Nomura’s McElligott Talks Georgia, ‘Neon Swan’ Parallel

Early Wednesday, while documenting the initial reaction to a likely Democrat-controlled Senate following the Georgia runoffs, I talked a bit about equities — mostly about rates and the dollar, but a little bit about stocks.

For markets, the delayed blue sweep manifests in higher yields, a steeper curve, and, likely, a continuation of the recent conjuncture of accelerating breakevens putting mechanical downward pressure on reals, which in turn drags down the dollar.

Of course, the reflationary trade in rates is the opposite of the vaunted “duration infatuation” and perpetual bull flattener to which markets became so accustomed over the “Goldilocks” years. The duration trade became embedded in myriad equities expressions, with big-cap tech being the most obvious example.

Hence, in my initial predawn assessment Wednesday, I wrote that for equities, it will be all about dispersion again, as big tech and secular growth favorites will probably come under pressure (or, if not, they’re likely to underperform), while small-caps and value will be favored on the assumption that this time, the pro-cyclical rotation can prove some semblance of sustainable.

Commenting on the Georgia outcome, Nomura’s Charlie McElligott delivered a similar assessment, writing that,

As ‘Secular (Growth)’ has been the well-over 5+ year hiding place for investors–the Tech / FANG+ / Nasdaq type-companies able to grow EPS and profits in a world devoid of yield and stuck in ‘Goldilocks’ economic conditions, which then too simultaneously had them underweight / short ‘Cyclicals (Value)’ –the unwinding of said legacy positioning has come in some rather furious waves, as highlighted by the unprecedented and massive ‘Momentum’ factor unwind events of November 2020.

The reference is to the violent rotations that played out following the election, when vaccine readouts and optimism around the selection of Janet Yellen for Treasury Secretary helped catalyze a spectacular month for laggards (like small-caps), sometimes at the expense of growth and other longtime favorites, which, in addition to benefiting from the pandemic’s deflationary side, also prospered from the “stay-at-home” trade.

The figure (below) is a throwback from November. The red arrow shows you the momentum crash associated with the pro-cyclical rotation that accompanied the initial vaccine readout from Pfizer on November 9.

We’re not likely to see anything of that magnitude following the Georgia runoffs. By now, consensus has coalesced around the view that a razor-thin majority at a time when centrist Democrats are terrified of the “socialist” label, isn’t exactly conducive to transformational change, and thereby is unlikely to presage the adoption of any “radical” agendas.

Still, the realization of the blue sweep will have consequences, both in D.C. and in markets, especially when you consider the Senate shift in the context of the Fed’s tweaked mandate (which makes inflation overshoots a good thing and seeks to facilitate a more inclusive labor market) and Yellen’s avowed commitment to fostering more equitable social outcomes.

Indeed, small-cap outperformance versus mega-cap tech wasn’t (and isn’t) confined to November — it’s running into a fifth month as the new year dawns.

“It’s now likely again that the flow out of Growth and into Value ‘dispersion event’ reaccelerates on [any] Rates / Duration escalation, which is why the poor man’s ‘Growth / Value’ proxy via US Equities futures show[ed] Nasdaq (Sec Growth) underperforming Russell (Cyclical Value) by a walloping” margin as the initial Georgia results rolled in, McElligott went on to say Wednesday.

As markets continued to digest the political shift, Treasury futures headed back to session lows. Steepening in the 5s30s accelerated, with the curve wider by 7bps. Yields were cheaper at the long-end by as much as 12bps.

Reiterating the points above about a more muted reaction compared to some of November’s rotations, McElligott did say “legacy ‘Growth over Value’ positioning is far more balanced now versus six months ago.” That means the kind of acute pain trades and “quant book shocks” seen late last year (and at various intervals over the past couple of years) aren’t likely this time around, the 99th%ile asset manager net long in Nasdaq futures notwithstanding.

That said, Charlie wrote that “the potential of an ‘inflation upside surprise’ as the truest macro regime change driver, and more importantly, as the most likely catalyst for a cross-asset volatility shock, now comes much closer to realization.”

That’s important, to say the least. But what, exactly, does it mean? Well, let’s take a brief trip down memory lane.

Those old enough to remember 2018 might recall that while it was the underappreciated rebalancing risk embedded in the VIX ETN complex that ultimately “caused” the event affectionately (or not-so-affectionately, depending on whether you quit your job at a big box retailer to short vol from your living room) known as “Vol-pocalypse,” the “trigger” event that tipped the first domino came the previous Friday, in the form of an above-consensus average hourly earnings print (accompanying the January 2018 NFP report).

Why was that a big deal? Well, because yields had been rising, and speculation that Donald Trump’s determination to overheat the domestic economy might ultimately prompt the Fed (under new management as of February 5, the very day “Vol-pocalypse” came calling) to lean more hawkish than they otherwise might, had markets on edge. Here’s how Bloomberg described it at the time (from a February 2, 2018 piece):

Nonfarm payrolls rose 200,000 in January, exceeding the median estimate of economists for a 180,000 increase, Labor Department data showed Friday, as the jobless rate held at a near 17-year low of 4.1 percent. Average hourly earnings rose 2.9 percent from a year earlier, the most since June 2009.

Stocks plunged by the most since 2016, as the data reinforced the Federal Reserve’s outlook for three interest-rate hikes this year under incoming Chairman Jerome Powell, and indicated that a fourth may be possible. The outlook for rate increases was already relatively firm, with businesses bullish amid strong demand, and further optimism on the heels of the tax cuts likely to underpin hiring and investment throughout the year.

On Wednesday, McElligott drew a parallel with that episode.

“Out of nowhere, the potential for a inflationary / growth overshoot — and thus, actual Fed tightening — went from 0 Delta to an actual ‘thing’ again, versus a market which had assumed they could ‘never’ tighten policy or unwind [the] balance sheet,” he wrote, referencing that fateful, February 2, 2018, AHE print.

He went on to say that while the VIX ETN extinction event (the “neon swan”) was, of course, due the retail VIX products’ EOD rebalancing requirements, the “true macro catalyst” for Vol-pocalypse was the “‘inflation upside surprise = Fed tightening’ risk finally realizing” in an environment where market participants, lulled to sleep during the low vol bubble, had acquiesced entirely to the notion that the Fed would never risk unwinding various carry trades embedded across virtually the entire market.

Now, many of the reflation puzzle pieces are “falling into place,” McElligott said Wednesday.

If we were to get some manner of inflation-scare-inspired drawdown in equities triggered by market participants suddenly pricing in a Fed that may not lay dormant in perpetuity after all, it would be supremely ironic.

Remember: It was Yellen who presided over the low vol bubble in 2017. Now, it’s Yellen who intends to preside over the kind of monetary-fiscal partnerships aimed at fostering reflationary outcomes.