The Cycle Is Shifting From Expansion To Slowdown: How To Trade It
Ahead of tomorrow’s closely watched CPI report which has been preceded by several surprisingly hawkish Fed speakers who have pushed both the dollar and Treasury yields notably higher, Nomura’s Charlie McElligott notes that the big data this week with obviously significant implications for Fed policy / Taper timing—and with it, tactical “bearish fixed-income” / “value over growth” expressions which are again being repositioned by some in the market ahead of Q4—will be US CPI and PPI data, where in-particular, we expect CPI Core MoM to settle to 0.6% in July from 0.9% in June, largely led by moderation in used vehicle prices”
To help explain what may be a key transition in the economic cycle, McEliggott then reminds readers that a few months ago when he was looking for direction coming out of the peak of “reflation” he used Nomura’s US Economic Quadrant work, which showed us that historically “it was the “Recovery” phase emergence out of the COVID19 contraction which would be supercharged for Cyclical Value / Leverage / 10Yr Yield “economically sensitives,” at the cost of all things “duration-sensitive” (Size, Low Risk, Growth), i.e. the “vroom vroom” period that was 4Q20 into 1Q21.”
This is shown in the relative performance of factors with a handful of yield-sensitive ones outperforming:
However, at the time the Nomura quant instead focused on the “next move,” which was that phase transition that emerged at start of Q2 in April from prior “Recovery” stage into that of the current “Expansion” phase, where he warned of a significant factor / thematic “downshift” as bond-proxies like Low Risk, Quality and Size were set to reverse higher and lead over the prior “economically-sensitive” leadership which he adds, “is pretty much exactly what has happened in Q2 and Q3, as we’ve been well-embedded into Expansion of “up growth, up inflation” where it seems the market sees the maturation of the cycle and begins to pull-forward the eventual implications of data overshoot.”
Fast forward to today when those thinking ahead will ask what the next Quadrant phase shift from current “Expansion” into the future “Slowdown” phase looks like.
In response, McElligott notes that once again it was those thinking one step ahead and trading on the upcoming shift that benefited: “it might seem counterintuitive, because outside of an obvious “reversal” impulse, you actually see some of the economic-/yield- sensitive factors begin to work again after they most likely have bombed out in the prior phase (Cyclical Value, ISM Mfg PMI Sensitive, Leverage and 10Y Yield Sensitive factors)….while conversely, the bond-proxy factors already smelled the slowdown and got their outperformance done during the trailing “Expansion” phase, thus subject to underperform in the “Slowdown” stage (i.e. Momentum, Growth, Defensive Value, Low Risk, Size and Quality as laggards).”
This means that the proper thinking is not how to trade the Slowdown phase, which has already been largely priced in, but what are the correct trades as we look yet ahead one more time, into the Contraction phase. However, such a stark reversal in market sentiment would likely require a catalyst, or trigger event, and that’s precisely what the upcoming Jackson Hole symposium would represent, especially if as many now expect, the Fed will telegraph the coming of the taper during its annual Wyoming outing (for more see What Goldman Really Thinks: “The Ante Will Be Upped When Taper Begins“).
Meanwhile, anyone expecting the S&P to crack despite the unprecedented gamma gravity around 4,400-4,425 which we have discussed previously has proven unmovable due to multi-billion “gamma gravity” there, will likely be disappointed because as McElligott explains, the SPX term structure “remains steep along with Skew and downside Put Skew at same extremes we’ve talked about for months—while upside Call Skew on a rank-basis has marginally firmed-up, but frankly just because it’s been so absolutely “low” as opposed to demand for upside Vol; so at this point, the most attractive upside is in QQQ as opposed to SPX at this point.”
Yes, perversely, as the economy enters the slowdown phase and prepares to shift to contraction, the best trade is to buy tech, as has been the case for much of the “secular stagnation” theme in the post financial crisis period.
Tue, 08/10/2021 – 11:11