Authored by Christopher Cole via Artemis Capital Management,

Read Part 1: Fragility In The Market’s Medium, here…

Read Part 2: Volatility Reflexivity and Liquidity, here…

Read Part 3: The Medium Is Liquidity… And It’s Vanishing, here…

Flows over fundamentals…

When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents. The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets. Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates.

Despite this trend, U.S. equities will very likely escape 2018 without a crisis or volatility regime shift because of the onetime wave of corporate liquidity unleashed by tax reform. Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate.

The first signs of stress from quantitative tightening are now emerging in credit, international equity, and currency markets. Financial and sovereign credits are weakening and global cross asset correlations are increasing. Meanwhile, China is executing a stealth devaluation of the Yuan which, since 2015, has been a reliable signal of turbulence in global markets.

Artemis predictive models have been consistently bearish through June and July, and as a result we have tactically increased tail exposure in S&P 500 index options and VIX. A higher than average exposure to tail risk has contributed to negative performance the last few months as volatility has remained in the low-teens.

Equity volatility is underperforming credit risk trend by some of the widest margins in history in both the U.S. and in Europe (see below).

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