Before you get too swept up in the prospects for a squeeze higher in equities into year-end, don’t forget that the confluence of bullish technicals which have variously conspired to ignite a powerful rally off the late October lows are playing out against a backdrop of tightening financial conditions.
That’s the message from Nomura’s Charlie McElligott, whose recent notes have revolved around the dynamics that have helped the S&P log four sessions of >1% gains since October 29.
Those dynamics, you’re reminded, entail hedge funds and asset managers being forced to buy after low-ticking their exposure on October 29, just prior to the rally that saw stocks close out an otherwise abysmal month with the best two-day gain since February. Those fundamental investors were caught flat-footed just as the systematic crowd (e.g., CTAs) and macro funds started to re-risk. That, McElligott argues, catalyzed a grab for exposure. To wit, from a note out Wednesday:
The “fundamental” active Equities universe then has essentially become a source of synthetic “short gamma” in the market, as with any rally in stocks, said performance-burned funds effectively “get shorter” the higher Equities travel, in turn contributing to these violent bear market rallies on “up” days, with funds grabbing exposure “dynamically hedging” futures on said move.
Between that, expectations for further systematic re-risking and buybacks, there’s scope for a tactical rally into year-end. That thesis was echoed this week by JPMorgan’s Marko Kolanovic.
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‘Max Pain’: Nomura’s McElligott Calls For ‘Broad Based’ Stock Rally
Marko Kolanovic Lists Multiple Bullish Catalysts For Stocks Following Midterms
But again, McElligott doesn’t think you should lose track of the larger, overarching narrative.
“Even with this +8.3% rally off last week’s lows to yesterday’s SPX highs, DO NOT be mistaken–we remain immersed within the ‘financial conditions tightening tantrum’ end-of-cycle phase”, Charlie writes on Friday, adding that “U.S. 5Y real yields sit at highs since early 2009, corporate credit Baa-10Y yield spread is 45bps wider off early February levels and the 90-day commercial paper-3m T-Bill spread has nearly tripled to +27bps since early September levels.”
(Bloomberg)
That, McElligott says, should be viewed in the context of the bear market in crude, 1Y UST breakevens the narrowest since October 2015 and ongoing troubles for late-cycle “coal mine canaries” (e.g., Homebuilders and Autos), which he reminds you are still singing.
(Nomura, Bloomberg)
He goes on to flag renewed flattening in the curve, and reiterates what we noted on Thursday after the Fed decision. “EDZ8Z9 is again up to 50bps of implied hikes in 2019 after trading down to 39bps two weeks ago, especially alongside the recent four year seasonality trend which has seen a flatter bias in the November/December timeframe”, Charlie writes.
(Bloomberg)
Finally, McElligott reiterates that the the biggest risk is still the “rogue inflation print” which would catalyze a “lights-out” trade. To wit:
What remains my largest concern with regards to the “pull forward” of the “end-of-cycle” trade into an outright “risk off” one (which I currently believe is a 1Q-2Q19 phenomenon, after either the March or June hikes)? A rogue inflation print to the upside, which to me is the “lights-out” trade as the Fed is thus cornered into accelerating the tightening pace, then likely drives a negative market response per “policy error” / “tightening into a slowdown” capitulation from the last of the “late-cycle expansion” holdouts in risky-assets.
In that context, you’re reminded that private sector wages and salaries accelerated at 3.1% in Q3, the fastest pace since 2008 and also that if there’s no breakthrough on trade when Trump meets Xi at the G-20, the U.S. is expected to move ahead with tariffs on the remainder of Chinese imports. That will drive up consumer prices in the U.S., raising the risk that the Fed is forced into a policy mistake by ongoing inflation pressure.
While the speed of fed rate hikes may cause a more dramatic response, doesn’t it seem like three more gradual increases in the fed funds rate will be sufficient to tamper the upside in the market? It seems like we have fallen into a pattern where the Fed says it will continue to hike and analysts claim to understand. But once it happens, it just dominates the news cycle. The trade war with China willl continue for some time. Lighthizer wants to change too many aspects of the trading relationship, including weaknesess in the WTO. China is not going to quickly capitulate, and may just try to outlast Trump. Or perhaps Lighthizer will just lose favor with Trump. If there were a quick solution to the trade dispute, it would have happened before the mid-term. The Fed wants to be in a position to provide a stimulus in the event of the next receission, and they can’t do it from where we are. And after the most recent tax cut, the tool of an additional fiscal stimulus seems out of the question. The question is whether there is anything on the horizon that will make the Fed change course. Maybe falling asset prices, in housing and stocks. Maybe lower investment rates. But if the labor market remains tight, the pressure to increase rates will continue, whether gradual or not. And whatever gyrations we see along the way, its hard to see much potential sustained upside until the rate hikes end.
For a layman like me, re-reading this three times and finally deciphering 60% of the jargon and even some of the meaning is a victory. “Lights our trade”. Very descriptive indeed.