MSCI Brazil ETF peaked on January 25 and has since declined 30.8%, officially entering crash mode. Despite this reality, investors have added $520MM in new money to this ETF during the time period which saw this equity market crash, writes Landon Whaley Wednesday.

Last week was null of any critical developments, and a lack of trading volume backs this reality. The July 4th lull provides us with a nice opportunity to discuss the most critical catalyst facing investors as we enter the back half of 2018: central bank policy mix.

The two most important variables impacting the risk and return of asset classes are economic conditions and how central banks respond to those conditions. We dedicate a great deal of research ink to discussing the Fundamental Gravity of various economies around the globe and the impact of those varying Gravities on how you should position your portfolio.

We nailed the shift in Fundamental Gravities of China, the Eurozone, Brazil and South Korea, and at a minimum had you out of equity markets before they entered crash mode. At best, for those of you with short selling in your bag of tricks, we helped position you for opportunity.

Central bank policy is a component of our Fundamental Gravity for each economy, so let’s take this opportunity to triangulate central bank policy across the U.S., Eurozone and Japan.

In the U.S., the Fed has painted a clear picture for two more rate hikes this year, along with a continued unwinding of their balance sheet. To that end, they won’t reinvest any of the proceeds of the $40B per month of maturing bonds during Q3, and in Q4, this number will reach $50B per month.

In the Eurozone, the European Central Bank is buying €30B EUR per month of mostly sovereign bonds during Q3, reducing their purchases to €15B EUR per month during Q4. They’ve also stated they are at least a year from their first rate hike.

While the Bank of Japan has been reducing the amount of bonds it buys, you can’t really call it “tapering.” These boys can manipulate yields with the best of them, which is the reason Japanese yields have fluctuated very little, despite the reduction in bond purchases and the increased volatility in yields outside of Japan.

The bottom line is that outside the U.S., conditions remain on the accommodative side of the central bank policy coin. Policy is becoming less accommodative with each passing month for the first time in a decade. When you understand this policy mix against the Fundamental Gravity backdrop characterized by growth slowing the world over, you can see why volatility across asset classes has risen from last year’s slumber and most of the world’s equity markets are underwater year-to-date.

Central bankers, unelected officials though they may be, wield a great deal of power and influence over financial markets. It’s critical for you to keep this mix of central bank policy in your mind as you traverse the next six months.

Nothing, including tariffs and trade wars, will impact your portfolio more than this mix of policy and how it shifts over time. Those who can navigate this sea of diverging central bank policy and Fundamental Gravities will be the victors, while those who cannot will have a first-hand tour of Davey Jones’ locker.

In this week’s macro theme, we review “Cry for Me Brazil,” which we rolled out on May 21. Since then, the iShares MSCI Brazil ETF (EWZ) has declined 13.7% and because of the policy mix we just discussed, this decline is only the beginning. As long as we have a Brazilian Fundamental Gravity characterized by growth slowing, coupled with the political induced volatility of a presidential election in October, then opportunity lies on the short side of Brazilian equities. 

NZT 48 for “Cry For Me Brazil”

This week, our smart pill explains why the macro environment is becoming conducive to being short the iShares MSCI Brazil ETF.

The Fundamental Gravity bottom line is that a continued deterioration in the economic data, coupled with political volatility, will keep Brazilian equities locked in a bear market, at least through October of this year.

The Quantitative Gravity bottom line is that it doesn’t get more bearish than what we are seeing with EWZ right now. All four dimensions of this market are decisively bearish and becoming more bearish by the day.

The Behavioral Gravity bottom line is that despite decisively bearish Fundamental and Quantitative Gravities, investors continue to plow money into this market. This behavior is humanness on display, doing exactly the wrong thing at exactly the wrong time.

We share detailed entry and exit guidelines with our research clients including specific price targets for risk and profit taking. In addition, we send out real-time alerts whenever we initiate or close a position in our Asset Allocation model.

If you’d like to receive the details for this short EWZ trade and be notified when we are initiating the position, please email us at ClientServices@whaleyglobalresearch.com. We will also provide you with a free eight-week trial of our research offering, which consists of three weekly reports: Gravitational Edge, The 358, and The Weekender.

Fundamental Gravity says what?

Two chief variables impact the risk and return of asset prices: economic conditions and how central banks respond to those conditions. Together, these variables drive what we call an economy’s Fundamental Gravity.

Brazil’s Fundamental Gravity just can’t catch a break.

Following the 11-day truckers’ strike, consumer confidence fell to the lowest level in over a year. Construction and overall business confidence are also in the proverbial toilet. May’s unemployment improved slightly, but unfortunately the improvement was not due to the creation of new jobs, but rather because more and more people are giving up on finding new jobs and leaving the workforce.

This cliff dive in confidence highlights the recession risk in Brazil, and the unemployment trajectory is foreshadowing a further slowdown in consumer spending. Remember, Brazil is only four quarters removed from its last recession, which lasted three years.

To add insult to injury, the U.S.-induced global trade battle is a negative for Brazil in the long run, despite some immediate benefits. The president of the Association of Foreign Trade of Brazil (AEB), José Augusto de Castro, has said that an escalating trade war will depress global growth and commodities prices.

We’d offer to Castro that both are already occurring, and a continued trade war will only exacerbate those fundamental realities.

Castro went on to say that Brazil’s trade surplus this year could get hammered by 25% this year, despite the trade friction’s early benefit to the country’s soy, corn and pork industries. If this friction perpetuates and the U.S. and China eventually succeed in forging a new trade deal, Brazil could potentially lose out on longer-term agricultural exports.

Given the three-year recession and weak economic growth since it ended, it’s not surprising that the iShares MSCI Brazil ETF (EWZ) is currently trading exactly where it was in December 2014.

EWZ has gone absolutely nowhere while experiencing four mind-numbing drawdowns in excess of 15%. The first EWZ crash occurred at the end of 2016, when it declined 19%. During 2017, EWZ experienced two significant drawdowns of -22% in May and -15% in October. The fourth drawdown is still being experienced, with a decline of -31% from the January 25 peak.

The current Fundamental Gravity posture in Brazil remains bearish for EWZ. In this type of Fundamental Gravity, EWZ averages a 1.7% quarterly decline with an average drawdown of -17.5% and posts positive three-month returns just 47% of the time.

The Fundamental Gravity bottom line is that a continued deterioration in the economic data, coupled with political volatility, will keep Brazilian equities locked in a bear market, at least through October 2018.

Quantitative Gravity says what?

As a quick reminder, the Quantitative Gravity component of our Gravitational Framework is not technical analysis, which is ineffective and misleading. Rather, we use quantitative measures based on the reality that financial markets are a nonlinear, chaotic system.

We’ve identified four primary quantitative dimensions of financial markets that affect price movement: energy (trend), force (momentum), rate of force (buying pressure), and a market’s irregularity.

Social is our measure of a market’s current energy (or trend). EWZ’s Social reading indicates it’s experiencing a hangover that no amount of IV fluids can help.

Momo is our measure of the amount of force behind the market’s current state. EWZ’s Momo turned bearish on March 19 and has been decisively bearish ever since. The last time EWZ’s Momo was this bearish was almost four years ago in September 2014!

Barometric is our measure of the rate of force behind the current Momo. EWZ’s Barometric tells us that sellers remain firmly in control of this market, and selling pressure continues to build.

Topo, which measures the probability of a drawdown, is indicating the drawdown risk for EWZ over the next 10 trading days is extremely high.

Most investors are hyper-focused on price action. Unfortunately, price is nothing more than the current point where there are equal parts of disagreement on value and agreement on price. If you’re new to our Quantitative Gravity framework, it’s important to note that the four quantitative dimensions of a market that we monitor typically move ahead of price. In other words, price is the last aspect of a financial market to move, quantitatively speaking. However, price is an important factor, and my bearish thesis for Brazilian equities will remain intact, as long as EWZ trades below $37.06.

The Quantitative Gravity bottom line is that it doesn’t get more bearish than what we are currently seeing with EWZ. All four dimensions of this market are decisively bearish and becoming more bearish by the day.

Behavioral Gravity says what?

Behavioral Gravity allows us to evaluate investors’ perception of this market and how that perception changes and shifts over time.

The iShares MSCI Brazil ETF peaked on January 25 and has since declined 30.8%, officially entering crash mode. Despite this reality, investors have added $520MM in new money to this ETF during the time period which saw this equity market crash. These folks are clearly not embracing a Gravitational Framework to evaluate financial markets.

The Behavioral Gravity bottom line is that despite decisively bearish Fundamental and Quantitative Gravities, investors continue to plow money into this market. This behavior is humanness on display, doing exactly the wrong thing at exactly the wrong time.

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