Posted by on January 12, 2017 2:53 pm
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Categories: Business Economy European Central Bank Inflation obamacare Real interest rate Reflation Stagflation United States dollar US Dollar US Dollar Index Yen

Having yesterday revealed what he believes is the single biggest risk to the buyside in general, and hedge funds in particular, in today’s market (the answer, for those who missed it, is the strong dollar suddenly turning weak, as it is continues to do today), here is the follow-up note from RBC’s Charlie McElliggott, explaining where we stand now.

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Where We Stand

As laid-out in yesterday’s Big Picture note “THE SINGLE LARGEST MACRO INPUT RISK TO THE BUYSIDE,” as asymmetrically ‘long US Dollar’ positioning ‘tips over,’ so too should we expect a drawdown on consensual macro and thematic-equity trades.

Tactical cases are everywhere for an extension / acceleration of mean-reversion trades, largely based-upon positioning excess and reversing technicals.

As the case has been built over the past month and a half in the “RBC Big Picture,” reversal strategies are a regular feature in the January landscape—especially after such clear trend developed in the back half of ’16 with regards to ‘reflation—those being:’

  • Long USD, stocks, small cap / domestically levered, value factor, cyclicals beta, inflation, high tax rate, HY / high beta credit (CCC over BB), CNH, curve steepeners, copper
  • Short USTs / ED$ / duration, euro, yen, EMFX / EM eq / EM bonds, growth, defensives, low beta / low vol, VIX, gold

As some of the reversion was ‘pre-traded’ in the back-half of Dec, it made sense to us that this January wouldn’t be an outright repeat of the violent VaR shocks experienced in a number of recent Januarys as ‘momentum’ reversed hard and everything from ‘bonds vs stocks’ to equity factors turned upside-down.

That said…the driver for the acceleration of ‘reversal trades’ yesterday into the overnight was the Barnum-esque circus of a press conference yesterday from President-elect Trump

Expectations were built for a more “Presidential” tone, with more granular ‘policy talk’–especially as it pertained to the nuances of the tax plan, fiscal stimulus, and the Obamacare unwind.  Needless to say, we got a “goat rodeo” instead, and it spooked a lot of the TACTICALLY long reflation crowd.

Reflationary growth expectations have clearly been a significant driver of the USD ‘bull case’—but the tax component (overseas profits $ repatriation / border-adjusted tax (BAT) system theoretically driving ~15% currency appreciation) has been a massive-input as well.  As stated yesterday, any resetting of expectations there (“watering down” of the BAT) will see a lower Dollar concurrently.

Sure, spec net Dollar positioning is at 1 year highs.  But even more than ‘just’ the cumulative FX positioning itself is the observation that the Dollar is the “grand unifying asset” of the “domestic growth / reflation” trade theme.  So in that sense, “long USD” is a factor embedded in nearly every one of the aforementioned popular macro longs and shorts.

The idea I have to again stress here is this: nearly all of the gains from these “reflation” trades were “last year’s business.”  Point being, YTD, most of these trades are moving from “not great” to now approaching “REAL negative PNL.”  As risk-managers are highly-sensitive to such start of year drawdowns and we near the ever-present “tight stops,” you have to BOLO for capitulatory flows (perhaps as best expressed by yesterday’s mega-impressive $20B 10 year UST reopening auction which saw a blistering 70% indirect bid, which caused a very significant squeeze in USTs across boards).

It should be noted that thus far, the ‘least’ relatively effected trades have been the thematic and factor trades within the equities-complex.  Reasons for this are ‘three-fold’:

  1. The very tactical nature of discretionary macro (making generalizations here but…) is concentrated on the FX, rates and commods side of the ledger as opposed to equities per se.  Thus, we’re seeing much of the reversal ‘profit-taking’ or ‘unwind’ concentrated in those ‘pure macro’ assets. 
  2. Equities flows are still being largely dictated by the slow-moving rotation of ‘real money’ as they reallocate portfolios after living under the old “slow growth / slow inflation” narrative.  Now we currently see said ‘sticky long-term money’ reallocation into cyclical sectors like financials, industrials and energy, as again evidenced by yesterday’s NYSE MOC with the largest notional sector buys being #1 Financials and #2 Industrials… by a wide margin (“pros on the close”), and has been that way a majority of days in ’17 YTD. 
  3. From a more tactical perspective, with the USD at the center of this unwind, the Dollar weakness has driven WTI higher, which in turn has kept the Energy sector and more importantly inflation-expectations “BID” (per the Quant-Insight macro factor PCA model, higher “inflation-expectations” continue to show as the largest positive price input driving SPX).

The US Dollar index (DXY) has now cracked lower through its 50DMA for the first time since the immediate period post- Election.  The 100 ‘psychological level’ also has some technical significance and is very much ‘in play’ now.  From there, we would have a looooong way to go down to the 100DMA (98.94) and the 200DMA (97.03). 

What can arrest this unwind from ‘metastasizing’ further?  The thing that drove the “true” basis for the “reflation trade” long before Trump won in the first place—the continued-ascension of cold hard global data.  As listed yesterday, the collective trajectory higher of the data has been nothing short of breath-taking, from global PMIs to Chinese inflation to US average hourly wages and ‘animal spirits’ confidence metrics. 

The data still makes a very real case for higher rates in the longer-term, and with it, more US hikes / quicker exits from say the ECB than the market is currently anticipating. Obviously this would be USD- positive.

Tactically-speaking in the ‘now,’ the Dollar reversal lower in this case is helping reignite the commodities bid as well, and with it, inflation expectations remain very strong (see Breakevens ‘strong like bull’).

And of course too, flow will be a massive driver of this: still being told that some in both the ‘overseas real money’ crowd and leveraged fund community would look to fade the rates move at say ~ 2.20 level.  In conjunction with the US varietal of real money rotating “growthier” in equities as well (‘turning the Titanic’ slowly), stocks can remain bid over the coming months (not for nothing, but I’ve had discussions with 3 large distressed credit funds in recent weeks who are concentrating much of the ‘going-forward’ within the equities universe—point being stocks continue to have that ‘best place to be’ perception). 

It still feels like there is another meaningful stocks rally to come, especially after the “positioning excess” is cleared through this “mean-reversion wobble” period.

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Only then can we begin talking about “the big short” around say a “stagflation” or “real rates” financial-tightening trade.


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