SUMMARY: We think 10yr yields are topping, so the risk reward of being long 10yr bonds is very interesting now. See this video, which we released last night, for details. For what it is worth, the most aggressive pushback on being short 10yr yields now came from the equity community. The macro / fixed income community has been more receptive. Our sense is that macro investors focus more on the magnitude of the financial conditions tightening and the impact it will have on an economy that still has very low trend growth (1.8%ish). And how inflation has been driven by HIGHLY unusual shocks combined with central bank mistakes. The equity folks seem to think rates need to go much higher to slow economic growth because we are in a higher nominal GDP regime (inflation) and real rates need to be MUCH higher to offset that.
The macro community puts more emphasis on the impact of tighter financial conditions (mortgage rates, credit spreads, equities etc on slowing economic growth) while the equity community focuses on the level of real rates.
We will see how this plays out, but we think combination of significant net worth reversal, fading credit impulse (that could reverse aggressively), tighter credit across the board, rest of world economic weakness, and the Fed’s commitment to killing inflation by taking on recession risk are MAJOR headwinds for 10yr yields longer term.
Growth has started to outperform Value, which is unusual relative to previous market declines. Market internals could be picking up on the economic growth slowdown that is becoming more obvious.
Every breakout in Low Vol has been sold quickly, only to then go on to make a new high. Low Vol has been the best factor BY FAR, but very volatile. It has also been the BEST trading factor, especially vs Earnings Turbulence. To the extent that we have some relative calm in the markets over the next few days (and the unprecedented stats on the selloff suggest that is possible), Low Vol will come under pressure. Low Vol is mostly made up of Defensives and Earnings Turbulence is Discretionary and Energy. Speaking of Defensives, we highlight a specific Staple short idea courtesy of John Roque. Trade details in the report below.
Full report below…
MARKET VIEWS: It was a relatively quiet night, but two things jumped out: 1) BoJ did nothing. They are not changing policy and inflation is still transitory. Kuroda seems to be hoping that rest of world central banks will do the work for him. 2) Russia gas supplies to Europe are slowing. The BoJ story just reinforces that currency vol will remain high and slowing gas supplies to Europe just reinforces the negative economic outlook for Europe. The breadth of US economic data has rolled (breadth does not imply significance – spending and labor data in the US are still too firm) and rest of world data is following. The global economy is going to slow aggressively…
…and with financial conditions tightening at the same time, credit spreads continue to come under pressure. US HY CDX spreads have moved wider, but the move in European credit spreads has been more aggressive. Weaker business spending will follow wider credit spreads and weaker business spending will be a significant drag on economic growth.
We have highlighted a few times that the return spread between Value and Growth should narrow, for non-macro reasons, going forward. The amount of crossover of stocks that are both Value and Growth is unusually high. That being said, a slower growth outlook should favor Growth stocks. Interestingly, Growth has outperformed on this latest move lower in markets and that is a departure from previous selloffs. Market internals could be picking up the sharp slowdown in economic growth that credit spreads, broader commodity prices (see CRB RIND), and inflation expectations are reflecting.
The correlation between Low Volatility and Earnings Turbulence is deeply negative. This pair is the best way to express risk-on vs risk-off in the market. Low Volatility has outperformed ALL YEAR, but in an extremely volatile fashion. Every breakout in Low Vol has been sold quickly, only to then go on to make a new high. To the extent that we have some relative calm in the markets over the next few days (and the unprecedented stats on the selloff suggest that is possible), Low Volatility will come under pressure. Low Volatility is mostly made up of Defensives,
Short Idea: Speaking of Defensives, John Roque likes shorting KHC. 1) It went from looking / acting strong technically as recently as mid-May to now acting very poorly / weak. 2) Sharp downside move on May 18 and then a downside gap on May 26 suggests to me that sellers are more aggressive than buyers here. 3) Daily momentum is oversold BUT in this environment that has meant that the item gets weaker and not that it rallies. 4) Weekly momentum decelerating at a rapid rate and working toward negative territory. John thinks it has risk to $30, with potential downside to $20.
KHC August $30 puts are ~$0.50, only 1.4% of spot. The bid-ask spread is wide, so consult your favorite options desk for updated pricing. Buying the puts outright sounds good to us, but we defer to options specialists for more sophisticated strategies.
