President Trump reiterated his threats against North Korea, while on a working vacation, that were made earlier in the week that the US would deploy “fire and fury”, saying he may not have been tough enough on the rogue country. The market sold off on Thursday, with the S&P 500 falling nearly 1.5% and the VIX rising 45% to close above 16 on the day. The expert view appears to be that North Korea wants the US to overreact and raise tensions on the peninsula so that it can ultimately bring the US to the negotiation table.
Apart from the Korean story, the approaching debt ceiling will increasingly become the focus of the market. The impact on interest rates is hard to predict given there are two opposing forces: higher rates from rising credit risk of the US and lower rates from a risk-off market dynamic. The impact on equities is less ambiguous – historically, the S&P 500 has fallen 1-4% preceding the eventual resolution.
This week marked the 10-year anniversary of BNP closing hedge funds allocated to US mortgages precipitating the shut down of the US interbank funding market and beginning the larger financial crisis.
US job openings rose to a record high in June underscoring US labor market strength. This and other similarly strong data will encourage the Fed to continue the hiking cycle despite tame inflation data. NFIB Small Business Survey reported a higher-than-expected rise in confidence in July.
The 35-point drop in the S&P 500 on Thursday came as a shock to the otherwise complacent market. Perhaps this is the start of the relatively higher market volatility that the consensus expected from the new and less experienced administration. However, this can very well turn out to be another head fake – calm returned on Friday as the buy-the-dip market dynamic continues.
The flight-to-quality assets this week were Treasuries, Gold, Yen and the Swiss Franc. Base metals also finished in the green, though they fell in the last two days of the week.
Closed-end fund investors had to act quickly to scoop up bargains because the long-awaited discount widening on Thursday began to close very quickly the following day. For example, the closely followed PIMCO Dynamic Credit Income Fund (PCI) fell 3% on Thursday to a discount of 5.5% from 2.7%, but then rallied over 2% the following day for a discount of just over 3%.
The severity of the price falls, however, was large. Taking another PIMCO fund – PIMCO Dynamic Income Fund (NYSE:PDI) suffered a 2.9% price fall on Thursday which was only the 7th worst price drop in the fund since it began trading in 2012.
Weekly sector returns performed more or less as expected. Equity-Linked, High Yield and EM sectors underperformed while Investment Grade, Senior Loans, Limited Duration and Munis outperformed.
Plotting the VIX index along with the CEF discount shows us three interesting things.
First, there is a good relationship between the VIX and the discount of our CEF index – whenever VIX spikes, CEF discounts tend to increase (the right axis is reversed).
Secondly, there appears to be a downtrend over the previous two years in both the VIX and CEF discounts of both making lower highs and lower lows. Improving earnings, a coordinated global growth story and lower macroeconomic volatility have all contributed to this dynamic.
Finally, the chart suggests that for discounts to widen to the attractive high single-digit area, the VIX may need to move closer to the mid-20s – a significant distance from the high of 17 achieved this week. So, investors may need to wish for more “fire and fury” than we just saw.
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