"Something is off," warns RBC's head of cross-asset strategy Charlie McElligott in the introduction to his latest market noting that the swing in US fiscal policy optimism is coming at a critical time as the China's liquidity tightening is spooking the reflation story.
SUMMARY:
Movement on US fiscal policy is currently driving US rates and equities higher, counteracting the tremendous negative implications of this ‘Chinese tightening / deleveraging’ story and the impact this is having upon commodities (industrial metals & crude) and thus, ‘inflation expectations.’
‘Connecting the dots’ between the crude oil / commodities selloff and a strong (negative) reversal in ‘mean reversion strategies’ both cross- and inter- sector (energy) within equities, as well as notable drawdowns in ‘momentum’ market-neutral strategies over the past few weeks.
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FISCAL POLICY OPTIMISM SWING COMES AT CRITICAL TIME, AS CHINA LIQUIDITY TIGHTENING STORY IS SPOOKING REFLATION:
The big +++ story overnight: Republicans are planning a ‘make or break’ vote on the ACA repeal today, as the GOP feels they now have the votes to pass the Trump campaign healthcare promise. This sudden swing to ‘movement’ / optimism speaks to the ‘pessimistic overshoot’ seen across the Street with regards to the consensually negative view on ‘fiscal policy’ implementation, following the administration’s / Republicans’ self-inflicted wounds of the past few months.
NOW, this opens the door again to not just tax reform (as it creates a much more benign revenue ‘starting point’ for tax-cut offsets), but potentially infrastructure as well, which might too be bundled into the tax plan. Yes, none of this is ‘imminent’ per se, but the sentiment-inflection here is swift and of extreme importance to the ‘reflation’ trade.
As such, equity futures and US nominal rates are currently holding higher, despite what looks to be a total breakdown in crude oil and commodities turning outright ugly now.
And today is seeing the move accelerate...
with the biggest single day drop since Nov 2016...
This newly-found ‘US fiscal policy optimism’ could not have come at a better time for the ‘reflation’ camp, who have been sweating bullets in recent days because our much-discussed ‘Chinese tightening / deleveraging’ theme is playing-out real-time and wreaking havoc on global commodities--particularly with industrial metals (Dalian Iron Ore limit-down overnight -8.0% and reopening down another -5% today). Look at the carnage on the Shanghai Futures Exchange, particularly in the MTD / QTD columns:
This comes following the total meltdown in copper (-4.0%, and another -1.7% move this a.m.) during yesterday’s US session, while too we see the breakdown in the crude oil complex accelerating with WTI making YTD lows this morning while falling through its trend-support line dating back to last August. BHP and RIO are the proxy for the breakdown in the equities-complex (while a popular US equities ‘inflation’ basket is crushed a massive -4.3% over the past five days), while too we see China- / resources- levered AUD come unglued in the FX space, now -2.3% month-to-date despite a very ‘meh’ USD. At the same time, we’ve now seen weaker Chinese Manu PMIs and Caixin Composite PMIs over the past week, in conjunction with an ISM Manufacturing misses in US.
All of this is tied-into the enhanced Chinese efforts to deleverage the economy via ‘measured tightening’ (higher money markets rates—see O/N SHIBOR again making new 2 year highs last evening) and reduced liquidity (net removals as MLF loans roll-off versus now-smaller / not offsetting RR cash injections and OMO’s). In conjunction with these quantitative efforts, the Chinese are also ‘cracking down’ on shadow financing and wealth management products, both of which participate in the liquidity / commodity-price feedback daisy-chain (to my point yesterday and in the past on higher short-term rates acting as ‘margin calls’ on ‘commodities as collateral’ financing trades).
Mark Orsley and I have been working on a “Chinese Liquidity Monitor” which tracks the PBoC’s various measures (repos, reverse repos, OMOs, SLFs, MLFs, Pledged Supplementary programs)—see below. The key point here: it’s not just the sharp decline in the ‘rate of change’ of PBoC ‘lending’ / ‘financing’ / ‘credit creation’….it’s that liquidity is being outright REMOVED.
It makes total sense too—the Chinese have recently used the ‘air-cover’ of the Fed’s own tightening to conduct their own--so the current timing is perfect, as a June FOMC hike became that much more of a ‘lock’ after yesterday’s hawkish message was successfully delivered (looking through the Q1 data softness as “transitory”).
The simple fact is that global liquidity--and thus, financial conditions as well--are tightening.
US real rates are gapping-tighter, as 5Y TIPS yields have swung from -24bps on April 12th to this morning’s +13bps. 3m LIBOR has MORE THAN DOUBLED since June and currently sits at highs since March 2009. As mentioned earlier, overnight SHIBOR printed another new 2 year high, same for Chinese 10Y government bond yields. US nominals are back approaching the upper end of their recent range as well. Yes, if this was a pure reflection of growth, it would be an outright ‘risk-asset positive.’ But it’s much more nuanced than that, especially from the Chinese ‘demand driver’ impact on the global economy. Tighter financial conditions à slower growth à lower inflation.
From a risk-perspective though, this is then counter-balanced via by-and-large ‘still expansionary’ global PMIs, BIG corporate earnings growth and now, into the aforementioned (and SUDDEN) positive uptick in sentiment around US fiscal policy movement. If fiscal can re-jigger ‘animal spirits’ (especially on the ‘optimism’- / confidence- side), then it becomes much more attractive to put those ‘reflation trades’ back on (rates shorts, long cyclicals / banks / value factor, potential to re-load USD length as well). To this point, I will continue watching that 2.40 / .45 level (smack-dab btwn 50- and 100-dma’s in UST 10Y yields and the overhead resistance level since late-March—H/T Mark Orsley)…while still feeling confidence that this ‘Chinese tightening’ story (and the impact it is have on commodities and thus, global inflation expectations) will keep US rates ‘anchored’ despite the Fed’s hiking intentions.
NOW LINKING THE ABOVE ‘COMMODITIES / CRUDE DISTRESS’ INTO A NOTABLE DEVELOPMENT IN EQUITIES FACTOR MKT NEUTRAL:
In yesterday’s note, I pointed-out particularly acute ‘unwind’ price-action in US equity 1m ‘momentum’ factor market neutral strategies seen on Tuesday—as ‘momo leaders’ were splattered, while ‘momo losers’ squeezed sharply-higher. We have now seen a ‘clustering’ of 1.5- to 2.0- standard-deviation drawdowns in the strategy over the past few weeks (almost dating-back to the start of the quarter frankly), which is anecdotally quite atypical in a ‘flat to up’ intraday tape. It would be safe to surmise that there is either signaling a rotation that is playing-out in the market, or conversely, an unwind of some sort.
Looking back to the start of the quarter though, we haven’t really seen that sector- or factor-level rotation generally-speaking, as thematically, ‘growth’ factors / sectors continue to lead, while at the bottom, we see cyclicals / value / anti-beta still lagging, as they have all year. But if looking at a strategy such as ‘prior quarter mean reversion’ you begin to see something interesting.
This is crude, but using a simple ‘Q1 mean reversion’ proxy (deployed in Q2), where I go long Energy (worst perf S&P sector Q1) vs short Tech (best perf S&P sector Q1), I see significant signs of ‘stress’ or outright unwind in recent weeks. The above portfolio run $-neutral has experienced a near 5% swing over the past 3 weeks, with the loss doubling over the past week alone--it’s likely this ‘rate of change’ that is the problem from the risk management perspective. This of course correlates with the breakdown occurring in crude oil, as WTI is now -11.8% over the past three weeks.
Sector-specific within energy, you see signs as well. Energy equities trader Ryan Businski noted the following ‘unwind’ behavior across Texas shale plays: “Seeing long sales across the Niobrara names today forcing unwinds/covering in Bakken names. WLL, OAS, CLR rallying with no news Bakken related.”
With the sector now -10.4% YTD within the S&P / -20.3% within the Russell, alongside a lot of talk in recent-weeks of a number of multi-manager shops shuttering energy books, I feel comfortable in stating that somebody’s ‘mean-reversion’ strategy (likely a stat arb / quant fund) has triggered ‘stop outs’ as the underlying commodities space now ‘catches down’ to the behavior already exhibited across the energy equities space throughout the course of 2017.