Early last month, Barclays rankled the bears and delighted those hoping it wasn’t too late to ride the S&P to ever higher highs by making a market “melt-up” their base case for US equities.
The rationale was fairly simple. Donald Trump and Xi Jinping had just struck a new trade truce in Osaka and the Fed was still set to ease policy.
“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”, the bank’s Maneesh Deshpande wrote, adding that “a positive equity market has historically not been a significant bar for an ease”.
Barclays was right on one of those points. Record high stocks did not, in fact, keep the Fed from easing, but instead of just sitting back and watching stocks rise, Trump decided to break the G20 truce barely a month after shaking hands with Xi. Subsequently, the PBoC allowed the yuan to sink below 7. Stocks crashed.
In a new note dated Wednesday, Deshpande takes a quick look at the recent selloff, which he calls “relatively orderly”.
“[It was] broad-based, and although assets exposed to trade war and growth slowdown underperformed, the pessimism is not extreme”, he writes, adding that “volumes across equity derivatives were consistent with the magnitude of the selloff, and cash volumes were below expectations”.
Of course, that could be a bad thing if it presages another wave of selling based on the admittedly anecdotal notion that there was no real “purge”. As of lunchtime Thursday, US stocks were well on their way to an extremely strong session thanks in part to a stronger-than-expected yuan fix, decent July trade data out of China and, perhaps, the prospect of fiscal stimulus from Germany (however far-fetched).
Wednesday saw the biggest comeback of the year on Wall Street, with the Dow rebounding from a 589-point morning swoon to close only marginally lower.
Walking through the Monday selloff, Barclays notes that “SPX put volumes were much more than expected given the market move anecdotally [and] it appears that the majority of this activity was because of investors monetizing their hedges by rolling them to lower strikes or longer maturities”. The same hedge monetization behavior manifested itself in VIX ETP redemptions.
Deshpande goes on to describe cash volumes as “relatively muted” (i.e., compared to predicted volume based on a regression of historical volumes versus S&P returns), which could suggest the long-only crowd is waiting to see whether things get more serious.
As far as ETF flows go, Barclays notes that the ~$9 billion of net outflows equity funds saw on Monday is a relatively paltry sum, which “perhaps reflects the fact that retail had not really bought into the current rally” in the first place.
When it comes to the prospect of more quant-driven selling, Deshpande sees a possible $100 billion in additional deleveraging from vol-control “over the next few days”, but tempers his assessment by noting that with SPX futures volumes now averaging ~$400 billion per day, “these additional flows should not lead to a material impact”.
Obviously, the events of the past week (i.e., since the July FOMC meeting) have increased the odds of further rate cuts from the Fed, and as we never tire of reminding everyone, that may well have been part of Trump’s gambit in upping the ante on China.
So, what does all of this mean for Barclays’ “melt-up” scenario? Well, Deshpande doesn’t mince words.
“Clearly, the probability of our ‘soggy soft patch’ scenario has increased”, he admits, referencing notes from earlier this year which struck a decidedly less optimistic tone compared to the bank’s assessment following the Osaka truce.
“While we are not adjusting our price target lower at this stage, clearly in the absence of a cessation of the trade hostilities, there is now downside risk to our current price target of 3000”, Deshpande concludes.
On the bright side, the S&P hit Barclays’ 3,000 target on July 10, so technically speaking, the bank was “correct” no matter how it turns out. Heads they win, tails your P/L is at the mercy of the president’s tweets.