You’d be forgiven if you’re feeling a bitÂ trepidatious about the outlook for risk assets at the moment.
After all, trade tensions are mounting and last week’s Trump-Juncker “deal” notwithstanding, there doesn’t seem to be a light at the end of this tunnel. There’s an argument to be made that any deal between Trump and the E.U. will likely make the President even less inclined to strike a conciliatory tone on China, although not everyone agrees with that assessment.
If you’re looking for evidence that America’s trading partners are still concerned about the prospect of the U.S. slapping tariffs on auto imports, look no further than reports out over the weekend that five countries are set to meet in Geneva to devise a strategy for responding in the event the car levies do indeed become a reality.
The trade worries, along with an unapologetic Fed, catalyzed the worst quarter for emerging market equities and FX since 2015 in Q2 and the more contentious the trade dispute, the more concerned investors become that a tariff-related slowdown in global growth could conspire with a stubbornly hawkish Fed to cause more pain for developing economy assets.
Meanwhile, stateside, Facebook’s disappointing revenue guidance and the subsequent pain suffered by everyone who had piled into the trade underscored the risk inherent in the FAANG contingent, which together has accounted for a disproportionate share of the broader market’s YTD performance. Relatedly, concerns are now mounting about unhealthy market breadth as FANG is on pace to underperform the broader Nasdaq 100 for the seventh week running.
What to do? Well, JPMorgan’s Marko Kolanovic (affectionately known on the Street as “Gandalf”) has some ideas.
For one thing,Â Kolanovic thinks now might be a good time to bet on the long-awaited growth-to-value rotation.
“Over the past week, we are seeing the first signs of a Value rally (and continuation of momentum weakness)”, Marko writes, in a note out Monday morning, adding that while “some investors fear tech weakness could lead to a much more significant market correction, we point out here that Value rallies are historically associated with â€˜Risk onâ€™ trades, and often coincide with strong performance of high-beta stocks, small-cap stocks, and Emerging Markets.”
As Bloomberg’s Luke Kawa noted on Monday, this is shaping up to be “by far the best day for Value > Growth of 2018.”
(Bloomberg, via Luke Kawa’s Twitter)
“Last week the Value rally did not feel like a typical â€˜Risk onâ€™ trade due to stock-specific weakness in the Tech sector and the impact it had on equity hedge funds”, Kolanovic goes on to write, referencing the Facebook debacle and the extent to which the 2-and-20 crowd was overexposed to the stock.
As noted above, Kolanovic’s call is predicated on the notion that “Emerging Markets and related sectors (e.g., Industrials), Value stocks, and Small caps can provide market leadership even in the absence of strong performance of Growth segments”. In other words, this whole ship doesn’t have to sink just because Growth finally hits the skids (and by “Growth” we of course mean in the factor sense, not in the sense of “global growth”).
Kolanovic does note that timing is critical here and as far as catalysts are concerned, here’s how he sees it:
As with any value trade, a catalyst is needed and is critical for timing the trade. Currently, we believe potential catalysts for the rally could be a weakening of USD, potential for the Fed to slow its pace of tightening, or any progress towards resolution of trade tensions (such as the recent developments on USEurope trade).
You’ll recall that back in March, Marko suggested that the fear of a sharp market correction imperiling the Trump administration’s “market scorecard” ahead of the midterms should act as a deterrent when it comes to the President’s propensity to escalate things too far. Kolanovic updates his take on the trade situation on Monday and I’ll get to that later.
For now, note that when it comes to positive externalities that could reignite a voracious bid for risk, a dovish Fed is perhaps the best bet. Here’s Kolanovic one more time:
We previously argued that the new Fed will likely be in sync with the Trump administration, which likes low rates, a weaker USD, and higher debt. Regardless of whether this materializes, our view is that a slower pace of hiking is the right thing to do given the divergence of US and international rates, as well as the enormous left tail risk of a potential late-cycle policy error. Should the Fed skip one hike, it would be a risk-on catalyst, lifting EM assets in particular.
Of course the irony here is that Powell may be somewhat constrained in his ability to skip a hike now that Trump has explicitly stated his (Trump’s) desire for lower rates. As Marko points out, Trump’s feelings on this issue weren’t exactly a state secret (and in this case “state secret” can be taken both figuratively and literally), but by making it explicit on CNBC, the President has set the stage for Powell’s Fed to be accused of politicizing monetary policy in the event of a dovish lean.