As Breakevens Plummet, The Narrative Has Reset

For those following the progression, and most recently - unwind - of the Trump reflation narrative, below are some critical observations from Charlie McElligott, head of cross-asset strategy at RBC.

Big Picture: Narrative Reset

On January 11th, I highlighted the risks developing via a potential breakdown of the USD--specifically as it related to its role as ‘chief proxy’ for the “reflation” trade.  Since that time, we have seen the Bloomberg Dollar TWI -2.4%, and with it, reversals in popular “reflation” trades despite BOTH flat benchmark S&P stock index and US 10Y yields over this period: ‘cyclical’ equities have lagged ‘defensive’ equities / ‘long duration’ significantly; ‘value’ has lagged ‘growth;’ ‘small cap’ has lagged ‘large cap;’ ‘momentum’ and ‘anti-beta’ factor market neutral strategies are significantly outperforming Q4 leaders ‘value’ and ‘size;’ popular ‘long copper’ significantly underperforming popular ‘short gold’;  crowded ‘EM shorts’ squeezing higher (from EEM to EMFX); popular short EUR +1.1% over this window et cetera. 

Again, the thought was that these crowded trades needed to see some of the froth come out…and that is exactly what has happened.  Today we see more of the same, with popular Q4 longs like ‘value,’ ‘high beta’ equities, HY, ‘small cap,’ ‘early cycle,’ ‘copper’ and ‘cyclicals’ all down sharply while popular Q4 shorts / ‘sources of funds’  like ‘long duration,’ ‘low vol’ stocks, ‘defensives’ and ‘growth’ all squeezed higher. 

A current snapshot of market behavior shows us that we are in the midst of a number of ‘other’ large symbolic pivots in the narrative / backdrop

"REFLATION’ BREAKDOWN CONFIRMED VIA ‘BREAKEVENS’: The much discussed ‘reflation unwind’ is now being confirmed by the last holdout of the trade—breakevens—which finally PLUMMETED lower today.  Feeding into this of course is crude, as ‘the’ proxy for inflation-expectations (and S&P energy sector -1.4% on session / -5.2% YTD, 2nd worst sector in the index). 

The downside of the USD firming-up (see next ‘bullet’ below) for risk-assets and the broad ‘reflation’ theme is the point made in recent “Big Picture” observations: crude sets ‘inflation expectations,’ which are a primary macro price-driver input for stocks, rates, credit and commodities (duh).  As the Dollar strengthens now, instead of being a representation of “reflation” as it was at the start of the year…USD now might be transitioning back to a more historical correlation where it is a drag on commodities instead.  This could again change where ‘higher Dollar / domestic reflation’ again “synch” if we were to receive ‘Trump policy clarity’ (taxes) or more robust ‘hard’ economic data that would in turn keep the ‘growth over financial tightening / inflation’ hope alive.

Ironically, to this ongoing point as crude as the most likely factor with regards to both left- and right- “tail” scenarios for stocks, we just received today’s API data after the close with gave us a shocking 14.27mm barrel build (vs a 2.5mm build expected)—which makes the 2nd largest weekly build in US history.  Gulp. 

DOLLAR PAUSES ITS OWN UNWIND, REACCELERATING HIGHER AGAIN: The USD remarkably is now UP 5 days in a row after that initial YTD sell-off which we spoke about up top, proving that its own positioning-excess has ‘come-off’(Mark Orsley today noting that total spec positioning in Dollar futures has been cut by 28% from the recent start of year highs).  This USD-move is largely driven by the move lower in said ‘breakevens,’ which along with ‘nominal yields’ grinding lower again too is helping send ‘real yields’ higher for the first time in weeks.  

Qualitatively too we see a combination of factors helping USD in recent days as well: 1) Fed walking market expectations for a March hike “back up” (Harker ‘pile on’ last night); 2) a growing-sense that a border-adjusted-tax system being included in the eventual Trump tax plan is again pivoting and need by repriced higher by the market (too much debate btwn House and Senate for B.A.T. to NOT be gaining-steam, especially following the ‘upbeat’ Rep. Kevin Brady comments this morning—per the consultants’ language on acceptance between the House and Ryan, B.A.T. probability should be closer to say 70 delta, but taking more time to get over the line with Senate); 3) ECB collective messaging on ‘comfort’ with EUR level and a dovish Draghi yesterday as well as generic EU geopolitical concern pick-up; and 4) very nascent signs of ‘soft’ data converting to ‘hard’ (specifically with regards to ‘labor’ market data, following last week’s NFP print).

NICE PERFORMANCE ENVIRONMENT WITHIN EQUITIES HF UNIVERSE: Ongoing strong YTD performance of the stuff that was essentially a ‘source of funds’ during “peak reflation trade” (‘growth,’ ‘anti-beta,’ ‘quality’ and ‘momentum’ factors all picking-up now after weak Q4’s).  This is indicative of an equities buyside which has increasingly ‘scaled back exposures’ to the ‘pure play reflation’ stuff and ‘thematic Trump policy trades’ which had become extraordinarily susceptible to a rogue tweet or headline.  Instead, exposure to ‘secular growers’ (tech, cons disc or healthcare) or idiosyncratic ‘event-driven’ names instead of ‘pure cyclicals’ is now the largest driver of equity HF performance from a bias-perspective, while overall factor dispersion and correlation breakdown provides an optimal return environment regardless of market direction (the ‘holy grail’ for M/N).  As such, we see that HFR Equity HF Index YTD is +1.4%; HFR Equity Market Neutral HF Index is +1.3%; and HFR Event-Driven HF’s +1.6% YTD.

One challenge going-forward though is the potential of a market breakout higher, where anecdotally I still don’t see a ton of risk-appetite per recent meetings / marketing and PB data on nets / gross.  “Rich valuations” with “Trump uncertainty” / “implementation delays of pro-growth policy” language is the baseline response from clients in US (and the dreaded ‘geopolitical / election risks’ in EU), which speaks to a ‘pain trade’ melt-up scenario being highly-likely as positioning data still shows that many are begrudgingly along for ride with only one foot in the water.

NOT-SO-MUCH FOR MACRO AND SYSTEMATIC HEDGE FUNDS THOUGH: The ‘reflation trend’ had been your friend in 4Q16 for macro funds, where there was a clear trade on post the Trump election, which added gasoline to the fire of “higher USD, short USTs / ED$, long small cap / high beta cyclicals, long crude, long copper, long CNH, long HY credit, short EM, short gold, short Euro, short Yen’ trading.  All the stars aligned, and collectively, Nov and Dec were the best back-to-back months in YEARS for macros. 
 
Then January of this year turned so hard that even scaled-down ‘long USD’ –related trades came off and took performance with it.  Now we chop on absolute index levels by-and-large, while the particulars under the surface (thematic rotation) drive the real returns…NOT DIRECTIONAL BETS / MOVES ACROSS ASSET-CLASSES.  Not for nuthin,’ but the same dynamic hurts CTA / trend-follower / systematic funds.  Not surprisingly, HFR Macro is -0.6% YTD, while HFR Systematic is -1.3% YTD and SG CTA Index is -0.5% YTD.  And we’re now seeing a number of high profile ‘brand name’ macro funds with January data that is worse than the above.
 
VOL BLEED EATING INTO ALPHA: Comments from two separate clients today on protection / directional vol bets dragging on performance:

“Seems like people getting crushed owning vol for a move.”
“Can’t have any premium on…realized vol just continues to bleed away.”

Despite the seeming rationale behind the generic refrain--“Is Donald Trump an 11 vol President?”—it seems that the potent-mix of +++ economic data making a case for 3 hikes (especially jobs, inflation and “soft data” per “animal spirits”) and /or a Fed looking at the risk of being ‘behind the curve’ in light of potential fiscal stim, along with the overall central bank shift away from flattening yield curves is allowing for dispersion of returns (on both the asset class as well as sub-asset class -level) to run like we haven’t previously experienced in the post-GFC era.  Interest rates are again being allowed to move per market forces--at least in the US—and as rates volatility suppression became the calling card of the QE era, interest rates as the ‘vol trigger’ mechanism within modern market structure / asset management is slowly being reset.
 
MISSION-CRITICAL FOR RISK-ASSETS GOING FORWARD: As stated, ‘soft’ data has to convert to ‘hard’ data in the coming months or else; not-just ‘reflation’ trades, but the backdrop for risky-assets in general, gets very mushy.  If the ‘hard’ data can’t see follow-through, the basis for much of what was touched-upon above gets tossed: the Fed would then again possible lower their dot plot as hiking expectations are reset; the rotation into cyclicals and “stuff that works in a higher rate environment” gets reset (exposing everything from financials to industrials to value to HY to bank loans), and we begin talking about the dreaded “stagflation” (remember to watch BE 2s10s curve inversion).
 
See below—first chart is the Bloomberg US Economic Surprise data category ‘breakout’ showing a snapshot of “soft data driving the beats” from Jan 30th.  The second is post- today’s data, which shows that the extent of the ‘soft’ data beats is declining, but against a move higher in ‘labor market’ beats (last week’s NFP).  The downside?  Retail and wholesale sector misses accelerated as an offset.  Stay tuned….

JPM: "Turning Points In Market Trends Are Occurring At The Fastest Pace In History"

Ever get the feeling that the market has become frustratingly fast in responding to new information, with violent swings in either direction coming ever faster even if ultimately the "BTFD" mentality always seems to prevail? Well, it"s a fact. 

As JPM reports in a new analysis, citing quantitative and qualitative metrics, markets have become more macro driven and react faster to the new information. A qualitative example below shows the reaction time for recent major events (August ’15 selloff, Brexit, US Election, Italy Referendum) that has compressed from weeks to hours (Figure below).

In empirial terms, this means that quantitatively, we are noticing a higher density of market turning points. The next figure shows the average variability of asset trends (averaged across major asset classes) that show turning points occurring at the fastest pace in recent history (~30 years).

Given the engagement of central banks with markets and geopolitical developments, it should not be a surprise that markets are more macro driven. Furthermore, thanks to the ubiqutous presence of collocated HFTs, which respond to to headlines in microseconds, not to mention that information is created and consumed at a much faster pace than e.g. a decade ago (think of twitter, smartphones, etc.), the market is generally much "faster."

As JPM"s Marko Kolanovic also points out, "an emerging class of fully automated quant strategies is also likely speeding up the market reaction – these strategies process and trade on new information (e.g. feeds from tweets, press releases, etc.) in real time. Finally, we now live in a world in which everyone is a momentum chasers. As a result, the increased popularity of trend following strategies is also likely to contribute to shorter and faster trends, as strategies react quicker and lead to potential over/undershooting of fundamentally justified levels."

What are the implications of this fast-moving market? Some further thoughts from JPM:

Macro investors cannot ignore these developments, as they will need to react faster, compete with machines, and will be left with more risk in the form of market turning points. CTAs provide a good illustration of the direct of impact of quant strategies on asset flows. Figure 7 shows estimated equity flows, and Figure 8 estimated bond flows (the red line is actual exposure of a broad CTA index to the asset class, i.e. fund beta, and blue line is our model based out-of-sample forecast of the same position – note close correlation between the two). In 2015 and early 2016 these investors took substantial positions in equities, and the recent shift from a record long to short bond position contributed to a widening of bond yields.

Fundamental stock investors cannot ignore quant strategies either. Stocks are increasingly driven by (market neutral) factor exposures at the expense of fundamental drivers. Figure 9 illustrates this for one particular low volatility stock (JNJ, correlation to sector vs. correlation to low vol factor). Ten years ago, JNJ stock returns were entirely driven by sector fundamentals, but currently half of the stock’s returns are driven by factor returns (low vol factor). We also notice an outsized impact of stock returns around quant rebalances that typically occur at the end of the month (and first week of the month). Figure 10 shows that probability of a large move for stocks in a momentum portfolio are up to 3 times as large during turn of the month rebalances, as compared to other days in a month.

That said, fast moving markets are becoming a problem for everyone, not just macro investors. Stocks are reacting quickly to news, which leaves human investors less time to act. An example is earnings announcements where stocks immediately adjust to a price level and there is very little post-earnings drift. Figure 11 shows the size of earnings moves (normalized to ~3%) that are realized as gap moves (as opposed to post earnings drift) over time. Note that over the past decade, earnings drift has largely disappeared as stock prices adjust instantaneously. Similarly, market correlation started exhibiting strong seasonality – they are high outside of earnings season, and quickly break down at the time of announcement. This seasonality is further exacerbated by the increase of passive assets that drive correlation higher (outside of earnings season).

Furthermore, the ongoing mega-shift of funds from active to passive strategies continues to distort the "efficient market."

According to JPM, the level of passive indexation reached all-time highs with estimated ~35% of equities invested in capitalization weighted indices (up from ~15% 10 years ago). If indexed assets are relatively small, passive investing is a great cost-effective strategy. Passive investors are effectively piggy-backing on the most efficient, optimal, market portfolio. However, if the asset base becomes too large, passive investing may prevent market efficiency and lead to a misallocation of capital (large companies get larger, and small ones do not have capital, regardless of fundamentals). A large increase in passive assets can also cause distortion of valuations (e.g. favoring momentum vs. value, large vs. small, etc.). Investors are increasingly asking whether the current level of passive assets is already a problem for markets, and even the economy as a whole.

Figure 13 shows the recent trend in passive vs. active flows, and Figure 14 shows the increase in passive equity assets (as a % of total equity assets) as well as the number of companies listed in the US (on an inverse scale). There is a significant negative correlation between the number of new listings and size of passive assets. Although the correlation between the two is highly significant, this does not necessarily mean that passive assets caused this decline of new listings. The trend of capitalization weighted indexation may peak and start reverting over the next few years, especially if factor and stock dispersion cause broad capitalization weighted indices to underperform.

What is the preliminary conclusion? Well, for human investors competing with algos, robots and "Artificial Intelligence", will become even more difficult, not least of all because so much capital has shifted and continues to flow from active to passive strategies. As a result, ordinary, carbon-based investors will find they are increasingly at a disadvantage, even as the market drift from "fair value" continues to grow, making a major market "repricing" event increasingly more likely, while assuring that the losses for active market participants, mostly of the electonic variety will be dire.

Unfortunately, with few regulators able to grasp the major shift below the market"s surface, and especially now that deregulation is about to sweep Wall Street, there is little hope any of these concerns will be addressed until it is too late. In the meantime, prepare for markets that keep getting even faster, even more micro-volatility, even if the BTFD impulse continues to prevail until one day, the disconnect is just to great and the long overdue "mean reversion" event finally kicks in.