It’s time to have the rebalancing discussion again.
Or at least if you’re a JPMorgan client it is.
As documented here over the weekend, US equities are on track to post one of their best November performances on record. And many analysts see scope for the rally to continue into year-end for a variety of reasons, ranging from generic “vaccine optimism” to mechanical flow catalysts tied to, for example, re-leveraging from vol-sensitive strats.
“Our thesis for post-election/post-vaccine implied vol compression continues unabated [as a] core catalyst for [a] year-end melt-up,” Nomura’s Charlie McElligott said Monday, reiterating the importance of “the second-order impact on systematic vol control–type strategies” which should “continue providing supportive re-leveraging flows… in the absence of another ‘shock.'”
Outperformance from equities (versus bonds) raises the specter of rebalancing flows and according to JPMorgan’s Nikolaos Panigirtzoglou, that could mean some $160 billion in equity selling at the end of this month.
As usual, Panigirtzoglou looks at four types of multi-asset investors with fixed allocation targets or a tendency to employ mean reversion — namely, balanced mutual funds, US defined benefit pension plans, Norway’s sovereign wealth fund, and GPIF.
When it comes to monthly rebalancing, Panigirtzoglou zooms in on balanced mutual funds, starting from the assumption that they were fully rebalanced as of the end of last month. He quickly notes that assumption might not be a safe one, flagging their beta to the S&P as evidence that balanced funds were perhaps underweight stocks in October, only to increase their exposure sharply in November.
“If the picture is a true reflection of how balanced mutual funds have been positioned in recent weeks, then there would be some vulnerability in equity markets in the near term from balanced mutual funds having to sell equities to revert to their 60:40 equity:bond target allocation, either by the end of November or by the end of December at the latest,” he wrote.
As far as investors that rebalance quarterly, JPMorgan points to the whales — Norway’s oil fund and GPIF — as well as US defined benefit pension plans.
All told, Panigirtzoglou estimates that between them, pension fund entities that “tend to rebalance on a quarterly basis” could need to sell as much as $150 billion in equities by the end of next month, assuming stocks do, in fact, continue to perform. That would be in addition to the estimated $160 billion in selling from balanced mutual funds, which he says is the more immediate risk.
I’ll just be as straightforward as possible here: This is a largely perfunctory mathematical exercise that, at best, puts a number to flows which can, depending on all manner of other factors (with the most obvious being countervailing flows and prevailing liquidity conditions), move markets.
Rebalancing events can have dramatic consequences under the “right” (and that’s something of a misnomer, but it’ll work) circumstances. In late December, 2018, for example, rebalancing flows into stocks in an environment where market depth and liquidity was virtually non-existent, helped rescue equities from suffering an even worse fate than they already did that month.
In short, the above is useful incremental information to consider, but I certainly wouldn’t obsess over it.