For months, JPMorgan’s Marko Kolanovic has argued that a rotation away from absurdly crowded defensives and momentum names and into value and cyclicals was in the cards.
That rotation came calling in early September, when bond yields rebounded off the rock-bottom levels hit in August, catalyzing one of the most dramatic factor rotations in recent memory. That played out just below the market surface, and produced a series of multi-standard deviation events which flew under the radar for anyone not willing to “look under the hood”, as it were.
As documented here on any number of occasions, the inexorable decline in bond yields is reflected in equities. As yields declined over the post-crisis period and central banks persisted in accommodation, investors crowded into bond proxies and other expressions that are tethered, in one way or another, to the vaunted “duration infatuation”. That’s effectively embedded “bond risk everywhere”, to quote SocGen’s Sandrine Ungari.
Well, this week, bonds sold off dramatically and that’s going to have serious implications across styles and sectors in the equity market where Kolanovic expects the rotation to continue, as higher yields “should boost cyclical and value stocks”.
Marko reiterates the bond link in his Friday note, illustrating how “two strategies that in theory should have little to do with each other” have been “nearly 100% correlated” recently.
That will be familiar to anyone who frequents these pages. In blue is an equity long-short selection of winning/momentum stocks or, more simply, a momentum factor. In orange is a cross-asset CTA strategy which Marko notes “doesn’t even hold any individual stocks, but rather mostly fixed income instruments”.
The tight correlation between the two is “yet another indication of the prevalence of groupthink and crowding across investment strategies”. This manifestation of groupthink comes courtesy of bonds and insatiable demand for duration amid recession worries tied to decelerating growth and, relatedly, the trade war.
This week, trade optimism triggered a dramatic selloff in bonds and barring a complete breakdown in negotiations, a “Phase One” deal accompanied by tariff relief is imminent. Generally speaking, one would expect the coordinated global easing push that played out in the first three quarters of 2019 will finally begin to manifest itself in better economic outcomes (e.g., an inflection in global manufacturing PMIs). If that’s the case, bond yields could rise further, thereby contributing to a further unwind in all of the myriad equity expressions tethered to the bond trade.
“There was broad skepticism [in September] that the rotation was just a blip, so we reiterated that it had only begun and by far the largest part of the rotation was still ahead of us”, Kolanovic goes on to say, adding that even though the rotation has continued and now sees value above its September highs, “our view is that this rotation should continue in Q4 and Q1”.
An accelerant could well be participation by real money. “The first leg of the rotation was limited to short covering by levered speculators, with little long only assets flowing into cyclicals and value”, Marko goes on to say. But with the fundamental backdrop perhaps set to improve sustainably thanks to a thawing of trade tensions and the lagged effects of monetary stimulus, a “larger rotation by real money managers” may play out once the interim trade deal is actually on the books.
As far as whether rapid yield rise will eventually prove too much for equities to stomach, Marko doubts whether that will be the case. He notes that last fall, when 10-year yields reached ~3.25%, the trade war was heating up (Trump had just slapped tariffs on $250 billion in Chinese goods), the Fed was still recalcitrant (Jerome Powell’s infamous “long way from neutral” remark came within days of the peak in yields) and the global PMI plunge was just getting started in earnest.
Needless to say, things are a bit different now. “A higher 10Y should be a boost for the rotation and likely positive for all equities apart from bond proxies”, Marko concludes.