While most traders may be clueless how to trade this painfully illiquid, directionless market, with some refusing to even participate and are instead "on the golf course", Nomura's Charlie McElligott, is not among them.
The head of cross-asset strategy has a clear idea of why the right tactical trade here remains to be "bullish Equities", which he justifies with broad institutional underexposure which makes the case for "renter" longs in Equities "as clients continue to voice desire to play for “January Effect” and gross-up books, especially against much more attractive entry points/valuations from the long-side"
Longer-term, however, he is anything but bullish and believes that as the market increasingly witnesses the slowing growth- and inflation- impacts of:
- “tighter financial conditions” / lagging negative impact of prior Fed hikes / QT,
- fading fiscal stimulus,
- deteriorating “wealth effect” due to recent market shocks and impact of spending and
- the cyclical reality of corporate deleveraging late in the cycle—which means lower CAPEX
... that early 2019 rallies are to be faded and/or used to move "up in quality" ahead of the upcoming painful end-of-cycle realities.
Looking at recent market action, McElligott concludes that this "late-cycle" trade is exactly what is occurring within US Equities, observing that yesterday’s "incredible" late-day rally showing a huge preference for "Quality stocks as 7 of 8 "quality" factors in the bank's factor suite up on the day, "and even more incredibly, 6 of 8 up MTD against most US equity indices down 9%, while equity hedge fund long/shorts are anywhere from -1.5% to -5% MTD."
What would it take for McElligott to reverse his long-term bearish view? Nothing less than a breakthrough in one of the following three major fronts:
- A Fed reversal towards EASING of policy / pausing- or stoppage- of the balance sheet unwind;
- A conclusive resolution to US / China trade in the form of a “deal”;
- A major Chinese policy easing “capitulation”
However, as it currently stands, none of those are remotely close “realizing”, according to the Nomura strategist who cites the bank's house view that China cannot appease the market’s "full QE and policy rate cut" desires, while China/US trade will be a few more months of “noise” with little signal.
But the biggest reason why McElligott is bearish has to do with a specific realization he made on the Fed’s balance-sheet unwind—which remains “untouchable” as per Powell’s recent commentary... as well as a quote from the Fed's 2012 Minutes which we first dug up back in January, and which McElligott noted yesterday, to wit:
“I have concerns about more purchases. As others have pointed out, the dealer community is now assuming close to a $4 trillion balance sheet and purchases through the first quarter of 2014. I admit that is a much stronger reaction than I anticipated, and I am uncomfortable with it for a couple of reasons.
First, the question, why stop at $4 trillion? The market in most cases will cheer us for doing more. It will never be enough for the market. Our models will always tell us that we are helping the economy, and I will probably always feel that those benefits are overestimated. And we will be able to tell ourselves that market function is not impaired and that inflation expectations are under control. What is to stop us, other than much faster economic growth, which it is probably not in our power to produce?
Second, I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.
My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.
Take selling—we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position. When you turn and say to the market, “I’ve got $1.2 trillion of these things,” it’s not just $20 billion a month— it’s the sight of the whole thing coming. And I think there is a pretty good chance that you could have quite a dynamic response in the market.”
Re-reading the above quote, especially in the context of Powell's FOMC "autopilot" commentary, McElligott writes that "it is increasingly obvious to me that J. Powell believes that the balance sheet expansion has engendered excessive risk-taking and outright asset bubbles, which in-turn are likely the largest systemic risks to the US financial system."
If the Nomura strategist is correct, that would have epic consequences for a market which is convinced that it is only a matter of time before the Fed put is hit for the simple reason that... there is no Fed put. As McElligott concludes, "speculation has always been that Powell and Jeremy Stein were the “catalysts” behind what ultimately became the “taper tantrum” episode in 2013 as well—and as a smart client said last night, "Just wait until the 2013 transcripts come out…the notion of the policy put is sorely mistaken."
The good news is that once the current pension fund reallocation concludes and the bear market rally ends and the vicious selling resumes, Charlie's theory can easily be tested if when the S&P drops back below 2,400.... then 2,300.... then 2,200... then 2,100 and 2,000... Powell still does nothing - much to the fury of President Trump - then yes, it will indeed be the case that any hopes for a Fed put will have been "sorely mistaken."