Having recently observed that markets are rapidly "losing the reflation impulse", in his note today RBC's Charlie McElligott comments on today's precarious attempt by traders, or perhaps just algos, to spur another push at risk recovery. We present the his full below in its entirety - his take on the role of crude in the reflation trade is key - but first we watned to bring attention to one particular chart, which highlights just how big the divergence has grown between equities and the rest of the fizzling reflation trade. As RBC notes, "Posit this chart of 2Y breakevens vs two popular measures of US equities ‘high beta cyclicals’ for a ‘pure read’ on the difference in worldview between equities and the rest of the ‘reflation’ trade."
Perhaps equities, now backed by the full faith and credit purchasing of the world's central banks, will be right this time...
And with that, here are the rest of McElligott's thoughts:
Four dynamics overnight driving a recovery in risk-assets:
- Japanese trade data showing exports rising +12% YoY (vs +6.2% est, rising at fastest rate in more than two years) and imports +15.8% YoY (vs 10% est, the largest gain in more than three years) as a signal of health in the global economy;
- Reuters Tankan poll showing more manufacturing ‘soft data animal spirits,’ with confidence amongst Japanese manufacturers up eight consecutive months to levels last seen prior to the 2008 GFC (while also noting that confidence in the ‘services’ sector too was at three-month highs);
- Saudi Energy Minister Khalid Al-Falih intimated in an interview with the WSJ that oil producers are moving closer to a deal which would extend supply cuts beyond June in order to reduce global stockpiles—although noting there is still work to do, and that the extension might not be for another six-month period. Crude sees a relief rally;
- Easing concerns around French election risk as per market behavior (and polling update showing Macron inching ahead of rivals), as evidenced by today’s successful OATs auctions where both the 3- and 5- paper was scooped at lower yields and similarly firm BTC’s than prior comps…while too we see EU banks leading all European sub-sectors on the day, +1.6%. The Euro itself is +40 pips versus the Dollar on the session. Optically, a classic EU ‘risk-on’ with periphery equities / banks leading, while Bunds are selling-off.
The USD is weaker against 8 of its G10 counterparts and a majority of EMFX, while the modest ‘risk-on’ tone sees global developed market bond yields higher as well. Critically for inflation, we see crude regaining its legs after yesterday’s shellacking, +1.0%, while copper gains as well +0.6%.
TURNING TO YESTERDAY / GENERAL OBSERVATIONS: Some great stuff here below on the fading ‘inflation impulse’ seen within the commods space and its impact on asset prices; a reminder on the importance of today’s TIPS auction as an ‘appetite’ indicator for inflation and US equities thematics (‘cyclicals’ / ‘value’ vs ‘defensives’ and ‘secular growers’); Fischer noting R.O.W. economic strength gives Fed justification in continuing on hiking path; sell-off trend into US equities closes; ‘momentum longs’ fading vs ‘anti-beta’ as the new leadership; and a frighteningly obvious observation regarding ETF impact on single-stocks.
- There was a fair-bit of inconsistency to yesterday’s cross-asset performance message. Sure, S&P sold off meaningfully from highs, but ‘defensives’ / ‘low vol bond proxies’ / ‘anti-beta’ mkt neutral were the “biggest losers.” Generally speaking, despite weaker stocks / wider HY / weaker EMFX, ‘safe-havens’ (USTs & gold in this case) were well-offered. And despite the crude beat-down -3.7%, we actually saw Qingdao iron ore break its losing streak and close +2.2% overnight.
- Crude’s purge was certainly critical to the selloff in stocks and risky EMFX from their earlier session highs yesterday. To see crude—the most critical asset input into ‘inflation expectations’ and singularly reflective of both the ‘deflation scare’ of 2015 and the ensuing ‘reflation trade’ in 2016—“pile onto” the already-witnessed carnage I’ve been noting in Chinese industrial commodities speaks poorly to the global ‘inflation impulse.’ Remember my point earlier in week: commodities (‘metals & ags’ and ‘wti & brent’) and general ‘inflation expectations’ are ‘top of the league table’ (alongside ‘risk aversion’ and ‘global sovereign risk’) as far as macro factor price-drivers of assets goes right now, per the QI PCA model:
- On this very note, my esteemed colleague in London Dave Brickell highlights to me that the Bloomberg Commodities Index is in danger of breaking its trend support line dating-back to the ‘global reflation pivot’ experienced last Jan / Feb.
- I want to reiterate my point made yesterday on the importance of today’s US TIPS auction with regards to ‘reflation / deflation’ optics:
“Tactically it will be critical to watch tomorrow’s TIPS auction as a read on ‘risk appetite for inflation.’ If we get a clunker, it’s likely we resume the ‘capitulation’ in the ‘short rates’ camp STAT, which is sure to drive more of the same ‘defensive’ / ‘low vol’ / ‘bond proxy’ equities leadership. Conversely, if the TIPS auction takes well, it should be read as the ‘reflation camp’ feeling again emboldened after the recent squeeze / cleaner position post ‘stop outs,’ and we’re likely to see $ rotating back into the ‘cyclical beta’ / ‘value’ / ‘small cap’ stuff tied to higher rates.”
Posit this chart of 2Y breakevens vs two popular measures of US equities ‘high beta cyclicals’ for a ‘pure read’ on the difference in worldview between equities and the rest of the ‘reflation’ trade:
Also a very interesting speech from Fed’s Fischer that seemingly didn’t get a lot of airtime it seemed yesterday. I note the speech because it seems clear to me that he was attempting to further prepare the market with a “statement of intent” on removal of accommodation, specifically this time around by voicing not only confidence in the “continued expansion of the U.S. economy”…but too with regards to the much firmer global economic back-drop we currently see as a difference-maker.
“But the main reason for the positive market reaction is that foreign output expansions appear more entrenched, and downside risks to those economies noticeably smaller than in recent years. In Europe, unemployment has fallen steadily; inflation and inflation expectations are moving toward central bank targets; and, while Brexit entails many unknowns, so far it has not resulted in significant financial market disruptions. China's economy also appears to be on a more solid footing, which has helped stabilize the renminbi as well as support growth in other EMEs.”
Basically, he’s saying that we’re capable of tightening ‘this time around’ because the rest of the world looks ‘okay’ for the first time in a long time. A simple thought, but a very worthwhile one to ruminate upon.
So looking at both of the above juxtaposing points on Fed willingness to hike into likely FALLING inflation expectations—this is where the market is struggling to break new ground. Thus, the ‘two camps’ I mentioned yesterday: those who believe in the economic escape velocity and ‘pending’ fiscal policy being able to drive growth and inflation to where it can overcome tighter conditions, versus those who see cracks (fading energy base effect, ‘hints’ of weakening consumer, C&I loan growth trajectory, inability of Trump admin to ‘move the ball down the field’ on fiscal policy) into higher rates / balance sheet taper, and view that as a recipe for a repricing of risk lower.
A two week string of ugly equities closes is notable with regards to the concept of both institutional and retail (ETF) redemption flows. Marginal ‘net’ selling in the NYSE MOC’s over the past 10 days (-$177.4mm) but perhaps again speaks to the ongoing rotation out of US and into EU / EM which I’ve referenced recently and confirmed from both EPFR data as well as sell-side fund manager surveys.
On a similar note, tracking ‘smart beta’ equity ETF flows we see an interesting dynamic developing: total inflows for the month of April are on pace for their lowest net # in at least six months, which is perhaps reflective of a general ‘loss of interest’ in US equities versus more attractive opportunities elsewhere in the world. From a factor-perspective, it’s ‘momentum’ (high over low, -$227.9mm) and ‘size’ (small cap over large, -$265.6mm) who are suffering the largest redemptions, while conversely, ‘growth’ (+$781.7mm), ‘multi’ (+$633.5mm) and least-surprisingly ‘low volatility’ (+$398.2mm) which are driving the inflows.
While on factors: ‘Anti-beta’ market neutral had seen high correlation to 12m ‘momentum longs’ over the past year, on account of the outperformance of ‘low vol’ during the first six months of 2016, as many remained largely ‘in their bunker’ post the deflation scare at the start of the year (and thus played ‘defense’ through the high divy yield / bond-proxies).
Now though as that impact fades, we instead see longer-term ‘momentum’ picking-up ‘reflation’ attributes off of the enormous move in the back-half of 2016 with ‘value’ / ‘high beta cyclicals.’ For this reason (as well as the shorter-term underperformance of recent ‘growth’ leadership MTD), we now see ‘momentum longs’ fading very hard, while ‘low vol’ / ‘anti-beta’ diverges higher into this month’s volatility jump / ahead of “sell in May.”
Finally, an observation from a new study out of researchers from Stanford, Emory and the Interdisciplinary Center of Herzliya in Israel, which seemingly confirms anecdotal observations which most of us have noted for the past decade. I leave this here and let the comments roll-in!:
“A single percentage point increase in ETF ownership has demonstrable effects on an individual stock, the researchers found. Over the ensuing year, correlation to the share’s industry group and the broader market ticks up 9 percent, while the relationship between its price and future earnings falls 14 percent. Meanwhile, bid-ask spreads rise 1.6 percent and absolute returns grow 2 percent.”