Matches

Rally skeptics abound.

I suppose that goes without saying. I’m not particularly fond of the “most-hated rally” label given that it ends up being applied to seemingly every rally at one stage or another. But I’ll concede there are more reasons to distrust equities than usual, with the caveat that prices are never “wrong” in a strict sense of the term.

The risk of recession is elevated. In the US, yes, but particularly in Europe, and in China too, as evidenced by July’s lackluster activity data and surprise easing from the PBoC. Corporate America is holding up ok thanks to pricing power, but margin headwinds are many. Consumers in the US (and across the developed world, for that matter) are beset by inflation that’s triple, quadruple or even quintuple target, depending on the locale. Wages are growing fast enough to imperil corporate bottom lines but not fast enough to keep up with inflation, a decidedly poor conjuncture for everyone involved. The rally from the June lows erased some of the de-rating which pushed US equities into a bear market earlier this year, thereby undermining the value proposition, especially given the prospect of lower earnings. And so on, and so forth.

None of that is new, though. It’s not so much that stocks “didn’t care,” as much as it was that under-positioning (inspired by the combination of the concerns enumerated above) ran up against a self-fulfilling prophecy. Mechanical flows into a thin summer market fed a nascent bounce, puts withered, vol receded, shorts were covered, the flat-footed grabbed for upside in calls, and around we went. Or up we went.

Read more: Mechanical Bull: What’s Really Behind The Summer Stock Rally

It helped that Q2 earnings weren’t as bad as feared, and a cooler-than-expected read on US inflation for July obviously helped too. But the mechanical aspect is still underappreciated, which in part explains why so many market participants were incredulous at the scope and persistence of the rally.

So, what’s next? Well, as noted here on Tuesday, US equities could lose some of the “gravity” that’s helped keep spot pinned coming out of OpEx. But that merely opens the door to a wider distribution of outcomes. We’d still need a vol catalyst — a match, as it were.

In a new note, Nomura’s Charlie McElligott sketched three scenarios with the potential to trigger a reversal in risk appetite and an uptick in vol. “What else could shock sanguine markets and reset the current ‘virtuous cycle’ of collapsing vol, mechanical re-allocation, covering and chasing back into equities exposure from the sidelines?” he asked. The “what else” was a reference to the notion (still popular in many circles) that Q2’s passable results only kicked the can on America’s corporate profit reckoning.

McElligott proceeded to elaborate on a trio of potential scenarios “which could re-introduce volatility.”

“As one of my core tenets, ‘upside inflation surprise’ is almost always a vol catalyst on the [implications] for a central bank hawkish policy accident, so any sort of reacceleration in US inflation data would send… the ‘past peak inflation = past peak Fed hawkishness’ narrative into a tailspin,” he wrote, on the way to noting that if (or when) the market finally accepts the reality of sticky core inflation and higher-for-longer fed funds, there’s a risk that any attendant repricing in rates acts as a “de facto ‘tightening’ from a trajectory-change perspective, all while the lagged impact of running restrictive begins to lean into US growth.” The figure (below) shows the Cleveland Fed’s core CPI nowcast (for August) with realized inflation (last print is July, obviously).

Recognizing the potential for underlying inflation to stay high even as falling commodity prices (hopefully) apply the brakes to the headline gauge, and keen not to repeat mistakes made in the 70s, the Fed will likely retain a hawkish messaging bias, perhaps starting with Jackson Hole next week. That’s the second potential vol catalyst. “The Fed is not yet close to achieving clear evidence of a sustainably lower inflation trajectory,” McElligott wrote. As such, officials may attempt to “rein back in the recent FCI easing ‘animal spirits,’ which make their supposed single inflation mandate task that much more unreasonable.”

That leads naturally to the third potential vol catalyst. “A resumption in hawkish rate vol and another reversal weaker in bonds after what has been a powerful short squeeze rally… could then act [to] further shake risky assets,” Charlie said.

Importantly, it’s possible there just isn’t time for any of those catalysts to “realize.” Absent a rationale for a resumption of rates tantrum behavior, equities could prove too alluring. “In order to have a chance at developing into something larger, a ‘macro vol catalyst’ may need to overlap this temporary ‘vol expansion window’ surrounding the upcoming equities OpEx, which is set to see a substantial gamma ‘unclench’,” McElligott went on to say. 

If that window closes with no drama, “the FOMO risks further build-out,” Charlie remarked, noting that “clients continue to ‘hate’ this rally [and thus] remain a source of ‘buyers higher.'” When taken in conjunction with the potential for tens of billions in re-allocation flows from vol control over the next several weeks and additional buying from CTA trend on a move through momentum signals, there’s certainly scope for upside.