Kolanovic: "Clients Are Asking If This Selloff Will Make The Quants Puke"

Having maintained radiosilence for much of 2018, on Thursday afternoon JPM's top quant reemerged, and pointed out that "many clients are asking if the recent risk-off move was significant enough to drive broader de-risking of such 'delayed response" systematic investors as CTAs, Volatility Targeting and others."

And while the two-day selloff at the start of the week was indeed unexpected, and quite violent, resulting in numerous sharp position reversals as Nomura's Charlie McElligott wrote on Tuesday, Kolanovic is far more sanguine, and writes that the recent market sell-off and spike in volatility was not large enough to trigger broad deleveraging among systematic investors, as the following excerpt reveals:

Consistent with our previous research, we think that the move was not large enough to trigger broad deleveraging. Equity price momentum is positive and trend followers are not likely to reduce equity exposure. While the recent move was concerning for its correlation properties (bonds, equities and commodities all going lower), overall the volatility of multi-asset portfolio is still very low, and the increase was relatively small (e.g., increased from —4% to —5%).

He also notes that while the sharp 2-day move was concerning for its correlation properties, overall the volatility of multi-asset portfolio is still very low, and the increase was relatively small.

"That we are in the midst of one of the strongest earnings seasons in the US, and global growth continues to be strong" also does not favor a continued sell off Kolanovic says.

Amusingly, after we quoted Kolanovic earlier this week saying that 2.75% in the 10Y is critical...

"should bond yields continue increasing (e.g. 10Y beyond 2.75%) this will risk an equity sell-off that usually triggers a broader deleveraging of var-based strategies."

... he is backing off from this assessment, now that the 10Y is above it:

A common question is at which level bond yields become an issue for equity multiples. While we quoted 2.75% a few years ago, this was at a time when global growth was significantly weaker than it is now (EM crisis, US earnings recession). We believe one should not look at a specific level of bond yields in isolation from the level of economic activity and positive catalysts such as fiscal easing. We think that the current level of rates do not yet pose a major risk for equity multiples.

Almost as if Gandalf was given the tap on the shoulder...

Finally, if JPM's clients shouldn't be nervous now, then when? To that, the JPMorgan quant "wizard" has this response: maybe in a a few weeks.

"In terms of timing market downside risk, we would be more concerned about the period after the Q1 earnings season, when fiscal reforms are likely to be priced in and central banks make further progress on the normalization of monetary policy."

His full observations below:

After a few days of market sell-off and an increase in market volatility, many clients are asking if the move is significant enough to drive broader de-risking of systematic investors such as CTAs, Volatility Targeting and others. Consistent with our previous research, we think that the move was not large enough to trigger broad deleveraging. Equity price momentum is positive and trend followers are not likely to reduce equity exposure. While the recent move was concerning for its correlation properties (bonds, equities and commodities all going lower), overall the volatility of multi-asset portfolio is still very low, and the increase was relatively small (e.g., increased from ~4% to ~5%). Also, there are other circumstances that are not in favor of a continued sell-off – we are in the midst of one of the strongest earnings seasons in the US, and global growth continues to be strong.

We also want to comment on two other issues: bond yields and tax reform. A common question is at which level bond yields become an issue for equity multiples. While we quoted 2.75% a few years ago, this was at a time when global growth was significantly weaker than it is now (EM crisis, US earnings recession). We believe one should not look at a specific level of bond yields in isolation from the level of economic activity and positive catalysts such as fiscal easing. We think that the current level of rates do not yet pose a major risk for equity multiples.

Finally, there is the question to what extent fiscal reform is priced into the market. We are of the view that tax reform is only partially priced into the equity market. We attribute the bulk of the recent market appreciation to the uptick in global growth, and weaker USD. Talking to our clients, we still find risk aversion and hesitance about the impact of fiscal reforms and political developments (e.g., mid-term elections, Nunes memo, etc.). The fact that small caps, tax beneficiaries, value and domestic stocks are lagging since the bill (e.g., vs. international, growth, large-cap tech) is evidence that fiscal reforms are not fully priced in. In terms of timing market downside risk, we would be more concerned about the period after the Q1 earnings season (e.g., in 'sell in May'), when fiscal reforms are likely to be priced in and central banks make further progress on the normalization of monetary policy.

QE - The Gift That Just Kept Giving - Is Now Taking...

I know the Federal Reserve doesn't effectively create money or directly monetize. I know this because then Fed chief, Ben Bernanke, told us so. But still, something has me wondering about that exchange, now almost a decade ago. The simplest of math.

The plan to utilize quantitative easing and avoid direct monetization went like this. The Fed would buy the Treasury debt and Mortgage Backed Securities (remove assets from the market) from the big banks. However, the Fed would force those banks to deposit the new money at the Federal Reserve. This would avoid the trillions of newly created dollars from going in search of the remaining assets (particularly levered from somewhere between 5x's to 10x's...turning a trillion into five to 10 trillion...or far more).

The chart below shows the Federal Reserve balance sheet (red line) and the quantity of those newly created dollars that the recipients of those dollars, the banks, deposited at the Federal Reserve (blue line). But the green line is the quantity of newly created dollars that have "leaked" out...also known as "monetized".

What is so interesting is the interplay of QE and excess reserves...resulting in the peak QE impact taking effect long after QE was tapered and had ceased. The trillions in assets remaining with the Fed, but the new cash went looking.

The impact of $800+ billion of pure monetization from late 2014 through year end 2016 was spectacular. In the hands of the largest banks (multiplied by "conservative" leverage somewhere between 5 to 10x's) could easily amount to trillions in new cash looking for assets. A "bull market" beyond belief should not have been surprising.

The chart below shows the Wilshire 5000 in red representing all US equities actively traded, national disposable personal income in blue (all forms of income after taxation), and the net monetization in yellow. The "bubbles" of '01 and '08 pale in comparison to the present explosion. However, the increase in income represented by DPI does not justify the increase. However, when the unlevered quantity of monetization is added, the picture is more interesting.

And the same variables and chart below, but focused on '08 until '18. The jogs in the monetization subsequently followed by the Wilshire are probably noteworthy...but the most recent decline in available monetization hasn't materialized in the Wilshire...at least not yet.

However, that change since 2017 should begin to effect the market in 2018. The change in flow from the declining Federal Reserve balance sheet coupled with fast rising interest payments on Excess Reserves (billions for the banks for not taking any risk, not making any loans to keep the cash locked away) should help to hold the Excess Reserves from declining any faster than the Fed's balance sheet reduction.

This cessation of "leakage" of new money coupled with extreme lows in savings, extreme valuations in asset values vis-à-vis disposable incomes and decelerating deficits with rising interest rates does not likely add up to a positive outlook.

Albert Edwards: "It Feels Similar To Just Before The 1987 crash"

Add SocGen's grouchy permabear Albert Edwards to the growing list of bond bears.

In his latest letter, the SocGen strategist echoes what we have said earlier this week, namely that equities are wobbling as yields rise above key threshold levels, and says that he agrees "with the bond bears that US yields will continue to rise, causing more problems for equities" ... with one footnote, a predictable one: "I do not believe bond yields have yet seen a secular bottom. I repeat my forecast that US 10y yields will fall below zero."

He is right: once the current infatuation with the reflation impulse is over which has been made possible by a record drop in the US savings rate offset by a historic surge in credit card usage - a carbon copy of what happened in 2011 when the ECB went so far as to hike rates assuming the recovery was here, and unleashing the worst debt crisis in European history - central banks will revert to doing what they do best: nationalizing capital markets and crushing savers with financial repression, the likes of which have not been seen yet.

In any case, it's good to see that despite his recent vacation to Jamaica, Edwards' gloomy disposition is right where he left it back in gloomy London, and as he admits "I can reassure readers I am restored to my bearish best."

Edwards' bearish sentiment was only boosted by this week's market performance, to which he offers the following commentary:

So used are we to the relentless rise of the equity markets, seemingly without pause, this mini-tremor actually felt like an earthquake. But maybe this is the start of something more.

Maybe indeed, because in the very next sentence Edwards goes all out: "Certainly, as we explained at our Conference, the current conjuncture feels similar to just before the 1987 equity crash. All that was missing was the slanging match over the weak dollar between the US and Europe, but we duly got that while I was away."

Ah yes, the dollar, but before the trade wars truly begin, everyone is watching something else: the yield on the 10Y, where Edwards differs from the consensus we observed earlier, and believes that a bull market will only truly start once yields rise above 3.00%:

Every man, woman and child seems to have decided that the US 10y bond yield has broken out of its long-term downtrend and we are in a bond bear market. Our own excellent Technical Analyst, Stephanie Aymes, shows that 3% (not 2.6%) is the key long-term breakout yield we should be watching. But she thinks that 2.64% was also significant as this means the RSI downtrend has now been broken (see bottom panel in chart below) and a run to 3% is now perfectly plausible. That though does not mean the bond bull market is over.

Edwards then decides to take a shot at the "great rotators" out of equity and into debt noting that...

With much anticipation the US 10y bond yield broke the critical 2.6% many regard as key to defining whether the current bull market is still intact or not (see left-hand chart below). With yields now closing on 2¾% and the 30y closing on 3.0%, many see this as a great time to dump bonds and switch into equities.

... however, he cautions that "this might not be so wise (see right-hand chart below):

Why? Because, quoting Stephanie Pomboy and showing our chart from yesterday, Edwards points that according to the MacroMavens economist, "stock prices are now be the biggest threat to the economy – even more than the Fed. Heaven forbid the market ever goes down". (The latest monthly reading just out shows a further surge above previous peaks – see right-hand chart below.)

Edwards then points out something else we showed on Monday: all the spending growth is thanks to a plunge in US personal savings:

US consumer spending growth is running way above growth in real average hourly (or weekly) earnings (see below). This gap is sustained by a slumping savings ratio, not jobs growth.

Then, taking a hint from yet another post on ZH - ironically also referencing 1987 and David Rosenberg's math on the latest GDP print - Edwards again highlights the "shocking slump" in the household saving ratio (SR) from 3.3% in Q3 to 2.6% in Q4, and also quotes Rosenberg saying that "without this decline in the SR, consumer spending would have only risen a paltry 0.8% in Q4 against an actual rise of 3.8%, and GDP would have risen only by 0.6% against an actual out-turn of 2.6%!" This quickly leads to the next rant:

The Fed's easy money policies have driven household net wealth to new highs and the SR has fallen hand in hand in the last two years. The US has now got double bubble trouble (ie bubbles in both corporate and household debt). Just like 2007, this is another economic boom fuelled by an unsustainable credit bubble that will inevitably blow up with a rooky Fed Chairman in place."

So in conclusion, Edwards' deflationary "Ice Age" is still with us, and eventually US rates will tumble, ultimately turning negative. "Why do I think yields could go negative?" Edwards asks rhetorically? "Well I expect that the true extent of how close the US is to actual outright deflation, and hence how high real yields currently are, will soon be

revealed. But before US 10y yields turn negative, expect them to visit 3% first."

And somewhere in the sequence of events, the SocGen strategist expects the crash of 1987 to make a repeat appearance. And why not: until just a few days ago, the stock market had its best start of the year since, well, 1987. It's what happened later in the year, however, that matters more.