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RBC's Story Of The Day: "Reflation Trade Back On With A Vengeance"

As noted this morning, there are three drivers to today's action: i) last week's Trump promise of "phenomenal" tax cuts, ii) tomorrow's Janet Yellen testimony before Congress in which she is expected to sound hawkish, and iii) the overnight end of China's reverse repo drought which injected CNY100 billion in liquidity in the banking system after a 6 week pause. It is these three that prompted a return with a vengeance to the "Trump Trade" euphoria, which as RBC's Charlie McElliggott writes in his intraday note, is why the "reflation trade is back with a vengeance."

Here is the head of RBC's cross asset desk explaining why after a few weeks of radiosilence on "Trumflation, the reflation trade is back on.

REFLATION BACK WITH A VENGEANCE AS POSITIONING-EXCESS REMOVED

From an ‘event risk’ perspective, the double of Tuesday’s Janet Yellen’s Humphrey Hawkins testimony commencement and Wednesday’s US CPI release I believe should set the table for another weekly grind higher in US rates.   It seems to me that the risk into HH is that due to data supporting the case to reach the Fed’s Congressionally-set mandates, Yellen will lean ‘hawkish’ and keep ‘3 hikes in 2017’ on the table—especially in light of ‘pivots’ towards the tighter end-of-spectrum from other Fed members.  The market’s current ~20% OIS-implied probability for March should likely be closer to a coin-flip as well (and is now ticking-higher as we speak).  

In conjunction with expectations for annual inflation to hasten at the fastest-pace since 2012 w/ Wednesday’s CPI data—as well as this latest ‘burst’ of Trumpian reflationary “animal spirits” (via the tax-plan talk) and China’s resumption of reverse repos overnight (in a symbolic reversal of the recent tightening trend) which bled-through to a major commodities rally (see next bullet)—I’d expect nominals to stay on the defensive this week. 

  • Popular macro / “reflation” trade positioning in general is getting “cleaner” as excesses with the Dollar longs, UST shorts and Crude and Copper longs have come off from the most extreme levels in recent weeks.  Most critically, the USD is in a better place again after 5 weeks of capitulation.  With the expectations on the aforementioned inflation data and Fed willingness to stay on message re ‘3 hikes,’ watch for ‘long dollar’ trades to reaccelerate again.
  • The Chinese reopening post Golden Week was an absolute doozy, boosted by the aforementioned ‘symbolic reintroduction’ of PBoC liquidity reversal into the market.  The hottest action was in the commodities space—Qingdao Iron Ore closed +6.5%; Rebar +3.3%; Shanghai Copper +4.9%; Zinc +3.5%; Lead +3.5%; Rubber +5.1%; Zhengzhou Cotton and Aluminum both +1.7% etc.  On the equities-side, MSCI China is now +13% off its Dec lows, with 85% of stocks in the index trading above their 200dma.  HS China Enterprise Index was +1.3% on the session, with Shanghai Comp +0.6%, CSI 300 +0.7% and Hang Seng (HK) +0.6%.
  • Not surprisingly with the Commods strength, we see EU equities sector leadership from the cyclical spaces—Materials and Industrials specifically.  Overall, the 5-day winning streak for the Stoxx 600 is the longest of the year, as EU equities longs continue to grow in tactical popularity due to +++ data trajectory, generally light positioning (overstated political risk) and still supportive monpol continues to make the space attractive (or perhaps even more attractively, short EGBs and their artificial QE-induced levels vs very strong actual economic data)
  • US stocks are obviously continuing their late last week melt-up for fundamental and mechanical reasons beyond the just the “phenomenal” tax plan one-liner though.  Higher nominal rates from better data and a return to earnings growth push--while a significant short-gamma profile at 2325 from dealers, along with a buyside choking on Q1 ‘long vol’ tactical trades into expiration, mechanically pull equities ‘up and to the right.’  Clearly the rejuvenation of “reflation” off the “phenomenal” tax-policy “Hail-Mary” last week is again extending the ‘cyclical-beta’ / ‘value’ / ‘size’ (small over large) trade.  Of course too, the move overnight in Chinese commodities and EU equities have set the table for perpetuation of these thematic “reflation” stories. 

This re-rack in “reflation” through “value” factor comes at an interesting time, as it’s been “growth” in the US which has truly provided the equities leadership YTD within the US stocks universe—Tech +7.2% (led by software, cloud, semis), Consumer Discretionary (think internet retailers) and Healthcare +4.1% (biotech, medtech).  Thus, NDX +7.5% YTD vs SPX +3.5% and RTY +2.3% going into today’s session.  This too has benefited equity HF fund performance, as 4Q16 filing data shows over 27% of AUM was held between the (“growth”-laden) Tech and Consumer Discretionary sectors alone. 

That said, today’s sector leadership is all ‘value’ though, so it creates some inherent market underperformance for many books: Financials, Industrials and Materials are the top 3 S&P sectors on the session.  And not for nothing, but per Bloomberg Smart Beta ETF flow data, I show a cool $5.1B into ‘value’ focused ETFs YTD.

Today’s US equity-factor behavior is “curious” (speaking to perhaps some broad market / index exposure-grabbing behavior over the two-day stock breakout) as it has been extremely rare to see both ‘value’ and ‘momentum’ perform “right way” simultaneously over the past two years.  “Pure Value” and “Pure Momentum” currently see a -23% correlation, and have been negatively correlated since the start of 2015.

‘MOMENTUM’ AND ‘VALUE’ FACTORS DRIVING PERFORMANCE TODAY—WHICH IS ABNORMAL:

MOMENTUM AND VALUE NEGATIVELY CORRELATED:

CORRELATION %:

One final point on US equities is the same I’ve been making recently in light of the Dollar’s consolidation and move higher (after ‘long USD’ counter-intuitively became a proxy for ‘long reflation’ over the prior months)—a renewed / higher USD could act to mitigate crude upside when the historic correlation mean-reverts.

For now, the market reaction is ‘higher real rates’ = ‘higher USD’ as Trump pro-growth and protectionist policies (BAT, overseas USD repatriation, tariffs) looks certain to create further Dollar strength, despite the incremental ‘weak USD’ jawboning from the administration.  Nominal rates have held in a range with real rates are again grinding higher.

As stated daily, crude remains the most critical single-security input to the leading macro factor drivers for S&P price (inflation expectations, credit spreads, 1 yr forward earnings ests, equity vol).  With the ‘energy base effect’ rolling-off in the coming months as it pertains to inflation data while the Fed seemingly continues to push the ‘3 hike’ narrative, “higher highs” in crude will be critical to sustaining “higher highs” in stocks moving-forward. 
 
STORY OF THE DAY—REFLATION THEME BACK ‘ON’ WITH A VENGEANCE: