ED HARRISON: Welcome to Investment Ideas. I'm your host Ed Harrison. In today's episode, we're talking to Charlie McElligott, Nomura's cross-asset macro strategy head, and we're going to look at a more tactical approach. We're going to look at the shorter end of the 6 to 24 month time horizon that we normally talk about and look at it from a very tactical perspective. So I hope that you enjoy what we have to say. Let's get right to Charlie.
Charlie, good to finally meet you in person here on Investment Ideas. I'm very interested in picking your brain because of the Fed. I really want to talk to you about this massive transformation from tightening bias to this easing bias that they're going through. And there's sort of a consensus that's going through right now.
And you know, I may have told you, this show's about the 6 to 24 month time frame, but from a tactical perspective, you have something that's very different in the consensus over up to the 6 month time frame. Can you tell me how the Fed plays into that?
CHARLIE MCELLIGOTT: Absolutely. So one of the key themes with regards to that 2018 regime that we were operating in last year, of course, was this idea of QE to QT. And what came with that was a new macro volatility regime as well. The match was lit with regards to that transition last year into this rolling vol event environment, based on a consensual embrace, the prior 5 plus years of what I call a slowflation.
And slowflation was this group think with regards to 2%ish GDP growth and sub 2% core CPI. That world view was that very constructive for risk assets Goldilocks scenario that we were dealing with. So you know, say within the equities universe, it was long secular growth, right, things like FANG, things like tech, story stocks that were able to grow regardless of the economic cycle that we were sitting in at that time.
You would barbell that long, similarly by owning defensives, low volatility bond proxy type plays, REITs/UTEs, which are actually two of the top performing sectors over this last one year period. That gave you kind of a hedged long exposure on the short side of this slowflation positioning was-- you know, you were based in cyclicals, because the perception was that we didn't have enough gearing on the economy to see those really cyclical sectors work.
So clearly, banks, energy, materials, industrials, things of that nature. What started happening last year, actually, that kicked off that vol scenario, if you think back about last January it was quite halcyon in the sense that risk assets were ripping over the course of January. Of course, this is all before the February 5th volume.
And the Fed had really managed that message through forward guidance for a long time. And what ended up happening was that we were actually, at that time, though, just hitting above trend growth and above trend inflation for the first time in a long time. The economy is really going.
ED HARRISON: It was almost towards the 3% low.
CHARLIE MCELLIGOTT: Right, right. So I mean, we were already transitioning into what I call-- my 2018 thesis was this two speed year thesis. The first phase was cyclical melt up. The second phase was financial conditions tightening tantrum phase. In that first phase, though, when you hit above trend growth, above trend inflation, you get this cyclical melt up. What ended up happening was that that fiscal stimulus at the end of an already hot overheating cycle, all of a sudden we lost our visibility in the path of rates.
The point is that inflation is the toggle with regards to Fed policy. Fast forward to now after all the calamity caused by quantitative tightening and our inability to handle, you know, 3% interest rate, here we are, and the Fed has pivoted the market kind of back to the future, back to this slowflation positioning, back to what works best in a slowing growth, low inflation, low yield world. And I think that's where the opportunity is to kind of go against the grain here.
ED HARRISON: So given that, in terms of what you think over the next 6 months, opportunity wise is it's the opposite of that.
CHARLIE MCELLIGOTT: Right.
ED HARRISON: So tell me what your positioning would be in terms of a trade over that 6 month time frame. And then we can probably go into some of what might take it further out than six months?
CHARLIE MCELLIGOTT: Exactly. So typically, when I speak about factors, in my daily piece, because I'm speaking with cross-asset investors, macro investors, fixed income investors, not just equity folks, I get a lot of query, why so much focus on equity factors?
And I view equity factors as real time macro indicators, both with regards to positioning and sentiment and risk, but also two, clear trends like inflation expectations, and particularly, watching how factors behave as it relates to some key macro input like the shape of the US yield curve.
What my core theme was was that you don't fear the inversions, which at a point last summer, that was a talking point, obviously, in the last few months, month and a half, that's been a big talking point, too. But the signal is really, you need to watch for the steepening. The steepening of the yield curve is telling you that we're about to inflect.
And so last summer, I started pushing a curve cap straight, which is just an option on the shape of the yield curve. And the beauty of a curve cap, and specifically, I was looking at the 5s30s, because it captures a large enough swath of the yield curve, both to capture some of the front end, more Fed policy centric stuff, but also the long end, which is kind of a long term view on growth and inflation.
And the beauty of the curve cap is that it doesn't matter if it's a bull or a bear steeper. What we've just kind of emerged out of and starting kind of late last fall, that 5s30s went from 20 bibs to the current let's say 60 bib. So it's tripled.
ED HARRISON: Right, yes.
CHARLIE MCELLIGOTT: But it's been a bull steepener. And that was because the market-- and my thesis was the market sniffs the slowdown. The market sniffs the slowdown before the Fed does.
ED HARRISON: Right.
CHARLIE MCELLIGOTT: And we begin to price out further Fed hikes, and instead, price in Fed easing. So at the front end does after pricing in all of that future hike because we are on autopilot and all those comments of misdirection of effectively ex post facto from the Fed, boom, you go back here, and then ultimately, the market, where we kind of stand now, you begin to actually price in easing.
The trick here is this, and this is why I'm shifting kind of from this bull steepener of the last, let's say, 6 months to now there's much more tactical view on a bear steepener is that this recent repricing in fixed income on the growth scare-- and the growth scare is real, and the growth scare is consistent with my message last year.
The growth scare is actually caused this time around by, I think, it's created a false optic due to the overshoot in rates that has occurred because of very technical factors, specifically negative gamma assets, negatively convex assets.
ED HARRISON: So like mortgages.
CHARLIE MCELLIGOTT: Exactly, mortgages, and to a certain extent the growth of short volatility strategies also playing in the fixed income space that had large flattening trades on, as well as kind of the variable annuity space. So those three players, predominantly mortgages, they really caused this mechanical overshoot, and I think it created a false optic that recession was imminent.
And I think, in light of that, this opportunity to reverse, then, this embrace back into this slowflation type of trade that we're seeing so crowded, specifically amongst equity investors, is really an opportune time to begin getting long the stuff that these folks are short.
ED HARRISON: So like value, basically.
CHARLIE MCELLIGOTT: Value, right. So why is it value? Value is really a nice way of saying it's stuff that hasn't worked for a long time, and why hasn't it worked? Because of slowflation. So what you've seen in April has been particularly telling. And I think it's a foreshadowing of what could happen, kind of on this 1 to potentially 6 month time horizon.
You've seen a very painful reversal, which is exactly what I'm talking about. Value longs are all ripping. Cyclicals are all ripping. And the longs for the slowflation view are the secular growth stuff. They've been acting as a source of funds. And the other part of that barbell long are the defensives, the bond proxies that have all been hit, because now we are repricing in a little bit better growth than the market was anticipating.
ED HARRISON: Just going beyond the 6 month time horizon, this could turn from a tactical perspective into a more strategic, longer term investment thesis. And what kinds of things have to actually be in place for that to occur?
CHARLIE MCELLIGOTT: No, it's the right call, because so much of what we're talking about right now is taking advantage of this legacy crowding.
ED HARRISON: Right.
CHARLIE MCELLIGOTT: Right, you know, hundredth percentile ownership of software, single digit percentile ownership of banks, right? Just to capture the spread on how crowded this kind of legacy positioning is. What makes it a sustainable macro phenomenon, one, are catalysts for steepening the yield curve, and there's a technical factor that I'll touch on in a second with regards to what I think the Fed is going to be kind of announcing in the next few weeks, as well as some other central bank policy that's critical for inflation going forward.
So the first, I would say, originates out of China.
ED HARRISON: Right.
CHARLIE MCELLIGOTT: We've seen, obviously, the impact as a major catalyst for the turn in risk assets since January that was created from the credit impulse, the social financing, the new Yuan loans, the credit pumping into the system, the liquidity pumping into the system, the largest reverse repo injection ever. That has a major impact on the global supply chain, global commodities, thus inflation and inflation expectations. So that's a huge catalyst for cyclicals.
We think that in-house, our view is that there still is one more turn lower in China in Q2. But at that point, the preferred policy path for the PBOC, beyond an additional RRR cut, we think even more so than the likelihood that you get an actual policy cut, will be that they ease the property sector.
ED HARRISON: Right.
CHARLIE MCELLIGOTT: And the property sector is an incredible driver and consumer of, as you can imagine with regards to the amount of infrastructure growth going on there, a huge consumer of commodities.
ED HARRISON: Right.
CHARLIE MCELLIGOTT: And with that consumption impact-- and you see it on nights overnight, like today, where you had, you know, steel up 3.5%, iron ore up 2.8%, you get these limit up type of days based on that positivity the more Chinese liquidity will be released, especially if it comes through the property sector-- that's catalyst number one to make this a stickier trade.
The second part is a little less tangible, and it's with regards to what the Fed has been talking about the last few months, since that January pivot, with regards to trying to get their arms around and try to dictate inflation expectations in the market. And they've had a heck of a time doing that. You know, anybody that's seen the BOJ since the '90s, it's not an easy thing to do.
What they're talking about doing, though, is it's a little bit of semantics, but it makes a difference with regards to forward guidance. And what they're talking about doing-- and nothing's been agreed to yet, and that's why actually this kind of 6 month time horizon is very interesting, because we think it will take shape over that amount of time-- that they will be announcing this inflation framework shift. And under that inflation framework shift, they could be announcing anything from inflation averaging, which would allow the Fed to run hot on inflation without bringing back that 2018 fear of Fed policy.
You know, the first time you get a core CPI beat or a big average hourly earnings beat, if people think that the Fed is going to come back in, positive inflation is a risk off moment. So if you think they're able to run hot and run over that an average for a while, then you can stick with some of these cyclical longs that will benefit from that type of inflation impulse.
The other is that if they move to outright inflation, inflation or price targeting. And that's been floated too. So there's a key Fed research symposium in January in Chicago--
ED HARRISON: This coming January.
CHARLIE MCELLIGOTT: No, this coming June, excuse me, in Chicago, and that's going to be, I think, where a lot of this stuff gets fleshed out into the market. If you can get one or even both of those catalysts, this trade, all of a sudden, in light of the consensual legacy under positioning in cyclicals, the crowding into seculars, the crowding into defensives, you're going to see another repricing in fixed income, meaning fixed income sells off, probably a steepening, probably a bear steepening of the yield curve. And that bear steepening the yield curve is going to correspond with a rip in value factor, and momentum factor is going to be hammered.
And the final point that I would make-- there's one more factor here that I think needs to get touched on-- is that there's actually something that the Fed is trying to do. Everybody's very focused on the shift away from quantitative tightening. They still have their mortgage portfolio that they want to be out of, and they want to continue to let that run down.
So in the sense that the market, you know, thinks QE right now, and that's fine because in a couple of months we'll be buying bonds again. The Fed will be taking reinvestment and buying bonds again, unequivocally. That's your definition of QE. Then you're good to go. But what they are going to be doing with those reinvestments is they're going to be focusing them more towards the front end.
ED HARRISON: Right.
CHARLIE MCELLIGOTT: And what I like to call reverse operation twist. And that reverse operation twist does the primary goal is that the Fed wants to shorten the weighted average maturity of their treasury portfolio, so that they're not a short volatility force in the market with regard to duration. I think they want to do that, plus it by definition is a steepener.
ED HARRISON: Right.
CHARLIE MCELLIGOTT: And by definition, being a steepener, you have this extra catalyst for this trade that we're discussing here. And I think that, too, will take shape in the coming months.
ED HARRISON: It's been good talking to you. I think that we're definitely going to have to have a follow-up.
CHARLIE MCELLIGOTT: For sure.
ED HARRISON: In the next six months. Maybe after Jackson Hole, that will be the time for us to talk.
CHARLIE MCELLIGOTT: That sounds great.
ED HARRISON: Great. Thanks again, Charlie.
CHARLIE MCELLIGOTT: Thank you, sir.
ED HARRISON: Charlie believes global central banks are now pursuing outright reflationary policy. And this is going to have a disparate impact on risk assets. So Charlie's investment thesis is a tactical relative value play. He says, go long value, which he defines as cyclicals that he sees as extremely undervalued right now. At the same time, he recommends going short against momentum, which he defines as a barbell long in safe haven assets for one, secular growth companies like the FANG stocks for two, and defensives and other low volatility bond proxies for three.
Beyond 6 months, Charlie says the tactical could become strategic or thematic if two things occur. One, the Chinese began easing in the form of cuts to the required reserve ratios or property sector deregulation, and/or two, the Fed shifts to a new inflation framework that allows inflation to run higher than its 2% target for longer.