“It is about a month since we published our 2020 outlook and despite having one of the most bullish targets on the street, the market has already realized more than half of our projected 2020 return”, JPMorgan’s Marko Kolanovic writes, rather dryly, in a new note out Wednesday.
Or maybe it’s not “dryly”. That’s one of the best things about Marko – you never really know if he’s just deadpan and matter-of-fact, or whether he’s employing some ironic humor in the course of reminding you that more times than not, he’s right.
“What is driving the rally?”, he goes on to ask.
Well, it’s not hard to explain. For one thing, central banks are back in the business of protecting markets.
If that’s too strong, suffice to say policymakers aren’t keen on exacerbating geopolitical uncertainty by deliberately over-tightening. 2018 served as a stark reminder that in a world where market participants are accustomed to loose policy, it’s easy to underestimate the damage one can do with an errant comment (e.g., “long way from neutral”) or one too many rate hikes. The easing impulse (as measured by the net number of rate cuts) was the strongest in 2019 in years.
Kolanovic notes that his “positive tilt is driven by central bank easing (e.g., Fed cuts and balance sheet expansion), progress in the US-China trade war, and an increase from relatively modest positioning”.
On the first point, in addition to the above, we would naturally point you to the following simple visual which shows that whether you want to call T-bill buying for reserve management purposes “QE” or not, and irrespective of whether you’re inclined to buy into the “mid-cycle adjustment” characterization of the three rate cuts delivered since July, the fact is that the balance sheet is expanding and rates are lower. That’s bullish, all else equal.
When it comes to central bank easing and trade progress, Kolanovic notes that those two bullish catalysts “remain intact for now but should be monitored closely”.
As far as positioning is concerned, Kolanovic paints a picture of hedge funds still underexposed, with equity beta sitting at just the 20th percentile versus history, while their beta to bonds remains elevated.
“CTAs are long equities but their exposure is not extreme, currently ~65th historical percentile”, he goes on to say, adding that “given the decline in volatility, volatility targeters are fairly long equities, with exposure in the ~80th percentile”.
Ultimately, he describes equity exposure as “higher than last year on average” but “not extreme”.
Next, Marko reiterates the bank’s preference for the pro-cyclical rotation trade. For months, he’s argued that the disconnect between bubbly bond proxies (e.g., Min. Vol. and Quality) and unloved Value/Cyclicals had reached unsustainable extremes.
That began to correct itself in Q4, as bond yields rose and market participants positioned for a continuation of the rotation in 2020.
And yet, as we’ve detailed here over the past couple of weeks, at least some folks have been fading that in January.
“After the September to December Value rally, this year investors sold Value and rushed into the same Momentum long-short trades as last year”, Kolanovic writes, on the way to noting that now, “the beta of global Hedge Funds to the Momentum factor is in its 99th historical %ile, and HFs are underexposed to Value (15 th %ile) and small caps (7th %ile)”.
Suffice to say Marko is sticking with the rotation call, reiterating that Momentum and bubbly Low Vol. shares will likely underperform Value thanks to ongoing central bank accommodation, progress on the trade front, an expected inflection in global manufacturing PMIs and possible “upticks” in inflation and commodities.
While that call hasn’t changed, Marko describes the Mideast tensions stemming from the assassination of Qassem Soleimani as a “geopolitical tail risk [that] is under-appreciated by the market and should be hedged”.
He starts by briefly recapping the dramatic knee-jerk reactions across assets in and around Iran’s counterstrikes on US bases in Iraq.
In the minutes after al-Asad airbase in Iraq came under attack, US equity futures plunged. Asia CDS blew out. The yen surged. Ultra bond futures tripped the circuit breaker. Cash yields plunged as much as 11.5bps. WTI futures stormed higher. And, in a true testament to the commencement of the apocalypse trade, gold rose above $1,600 for the first time since 2013.
Briefly, the reaction in equity futures took Spooz below levels that, at least on some desks’ estimates, would have flipped dealers’ gamma profile negative.
Fortunately, the kind of cascading, selling-begets-selling dynamic that’s characterized so many of the harrowing episodes that have interrupted markets over the past several years was short-circuited, but Marko warns that had the timing been different, the situation could have escalated.
“Had it happened during market hours, such a move could have triggered broader systematic and discretionary selling”, he says. Then, he warns that Trump’s pretensions to peacekeeping notwithstanding, exactly nothing is really “fixed”, per se.
For Kolanovic, the market simply isn’t priced for another material escalation. “None of the underlying issues were resolved”, he writes, citing the new sanctions on Iranian metals and Tehran’s decision to completely abandon its commitments under the nuclear accord. Next, he says the following:
This will not remove risks but, rather, may push the US and Iran further down a collision course. The current consensus (as reflected in various market measures, e.g. oil, VIX, energy stocks, broad market, etc.) is that there is little or no risk of escalation near-term. Does this make sense? Increased sanctions are currently harming Iran’s economy, and the regime may not survive a second Trump term. So from the perspective of the regime, the escalation that started over a year ago (tanker incidents, Abqaiq attack, etc.) is not likely to stop but rather may accelerate. The timing of escalation may be influenced by the political calendar as US political divisions, oil prices and the stock market can have a significant impact during the election year.
In case it’s not clear enough, Marko thinks that’s something that needs to be taken into account, even if you, like JPMorgan, harbor a generally upbeat take on equities in 2020.
“Many of these considerations indicate that the risk of escalation is high going into US elections, in our view, and the market currently is not pricing any significant risk”, he cautions. “We believe investors should hedge this risk going into US elections”.