By Charlie McElligott, MD at Nomura Cross-Asset Strategy
Hints Of Transition To “Late Cycle”/”Pre-Recession” As Key Levels Hold
- Rates flows showing no urgency to cover from shorts / no urgency to ‘dip toes’ from real money/little-to-no gamma- or convexity-hedging = still room for USTs to go lower
- Yet 3.2% in 30Y UST yields holds early—a reversal LOWER in rates would skewer much cross-asset thematic positioning
- Equities rallied on “still easier” financial conditions with flattish “real rates” and MUCH weaker USD
- However, an early test of 2720 “congestion” / resistance in ES1 has failed
- SPX and Volatility analogs tell similar story: re-test of equities lows is likely coming, followed by a rally looking-out on 3m / 6m basis
- “Late-cycle” indications from the CPI ‘particulars’—alongside rising yields—are the “playbook” for weaker US Dollar from here
- Typical “late-cycle” / “pre-recession” behavior would tell investors to avoid expensive stocks as “Value” outperforms—potentially meaningful confirmation of where the economy stands
First—a few levels of note worth reiterating: 2720 in SPX and 3.20 in UST 30Y yield, both of which have ‘held’ so far this morning.
Regarding yesterday’s selloff in USTs, comments from our Rates team were extremely telling from the positioning perspective, in that there was very little “stress.” My outstanding colleague Darren Shames noted that the shorts were in no rush to cover, communicating high conviction that yields still have more room to move higher. Real Money simply wasn’t there, feeling like there is still more move to shake out / better entry-points, potentially eying that ~3.20% level in the 30Y that has held since 2014. Darren too mentions that convexity hedgers were present to a certain extent, but by no means forcing the flows—even at the worst levels of the day. When viewing that alongside his observation that dealer gamma hedging flows too were negligible, it indicates that the “sellers are lower” supply still has yet to be seen (although notable that ~7k futs traded overnight as yesterday’s 120-08 low in TYH8 was breached—looks like a “stop loss”).
As previously stated, it’s the move in “real rates” that risk traders need to keep an eye on. My yesterday afternoon piece focused on this, because despite the move in nominal yields, the “gap” move in inflation expectations (thus the widening in breakevens) actually kept “real rates” stable on the day. This in turn provided relief from the recent equities-theme of the negative impact of “tighter financial conditions.”
However, I REALLY think that it was the USD breakdown which provided the most relief for US equities. The Bloomberg Dollar Spot index sits on the cusp of breaking-down to a new 3.5 year lows with a frightening amount of room to fall (no support til 1065—the 76.4% retracement of the 5 year BBDXY rally—which is another -4.5% move).
What drove this next leg lower in the “short USD trade,” especially after the better inflation print? Well…outside of the Retail Sales clunker, it’s a larger view of what the particulars of the inflation report said about the status of where the US economic cycle is (hint: late-stages).
Essentially, the pace of the inflation running at a 2.9% annualized rate over the past three months (strongest since ’11) is a “tell,” while too seeing previously-lagging sectors like “medicare costs” finally pivot-higher speaks to this turn in “late-stage-cyclicality.” So as we move a “new world” of higher-rates in conjunction with “end of cycle,” this is a potent cocktail for a major beatdown in the prospects for the US Dollar from here.
So as it pertains to stocks then, a few points:
Big picture and as previously referenced, SPX is now in that “congestion zone,” and earlier this morning touched—and failed—at that 2720 resistance I noted. Today’s flows / opening print might indeed chase it back up, but I’ll be watching to see how much institutional “follow-through” there is here, as I continue to see potential for a fade.
Anthony Antonucci has run a number of evolving “market shock” analogs (TWO -3.5 SD ‘down’ moves followed by a +2 SD move ‘up’) and, on average, the market re-tests lows within a month. From there however, we form a “tradeable-bottom” and travel higher on a 3 month basis. The sample-set isn’t terrible either—7 examples—1946, 1966, 1970, 1973, 1987, 2011 and 2015. Anthony also notes that “…the highest correlation to this current period on SPX returns is Aug11 2015 and yes we rallied for next day or 2 (2739) and chop and a few weeks later we test the lows and rip again.”
Volatility also tells a similar “sequencing” story in that “volatility spike and reset” analog looks similar to the “chop then higher” story. Looking at the VXO (the OEX VIX which has a longer history), we looked at scenarios when the index trades above 30 then sells off more than 50% as the market rallies and vol comes in.
The message here from these analogs?
That I think you’re gonna have another chance to buy stuff lower, before another rally off the back of a “tradeable bottom”…and more importantly, that higher volatility / “chop” is “here to stay.”
* * *
Thematically as it relates to the “late-cycle” commentary above, it was notable to see “high beta” / “cyclical beta” to perform the way they did (e.g. a basket of ‘beta energy’ closed +4.2% on day; ‘high beta’ basket was +2.8%; leveraged balance-sheet +2.4% / high default risk +2.3%). Generally-speaking, you’d expect to see “Value” again start working in a “late-cycle” / “pre-recession” backdrop (acknowledging of course that this “pre-recession backdrop” classification will be viewed as controversial–but by the NBER economic cycle “definition,” it’s the phase which follows “pure expansion”). The trick or “issue” however is that this stuff has been a lot of the underweight or short in the market.
A study by O’Shaughnessy Asset Management on factor performance over the business cycle notes the underperformance of ‘expensive’ stocks versus ‘cheap’ ones in the late-cycle phase, aka “Value” factor market-neutral performance:
“Striking in the Pre-Recession periods is the strong high-low spread for Value of 17.8 percent, which suggests that investors shun expensive stocks when economic growth is in question. In fact, across the various regimes in our study, the low Value (expensive) decile excess return of -12.4 percent is the lowest. The trend of expensive stocks underperforming starts well in advance of an official recession and extends through the early recovery Post-Recession regime.Not only do these stocks deliver poor excess and absolute return, they tend to exhibit extreme volatility. While high Value (cheap) stocks had a standard deviation of just 14.8 percent annualized, low Value (expensive) stocks had a standard deviation of 30.3 percent.”
Thus, I’m watching “Value” performance as closely as ever—either as another “false dawn” or as an indication that investors are beginning to transition into “late-cycle” / “pre-recession” positioning.