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RBC: "The End Of Q1 Has Been A Bit Of A Crash-Landing For Many Traders"

With the reflation trade seemingly dead, the logical outcome is that the "disinflation" trade will soon follow. However, as that would undo most of the recent gains, central banks will fight tooth and nail to prevent that from happening, but can they? As RBC's Charlie McElligott writes in his morning note, "some large players in the market believe that the Fed had indeed been incorporating anticipation of ‘fiscal policy", Trump policy which may now not be coming until late 2017 or early 2018 (if at all). Additionally, after chasing the reflation trade, "many systematic ‘trend’ funds have even turned the other way—most-clearly, with some now shorting USD against long Euro / Yen, and some short-term models going long rates. "

As a result, "after a joyful 6 month stretch to end 2016 — the end of 1Q17 is nearing, and it’s been a bit of a crash-landing, with discretionary players and generalists ‘tapping’ on large swaths of the ‘reflation’ trade, and 2017 late-comers to the trade ‘under-water’ (negative returns YTD from ‘long USD’ / ‘long banks & cyclicals’ / ‘short rates’)."

Which is why, the RBC cross-asset strategist believes that if nothing changes, the reflation is over, however there are two conditions under which it may come back:

This is why the only chance in my mind for true ‘reflation’ to come back alive is going to require either 1) a break higher crude oil (higher inflation expectations, maintain / extend ‘energy base effect’ to keep driving yields higher) or 2) movement on tax policy, most notably via incorporation of a revenue driver in the form of a BAT or VAT (more likely as per ‘watered down’ compromise IN ORDER FOR PASSAGE) which in turn would drive US Dollar appreciation and higher US yields.

McElligott's conclusion: "this higher USD / higher rates / higher sentiment around a tax cut would be a game-changer for resetting the course of asset returns.  Without movement here, the market is looking increasingly binary, with momentum building again in the ‘disinflation’ camp the longer we stay ‘stuck’ in status quo, ESPECIALLY into the back-half of the year, with the Fed again hiking and the ECB transitioning towards ‘tightening’ as well."

In other words, we need a sharp reversal to the upside or else all the momentum of the past year following the "Shanghai Accord" will soon be lost.

McElligott's full note below.

THE REAL ROTATION(S), AND WHAT IS NEEDED TO REJIGGER REFLATION

NEAR-TERM: Early glimpse sees ‘risk reticence’ from real money to move into month- and quarter- end, although there are signs of ‘tactical mean reversion’ strategies being deployed into / take advantage of mechanical rebalancing trades from asset-allocators

LONG-TERM: The same way that market forces were indicating ‘reflation’ well-before Trump’s ‘fiscal policy kicker’ late last year, we have now seen months of thematic price information showing us that the ‘US domestic-led reflation’ trade is late-cycle (negative returns YTD from ‘long USD’ / ‘long banks & cyclicals’ / ‘short rates’)

  • As such, now seeing greater investor interest in deploying risk AWAY FROM US and into rest-of-world to minimize ‘Trump policy implementation risk’ in addition to attractive relative valuations and earnings growth (vs US)—essentially better ‘risk / reward’ elsewhere
  • Inside US, shift away from last year’s reflation leaders ‘cyclicals’ and ‘value’ painfully clear now YTD, with ‘growth’ (secular-kind—i.e. tech, biotech, consumer disc) and ‘anti-beta’ (defensives / low volatility) as the YTD performance leaders
  • To see ‘animal spirits’ revived in thematic ‘US domestic-led reflation’ trades—it will likely require either 1) a break higher crude oil (higher inflation expectations, maintain / extend ‘energy base effect’ to keep driving yields higher) or 2) movement on tax policy, most notably via incorporation of a revenue driver in the form of a BAT or VAT (more likely as per ‘watered down’ compromise IN ORDER FOR PASSAGE) which in turn would drive US Dollar appreciation and higher US yields
  • Without one of the two scenarios above occurring in coming-months, the market view is looking increasingly ‘binary,’ with crude ‘stuck,’ yields fading lower again and risk-sentiment fading—especially into back-half of year with potential for Fed hike and ECB shift towards ‘tightening’

* * *

 A lukewarm re-embrace of US stocks following the Sunday night / Monday ‘fiscal policy’ freak-out, as yesterday’s risk recovery tuckers-out.  Looking at the broad landscape, Yen strength is forcing carry-trade unwinds (DB G10 Carry Basket -2.9% MTD), the US Dollar is now -3.0% YTD as the market’s chief ‘reflation’ proxy, US equities cyclicals are being crushed (the US banks ETF is -10.2% in less than a month, S&P energy is the worst-performing sector YTD -9.7%) and S&P minis are currently -2.3% from their March 1st highs.  Clearly not an inspiring back-drop for many to deploy risk into month- and quarter- end, although it’s exactly the time when one should be putting on mean-reversion strategies for tactical alpha extraction from mechanical rebalancers (as such early today, we actually see leadership from MTD ‘laggards’ like WTI and ‘risky equities’ like ‘cyclicals vs defensives’ pairs / ‘high-beta’ / ‘inflation’).  To the ‘low risk appetite’ point made above, we currently see Spooz and US rates unable to move higher despite the highest ‘headline’ print in US Consumer Confidence since 2000, with labor differentials making new cycle highs (H/T Oubina).  The ball is in your court, Fed.

Stepping-back, we are again seeing increased risk appetite outside of US, most notably Asia (ex Japan), Emerging Markets and EU (S&P -1.3% over past 11 sessions vs MSCI Asia ex Japan +4.2%, SXXP +0.5% / DAX +0.7%  and MSCI EM +4.3%).  This ‘rotation to R.O.W.’ has become increasingly evident over the past few weeks, and makes bunches of sense--both with relation to relative valuations and ‘earnings growth’ trajectory—but also in light of the current US fiscal policy wobble, which is driving a ‘thematic shakeout’ under the hood of US equities.

There has been an evolving fact-pattern showing that investors in US equities were becoming increasingly wary of last year’s ‘reflation high flyers’ for nearly four months now--most notably in the form of ‘cyclical vs defensive pairs’ and ‘value market-neutral’ (long ‘value’ factor, short ‘growth’ factor) both peaking back at the beginning of December (alongside US Dollar).  Then in January we saw ‘leveraged beta’ (high risk credit / equity plays) peak, as we began to see a move ‘up in quality’ begin to develop.  In February, ‘inflation longs’ and ‘cyclical beta’ peaked, alongside WTI crude and US high yield credit, all of which have since traded markedly-lower.  And on March 1st, we saw ‘US banks,’ ‘small caps,’ ‘high-beta,’ ‘value factor longs,’ ‘domestic US exposure,’ ‘Trump tax beneficiaries’ and ‘high Sharpe Ratio’ all peak and fade ever-since. 

Conversely, emerging markets equitites (EEM) made lows in December, alongside ‘growth factor longs,’ ‘defensive equities’ and gold as US ‘real yields’ (as measured by 5Y TIPS) hit their highs; ‘quality factor’ and ‘low-risk equities’ made lows in January; ‘anti-beta market-neutral’ made lows in February etc.  Now, most of these are holding at or near highs.  Again, the point-being that we have seen a multi-month rotation AWAY FROM ‘high-beta cyclicals,’ ‘value’ and ‘high beta / risk’ which were the face of ‘reflation 2016’ and now INTO either low-beta bond-proxies (benefitting from the rates short squeeze) or ‘secular growers’ like US tech / biotech / consumer discretionary. 

Recall last year at this time, when I began noting ‘price is news’ indications that we were seeing signs of an ‘inflation impulse’ namely in thematic equities and factor-behavior (via the Yellen “weak Dollar policy” pivot coming out of the G20 in Shanghai) to highlight risks with the ‘low growth, low inflation’ narrative and the scale for a massive reversal with  the ‘long duration’ trade in fixed-income?  And how over the ensuing months, we saw signs of this accelerating inflation input into CPI / PPI prints off the building ‘energy base effect’ as crude turned much higher, while too we saw global PMIs rotating meaningfully higher?  Point-being, before ANY of the ‘fiscal policy upside kicker’ following the Trump election, the “Big Picture” was one of first pieces on the Street to highlight the turn in global growth, and thus, substantiate the tremendous risk in consensual ‘lazy long’ fixed income positioning and the upside in equities ‘cyclical’ sectors which had been left for dead (thus, ‘value’) for years.

Well, after a joyful 6 month stretch to end 2016—the end of 1Q17 is nearing, and it’s been a bit of a crash-landing, with discretionary players and generalists ‘tapping’ on large swaths of the ‘reflation’ trade, and 2017 late-comers to the trade ‘under-water’ (negative returns YTD from ‘long USD’ / ‘long banks & cyclicals’ / ‘short rates’).  Now many systematic ‘trend’ funds have even turned the other way—most-clearly, with some now shorting USD against long Euro / Yen, and some short-term models going long rates.

* * *

We are now at a critical juncture as we transition into 2Q17 where funds will choose to stay ‘parked’ in the ‘hiding places’ where they already sit very heavily-allocated (for equities, say long ‘secular growth’ sectors), while many scale-back their ‘higher rates’ bets (and likely, banks positioning) and some even begin to short crude oil again.  Basically, many are downshifting away from ‘reflation.’ 

Why?  It looks increasingly clear to me that some large players in the market believe that the Fed had indeed been incorporating anticipation of ‘fiscal policy,’ despite their statements otherwise.  So now, the market reassesses rate hike probabilities, as evidenced by current implied probabilities of a third hike this year coming at just 40%.

The importance of oil is still very significant here.  If OPEC’s likely ‘extension of production cuts’ story can’t overcome the ramping of US production, the drag on yields could be very difficult to overcome for risk assets, especially with the role that inflation expectations play in HY credit spreads and equities.

And if data such as the aforementioned mega Consumer Confidence print this a.m. can’t drive higher yields (‘soft vs hard data’ issue), it does seem that the reflation / higher rates trade is in real jeopardy.

This is why the only chance in my mind for true ‘reflation’ to come back alive is going to require either 1) a break higher crude oil (higher inflation expectations, maintain / extend ‘energy base effect’ to keep driving yields higher) or 2) movement on tax policy, most notably via incorporation of a revenue driver in the form of a BAT or VAT (more likely as per ‘watered down’ compromise IN ORDER FOR PASSAGE) which in turn would drive US Dollar appreciation and higher US yields.

The second point on incorporation of a BAT or VAT (more likely now) into the tax plan is a triple-whammy too, because it increases the likely of a re-engaging on a deeper corporate tax cut; its passage reinvigorates ‘animal spirits’ with regards to market sentiment behind the Trump administration’s ‘pro-growth’ policies; and it would drive meaningful USD (and thus too, rate) appreciation…but not the kind that frightens the market, i.e. the 20% theoretically appreciation via a BAT which I’ve said in the past could act as a ‘margin call’ on global trade.

This higher USD / higher rates / higher sentiment around a tax cut would be a game-changer for resetting the course of asset returns.  Without movement here, the market is looking increasingly binary, with momentum building again in the ‘disinflation’ camp the longer we stay ‘stuck’ in status quo, ESPECIALLY into the back-half of the year, with the Fed again hiking and the ECB transitioning towards ‘tightening’ as well.