On a day when Chinese equities staged a mammoth rally the likes of which hasn’t been seen since 2015 when mainland shares were busy setting themselves up for one of the most nauseating crashes in recent market history, Nomura’s Charlie McElligott is out calling this the “reflation window.”
Specifically, McElligott thinks the details of recent Fed communications combined with China’s increasingly manic stimulus efforts and the currency stability pledge in the fledgling Sino-US trade pact together serve as a “tactical trading ‘green-light’ to pursue ‘reflation’ themes.”
When it comes to Fed communications, Charlie reiterates the notion that an effort to shorten the WAM now in the interest of freeing up room for another Operation Twist later as well as prospective change to the way the committee thinks about inflation are both catalysts for the steepener, something that would have clear ramifications across assets.
“The Fed’s breathtaking policy pivot adds the ‘double-whammy’ which I have been anticipating after Friday’s FOMC-speak gauntlet, where both 1) the ‘Reverse Operation Twist’ mechanical shift to alter the composition of the balance-sheet (shrinking the weighted average duration of the UST portfolio via directing reinvestments into the front-end, while allowing for MBS to continue ‘running off’) alongside their 2) pursuit of a new framework to increase inflation expectations (either through ‘averaging’ or ‘targeting’ to allow for ‘overshoot’) look closer to realizing and will have a profound thematic impact on investor behavior over the coming months”, McElligott writes, adding that between Fedspeak, the kicking of the proverbial can on trade talks and the prospect of a stable yuan (where “stable” is likely to mean stronger versus the dollar in the near-term), a number of reflation catalysts are now in play, effectively “green-lighting” the following:
Long Steepeners, Long Breakevens (TIPS over Nominals), Long Gold, Equities RV trades like US ‘Value over Growth’ (“pure play” on curve steepening) / ‘Cyclicals over Defensives’ and EM Eq over DM (my prior 2019 EEM/SPY- and FXI/QQQ- trades on ‘mean-reversion’)
On China, Charlie reiterates the notion that the January credit growth data is “a major ‘reflationary’ catalyst [and] shows no-signs of letting-up.” Of course the question, as ever, is whether Beijing will be successful in reflating both the domestic and global economies given diminishing returns on credit creation.
Looking at what “matters” (so to speak) from a macro factor perspective, McElligott reminds you that the reflation theme is mission-critical.
“‘Inflation’ matters most to SPX, with ‘Metals’ and ‘Inflation Expectations’ making up four of the top five largest sensitivities (Iron Ore, Copper, 2Y Inflation Expectations and 5Y Inflation Expectations)”, he writes.
That said, Charlie includes the usual caveat about these moves being more “for rent” than something you should “purchase” (as it were) given where we are in the cycle.
“The ‘end-of-cycle’ investor skepticism mentality too remains firmly in place, with most voicing a desire to only ‘rent’ these themes against a rapidly-aging business cycle which is being propped up by central bank dovish spasms and capitulation”, he cautions, adding that the flows picture continues to tip consternation. To wit:
In the meantime, global $$$ flows are clearly “defensive” in nature, with Global Bonds leading inflows (+$39.2B over the past month) while Global Equities continue to be purged (-$30.9B for the last month)
US Equities outflows in particular continue to evidence the skepticism of the rally, with Institutional outflows (-$2.6B on the wk, and -$14B for the past month), Retail outflows (-$1.7B last wk, -$8.8B for the past month), Active outflows (-$3.1B on the wk, -$9.5B over the past month) and Passive outflows (-$1.2B wk, -$13.5B past month)
Given that, what accounts for the rally in US equities?
Well, Charlie says it’s short-covering, CTAs pivoting from short to long and, of course, buybacks, which he guesstimates have totaled more than $140 billion so far in 2019.
As far as the short covering goes, McElligott starts in mid-December (the 14th) and documents how things have evolved through the end of last month (i.e., through the most recent available data point). Here’s the breakdown (including the YTD figures):
Using mid-Dec 14th date through Jan 31st 2019 (most recent data), we have seen $39.4B of Cash Equities covering; $19.8B of Futures covering; and $8.1B of ETF covering for a total of $67.3B of notional short-squeeze(YTD, is $39.4B across Cash $24.6 / Futs $3.3B / ETF $11.4B)
Finally, if you’re looking for a check on CTAs, Charlie notes that his QIS model “estimates that CTAs were -$65B ‘Max Short’ in S&P by mid-Dec, and upon the cover and flip to ‘Max Long’ are now ~+$50.2B notional net long for a cumulative +$115B of demand.”
Ultimately, the takeaway here is the bit about reflation. As documented extensively in the “diminishing returns” post linked above, there are serious questions about whether DM central banks and China will be successful in reflating the global economy this time around given capacity constraints for developed market policymakers (i.e., limited scope for rate cuts and balance sheet expansion) and the reality of too much leverage and a clogged policy transmission channel for the PBoC.