When last we checked in on JPMorgan’s Marko Kolanovic, he was doing whatever the “Gandalf” version of a victory lap is after redeeming himself from a rather un-wizard-like call.
On February 1, Kolanovic suggested that an avalanche of forced deleveraging from the systematic crowd was unlikely despite recent market volatility. Here’s the quote:
Consistent with our previous research, we think that the move was not large enough to trigger broad deleveraging. Equity price momentum is positive and trend followers are not likely to reduce equity exposure.
To be fair (which is something some commentators aren’t in the habit of being), Marko had no way to know that the following day would be defined by an AHE beat that tipped the briskest pace of wage inflation since 2009, although I guess one could make the argument that it wasn’t all that hard to predict, given an economy operating at full employment.
Whatever the case, he “updated” his view on the situation over the next couple of sessions and then essentially gave everyone the green light to buy the dip by variously suggesting that the systematic deleveraging was over. His colleague Nikolaos Panigirtzoglou (who writes the bank’s popular “Flows & Liquidity” notes, usually out on Fridays) reinforced that message with a fortuitously timed note that some say helped fuel the late-afternoon rally on February 9 that essentially set the stage for last week’s impressive bounce off the lows. Here was the title of that note:
That was literally blasted out in all-caps by Bloomberg at 3:30 ET on Friday afternoon as follows:
- CTA/RISK PARITY FUND UNWINDING MOSTLY BEHIND US, JPMORGAN SAYS
According to BofAML’s estimates, the CTA and risk parity deleveraging that accompanied February’s turmoil was something on the order of $200 billion, but as Marko noted, it might well have been the fear of further forced selling by rules-based strats that was keeping carbon-based traders gun shy, so proclaiming that the programmatic unwind was over was one way of removing the psychological overhang.
Fast forward to last Friday and Kolanovic (along with Bram Kaplan) reiterated the all-clear message as follows:
Global equity markets tumbled last week and volatility rose sharply. In last week’s Market and Volatility Commentary, we advocated buying the dip as the drivers of the sell-off were entirely technical in nature and equity fundamentals remain strong, and markets have since recovered more than half of the sell-off. The sell-off was driven by a waterfall of selling flows from systematic strategies (Vol Targeting funds, CTAs, and dealers hedging short gamma exposures) triggered by the rising volatility and bond/equity correlation, and reversal in momentum, as well as fundamental investors who sold in anticipation of these flows and due to weakened sentiment.
With nearly all of the required de-leveraging by systematic investors behind us, we believe markets should continue to recover. Further, systematic investors could begin to re-lever equity positions as momentum is positive at all but short-term horizons (allowing CTAs who were stopped out on the sharp sell-off last week to reenter longs) and realized volatility begins to decline (causing Volatility Targeting funds to gradually re-lever).
The idea there is that early February’s forced systematic unwind was set to be late February’s tailwind as the deleveraging offer turned into a re-leveraging bid.
This week’s rather lackluster action notwithstanding, that seems to be kinda, sorta accurate at least to the extent we haven’t seen anything that looks like automatic selling. Well in his latest update (dated Thursday), Kolanovic notes that “[last week’s] one-week rally was very fast (~99th percentile one-week up move vs. S&P 500 trading history)” which raises the question about whether there’s more room to run. Here’s his take:
To give some insights on that, let’s look at the positioning of investors and expected flows. First, we note that the Hedge Fund beta to equities experienced an unprecedented drop over the market sell-off (Figure 1).
This de-risking (and in some cases shorting) happened largely via buying of downside options (and selling of index products) and might not be entirely captured by prime brokerage data. For instance, open interest on index put options rose by ~$500bn shortly after the sell-off. Hedge funds went from a near-record-high equity beta, to a near-record-low equity beta. This move started to revert last week, but has plenty of room to increase (table in Figure 1).
In terms of systematic selling, this is largely over. In fact our models show that volatility targeting strategies may now start very slowly rebuilding their equity positions. One should also keep in mind that most pension funds rebalanced at the end of January, and global markets are now ~5% lower from that point (~90th percentile by size of the drop). Next week is month-end, and buying from fixed weight allocators could be substantial. These flows will be a headwind for any near-term bearish thesis.
So that’s all bullish and the latter bit about the pension rebalancing is notable, especially in the context of something Deutsche Bank noted on February 9. Recall this:
At the time of writing equity declines had accelerated enough to imply that the re-balancing “bid” for fixed income from pension investors had now become a re-balancing “offer”. That is, equities outperformed fixed income to the downside, and – as of Thursday’s close – to maintain static weights, pension investors would likely have needed to sell between $10-15 billion of fixed income to buy equities, rather than vice versa. This was the world turned upside down.
The bounce in equities since DB penned those lines has probably changed those numbers, but the dynamic is the same.
To be honest, that’s about it. I mean, Kolanovic goes on to shoot down the idea that the market will read too much into the inflation data in terms of what the Fed’s reaction is likely to be with regard to nascent signs of upward pressure on prices against a backdrop of expansionary fiscal policy and an economy at full employment.
Basically, his argument is that people are blowing the data out of proportion or else extrapolating things they shouldn’t extrapolate and besides, one-sided spec positioning sets the stage for a short squeeze should bonds end up rallying. To wit:
While we think that inflation and yield fears are overblown near term, this is more difficult to disprove. We would like to point to the record speculative bond futures shorts from both fundamental and systematic investors. Figure 2 shows that speculators have amassed the largest short position in the history of bond futures trading.
When there is such a large short position, there is always risk of profit taking, or worse a proper short-squeeze. We also note extreme sentiment swings and the media playing into fears of inflation, while largely ignoring important points such as those most recently voiced by the Fed’s Harker and Bullard. Inflation discussions have recently centered around ‘linear extrapolation’ of inherently noisy data points, and focus on ‘old news’ (e.g., the nearly month-old Fed minutes yesterday). There is no mention of structural deflation via demographics or technology/AI.
One thing about that latter bit. If what markets are worried about is the Fed getting spooked not so much by the near-term data itself, but rather about the possibility that fiscal stimulus will end up supercharging inflation pressures, well then the structural deflationary factors probably aren’t paramount because after all, the Fed has a penchant for acting confused about the role those structural factors might be playing.
So if the worry is that the Fed overreacts (i.e. upside risks to the tightening path grow as the Fed looks at the data through the lens of ill-timed fiscal stimulus), I’m not sure “structural deflation via technology/AI” are going to mitigate the market’s worries because the Fed doesn’t seem too excited about taking those factors into account.
Anyway, take all of that for whatever it’s worth.