Has faith in the reflation narrative run too far out ahead of reality?
That’s one of the key questions headed into 2020. And it’s a question that would have seemed nonsensical a scant four months ago, when the 2s10s inverted.
Q4 has marked a turning point for the macro story. Despite what some say is little in the way of evidence (outside of the US, anyway) to support the notion that the incoming data is on the verge of inflecting for the better, yields have risen sharply off the August recession-scare nadir, and the curve has clawed its way back out to 30bps (even as the term premium curve remains inverted).
That, in turn, has had predictable ramifications for a variety of equities expressions tethered to the “duration infatuation”. High beta is back, for example, and Value has outperformed Min. Vol., in what some have suggested marks the beginning of the end for one the market’s most notorious bubbles.
Whether or not this can continue is the source of some disagreement. JPMorgan, you’ve probably heard, is sticking with the trade.
“While the valuation spread of Low Vol versus Value has retreated partially, it still remains close to cycle high”, the bank’s Dubravko Lakos-Bujas notes, adding that “the correlation between Value and Momentum, once near 30- year lows, has partly reversed (to ~18%-tile from ~7%-tile), but still signifies considerably oversold positioning for Value”.
That’s a more precise quantification of the crude visual representations in the charts above (the pink line in the top pane and the blue line in the bottom).
Lakos-Bujas continues, writing that “by contrast, Low Vol remains overbought with the correlation between Low Vol and Momentum near a 30-year high (~90%-tile)”.
As alluded to above, the assumption is that this rotation can continue as the macro inflects. “A synchronized upturn in leading indicators of the global cycle suggests that the relative Value trade still has some room to run”, JPMorgan contends, recommending folks stick with the Long Value versus Min. Vol. trade.
And yet, some see this as having run too far, too fast. Nomura’s Charlie McElligott, for instance, suggests fading the recent “giddy” pile-on into the reflation narrative.
“My favorite TACTICAL (short-term / 1 month) contrarian trade out of the gates for January in order to fade (or hedge) this sudden shift to a ‘reflationary growth’ 2020 outlook is a ‘1m Reversal’ strategy in US Equities”, he wrote Friday, in the same note that found Charlie elaborating on his macro views for the new year. Here’s the trade, in short:
Essentially this strategy takes the monthly performance snapshot of the Russell 1000 leadership deciles, then on a once a month basis, would go LONG the bottom decile (worst 10% of the index) versus SHORT the top decile performers (the top 10% of names in R1k) on the month
In this case, you’re effectively reversing the current performance dynamics we are seeing so far in December, which is this large outperformance of Cyclicals / Value / High Beta over Duration Sensitives i.e. Secular Growth and Defensives / Min Vol
Throw in a bullish seasonal for 10Y futs, and you’ve got a recipe for a “reversal of the reversal” – where that means Q4 represented a reversal of the vaunted “slow-flation” trade both in rates and stocks and the prospective outperformance of the “old” favorites (i.e., Duration Sensitives, Secular Growth, Defensives and Min Vol) in January is a reversal of that reversal.
And yet, some believe the love affair with the long-end may have finally run its course for good, or at least for the foreseeable future, amid the tentative abatement of trade tensions and assumptions about an inflection in the data.
Goldman, you’re reminded, included a call to stay long 10-year breakevens in the US with a 1.9% target and a stop at 1.55%, in their top trades for 2020.
In his latest note, JPMorgan’s Marko Kolanovic – who in October suggested the unwind associated with extreme the divergence between value stocks on one side and low volatility and momentum stocks on the other side, might ultimately end in true “XIV” fashion (a reference to the February 5, 2018 short vol. ETN “extinction event”) – doubled down on the call.
“While the upside for broad-based large-cap indices [in 2020] is modest, we think that there is an extraordinary opportunity to rotate from very crowded longs in defensives, low-volatility and momentum stocks and buy under-owned and heavily shorted Value, Cyclicals, and high-beta stocks”, he wrote earlier this month. “The crowded positioning is reflected by record valuation spreads, high investor gross leverage, and near abandonment of deep cyclical sectors such as Energy and high-beta stocks”.
As a possibly-relevant aside, Peter Lynch told Barron’s this week that oil and gas stocks might well triple going forward. “Everybody’s assuming the world’s not going to use oil for the next 20 years, or five years, or next year”, Lynch said. “You wouldn’t know it from the stocks, but oil is 25% higher than a year ago”.
Kolanovic acknowledges that much of this depends on yields – indeed, that’s almost a tautology at this juncture.
“This record divergence of stock valuation was driven by negative bond yields, and we recognize that our call implicitly requires higher bond yields and a steeper yield curve”, he says, adding that in JPMorgan’s view, “that will also happen, as the global PMIs recover and the trade war starts to abate”.