Nomura Calls The End Of Normalization: "The Fed Is Blinking In Front Of Our Very Eyes"

In the end, the modest decline in central bank balance sheets as quantitative easing turned to quantitative tightening may have proven too much for the market to handle...

... and according to Nomura's cross asset strategist Charlie McElligott, the Fed is "blinking" in front of our very eyes, and "correcting to market forces which for months had correctly been fading the dot plot and telling us that policy was already perceived as running at “neutral”—with some cyclical bellwethers pulling-forward an outright “restrictive” policy view (see: Homebuilders, Autos, Regional Banks)."

And now, McElligott writes in his Monday morning note, following the tone shift “less hawkish / more dovish” from Fed’s Clarida and Evans last week (alongside Powell’s own acknowledgement of slowing global growth), further adjustments to consensual “hawkish” positioning await, the market is anticipating a 2019 Fed “pause” which likely then signals the end of normalization altogether.

As the Nomura trader reminds us, Powell’s “…a long way from neutral” comment in early October was THE accelerant for the “financial conditions tightening tantrum” that destroyed YTD performance for many funds (and which had been at the core of my “Two Speed Year” thesis communicated since the beginning of 2018)

So fast forward to Powell last Wednesday, when Powell realized that "tone matters" and where he acknowledged that the Fed is “well aware of” the three key challenges to growth in 2019—fading fiscal stimulus, slowing demand abroad and the lagged-impact of the prior policy normalization.

This was followed two days later by the Fed vice chair who on Friday “changed the game,” where as opposed to Powell’s prior “…a long way from neutral” comments (which indicated not just multiple additional hikes but too the potential to run outright restrictive / above neutral), Clarida moved the goalposts: “…I think being AT NEUTRAL (edit: my emphasis) would make sense” which EFFECTIVELY REMOVED A HIKE from forward expectations.

So who is most exposed to sudden shift in the Fed's down and the adjustment in lower Fed expectations? According to Charlie, the answer is the following:  

  • The US Dollar’s best days are behind it, as the prior tailwinds from 1) fiscal stimulus-, 2) rates differentials-, 3) superior growth relative to R.O.W.- and 4) “hawkish” Fed- ALL FADE profoundly in 2019 (this of course is a catalyst for long suffering Euro-, EM- and Commodities-)
  • Most importantly, my ultimate “end of cycle”- / “sniffing the slowdown”- signal is further crystalized, with UST curves now (bull) STEEPENING, as prior market expectations of future hikes are removed from the front-end
  • With this transition to a steeper curve—ESPECIALLY if due to a perceived “slowing” into “pre-recession” stage—we should expect the recent US Equities thematic reversals to gain strength deeper into 2019 as well (with “the final” hike likely in March or potentially June): into ‘Value,’ ‘Quality’ and ‘Low-Risk’ and out of ‘Growth’ and ‘Momentum’

But before bulls rejoice and bid up stocks into the Fed's relent, the Nomura strategist notes that even though a Fed pivot “less hawkish / more dovish” elicits “bullish” muscle-memory in Equities, he urges readers to remember why it’s happening: "because growth is decelerating, fiscal stimulus impacts are rapidly diminishing, financial conditions are net / net “tighter” and policy nearing the level where it is no-longer “stimulative."

This further cements my long-discussed investor “psyche shift” from the prior risk-POSITIVE “we are growing faster than we are tightening” to the risk-NEGATIVE one where “we have tightened ourselves into a slowdown”

It's not just McElligott who calls time on the Fed's rate hikes: the market seems to agree, with the 5s30s curve at 19 month highs, while EDZ8Z9 is implying just 35bps of hikes; EDH9H0 (March ‘19 / March ‘20) 25bps of hikes; and - as we noted last week - the EDZ9Z0 at -2bps indicating Fed EASING on the margin in 2020.

As as the curve bull steepens, "value" stocks are emerging as the winner, as growth stocks are repriced lower. Indeed as McElligott ntoes, "global Equities “Value” factors measures up across the boards overnight, per our European- and AsiaPac- factor monitors."

It's not just fundamentals that are behind the move however: so are technicals according to Nomura:

The thing is this: right now “Value” factor market neutral is MUCH less about “Value Longs” sprinting higher than it is about the destruction of “Value Shorts” which are being hammered lower—as “Value Shorts” are (not surprisingly) very “Growth-y“ and “Momentum-y“

Or, as McElligott explains, this is just another reason that historically as we transition from the “late-cycle expansion” to “pre-recession” stage, we typically see “VALUE” outperforms “GROWTH,” because investors move into the “cheap” stuff at the cost of “expensive” stuff, especially ahead of an inevitable “easing” cycle thereafter.

In any case, whether due to 1) “end of cycle” view accelerating, 2) monetization / protection of YTD gains or the most likely 3) a mix of both points #1 and #2, McElligott points out that Macro Funds are "absolutely nuking" risk-on positioning into year end across the board, to wit:

  • Macro Fund Beta to SPX down to just 17th %ile (from 39th %ile, and was 79th %ile one month ago)
  • Macro Fund Beta to Eurostoxx down to just 22nd %ile (from 76h %ile, and was 87th %ile one month ago)
  • Macro Fund Beta to EEM down to just 5th %ile (from 34th %ile, and was 67th %ile one month ago)
  • Macro Fund Beta to Nikkei down to just 39th %ile (from 80th %ile, and was 94th %ile one month ago)
  • Macro Fund Beta to Crude Oil down to just 34th %ile (from 84th %ile, and was 98th %ile one month ago)

Finally, as the rush to cover accelerates, the latest fund flow data shows that mutual funds have also cut their beta down to that of the S&P, while long-short HFs have added back beta modestly despite the ongoing deleveraging and gross/net down. As a result, on the week, US Equities Mutual Funds significantly outperformed Long-Short HFs (-1.03% for MFs vs -2.31% for HFs, all against -2.65% for SPX) as MF Beta to SPX reduced down to 53rd %ile (from 93rd %ile) alongside cutting of Beta to “Momentum Longs” down to just 25th %ile (from 39th) while HF L/S took-up Beta to SPX to 94th %ile (from 88th) in conjunction with Beta to “Momentum Longs” up to 92nd %ile (from 83rd %ile). Yet unlike previous attempts by hedge funds to Buy The Dip, prime broker data showed continued “de-grossing” / “de-netting” of exposure in “crowded longs” / “crowded shorts."

So as vanilla mutual funds hunker down ahead of what could be a market rout, while hedge funds scramble to put on high beta positions in a last minute chase of performance amid prayers of beating benchmarks and halting future redemptions, the question is who will be right with less than 6 weeks left for both underperforming sides to make their year...