RBC's head of cross-asset strategy, Charlie McElligott warns that "it’s now clear that as I’ve been anticipating, there is a significant amount of equities buy-side discomfort as consensual positioning is now driving the first period of sustained market underperformance in some time, all on account of the flagged factor-rotation I’ve been focused-upon."
Having detailed his thesis consistently (and most recently this morning - see notes below), McElligott's quick message this afternoon should be heeded by many staring at the tumble in FANGs and surge in Small Cap Financials - something big just changed...
As I’ve been pushing over the past few weeks, the over-extension of positioning and factor relative ratios (most notably ‘value : growth’) sent up the ‘red flags,’ and the moment that rates began to lose that downside momentum, we made the call that the rotation was officially beginning.
Here are the optics of the ensuing scramble, obviously still early stages, but with plenty of room to run as long as rates continue to cooperate (higher). Worth noting on that point, that we are seeing fast-money re-engage in fixed-income shorts again today on rates / futures desk…which as I’ve stated is mission-critical to sustain this reversal.
The trick TODAY from a ‘performance-perspective’ as opposed to yesterday, where just the ‘shorts’ / ‘underweights’ squeezed higher against ‘the masses’…today we are now seeing the consensual longs begin to ‘suck wind’ in addition to the short / underweight outperformance, just as I’ve anticipated, as ‘growth’ / ‘momentum’ / ‘low vol’ turn into a ‘source-of-funds’ to rotate into the ‘cyclical’ / ‘value’ / ‘size’ (small caps) stuff.
Thus, my ‘mean reversion’ model is EXPLODING HIGHER +185bps, while my generic ‘equity long-short’ model (capturing consensus positioning) is -65bps!
MEAN REVERSION MODEL = RIPPING HIGHER AT +185BPS ON SESSION:
WHILE MY ‘CONSENSUS’ EQUITY LONG-SHORT MODEL NOW IS SPANKED -65BPS:
SHOWN ANOTHER WAY—GENERIC EQUITY L/S POSITIONING IS EFFECTIVELY ‘LONG TECH / SHORT ENERGY’ OR ‘LONG GROWTH, SHORT VALUE’ (note: the data / chart does not reflect today’s reversal).
EQUITY QUANT FACTOR STRATEGY ROTATION INTO ‘VALUE’ MARKET-NEUTRAL (LONG VALUE, SHORT GROWTH) AND ‘SIZE’ (SMALL OVER LARGE) SEE YTD-LEADERSHIP REVERSAL, ESPECIALLY WITH ‘ANTI-BETA’ (LONG LOW BETA, SHORT HIGH BETA) STRATEGY NOW PLUMMETING, IN ADDITION TO ‘MOMENTUM’ AND ‘GROWTH’ NOW AS APPARENT ‘SOURCE OF FUNDS’:
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And by way of background, here is full breakdown of the rotation disucssion as we noted earlier...
Amid yesterday's "nothing-burger" from the big-three event risks, the market initially shrugged off any worries. However, as RBC's head of cross-asset strategy, Charlie McElligott notes, "all of the juicy stuff continues to occur under the surface within the US equities complex."
OVERNIGHT: Annnnnnd…one big ‘nothing done.’ Completely unsurprisingly, yesterday’s “risk-event trifecta” laid an egg, where even the lone ‘surprise’ of the three—the loss of an outright majority for the UK Conservatives (nonetheless with largest share of the vote), meaning a ‘hung parliament’—drives only a modest rally in Gilts (back to Wednesday’s closing levels) while GBP weakness (as expected with Labour closing the gap) again sends the FTSE 100 higher +0.8%, as the largest UK corporates benefit from the weaker currency (same response as Brexit, just on far-lesser scale).
Hilariously, GBP 3m10y implied vols still sit close to all-time lows, with 1 month realized vol at ~2.5bps / day. The only real global markets ramification is a modestly higher USD via the weaker GBP, which in turn only means ‘flat’ EMFX basket--color me utterly underwhelmed, again. VIX is -2.0% overnight, while Gold and USTs are modestly weaker (2.20, 2s10s at +88bps), against global equities higher: Spooz are +10bps (while again today we see further small cap O/P with Russell +30bps early), the Nikkei closed +50bps, Eurostoxx is currently +20bps and DAX is +40bps, while GBP IG OAS trades a lame +1.5bps wider / GBP HY +2.5bps and having little impact on risky EU Xover and US CDX HY. Zzzzzzzzzzz.
WHERE THE ACTION IS: With US rates avoiding outright breakdown and settling-back into a tight 4bps range over the past two days while even spastic Crude chills out ($0.50 band over two sessions!), all of the juicy stuff continues to occur under the surface within the US equities complex.
Yesterday in fact just might have kicked-off ‘the beginning of the end’ of the YTD equities ‘risk barbell’ trade (long ‘growth,’ long ‘defensives,’ short ‘cyclical beta’ / ‘value’ / ‘small caps’), as my much-discussed theme of a pending equities factor-rotation began to gain significant-steam. Let’s call it “first inning” (thank you, Jon Simon).
For my cross-asset readers not into the wonk / micro of equities, this is relevant in the sense that it could have a significant reversal in current consensual buyside positioning (driving strong equity fund performance YTD), which is based upon the consensual view that US growth is ‘okay but slowing’…and slowing into a tightening regime at that. And for clarity-sake, by no means is this burdgeoning and likely tactical shift into ‘cyclical equities’ (or ‘value’ factor as it currently stands) equivalent to the outright ‘reflation’ trade euphoria of late last year / start Q1 this year, which was based-upon a larger global recovery and acceleration off the energy ‘base-effect,’ Chinese credit-pumping driving much of the inflation impulse via the supply chain and CB willingness to allow curves to steepen…PLUS the siren-song hopes of US fiscal policy benefits post the Trump election.
BUT it does rhyme somewhat, as a reversal in the equities-regime is largely dependent upon higher rates driving economically-geared leadership as opposed to the current regime, where equities investors are either piling into companies that are able to grow ‘secularly,’ not ‘cyclically….or conversely, piling into ‘low volatility’ bond-proxies for their yield or ‘income.’ The losers in this scenario have been the ‘value’ stuff that’s been left for dead after 8 years of ZIRP and QE-induced low rates and flat curves—again, ‘cyclical’ stuff.
During the afternoon of the US session Thursday, we saw at peak a 2 standard deviation move to the upside in the 1 day-performance of 12m ‘value market-neutral’ (what I've been banging the drum on for a while now, nobody really 'there' for this trade and will be source of pain IF a rally in cyclicals was to sustain—Financials, Industrials, Materials and Energy as four of the S&P’s top six performing sectors on the day), juxtaposed against a 2 SD move to the downside in 'anti-beta' mkt-neutral (defensives coming unglued today, with REITS, Telcos, Staples and Utilities as four of the S&P’s five worst performing sectors on the session).
ANTI-BETA MKT-NEUTRAL 2 SD MOVE TO DOWNSIDE, WORST DAY SINCE NOVEMBER 30TH:
LARGEST POSITIVE MOVE IN ‘VALUE’ MARKET-NEUTRAL SINCE DECEMBER 1ST:
This of course is a major reversal of YTD-trend. As I’ve been saying, ‘value’ has been 2017’s whipping boy (for the right reasons, as rates retrenched and inflation expectations have again faded lower), while ‘anti-beta’ has, along with ‘growth’ / ‘momentum’ / ‘quality,’ been a ‘hiding place’ for equities investors—especially with the never-ending AUM inflows into behemoth income fund / divy yield / low volatility products. So as noted in yesterday morning’s note, when you see such a robust reversal in a very clear outright YTD theme—AND ON MULTIPLE-FRONTS--you need to pay attention to it as a potential signal of change being afoot.
Directly being affected by this reversal in ‘value’ / ‘cyclical beta’: small caps (Russell 2000 outperforming SPX by an astounding +150bps on the day), which are of course enormous YTD laggards but more importantly, ‘cyclically-geared and high-beta.’ The fact that 28% of the Russell weighting is financials too adds some ‘ooomph’ to the move obviously as well.
Perhaps just as important is that we are seeing EVER-so-slight signs of ‘growth’ beginning to fatigue. Not even in the stratosphere of being used as an outright ‘source-of-funds’ right now—but to see the equity world’s most crowded overweight not doing the heavy-lifting on index could be read two ways: that it is a HEALTHY thing on the index-level to see other sectors pick-up the slack; or, conversely, that it’s a WORRYING thing when your leadership is losing momentum, and that two of the key ‘growth’ sectors (healthcare and consumer discretionary as the 2nd and 3rd best performing sectors YTD) are underperforming the S&P index by -30bps and -70bps, respectively, on the Thursday session.
Again, this isn’t causing performance issues right now, because again, you’re not seeing the ‘pukes’ in tech longs or mega-squeezes in, say, placeholder underweights like Energy—hard to imagine that occurring with WTI sitting still with a $45 handle. Most importantly, and to be fair for ‘context,’ we see this move higher in US rates STILL only +8bps from YTD lows made a few days ago. As I will keep saying—a more meaningful / ‘stickier’ factor-rotation (where ‘value’ can sustainably outperform ‘growth’) is going to require a true rates reversal with higher outright nominal yields.
As such, ‘higher rates’ may seem like a pipe-dream at this juncture, in light of the multi-month ‘slow-flation’ case I have been making on global shift ‘tighter’ bleeding into downgraded global growth projections and lower inflation expectations. Piling onto this, recently slowing US data adding a bit more ‘equilibrium’ to previously ‘hawkish’ Fed-speak; 2) China’s recent open market operation LIQUIDITY INJECTIONS to counter disruptions created by their own deleveraging efforts (always gets a chuckle out of me); and 3) today’s ECB meeting, which pivoted BACK-TO a rather dovish stance, certainly relative to recent broad ECB-messaging as well, off the back of the downgrade of the ‘balance of risk’ assessment post French election and the obvious recent upward trajectory of PMIs. It’s entirely logical to think that this modicum of ‘dovish backpedaling’ means rates are seemingly going nowhere for a while, especially with US fiscal policy outright being ‘left for dead’ in the collective market psyche as the Trump investigation quagmire saps legislative efforts.
Again though, this game is about positioning imbalances and expectations overshoots—and it’s possible we’re nearing the pendulum having swung a bit too far in the other direction…soon. Just as rates shorts and duration underweights have been covering / adding USTs at such a clip in recent weeks, the asymmetry risks turning in the opposite direction—especially when it is synchronized with the potential ‘crowding’ into the NOW CONSENSUS VIEW of slower growth, and the implications this will have on the Fed (market pricing-in significantly more ‘dovish’ scenarios than recent past).
With the potential for a seasonal uptick in US economic surprises experienced every month on average in H2 over the past seven years, this overly pessimistic positioning both with regards to the ECONOMIC EXPECTATIONS overshooting to the downside—plus, in the view of Tom Porcelli, a Fed that is resolute in two more hikes plus a balance sheet taper--you have the catalyst for higher rates fireworks potentially ‘in hand.’
And if you get those, even just tactically over a couple of months, these ‘growth : value,’ ‘quality : size,’ ‘anti-beta : beta’ dynamics are certain to reverse.