Rejoice, sports fans, Nomura’s Charlie McElligott is back.
Fresh off what he describes as “the annual holiday brain ‘de-frag'”, Charlie gets right down to business.
“So what screws up the trend/momentum backdrop?”, McElligott asks, before reminding everyone that the short vol/easy carry environment is “almost entirely based upon the expectation of global central banks shifting back towards easing”.
The most obvious answer is a hawkish surprise from either the ECB (this week) or the Fed (at the end of the month). Of course that’s not very likely right now, with Mario Draghi having essentially pre-committed to more easing during his remarks in Sintra and with Jerome Powell having made it clear that the blockbuster June jobs report (and, by extension, the hottest core CPI print since January 2018) will not be enough to deter the Fed from an insurance cut.
“I think [a hawkish disappointment] is honestly a very low delta outcome, as both ECB and Fed have ‘dovish-ly overshot’ even the most extreme ‘dovish’ consensus YTD”, McElligott writes, adding that “even with a ‘just’ 25bps cut from the Fed, the ‘hawkish cut’ market response risk is low [and] likely counterbalanced by the expected end of QT alongside strong forward guidance and with potential for yet another IOER cut”. Throw in a possible nod to the standing repo facility discussion and the Fed has a variety of options for ensuring markets don’t come away disappointed.
So, what could spoil the party? Well, a convincing upturn in the data, of course, because this is still an environment where overtly good news would likely be digested poorly by a market which has convinced itself that perpetual monetary accommodation is inevitable.
“The largest risk to this global central bank ‘easing parade’ and end-of-cycle ‘Slow-flation’ consensus would be a good old-fashioned ‘bottoming-out’ [and] ensuing bounce in global growth data”, McElligott says. In the event the data did inflect convincingly, the two pain trades are as follows:
- Rates would be that same “Front-End selloff / Bear Flattener” scenario, as a perceived “start of easing cycle” then truly becomes “just an insurance cut” (although Open Interest, TFF, CME and CFTC data show generally have shown positioning “off the extremes” I was noting back a few weeks ago)
- Locally, Equities would be less about a broad directional trade “up” or “down” [and more about] that same dynamic where Cyclically-sensitive SHORTS i.e. “Value” / “Beta” / “High Vol” / “Size” would outperform vs Duration-sensitive LONGS i.e. “Growth” / “Min Vol” / “Cash / Assets” which are incredibly “crowded into”—thus a pure “Reversal” risk which rationally would then thematically mimic the behavior experienced on nearly all of the significant fund performance “drawdowns” days experienced year-to-date.
Charlie goes on to take a fresh look at positioning in the light of the ongoing rally.
“Macro funds have taken-up risk VERY meaningfully vs 1m ago, with macro fund performance ‘Beta to SPX’ now 92nd %ile (vs 47th %ile 1m ago)”, he writes, on the way to noting that risk parity has “continued to add to G10 Bond exposure back near the highest weighting % in our series history at 232.3%, while the Global Equities allocation remains near 21 month lows at just 35.8% despite the enormous rally YTD”.
As far as CTAs are concerned, McElligott says that while fixed income “shows the same legacy ‘+100% Long’ signal across G10 Bonds and Front-End Rates as has been firmly in place since 4Q18, over the past 1m, we have seen a meaningful deleveraging in the trade size, meaning they have been sellers in G10 Bonds”. In equities, CTA positioning “remains bifurcated” on Charlie’s model, with “‘+100% Longs’ holding across SPX / Nasdaq / EuroStoxx / FTSE / CAC” compared to what he calls “choppy” positioning in Russell 2000, Nikkei and DAX futures.
As far as the Long/Short crowd is concerned, McElligott notes the obvious, which is that they’ve been forced to take up their exposure as the rally rolls on, although net exposure remains relatively subdued, as funds’ beta to the S&P has risen to the 27th %ile versus just the 3rd %ile a month ago.
Charlie also flags “topped up” asset managers, who have added nearly $30 billion in US equities futures over the past month. On the downside, he notes that “it looks like we could be seeing evidence of DE-RISKING last week, as per Mutual Fund performance ‘Beta to SPX’ declining meaningfully to 77th %ile from the prior week’s 95th %ile”.
He also echoes JPMorgan’s Marko Kolanovic in pointing out that dealers’ gamma positioning is likely to keep things “long and sticky”. Here’s a bit more granular color, from Charlie:
The “gravity” of the 3000 strike remains obvious as per spot’s “pull”; however, the 3000 strike ($5.2B of combined Gamma) has now been surpassed by the upside 3050 strike ($6.0B) and a lot in-between ($2.7B at 3020, $3.1B at 3025, $2.2B at 3030, $2.7B at 3040) with a chunky $3.3B at 3100 as well. Importantly, the 2950 strike too remains “lumpy” to the downside at $3.0B–which “matters,” as our analysis shows that SPX / SPY combined Gamma would see dealers flip “Short Gamma” ~ 2966 on the way down.
All in all, the takeaway from McElligott’s return to the desk is that what was working when he left is still working. The market zeitgeist is intact.
As he puts it, “all things ‘trend’ and ‘carry’ have continued to work… which speaks to the halcyon cross-asset ‘Short Vol’ trading environment”.