Wall Street capitulates to MB asset allocation

Over this year we have watched as various Wall Street investment houses have made a hash of sector rotations and equity factors.  Today I can report that they are increasingly falling in behind MB (which may not be a good thing!).

The most bearish on stocks and hawkish on inflation has been BofA. No longer!

Tale of the Tape: China = best government bond marketYTD (4.5%), 2nd best currency vs US$ (0.9%), worst HY bond market (-4.8%, spreads>1000bps), worst MSCI equity index (-5.7%); like Japan 1990-2007, China the new global deflationary force.

BofA Bull & Bear Indicator: drops to 6.1 from 6.4 on breadth (Chart 1); likeH2’17, Bull& Bear Indicator in “bullish holding pattern” since March (note 2017 trend ended with Feb’18 sell-signal triggered by 10-year UST yields up toward 3%).

Feel the Yield in Me: global government bond yield0.4%, IG bonds1.6%, EM sovereignbonds 3.5%, HY bonds4.2%, 10-year UST yield back below dividend yield of S&P500…all despite $31tn of global monetary & fiscal stimulus, US debt per capita surging from$69k to $82k (Chart6), >3.7bn Covid-19 vaccinations, shortest recession/fastest recovery of all-time, surging inflation…these are the days to cherish.

Consensus trends: upward revisions to 2022 US GDP have stalled (4.1% -Chart2), to CPI still rising (2.5%), 10-year UST yield (end-year) stalling at 2.2%,EPS estimates trending down from 17% to 11% (Charts7-9); similar patterns in Europe consensus forecasts.

US stocks surpassed their Mar’2000 highs versus IG corporate bonds (Chart10); resilience of credit markets (ex. China) remains positive for global stocks; like 2000 v high EPS concentration in global stocks (tech & e-commerce sectors = 33% of total EPS compared to: 2000 dot.com bubble TMT = 25%, 2006 housing bubble financials = 29%, 2008 China/oil bubble energy & material = 25%-Chart11); note 2000 only year that offers comparison with 2021’s weird ranking of commodities (32%) & REITs (21%) as #1 & #2 best performing assets (Chart19).

It’s Just a Phase:”reopening rally” kick-started Nov 3rd by election/vaccine =stocks/credit up big, yield curve steepens & weaker US$, cyclicals>defensives; “inflation boom” kick-started Feb 16th by blowout Jan US retail sales = commodities up big, yields surge, long-duration tech cracks, value>growth; “peak growth/policy” kick-started June 16th by hawkish FOMC (+ China ease) = yield curve collapse, bonds>stocks/commodities, dollar up, growth defensives>value cyclicals; we say own defensive quality in H2 = good market hedge H1 (peak policy) & good macro hedge H2 (peak profits)…long defensives in vaccinated markets US/EU (see consumer), long cyclicals/reopening in markers with vaccine-upside, i.e. Japan/EM.

Gone is the commodities long and inflation panic as China becomes “the new global deflationary force”. Could not have put that better myself. I still see the base case for muddling through as falling yields lift quality/growth assets. But my risk case for a material correction is still unusually high on a growth scare as the US and China slowdowns converge plus the global inventory cycle slows and commodities deflate. All made worse by the Fed’s policy error.

The relentlessly bullish Goldman has also fallen in with MB:

Despite volatility early in the week, the S&P 500 trades at an all-time high of 4412 and has enjoyed an unusually long run without a pullback. The S&P 500 declined by 1.6% on Monday, but reversed that dip on Tuesday. There have nowbeen 179 trading days since the last 5% S&P 500 pullback. This stretch compares to a historical average of 94 days and now ranks as the 15th longest period without a 5% decline in the last century. The 404 days ending in February 2018 stand as the longest on record (Exhibit 1). The growth concerns that caused Monday’s decline have been weighing on the market’s pricing of economic growth for several weeks. With theDelta variant leading to rising virus case counts in the US and around the world, investors have questioned the path of the economic recovery.

Since the start of June, our Cyclical vs. Defensive basket pair has declined by 9pp, S&P 500 volatility skew has jumped, and the 10-year US Treasury yield dipped from 1.6% to 1.2%. We think the Delta variant should pose a minimal risk to the US equity market. From an economic perspective, wide spread vaccinations and strategies focused on containment suggest limited medical and economic downside risk even if infections continue to rise.

From a flows perspective, robust household cash balances and corporate buyback authorizations should continue to support inflows for equities, increasing the likelihood that market participants perceive a pullback as a buying opportunity. We forecast household equity demand will total $400 billion this year and US corporates will account for $300 bn.

We believe investors should balance tactical positions in virus-exposed cyclicals with longer-term strategic positions in high-quality secular growth stocks. The market’s recent rotation toward Growth stocks and quality factors is consistent with the typical pattern observed in the current stage of the business cycle. However, while economic growth is decelerating, the exceptionally strong pace of GDP growth and upside risk to interest rates suggest investors should not rotate completely into Growth stocks. The macro model we created last month showed how both the economy’s first derivative (growth) and second derivative (acceleration), along with interest rates, are important drivers of equity factor rotations. Recently, Growth stocks have outperformed by more than the model would have implied even taking into account recent disappointing economic data and the unexpected decline in rates. Our economists’ forecasts suggest more factor volatility in the near-term (similar to the dynamic highlighted by our colleagues in Europe) before Growth stocks resume consistently outperforming by late 2021 or early 2022. We also recommend investors focus on stocks with high pricing power, a “quality” attribute typically rewarded when GDP decelerates…

That’s called shutting the gate after the horse has bolted. Goldman has been on the wrong side of falling yields and the quality growth rotation for months. It is also interesting to note that the GS yield outlook for 1.9% by year-end is much more consistent with selling growth. As well, emphasis on the commodity long is gone.

Morgan Stanley is making more sense than GS:

Even though economic growth remains on a firm footing, our strategists are concerned about valuations across a wide range of asset classes. As always, markets are forward-looking and reflect not only expectations of a robust global economic recovery but also the uncertainties around the recovery path. As our chief US equity strategist, Mike Wilson reminds us, it is important to keep in mind that while overall growth is still solid, the rate of change has peaked, as reflected in the consistent underperformance of small-cap and lower-quality stocks over the last few months. He favors stocks with earnings stability rather than growth. His recent upgrade of Consumer Staples and downgrade of Materials is reflective of his more defensive stance on US equities.

We continue to believe that the recent plunge in Treasury yields is really about positioning unwind. Furthermore, improving prospects for the passage of an infrastructure package by the US Congress would put upward pressure on yields. Guneet Dhingra, our US interest rate strategist, remains firm in recommending 10-year US Treasury shorts, with the expectation that yields will retrace the declines of the last couple of weeks. We still see 10-year US Treasury yields ending the year at 1.8%.

In currencies, our view is that the US dollar will continue to gain ground in the short term. James Lord, our chief currency strategist, sees (1) the lower likelihood of travel and other restrictions in the US relative to several countries in Europe and Asia and (2) the growing divergence in both inflation trajectory and monetary policy between the US and other large economies as rationale for the long US dollar view.

Same view of the FAAMGS but balancing that with staples not cyclicals. That is where the MB Fund is now tilted.

Finally, Deutsche confirms where the money is going:

US large cap equities still the exception to a broad based weakening in momentum across asset classes

Our measure of cross asset momentum breadth remains slightly negative, with most asset classes seeing weakening risk-on momentum over the last 3 months. Large cap US equities remain the exception, and the S&P 500 as well as the Nasdaq 100 have continued to rally to new highs. Most other equity indices in the US and globally have been trading flat to down for several months now, and breadth within the S&P 500 has been weak but starting to pick up again.

Equity positioning has edged lower but rotation into large cap Growth underway

Over the last two weeks our consolidated indicator of equity positioning has declined somewhat from the top of its historical range but remains elevated (81stpercentile). The move lower was broad based, with both discretionary and systematic investors reducing their exposure. Discretionary positioning remains high (89th percentile) and still in line with macro growth that is no longer rising but has not yet fallen either. Put/call volume ratios rose on Monday but reversed swiftly.Net call volumes (calls minus puts) overall have been declining in July after a move higher in June. The recent move down comes as large cap volumes have also pulledback while small cap volumes remain subdued after a brief surge in June. Systematic strategies (60th percentile), especially Vol Control funds, reduced their equity exposure slightly as realized vol rose this week. Net futures positions in theS&P 500 remain long and near the highs even as those in small cap Russell 2000 futures have turned sharply short. Flows into equity funds (ETFs + mutual funds) have slowed from the record levels seen in March but remain quite robust (averaging $10bn over the last 4 weeks). As the market sold off on Monday, fund in flows were actually quite strong, as investors bought the dip. Value and Cyclicalfunds have been seeing outflows over the past month after getting robust inflows from November 2020 through mid-June 2021. Growth funds on the other hand have seen inflows accelerate over the last month after getting only muted flows since March.

Bond shorts continued to be pared

As bond momentum continues to turn up, CTAs have cut their shorts in bonds to the lowest since February. The recent move up in bond momentum has been accompanied by bond-equity (returns) correlation again turning negative, in line with the pattern in place for the better part of the last 2 decades. This improved portfolio diversification has likely further supported increased bond allocations byCTAs as well as by Risk Parity funds, countering rising bond volatility. AggregateUST bond futures positioning remains short but range bound since March. In FX ,longs in the US dollar continue to rise. CTAs are already quite long and CFTC days shows that the longs in other currencies have continued to shrink while the shorts are getting larger. In commodities, net long positions in oil futures have fallen back to the middle of their historical band, while gold longs have risen slightly; copper positions have remained flat over the last few weeks.

It remains my view that China has killed the global reflation with credit clamps and the Fed is cremating it with a policy error. New OPEC oil supply has not helped.

All recent price movements are consistent with this fading outlook.

My base case remains that we bumble through the growth air pocket. But I have an unusually high-risk case that the Chinese and US slowdowns converge through H2 and the global inventory cycle plus the commodities bubble end together.

So, as Wall Street increasingly capitulates to the MB Fund worldview and consensus grows, the asset allocation questions become more uncomfortable.

Can a narrowing US stock market, driven largely by FAAMGS maintain the rage? Or will they roll and pull the broader market down?

Will either or both of the PBoC and Fed panic? The former has begun to but has a long road to travel before growth turns. This will need outright cash rate cuts. The latter has deployed the jawbone with some short-term success in supporting equities but has not even begun to contemplate later taper or more QE.

This is a seriously fragile market subject to unusually swift factor rotations…

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