Regular readers are familiar with Nomura’s Charlie McElligott, whose daily musing we’ve documented here pretty extensively of late.
On Friday, for instance, we brought you some highlights from his latest note that found McElligott reminding folks that it isn’t the curve inversion you should fear, but rather the subsequent steepening as the market “sniffs out” the end of the Fed’s tightening cycle.
Prior to that, we documented his (extremely) prescient mid-August call to play for a bounce in the “consensus” U.S. equities fund strategy/Long Growth/Momentum after a period of egregious underperformance exacerbated by the late-July selloff in Facebook and FANG+ and also by a squeeze in some of the market’s most-shorted names.
Thanks in no small part to the dollar taking a mid-August breather (on the heels of Trump’s Fed criticism, the PBoC’s move to squeeze yuan shorts, and the market’s dovish interpretation of Jerome Powell’s Jackson Hole speech), EM got a fleeting reprieve and the concurrent reduction in spillover risk from international turmoil to U.S. equities helped push the latter to new record highs. Along the way, hedge funds were forced to grab for exposure in order to catch up with benchmarks that had left them behind.
All of that was inline with McElligott’s recent daily observations.
Well happily, he showed up on the latest edition of Erik Townsend’s MacroVoices podcast and with their permission, we wanted to reprint some excerpts from that chat during which Charlie documented the evolution of modern market structure and how he’s adapted his approach to research to keep pace with the times.
Below, you’ll find Charlie touching on a lot of the topics we’ve delved into here, including the risks associated with the rise of systematic strats, the potential for rapid unwinds and forced selling to catalyze “flash” events and the consequences of late-cycle stimulus.
In addition to the excerpted passages from the transcript, you can find the accompanying podcast and slide deck below. Do check out the website for MacroVoices when you have a second. It includes links to all manner of insightful interviews with some of the best and brightest macro minds.
Erik: Charlie, for people who have been following your writing since you joined Nomura in January – I remember the first piece I saw that really got my attention was where you described this perfect storm after the VIX complex blew up. You said, look, if we get to certain levels on the S&P it’s going to trigger the commodity trading advisors, they’re going to start systematic selling, it’s going to unleash a whole bunch of things.
Fortunately, we never got to that level. But I was very impressed with your analysis. As I followed your work since then, I noticed that, though you tend to be writing about the here and now – because that’s the way institutional research is structured – I am able to assimilate a framework, if you will, that seems to guide your thinking, which I’ve pulled together from reading several of your pieces.
Can we try to present to our listeners a summary of that framework? How you think about markets and how this all fits together? And from there I want to go into much more detail on your slide deck and a number of other questions.
Charlie: I would say that the way I approach the job with regards to assessing and the cross-asset macro landscape, from a high frequency, meaning more of a closer to the net-end user, the net-end trade idea-driven approach – as opposed to a research deep analytic dive, kind of slower moving – is that because in the post-financial-crisis world, trade time horizons, macro regime shifts, factor rotations, systematic leveraging, deleveraging, are a permanent part of our landscape.
So, I need to have a medium- to longer-term 6- to 12-month view on where we’re looking, while still having a day-by-day kind of directional call. Favored trades, world view. Where are the pressure points? Where could things go wrong? Where is consensus? And where are the asymmetries there when crowding can tip over?
With that said, as I started here at Nomura back in late January – right before the vol, even – I kind of saw this framework and I called it a two-speed world thesis. Mind you, as I got back on my feet in January, after my non-compete gardening leave time, what I saw was immediate.
As I mentioned earlier, the importance of systematic strategies, vol control strategies, risk parity of course, following CTA’s, those are a critical part of what I do on a daily basis, certainly based within a very vol-centric world. Because the changes, the inflections that are made happen unemotionally and happen with significant leverage behind them.
And what I saw immediately when I came in – I was reassessing the world at the time – was that the most crowded trade in the world, kind of ex-long-FAANG/ tech at that time, was that there was an implicit short-dollar trade in almost every macro trade that we look at across both our risk parity and CTA models.
Certainly, there was a max long equities world view. Obviously, large cap equities, certainly tech, Nasdaq, which benefit from those overseas revenues. But then, also, there was a huge bearish rates trade as people set into the year.
There was a massive blank in euro and yen on the view that policy was going to reconverge – this idea that we were heading [for] this dual growth. So, as opposed to the prior two years where it was just US economic escape velocity and rest of world behind, everybody got really bulled up on the prospects for Europe, for Japan, for emerging markets, for the rest of the world to play catch-up.
With the twin deficits within the US, this very bearish US dollar view began. People were max long crude, max long commodities. That was a pretty consistent theme.
And when I see something that consensually embraced, certainly within the systematic leveraged community, the trend community, coming off a year like 2017 where being long S&P was a 4 Sharpe ratio trade, my warning signs were up.
Promptly, we had the equity vol event. I joked to clients that we all knew what was happening within the leveraged to VIX ETN complex. We knew that those daily rebalancing, the daily vagary balancing at the end of day, was going to tip over at some point. And I called it a neon swan for a long time.
But something set that off. And in my mind what set that off was – if you went back to December, you had the first passage of the tax reform bill in the Senate. And shortly thereafter, at the start of December, you had the bottoming, the cyclical bottom in US Treasury term premium. Basically, interest rate volatility risk.
And I think what that spoke to was that we were at a late cycle and the economy was already at breakout speeds at that point.
Now we’re adding gasoline to the fire. Effectively, within the next month we also got this dual fiscal stimulus of the deficit spend and what that did, when Treasury term premium bottomed, the entire crossed-assets volatility world also pivoted and broke higher after that point.
In my mind, that moment when the forward-looking path for interest rates became clouded for investors across the world, across multiple asset classes, you no longer knew that late in the cycle, adding on dual fiscal stimulus, what that was going to do with regards to central bank policy with regards to inflation. That’s where the rolling volatility events of this new regime took place.
Within a week of that, you had the peak in S&P one-year forward earnings estimates. You had, that same week, the peak in cryptocurrencies. Within a few weeks you saw the tights in credit spreads.
In January you had a spot up VIX up environment across the equities complex where you had that massive risk rally within stocks. But at the same time, VIX was trading up. Which is a precursor, one of those moments where, sitting on a ball desk, you’re anticipating some sort of crashy, wingy type of event.
There were a number of indicators in that two-month period that something had inflected. To take it back to that larger two-speed year thesis, the first phase was what I called the “Cyclical Melt-Up” phase. Which was classic late cycle, where the economy and its current shape with the enhanced expectations, the animal spirits of the tax cut, the animal spirits of the deficit spending, you typically see commodities and inflation-centric high-beta assets outperform.
My view at that time was if you want to be within the rate space you want to be long tips, short nominals, long break-evens. You want to be bearish fixed income in general, from the US Treasury side.
And on the equity side you want to be long cyclical. The stuff that works, that, frankly, some of which had been left for dead for a long period of time, the stuff that gears when you have interest rates moving higher from real growth.
So financials, materials, energy, industrials, the deep cyclical types of sectors.
And that’s exactly what we got over those next six months. You had very consistent, pretty high Sharpe ratio, even with the volatility event in February and some disruptions thereafter in the coming months. These trades kept generating returns.
To fast forward, in May and June I started seeing some signals that there was this shift developing into my phase 2. And my phase 2 was what I called the “Financial Conditions Tightening Tantrum” phase.
This was basically a transition from a very directional, long risk, long inflation, long cyclicals, bearish fixed income type of view to a much more difficult tactical phase – where trading windows, time horizons on trade were going to be multi-week, every-month kind of powerful reversals market – neutral trades to protect yourself, seeing relative values, sector selection really take precedent.
And in mid-June I sent out a note talking about this downshift, that it was time to get tactical. And I think it makes sense probably to go over some of those indicators I saw at the time that, frankly, signaled to me that we were transitioning out of this smooth sailing phase into this very late cycle and, effectively, pre-recession phase.