For Some, A Market ‘Melt-Up’ Is Now The Base Case

The “melt-up” chatter is getting louder.

With the US and China set to hold fire on further trade escalations (at least until Trump decides to take out his Sunday frustrations on his “good friend” in Beijing) and global central banks now pot committed to providing further accommodation, the ingredients for an extension of 2019’s equity rally are in the mixing bowl.

Presumably, all it’s going to take to whisk them together is a catalyst that pulls in key investor cohorts who have been reluctant to participate.

That notion (that a “force-in” will eventually materialize) has underpinned the bull thesis for months.

“For all the points I’ve been making on ‘under-positioning’ within equities as a catalyst for new highs in the near-term (where I’d note extensive client frustration with this point–because SO many continue to voice a desire to ‘short the tape’ post G20), we are now very clearly seeing a major ‘net-up’/’gross-up’ trade going through week-to-date, as funds are forced to re-engage into this US equities breakout”, Nomura’s Charlie McElligott, who earlier this week suggested a melt-up is the most likely early summer scenario, wrote on Wednesday.

“After the G20 meeting in Osaka, our melt-up scenario has become more probable, in our opinion”, Barclays writes, in a new note which serves as an update to a previous piece documenting the likelihood of further gains on the S&P.

Read more: Why One Bank Thinks The Probability Of A New Equity ‘Melt-Up’ Has Increased

The bank goes on to say that “the open-ended nature of the truce, coupled with the looming 2020 Presidential election, probably means that both parties have incentives to continue kicking the can down the road”, which, taken at face value, means an all-out escalation scenario is unlikely in the near term.

Meanwhile, expectations for Fed cuts have remained sticky, despite the trade truce. While renewed trade tensions were indeed a factor in cementing the case for insurance cuts, the global manufacturing slump was already beginning to show up stateside. Barclays cites “recent weakness in the industrial/manufacturing sector of the US” and, of course, “persistently low inflation” as other factors influencing the Fed’s decision calculus. It goes without saying that some of the observed weakness in US PMIs is down to trade tensions, which means some of this amounts to question-begging, but you get the idea.

Critically, the trade war isn’t actually going away. The USTR’s decision to publish a list in conjunction with proposed tariffs on another $4 billion in EU goods, the lingering threat of auto tariffs, Trump’s spat with India and, overnight, an escalation with Vietnam (which has benefited enormously from trade diversion this year) all suggest trade tensions will remain simmering on the back burner. That too will ensure the Fed remains vigilant and inclined to ease.

“We note that although the risk of an immediate escalation of a Trade War have eased in the absence of an actual deal, the simmering uncertainty is likely to continue weighing on business planning”, Barclays goes on to write. “In addition, given the bipartisan support for some sort of China ‘containment’, companies are likely to continue to re-evaluate their global supply chains”.

The point: A trade “truce” that doesn’t resolve anything, leaves existing tariffs in place and leaves lawmakers on both sides of the aisle unsatisfied, is hardly enough to make the Fed believe the threat has passed. Indeed, that may be intentional. Trump likely doesn’t want to make Jerome Powell think there’s no reason to pull the trigger on cuts.

In addition to these high-level, macro considerations, Nomura’s McElligott notes that “with the VIX futures curve now so steep into contango, systematic roll-down players are again growing their short vega positions and shorting front VIX futures contracts, which creates a ‘second-order’ catalyst for higher equities, because dealer hedging of this flow is daisy-chaining into more Delta buying and/or more Gamma at upper strikes”.

“Taken cumulatively, there is just MONSTER notional $Gamma at UPSIDE strikes in SPX [and] consolidated SPY options which acts to ‘pull’ us higher”, Charlie continues, adding that “the 3000 strike is nearly a MULTIPLE of other strikes from a $Gamma perspective, but there are lumpy notionals all the way up (2975, 2980, 2990, 3000, 3025 and 3050)”.

(Nomura)

Speaking of 3,000, that is Barclays’ new target for the S&P. The higher PT reflects the removal of additional tariff impacts projected previously.

Finally, you might be wondering if further gains in equities will deter the Powell Fed from going ahead with rate cuts. A look at history suggests the answer is no. The following chart shows Fed cuts aren’t uncommon when trailing returns are positive.

(Barclays)

Barclays drives the point home. “Indeed, the ‘insurance cuts’ during 1990s were done when the equity markets were rallying”, the bank writes. “Clearly, a positive equity market has historically not been a significant bar for an ease”.

Clearly.