Marko Kolanovic Flags An ‘Unprecedented Divergence’, Says ‘Something Has To Give’

On July 30, JPMorgan’s Marko Kolanovic called for a rally in emerging market and value stocks contingent on certain conditions, one of which was the Fed taking a pause on rate hikes.

Since that note was published, EM has of course come under more pressure amid the collapse of the Turkish lira and the prospect that ongoing strength in the U.S. economy coupled with nascent signs of domestic inflation pressures will force the Fed to stick to the course, pushing the dollar higher and leading to a further tightening in financial conditions.

At the same time, strong corporate earnings and the prospect of record buybacks continues to push U.S. equities higher (to all-time highs hit on Tuesday), despite bear markets in Chinese equities, EM stocks more generally, copper and European financials (to name a few). In other words, there is historic divergence between what’s happening stateside and what’s happening across the globe.

“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”, Kolanovic wrote, adding that “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.”

If the Fed did decide to skip a hike, it could act as a circuit-breaker for the self-feeding loop that’s pushing the dollar up amid a widening policy divergence between the U.S. and the rest of the world.

One person who agrees with Marko is Donald Trump, who on Monday took his criticism of the Powell Fed up several notches, leading directly to weakness in the dollar and a restoration of ex-U.S. risk sentiment.

On Tuesday, Kolanovic is back and in a new note, he writes that “the recent divergence in the performance of US Equities vs. the rest of the world is unprecedented in history.” Here’s more:

If one looks at price momentum — it is positive for US stocks and negative for Europe and Emerging markets across all relevant lookback windows. This has never happened before. Over the past 20 years, even the individual regional indices rarely had such a divergence (for instance, the divergence of US and Europe momentum happened only 2 times).

Given that this is such a rare occurrence (has never happened for both Europe and Asia), it suggests to us this is a market condition that will not persist. In other words, something will give — either the US will fall or EM and Europe equities will catch up and move higher (the historical sample of these events is too small to statistically infer which way this convergence will most likely happen). We believe this market setup has been driven, in part by fundamentals, but also significantly by technical drivers.

Kolanovic goes on to detail precisely what we laid out earlier on Tuesday while documenting the S&P’s ascent to fresh all-time highs.

Risk assets began the year on a torrid run as the S&P blew through multiple analysts’ year-end targets in the first three weeks of 2018, but a series of shocks including the largest VIX spike in history, a tech selloff tied to regulatory jitters and concerns about the burgeoning global trade war tripped up previously ebullient sentiment.

Ongoing strength in the U.S. economy coupled with strong corporate earnings and the promise of record buybacks catalyzed by the tax cuts ultimately carried the day and pushed the S&P to all-time highs just a day ahead of scheduled talks between U.S. and Chinese representatives who hope to make some headway on the trade dispute before the Trump administration moves ahead with tariffs on additional $200 billion in imports.

“Trump’s tariffs and sanctions [are] causing broad equity risk aversion and a rally in the USD [but] this has happened against a backdrop of strong support for US equities from buybacks, tax-related earnings boosts, as well as inflows from systematic strategies since April”, Kolanovic continues, adding that “the strong buybacks and earnings both resulted from the large (~$1.5T) US fiscal stimulus that increased the fiscal deficit.”

Of course the fiscal stimulus is also putting pressure on the Fed to hike and when combined with USD+ technical considerations such as repatriation flows and the deluge of Treasury supply, pressure has mounted on ex-U.S. equities. Here’s Marko summarizing:

In summary, buybacks are creating a shortage of US stocks, the Fed is creating a shortage of US dollars, and Trump’s trade wars and sanctions are further boosting the USD.

So that’s the fundamental backdrop, but Kolanovic notes that technical factors are also at play. To wit:

Low liquidity is magnifying the impact of any fundamental and speculative flows, resulting in large moves and numerous flash crashes (e.g. ZAR, TRY, several prominent stocks, etc.). Systematic equity investors are on one side shorting Europe and EM equities, and on the other side buying US equities.  For instance, CTAs and related macro trend-following strategies currently have about average long equity exposure in aggregate (52^nd percentile). Given that all trend signals in Europe and Asia are short, and all US signals are long — these investors have large long exposure to US stocks and short exposure in Europe and Emerging market stocks.

How does the unprecedented convergence described by Kolanovic evolve? Well, in one of two ways. Recall that earlier on Tuesday, we suggested that investors should be watching the dollar for signs of where risk goes next. The Bloomberg dollar index has fallen to a one-week low.

(Bloomberg)

Consistent with everything said here on Tuesday and also with Kolanovic’s July 30 note, the key here is a weaker dollar if what you’re looking for is a reinvigoration of across-the-board risk-on sentiment.

“There are two likely ways this convergence can play out”, Marko writes, before elaborating as follows:

1. ‘Risk on, USD down’ outcome with EM and value assets staging a rally and USD selling off, while US stocks continue going higher (but lagging).
2. Alternatively, we could see a “Risk off, USD up” convergence, with US markets selling off and catching up with the poor performance of Europe and EM assets, e.g. driven by a continuation of the trade war and further USD strength (for now we will ignore a spectrum of ‘in-between’ outcomes).

For his part, Kolanovic is sticking with his call from late last month. “We think that the more likely outcome is a ‘risk on’ convergence, given decent global growth, cheaper valuations outside of the US, a continuation of buybacks in the US, intensified criticism of rate hikes and strong USD by US administration, new stimulative measures in China, and ongoing negotiations to resolve trade war with China”, he concludes.

So there you have it, straight from Marko himself. And when it comes to the weaker dollar pillar of the risk-on thesis, do note that Kolanovic has Donald Trump in his corner.