Authored by Chris Metli, Head of US Quantitative and Derivative Strategies at Morgan Stanley
Economic data is deteriorating. Earnings growth is negative. Trade risks are high. But these facts are well known by the market.
There has been a massive flight to quality over the last year, and equally important, correlations between all of the long safety/short global growth trades is at historical highs. Crowded bearish positioning means that the asymmetry in equities is to the upside, even if the base case should be for more downside. A positive growth catalyst would be highly disruptive to portfolios for many types of investors, and playing for the unwind of ‘flight to quality’ is the most convex trade in the market today.
Defensive positioning both across asset classes and at the thematic long/short level within equities is extreme: Over the last year a net $550bn has moved out of equities and into bond and money market funds (larger than in 2016).
A net $80bn has moved out of cyclical and value ETFs and into defensive sector, high div, and low vol funds over the last year (dwarfing the safe haven bid seen in 2016).
The gap between Growth vs Value positioning for L/S Hedge Funds is the widest it’s been since at least 2010 and equity L/S HF net leverage is in the 11th percentile since 2010 per the MS PB Content Team...
... while gross leverage is in the 79th percentile – indicating that there are plenty of shorts that need to come off should views on global growth change. And factor valuation spreads are at extremes.
The defensive rotation started in 3Q18, and US Equity Strategist Mike Wilson has been recommending this trade since June 2018(1). But what really stands out in 2019 is the fact that correlations between the consensus flight to safety trades, both within equities and across asset classes, has increased to levels last seen in 2016 and 2008.
In 2007/8 flight to safety was the right trade, but in 2016 it was not. And in the event 2016 is the right playbook, as one trade comes off, they all could.
As MS Cross Asset Strategist Andrew Sheets notes(2), “If better growth data boost yields and steepen the yield curve, this could support a major rotation away from growth and quality towards value and lower-quality stocks. This is a rotation that active managers are generally positioned against.”
To be clear, we aren’t necessarily calling for this pro-growth rotation to happen – betting against current consensus positioning is convex for a reason: it’s a low probability event. And there’s good fundamental reasons for the flight to safety to continue: macro data is decelerating with global manufacturing PMIs moving further into contraction for the second consecutive month...
... and the Morgan Stanley Business Conditions Index moving down to 17 in August (~2008 levels), earnings revisions breadth remains negative, and trade risks remain high.
But there is a possibility (even if low probability) of a return to growth. The consumer remains strong and a surge in mortgage refis this year could potentially boost spending. Both the Empire and Philly Manufacturing surveys recently surprised to the upside, despite survey periods that covered the latest trade re-escalation.
And governments are floating fiscal stimulus ideas (why not when money is free?) – a 50bn Euro stimulus from Germany, payroll tax cuts in the US, and lifting the annual quota for local government special bonds in China to fund more infrastructure spending. And against this backdrop global central banks are easing financial conditions. While an improvement in growth could change that trajectory, investor sentiment and markets can turn faster than central banks can turn more hawkish.
Given the low probability but high potential convexity of a move, the best trade to position for or protect against a pro-growth rotation is to buy calls on the ‘unloved’ areas of the market: Cyclicals, Small Caps, EM, Value, etc.:
- IWM has high leverage to rotation given its Value vs Growth exposure and implied volatility is cheap. Buy IWM Oct 160 calls (15 delta) for ~45 bps. Small caps have underperformed large caps and returns relative to the S&P 500 are back to 2003 levels. IWM implied volatility relative to the SPX is in the 9th 10-year percentile. And relative to the S&P 500, Russell 2000 is overweight Value and underweight Growth by the most since at least 2006.
- EEM implied volatility is cheap and upside skew is steep. Buy EEM Oct 43 calls (15 delta) for ~60 bps. Emerging markets have suffered from trade disputes and a stronger dollar and have seen steady outflows in recent months ($17bn out of EM ETFs since May’s peak in flows) as investors seek the relative safety of developed markets and the US. Implied volatility is cheap relative to the SPX at the 3rd 10-year percentile, and upside skew is steep (i.e. calls cheap) at the 70th percentile.
- Growth vs Cyclicals is a consensus trade and at risk – short MSZZGRCY, or buy 3m 105% calls (38 delta) on Cyclicals (MSXXHBC) for 3.25%. Growth has outperformed Cyclicals by 40% over the past year and is at risk of reversal in the event of a pro-growth rotation given the positioning laid out above, above-average valuations (60th %ile) and long crowding in the secular growth trade. Shorting Momentum (MSZZMOMO) has similar characteristics given a high (~75%) correlation to Growth vs Cyclicals.
Notes: All pricing indicative
- It's More "Risk On" Than You Think; Upgrading Utes to Overweight, Michael Wilson, June 18, 2018
- What Would Make Us More Optimistic?, Andrew Sheets, Aug 18, 2019