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Editor's Note: Hamish Risk | November 10, 2020
These are treacherous times in markets if the past 4-5 trading sessions are anything to go by, but at least there is now some light at the end of the tunnel in this most difficult year. Today’s briefing highlights some views on yesterday’s momentum factor crash and related cyclical rotation, asking whether it has further legs in it, how much had already been priced into valuations, and what’s the risk of overshooting as COVID curves across turn higher and much steeper. Quant Insight’s analysis shows that based on their macro regimes, some of the cyclical sectors are already above fair value, while Cornerstone Macro see the news as a potential boost for industrials, but warns against getting too enthusiastic on value stocks in the absence of more fresh, positive news. Meanwhile, Ollari Consulting explains why it has been a rational response to good news that has the potential to unleash animal spirits and trigger a further rotation away from tech, while UBS sets out why the dollar is likely to suffer as the global economy rebounds in the years ahead. Macro Insiders have the final cautious word, noting the damage the pandemic has done to the real economy, and the prospect that the rollout of the panacea maybe at least a year out.
cyclical rotation Macro regime Quant Insight
1. The great rotation; does the macro regime justify it?Quant Insight’s models use algorithms to untangle and isolate which macro variables (typically correlated) are driving asset prices and relative valuations, and which securities are most sensitive to changes in particular macro factors. As they highlight, yesterday’s vaccine news encouraged an aggressive equity rotation as beaten-up value stocks that took hope from the idea the coronavirus end-game may be beginning. Amid the euphoria, its worthwhile looking at the relative value of some of these sectors to to get a sense of where the opportunities are for investors. Using the Qi framework, which provides a real-time gauge of sector valuations versus their macro regimes, Qi’s Huw Roberts has looked at the 10 biggest Fair Value Gaps amongst US ETF relative value models, subject to the model being in a macro regime. It’s produced some interesting conclusions. Their models show that three cyclical sectors – Metals & Mining, Industrials and Banks (US regional bank ETF) – are at one-year highs versus SPY. So too are small caps versus large caps, per the Russell 2000 vs S&P500 model. This suggests, says Roberts, that there has already been a fair amount of ”good news” priced into these sectors already, relative to their respective macro regimes. In the case of metals and mining key macro drivers would be the US Dollar and copper and iron ore prices and for banks, inflationary expectations and high-yield spreads. The key question now is whether yesterday’s news is enough to shift these macro drivers significantly to justify these richer valuations.
equity rotation value stocks Cornerstone Macro
2. Will it continue?Michael Kantrowitz at Cornerstone Macro has put out a note following the surge in value stocks created by the Pfizer vaccine news, aimed at questioning whether the move can continue. He points to a few charts he says can help answer the question, noting every day that value stocks have ripped higher in 2020, it was a news-driven move, and most of those rips higher were not sustained. Without incremental news, the move is unlikely to be sustained argues Kantrowitz, who notes the performance between high beta and low volatility stocks has nothing to do with valuation and everything to do with macro momentum. In other words, he says, as long as the data continue to improve, investors are willing to buy higher beta stocks. So, the question, according Kantrowitz about the sustainability of this rally is what is propelling it, and will it continue, and he doesn’t think it’s a question of valuation. Indeed, he says given how high beta stocks have now “caught up” to the macro data, he believes the market is approaching fair value – and thus, there isn’t a great bet to be had on value. Rather, says Kantrowitz, industrials have a lot more room to “catch up” on the macro data, and look like a better risk reward than betting on high beta to outperform low vol. Indeed, he has been overweight industrials in 2020 and continues to like them as his favourite cyclical group.
equity rotation investor sentiment Ollari Consulting
3. UnemotionalThe world still faces hurdles, but markets are facing a fundamental shift with the news of a Covid vaccine meaning there is a bright light at the end of the tunnel says Christophe Ollari at Ollari Consulting. Far from being an emotional reaction, he says the rotation trade witnessed on Monday away from tech made perfect sense, and there is every reason to believe that a decent part of the post-Covid forced digitisation will be reversed. According to Ollari, Biden’s election win with a likely legislative gridlock is a goldilocks scenario for equities, delivering the best of both worlds, with a more predictable US trade and foreign policy together with some fiscal expansion and a Republican Senate acting as a buffer against tax hikes and frantic regulation. Furthermore he says with consumers sitting on large pile of savings that they could quickly spend, monetary authorities likely to keep the policy taps open, animal spirits are likely to return to the markets in the weeks and months ahead.
bitcoin COVID-19 gold Inflation Macro Insiders
4. Clean upA sobering update from Raoul Pal from Macro Insiders explains that with the US election out of the way, markets will focus on Covid-19 and try to balance that against the news of a potential vaccine. Today the markets are euphoric, but that kind of euphoria can easily fade, he says. Indeed, according to Pal, Covid is going to be a huge problem in the US until the vaccine rolls out, potentially going “exponential” against the backdrop of having no functional and effective government, Thanksgiving and Christmas all coming. He says that means that with the UK and EU all ready to warm up the printing presses, the US, with no stimulus, is going to need the Fed. Don’t forget the economy everyone is trying to save is the small- and medium-sized enterprises with no cash flows, not the tech companies, says Pal, who adds the current market rally doesn’t help anyone and that means more printing is to come. He says that if the world is saved then record amounts of stimulus in the system will potentially cause a spike in inflation and even lead to a collapse in the dollar. On the other hand, says Pal, if things get worse first and are more deflationary, then the Fed and others will keep printing. That, he says is a messy backdrop for more assets. Gold and bitcoin, according Pal, are set to the main beneficiaries with the latter potentially the most dominant trade he has ever seen in his life.
FX vol US dollar UBS
5. Checkmate for USD through 2023Aggressive Fed rate cuts have undermined the dollar’s yield advantage and relatively large fiscal stimulus has also spurred renewed US current account deterioration, according to James Malcolm at UBS. Both of these were key drivers of prior dollar down-cycles, he says and pressure from these quarters is set to build in 2021 even absent a Blue Sweep, he adds. A global recovery should slowly take over to drive the greenback lower still in 2022, says Malcolm, and he expects a repeat of the typical pattern whereby the dollar falls hard and fast during the first three years after peaking. EUR, JPY and CAD are apt to be core beneficiaries, with Sterling and the Scandies constituting purer valuation plays, while CNH can play a key role in adjustment for the first time ever. As for its impact on FX vol, Malcolm writes that contrary to conventional wisdom and prevailing pricing, volatility rises during early stage dollar downturns. When the prevailing regime gives way, he says implieds reset at a significant premium to realised and vol curves steepen as medium-term uncertainty increases. Fiscal uncertainties and rates constraints may reinforce this tendency, according to Malcolm.