With everyone suddenly back on the deflation (or un-reflation, or disinflation) bandwagon, is it possible that the crowd will once again be caught wrongfooted? According to RCB’s Charlie McElligott the answer, not surprisingly, is yes and in his latest market note, the cross-asset strategist says ignore the noise coming out of the Fed and focus on China instead. He explains why below:
I Further build the case for a tactical factor-reversal trade (1-3 month scope), where on account of a number of ‘higher rates’ macro catalysts and quant seasonality trends, I see scope for ‘Value’ and ‘Size’ to reverse their recent underperformance relative to ‘Anti-Beta,’ ‘Growth’ and ‘Momentum.’
The latest data-point strengthening my view on the trade is the positive impact that the past few weeks of PBoC liquidity injections are likely to have on the industrial metals complex, which in turn will further feed through to ‘inflation expectations’ as a POSITIVE driver, capable of arresting the recent breakdown there. This in turn would act as a catalyst for higher rates which can ultimately inflect popular ‘slow-flation’ trade positioning.
The case I’ve been making over the past few weeks + with regards to catalysts for ‘higher rates’ driving a tactical trading opportunity INTO ‘value’ and ‘size’ over the next 1-3 month window, in my humble view, continues to strengthen.
To revisit the thesis and catalysts for a reversal ‘higher’ in rates how it would drive a reversal in the equity factor m/n leadership regime:
- Consensual Narrative: ‘Slow-flation’ outlook (collapsing inflation expectations and downward US data trajectory) has now capitulated and nearing ‘all-in,’ driving potential for US rates to overshoot to the downside / risk of a reversal higher in US rates
- Macro / Factor Relationship: Significant ‘positive convexity’ with ‘Value’ and ‘Size’ factors (the QTD- and YTD- worst performing 12m factor mkt neutral strategies I track) and ‘higher nominal interest rates.’ Conversely, there is significant negative sensitivity with ‘Anti-Beta’ (‘Low-Risk’)- and ‘Growth’- factors in the face of ‘higher rates’
- Stretched Positioning: Crowded ‘Slow-flation’ narrative means crowded trades: ‘risk-barbell’ approach from the long-side of + ‘Secular Growth’ and + ‘Defensives / Bond-Proxies’ against short / underweight ‘Cyclicals’ and ‘Small Caps’ popularity of positioning is being ‘proved out’ by factor / strategy performance data, and leaves it exposed to ‘tipping over’
- Macro Seasonality: 1) ‘US data beats’ (higher) and 2) ‘US 10Y breakeven inflation’ (higher) as ‘higher rates seasonality catalysts’ commencing in July and into back-half of year on average over the post-GFC era
- Trade Location: Opportunistic ‘entry points,’ as both ‘Momentum’ and ‘Anti-Beta’ market-neutral (12m) strategies see their best monthly return in June on average over the past 15 years as set-up for this ‘reversal’ strategy
Compelling, I think.
In addition to the above thought-process, I’d highlight a separate point I made on Tuesday regarding the recent “flinch” from the PBoC with regards to a recent LIQUIDITY INJECTION pivot via OMO’s and the MLF, where the past few weeks have seen the most ‘cash’ into system since the ‘standard seasonal injection’ period prior to the Lunar New Year holiday (dwarfing this week’s small net withdrawal of 60B yuan by 8 x’s) which I believe has been ‘lost in the wash’ for many in Summer holiday season. Posit:
At the same time, Chinese money market rates have turned lower (“less tight”) this week: overnight SHIBOR is -8bps on the week; yd repo is -22bps (!) from the Tuesday highs; 1y govt bond yields -13bps on the week.
As much as both Mark Orsley and I have been highlighting since March that PBoC deleveraging efforts were the root cause of the “fading global inflation impulse,” this is a clear example of even-just a short-term policy pivot which is RE-FLATIONARY, especially in conjunction with the Yuan on pace for its largest weekly drop in three months. That’s a ‘pro-inflation’ double-whammy.
The purest expression of this turn is Qingdao Iron Ore, +6.4% since mid-last week as the liquidity injections kicked into ‘high gear,’ breaking the three month downtrend as highlight by Mark yesterday.
Tactically-speaking, this has the potential to be a BIG deal for short-term direction of rates and risk assets, even if ‘just’ an ‘oversold bounce’—as both are dictated by ‘inflation expectations,’ specifically with ‘Iron Ore’ as chief proxy / factor variable.
I will now turn to the QI macro factor model and BASH YOU OVER THE HEAD with the ‘’sensitivities’ across key assets / equities factors / themes with regards to ‘Iron Ore’ in-and-of-itself, and broad ‘inflation expectations.’ With regards to the ‘factor reversal trade’ I am proposing above as well, the below ‘sensitivities’ are the ‘convexity’ I am speaking-to:
US 10Y Yields—
US EQUITIES FACTORS
US Equities ‘Value’—