For Citi, This Is "The Biggest Fear For Equity Markets"

While recent price action feels largely sentiment driven – Citi takes the opportunity to note what we have already shown on several occasions, namely that the correction to stocks accelerated last Friday following the US Non-Farm Payrolls print, and specifically the response to the especially good (and woefully misinterpreted) wage inflation print, which Citi's Global Macro Strategy team believes is "the biggest fear for equity markets." 

In addition to last Friday's rapidly rising average hourly earnings print, Citi notes the ISM prices paid number is now at the highest level since 2010, whilst University of Michigan household income expectations one year ahead are surging.

Commenting on these rapidly rising inflationary indicators, Citi's Jeremy Hale notes that "perhaps the equity market is getting worried that we are seeing sustained inflationary pressures."

We have shown previously in our Global Asset Allocation that moving from a 'Goldilocks' environment (solid growth, benign inflation) to one of increasing inflation, generally sees volatility increase in equities and Sharpe ratios decrease.

In fact, Citi believes that 1987's Black Monday crash was a consequence of the shift from "goldilocks" to "reflation."

Which means that the biggest risk is also the most obvious one: the negative impact of rising wages on corporate profits:

Furthermore, if we see wage inflation rises, past cycles show great difficulties for firms in passing wage costs to prices in an increasingly open economy. We wonder if equity markets are now becoming concerned about potential margin compression for firms.

They are, and just in case there is still any doubt what is causing the market shock, here is an excerpt from a recent note by Rafiki's Steven Englander, discussing "how it can go wrong for asset markets."

My short answer is that the worst possible outcome is that we hit our inflation targets anytime soon. A quick acceleration of core inflation from 1.3% in the US, 0.2% in Japan and 1.1% in the euro zone to approximately 2% in each country would mean that real interest rates would have to rise to roughly their equilibrium very quickly. It would also mean that the UR was almost certainly well below the NAIRU, so the tightening would temporarily have to be beyond the long-term equilibrium.

Some FOMC members have argued that a long period of below target inflation should be offset by a roughly equal overshoot – this would be roughly equivalent to price level targeting. The same problem emerges. If we get to, say, 2.3% relatively quickly, the message is that you have to tighten abruptly because you overshot full employment. From an asset market perspective hitting the inflation target means that the friendly central bank is not as friendly anymore. There might be a gain in output but the confidence in the reaction function and ongoing low volatility would be much less.

For asset markets the last seven years have been like heaven, all investor needs being taken care off by a transcendental power who makes sure nothing goes wrong. Hitting inflation targets is getting tossed out of heaven and having to live in the real world that we lived in before volatility collapsed.

In this normal world, central banks tighten at times when the economy is softening because they are much more cautious on stimulus when inflation is on target. This restores the downside to asset market pricing that the central banks effectively removed when inflation was below target.

Similarly, policymaker tolerance for asset market exuberance drops when inflation is at target. They then view rapidly appreciating asset prices as a forerunner of further inflation. Whereas policymaker hands are tied to some degree when inflation is below target, once inflation is at target policymakers are more comfortable acting on asset prices that look out of line.

Bottom line – investors should hope that we keep missing inflation targets, it is the best guarantee of continued asset market robustness. In the limit, as investors we want to get to inflation targets very slowly. Any faster, monetary policy would have to switch from stimulatory to restrictive (not stopping at neutral) before we get to the target. Otherwise the odds are that we overshoot. Once the target is achieved or is in sight, the central bank friendliness to the market is gone, so the forces restraining volatility disappear and asset market risk is more two-sided again.

Bridgewater Bets Big against Largest Banks in Spain & Italy

World's largest hedge fund puts down $13 billion to profit from trouble in Europe. 

A lot of people have lost a lot of money in the recent financial market convulsions, but there's still plenty of money to be made by betting against the companies, as the world's largest hedge fund, Bridgewater Associates, showed this week. It bet heavily against four of Spain's biggest corporate hitters. The fund took up short positions worth €1.2 billion, or 0.5% of total shares at Banco Santander, BBVA, Telefónica and Iberdrola.

The gamble has already reaped dividends. Shares of Iberdrola, Spain's biggest utilities company, Telefonica, Spain's struggling telecoms giant, and Santander, Spain's biggest bank ended the week around 5% lower, while BBVA tumbled 4%. Bridgewater placed its best against the two large Spanish banks last week, just as they presented annual results that largely disappointed the market. Since then, both banks have lost close to 10% of their market cap.

These short bets are part of the firm's $13.1 billion in shorts against 44 European companies, according to EU regulatory filings, reported by Bloomberg. Among the notable short positions, in addition to the Spanish banks, are Total, Airbus, BNP Paribas, ING, Intesa Sanpaolo, Eni, Sanofi, and Axa.

At the beginning of the week, Ray Dalio, founder of Bridgewater Associates, made light of the recent rout in global stock markets saying in a blog post on LinkedIn that "this is classic late-cycle behavior," adding: "These big declines are just minor corrections in the scope of things . . . There is a lot of cash on the side to buy on the break, and what comes next will be most important."

Investors will nonetheless be wondering why the world's biggest hedge fund is shorting Spain's two biggest banks, whose shares had been on an 18-month roll. Until last week that is. As we warned in December, 2018 could prove to be a stressful year for Spanish banks, for three reasons:

Painful new rules. The introduction in January of a new accounting rule, known as IFRS 9, will force banks in Europe to provision for souring loans much sooner than at present. One direct result will be that banks will have to hold more capital on their books, and that will have a detrimental impact on their profits. BBVA calculated that as a result Spanish banks will have to increase their provisions by 21% — around €5.2 billion — to comply with the new requirements. This amount may be manageable for the industry as a whole, though some lenders, in particular the smaller banks, will suffer more stress than others.

Potential indigestion from Popular take-over. The decline and fall last year of Spain's sixth biggest bank, Banco Popular, served as a reminder (a painful one for the bank's 300,000 shareholders) that Spain's banking system is far from fixed, despite the tens of billions of euros thrown at it. Now, the attention shifts to just how well Santander will be able to digest the collapsed bank it bought for €1

Exposure to high-risk markets. As the IMF warned in a report last year, BBVA's largest international exposures by financial assets are concentrated in the UK, the US, Brazil, Mexico, Turkey and Chile. At least four of those six markets — Brazil, Mexico, Turkey and the UK — are likely to face headwinds in 2018. In the US, Santander's subsidiary, Santander Consumer USA, is dangerously exposed to the subprime auto-loan sector, which is already taking a toll on global profits. So great is both banks' exposure to Latin America's two largest economies — Mexico (which accounted for 40% of BBVA's global profits) and Brazil (which provides 26% of Santander's) — that if things deteriorate in either or both of these key emerging markets, the spillover effects will be felt almost immediately in Spain's banking system.

There could also be another reason for Bridgewater's bet: the continued systemic weakness of the Eurozone's periphery.

After all, Spain is not the only Eurozone economy that Dalio has massively shorted. In the last three months his fund has tripled its short bets against Italy, the Eurozone's third largest economy and arguably weakest link, to €2.45 billion, up from €900 million in October. A total of 18 firms have been targeted including Italy's main utility, Enel, the national oil and gas company Eni and the pan-European insurer Generali. Like Telefonica and Iberdrola, Enel and Eni are among the largest beneficiaries of the ECB's massive corporate bond purchase program which could come to an end as early as September this year. The firm's funding costs could rise sharply thereafter.

Most of Dalio's short bets in Italy are targeting its still fragile financial sector. His biggest short is against Italy's second largest bank by assets, Intesa Sanpaolo, which is widely viewed as Italy's most stable bank. In fact, it was the only bank in the country that was big enough and in sound enough health to absorb the two ailing mid-size Veneto based banks Banca Popolare di Vicenza and Veneto Banca in June 2017.

The bank will win the battle, CEO Carlo Messina confidently predicted in a Bloomberg Television interview on Thursday. The bank has seen its shares slump 4% over the last three days but they are still 45% higher than they were this time last year.

"When [Dalio and I] had a conversation in October, he was short Intesa Sanpaolo and Italy," Messina, who leads Italy's biggest bank by market value, said in the interview. "I told him he could lose money on our position and in the end I think he lost money. Again, increasing the position, I think he's losing money again."

Whoever wins this financial duel, the stakes are high. Even for a firm the size of Bridgewater Associates, with an estimated €122 billion of assets under management, short positions of €13 billion concentrated in the Eurozone represent a lot of risk. For the Eurozone, the financial stability of its third and fourth largest economies, both of which are still very fragile, well, that's priceless.

Fabrizio 

Dalio's $13 Billion Short: Bridgewater Unveils Its Biggest Ever Short Position

Last October, Italy's government was angry when the world's largest hedge fund, Ray Dalio's Bridgewater unveiled it had amassed a sizable $713 million short against Italian financial stocks, its biggest disclosed bearish bet in Europe.

Then last week, and just one month before Italy's March 4 elections - which the broader market stubbornly refuses to acknowledge are a risk factor - Bridgewater tripled down on its bearish bets against Italian banks and insurers, making the position the largest thematic short carried by the world's biggest hedge fund.

As we reported last Thursday, Bridgewater boosted its bearish bets against Italian companies to $3 billion and 18 firms, up four-fold from just over $713 million in early October, further infuriating Italian authorities. As Bloomberg added, Bridgewater's bearish bets against European companies as a whole totaled $3.3 billion, spread among 20 names. In addition to his previous negative exposure, Dalio disclosed a short position in transport-infrastructure provider Atlantia and added to its largest short bet, against lender Intesa Sanpaolo SpA.

The growing short comes just days after Dalio told a Davos audience that "holding cash is now stupid"... and literally days before the biggest market crash since Lehman.

Fast forward to today, when Dalio's bearish fascination is starting to get a little concerning, because according to the latest Bloomberg summary, Bridgewater now has at least $13.1 billion in European Union shorts, quadrupling the $3.2 billion short from last week, and over 18 times more than the fund's original position last October.

In the past week, Bridgewater put more than $1 billion to work betting against oil giant Total SA - making it the firm's largest disclosed short holding in Europe. 

As Bloomberg notes, Europe's energy titan has been riding out the biggest industry downturn in a generation by selling assets and cutting spending. The hedge fund also started a bearish Airbus SE position, investing about $381 million against the aircraft maker. Among other short positions, it disclosed wagers against BNP Paribas SA, ING Groep NV and Banco Santander SA.

Amusingly, since the Feb. 8 regulatory filings were made public, Total fell 1% as markets slumped, while Dalio's other shorts, Airbus, BNP Paribas, ING Groep and Banco Santander sank roughly 2%.

A list of Bridgewater's top 10 shorts is shown below:

At the risk of repeating ourselves - which we think under these circumstances is worth it - we will remind readers that on January 24, Dalio told a naive, fawning Davos audience that:

"We are in this Goldilocks period right now. Inflation isn't a problem. Growth is good, everything is pretty good with a big jolt of stimulation coming from changes in tax laws. If you're holding cash, you're going to feel pretty stupid."

And as Dalio was dissembling, he was quietly assembling Bridgewater's biggest ever thematic short in his fund's history.

So yes, perhaps if you're holding cash, you will feel pretty stupid eventually, but not after last week's global market plunge; however, you will certainly feel much dumber if you actually believed Dalio.