In the years after the financial crisis, as central banks engineered a blissfully uninterrupted rally in risk assets, investors could easily afford to remain ignorant of the growing influence of systematic, trend-following strategies that have come to dominate price dynamics in global equity markets.
But, as evidence by the sudden reintroduction of two-way equity market volatility beginning with the 'Shocktober' selloff and continuing through the historic pre-Christmas selloff, those days are over. And as investors from Leon Cooperman on down to aging workers plunking their retirement savings in SPY struggle to understand the nuances of the new investing paradigm, one equity derivatives strategist has emerged as the market's eerily prophetic guiding light. That man is Nomura's Charlie McElligott, and his CTA model that tracks one of the most influential class of systematic traders.
As we have assiduously documented in these pages, as other strategists were left slackjawed by the violent downturn in US equities and the bottom falling out of the formerly market-leading tech stocks, McElligott successfully lined up the dominoes of the selloff, leading him to make a series of eerily accurate calls about the duration of the selloff and - even more importantly - the 'bear market rally' that has endured for the past three weeks.
Fortunately for investors who don't have access to his daily market notes, McElligott laid out his views on everything from the implications of the yield curve on equity markets to the risk that a slowing Chinese economy to the mechanics undergirding his CTA model in an epic, hour-long interview with MacroVoices (readers can listen to the full interview below) that is reminiscent of the final scene from the Godfather:
Here's a breakdown of the topics discussed:
- China Trade Collapse
- Update on China Credit Impulse
- PBoC Liquidity Operations
- Bear market rally or continuation of bull market?
- Fading the Fed’s economic optimism
- Sequencing that could cause a force in on the equity markets
- CTA Model Positioning across asset classes
- Positioning in risk parity funds
- Purge in equity fund flows in Q4 2018
- Fear the steepener
True to form, the McElligott interview was accompanied by a chart book where the Nomura strategist - whose calls elicited blowback from strategists at other banks (and even from within Nomura itself) over whether systematic funds were truly to blame for the selloff - offered more support for his calls.
Instead of offering a detailed breakdown of topic explored by McElligott and Townsend during the interview, we're going to break out a few highlights (and their attendant charts), separated by topic.
Weakening Chinese Data
Townsend: Why don’t we jump into your chart book and talk about China? What is driving the situation, and how China is going to play into market action as this whole trade talk thing gets resolved in the next several weeks or months?
McElligott: I appreciate the opportunity to be on again and speak with you.
I had a great time last time. And it expanded some of the folks that I interact with. So thank you for that. I think, as we look to base this conversation out of the impulse that’s originating out of China, and, last time we spoke, we did touch on that idea of the Chinese credit impulse – that credit impulse, of course, with regards to the government’s forcing, pushing on a string of credit out through social financing, through new loan growth, through efforts to stimulate money supply, that has been the “past is prologue” playbook for Chinese responses to liquidity tightening in economic slowdown. I think what the update is since maybe we last spoke, with regards to the continued degradation of the Chinese economy, has been twofold frankly. You’re dealing with a situation where policies have been very focused on preventing financial crisis and a credit freeze. Other policies, they’re trying to support growth, but not enough to offset some of the negatives that are developing.
And it’s both domestic demand issue and, from the folks that we have boots on the ground economic contact with there, I don’t think a lot of folks in the West understand the incredible cynicism, skepticism, pessimism view from the ground within China.
I think that, also, risk markets, global markets, have been anticipating a more holistic BOOM- POW response from Chinese authorities, from the policy setters, from the PBOC, from the Ministry of Finance, more than what the Chinese authorities are able to provide – meaning there is no short-term QE solution, rate-cut solution that would give the market what it wants.
Instead it’s been these very piecemeal attempts. I think we’ve had now four triple-R cuts since last January. We’ve had a number of value-added tax cuts and corporate income tax cuts. The fact of the matter is – and certainly mandating putting more pressure on local authorities and banks to stimulate that loan growth, that credit impulse – they are now in a really tricky part of their process right now.
And I think, generally speaking, it was consensus. Folks understood that when you pile on the trade war and the impact that the tariffs are having on Chinese trade that you’re in a situation where, because of the tariffs implementation, there was this potential relief by pulling forward much of the ordering from clients of Chinese counterpart corporations.
And you did see that to a certain extent – very limited extent – in some of the Q4 monthly data that’s coming out. I think what’s happened in the last couple of days is that – you actually saw in the Chinese trade data yesterday export growth was down 4.4% year over year, which is a negative read on industrial production and employment on GDP.
And then import growth was down 7.6% year over year, which also speaks to this further domestic demand slowdown. It’s highlighting that we’ve already hit the end of that tariff frontloading effect. So you’re really now dealing in the market – and we’re going to talk on this very tactical, very positioning-driven risk rally that I’ve been making the case for since mid-December.
But I think now you’re at that point in the market where there is a lot of discomfort in owning this rally, because you are seeing this negative global growth impulse out of China really get picked up in the global data. And our in-house view – Ting Lu, our Chinese economist, has been way more aggressively negative than the rest of the market and continues to be – is that it’s only going to get worse in Q1 and Q2, especially now that that tariff frontloading effect is gone.
Townsend: Now I want to ask a qualifying question. When you say that it gets worse into Q1, I’m assuming we’re talking about the Chinese economic data getting worse. But I could imagine that translating to more accommodative policy. And, potentially, US markets could be rallying as the US Fed gets a little more accommodative because of what they’re afraid of. So are we necessarily expecting global markets to be worse? Or do you just mean the Chinese economic data gets worse in Q1?
McElligott: It’s the right question to ask. It’s a critical clarification. We’re absolutely speaking with the Chinese economic data which, in turn, is having this dragging effect globally. We saw the German GDP print yesterday confirm the slowdown fears. It’s, of course, a known thing, right? Germany is the world’s third largest exporter, the largest economy in Europe.
It’s very much representative of the flu that has originated out of China. I think what this next wave is, with regards to that Q1–Q2 behavior in China, is that you’re now going to see a situation where, instead of this growth deterioration or growth deceleration, it’s now going to become – which has been due to this deleveraging campaign that began two years ago, so it’s self-inflicted – you’re now going to see the credit crunch in H1.
That’s really where I think you’re going to start seeing the narrowing impact and the smaller response that their economy is getting from these various piecemeal stimulus and easing efforts. They’re smaller, they’re more narrow, they’re less effective than past policy stimulus. Now you’re going to see the payback for the frontloading of exports.
You’re going to see probably now the property market corrections, certainly in the lower-tier cities, is our house view. And probably more defaults and widening of credit spreads in China. That, ultimately – which you are highlighting specifically here Erik – that is things getting worse to force that much more aggressive policy response from Chinese authorities that ultimately puts us back on track for a global economic pivot off of these H1 2019 lows is what we are anticipating.
Fear the Steepener
Townsend: Charlie, I want to skip ahead in the interest of time to Page 20 in the deck because I want to revisit a topic we discussed in your last interview. Where so many people fear an inversion or a flattening of the yield curve, you say we should actually fear the steepening of the curve. What do you mean by that? It seems counterintuitive to a lot of people. What do you mean by it? And maybe talk us through the charts to explain your point.
McElligott: My long-time message has been that the key here with regards to the hyperventilation on curve inversions – The inversion obviously precipitates the steepening of the curve, but what really matters is that the curve-steepening side of the where-we-are-in-the-cycle indicator is telling us that – I have used the term in a number of my pieces, and maybe even on our last call – that the market has finally sniffed out the slowdown. We’ve figured out that the policy tightening, the normalization, have impacted the real economy, that the lagging impact of tightening is starting to lead into financing and funding and the costs of capital.
And it’s causing behavioral shifts with corporate management, CAPEX discussion that we had before, and, ultimately, it’s affecting the actual output in the real economy. So when I say that what matters most is actually the steepening, as the cyclical risk-off signal, that’s exactly what we’ve seen – over the last number of US recessions – is that you don’t need to worry about trying to reverse engineer the timing of the inversion into when does the US recession start, just because there is no historical kind of signal there. It’s incredibly noisy. What does signal – because it’s closer to the real event happening – is that, when you get this steepening, that’s the market picking up the slowdown and confirming the slowdown. The charts on Slide 20 show you the extent of the front end.
We’re looking at eurodollar spreads. And this shows you the extent by which the markets went pricing out the end of the Fed normalization cycle and pricing in the easing cycle. And at the peak of early January, before the Fed’s pivot (basically), before the Jerome Powell and Richard Clarida double whammy messaging that the markets had forced them to take a knee, we were at a point where we had priced in almost a full cut in the end of 2019. There were times since July of last year that the eurodollar 2020 calendar spread was telling us that the Fed was on the margin looking to cut. That clearly escalated to a full cut over the course of the last couple of months. What was still amazing in that real panicky December and then pre-Powell period in January was that we pulled forward that Fed easing, that Fed cut, from 2020 into the end of 2019. And that just captures the accuracy, frankly, by which the equities markets began pricing in this real recession risk. And that we spoke about in those deeply cyclical sectors.
So we have since moderated. The dovish Fed pivot has done enough right now to offset the policy error concerns. They are telling us they’re going to be patient, meaning there is no pause probably for the next two – well, let’s say this: There is probably going to be a pause through, at a minimum June.
And that’s why you’ve seen a modest steepening again in these curves, in these eurodollar short-term curves. What I think is pretty important, though, is to get a little perspective (Slide 21) of the more traditional US Treasury curves and just get a grasp of where we have come on a larger lookback since, say, 2009 over the post-crisis period. You’re looking at 5s 30s, you’re looking at 2s 10s, you’re looking at 2s 30s – and you get a sense for the incredible flattening that has occurred, which has been by design.
That has been by design because it eases financial conditions, it eases financing costs for corporates to do things that could stimulate growth. That’s what the Fed has been doing with their balance sheet purchases, with their reinvestment plans. That’s what they have been trying to create. Now the market is seeing the impact of the reversal of these policies and we are just now beginning this very nascent steepening.
And that is hyper, hyper, hyper-critical because the shape of the yield curve impacts so many things across the asset spectrum. In particular, I’ve always focused on the impacts that this has within the equities space. Things like cyclicals versus defensives, and certainly a real talking point that I’m going to be focusing on (and I focused on it in my note today) in the months ahead – huge impact with regards to this value-versus-growth debate within the US equities space.
But, yes, the concern, and the trigger, and the more near-term tactical signal is the steepening of the curve. Because that’s telling us the slowdown is here, the slowdown is real. And that, typically, at that point, even though the Fed can have some impact with regards to liquidity provision, as far as softening the impact on the depth of the recession, a slowdown is an inevitability and that’s where we need to watch. Because in prior examples – and that’s what I go over on Slides 22 and 23 – a year before the ultimate risk-off events, you begin seeing the curve steeping begin.
And sometimes it’s less than a year. That’s also important to note.
The CTA Model
Townsend: Okay, Charlie, with that backdrop in place, let’s go ahead and dive in at Slide 9 in your deck to the CTA model positioning estimates that you’re showing now. What is this graph showing us? And why don’t you walk us through the next couple of charts in the deck here?
McElligott: So I think really what I wanted to grab there was not simply just in regards to this capture of general risk sentiment, but also, too, capture this idea that the trend has been very much about a slowdown posture. And of course a CTA model is not worrying about a macro output per se. There might be macro overlays, unequivocally. There could be humans that are kind of tilting the behavior to some extent with regards to exposures.
But, generally speaking, that’s against the point of the quantitative strategy. What this is capturing though, against a backdrop of some other things that I’ll bring up, is that you’ve really seen markets – whether it’s these systematic trend models or a later risk parity or discretionary long-short – pivot into a very risk-off stance. Which is a huge part of the reason that we find ourselves now 270 handles in the S&P off the lows made two weeks ago. What you’re seeing (particularly here, in that top bucket), you see major markets.
It just goes to some of the primary risk asset and key cross-asset securities that can give you a sense for this much more risk-off positioning. You see the max short in the S&P 500 in Euro Stoxx, in Nikkei, the two G10 FX crosses there, eurodollar, euro/US dollar, and US dollar/yen – obviously, the dollar/yen short – both of those expressions are very risk-off there – short dollar/yen and short euro speak to that similar footing in the FX space. And then that middle bucket is looking at rates. So Treasuries, 10-year Treasuries – and you have a max long. Then you look at crude.
Brent and WTI as global growth, consumption, the global economic engine, are also max short. And then you look at gold – and this is, I believe two days old, this snapshot – but gold at basically 50% long position. You look back to the far right column versus a month ago, that was an incremental short. And you see – again, looking in that month prior, that far right column, one month in parentheses – you see, generally speaking, the escalation of this kind of risk-off positioning over the last month. The next bucket down goes just a little bit more granularity across the global equities bucket. And you see the extent, again, of the short positioning. A lot of max short, negative 100s.
However – again, as I highlighted, this was a snapshot, I believe, from Monday morning – you do see that Russell 2000 had begun covering. You see that FTSE 100, Hang Seng, ASX, and KOSPI had all covered from that max short position, which was a precursor that told us that we were getting the ball rolling, that this max short bearish positioning had overshot. And then the right side of the screen speaks to the fixed income side of the risk-off positioning. You recall, for almost the entirety of 2018, one of the most crowded trades on the board for sure was bearish fixed income, bearish Treasuries, bearish rates. It was based upon above-trend growth, above-trend inflation, the tailwinds of fiscal stimulus, of the Phillips curve of labor impacting wage inflation. All of these very globally cyclical bullish phenomena.
Plus the reality of Fed Treasury issuance, where supply – there was going to be this supply shock due to the deficit spend, realities that we touched on earlier – that it was just going to really lean on global fixed income. And by the end of the year – this is always part of my thesis and it goes back to that Chinese credit impulse slide. Once you lose that credit impulse and commodities and inflation expectations and industrial metals and cyclicals versus defensives ratios – those all started coming off because you’re unable to create the demand side into this tightening liquidity backdrop via the Fed’s QT, via China’s deleveraging efforts, via later the ECB slowing their bond purchases and even the BOJ tapering their bond assets. What it ended up doing was create this very real slowdown in the back half of 2018 that got picked up in the very cyclical data, the very cyclical US data as well as global manufacturing data.
I mean, the JP Morgan global manufacturing PMI index is down nine of the ten months. Those types of things forced people into this much more defensive slowdown posture which was the opposite of the bearish rates, bearish Treasuries trade. It was instead max long Treasuries, max long European government bonds, and max long JGBs, and onward from there.
That’s Slide 9 for you.
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Of course, if McElligott's model is once again proved correct, the equity bulls who have retaken the market should probably tread lightly: Because the rally we've experienced so far this month is only a temporary lull...
...and as McElligott warned in one of his earlier notes, there's a whole lot of downside risk left.