Citi’s Matt King: “We Think You Should Sell”

In a surprisingly bearish report, Citi’s Matt King has issued a new, long-awaited note in which he asks rhetorically “what’s a manager supposed to do when by early March your asset class has already exceeded your expectation for full-year returns? Take profit and take the rest of the year off, of course! And if it carries on rallying, go outright short!” And yet, he adds, “somehow nobody seems to want to.” The reason for that, according to King is that as we showed demonstrated last week using JPM and BofA data, “the rally owes more to inflows and short covering than to institutional investor exuberance. And part is that the economic data do seem genuinely to be improving.”

Nonetheless, King’s assessment of the current environment is downbeat and to the point: “sell we think you should, not only in € credit (as we advised a couple of weeks ago) but also more broadly.”

He then lays out seven reasons “not to trust your inner Trump”, which are as follows:

1. The Fed may stop the inflow party

The Citi strategist begins by noting that “perhaps the best reason to remain long is that institutional investors seem not to be.” He adds that the vast majority of the FI investors we have seen in recent weeks still believe in secular stagnation, and further notes that “to judge from our survey, overall positions have been creeping longer, but this is due overwhelmingly to positions among $ investors: those in € and £ credit have actually been falling (Figure 1).”

King joins the strategist bandwagon pointing out to the source of recent inflows and states that “the principal driver of investors’ buying seems to have been a response to mutual fund inflows. Not only equity funds but also bond (including both credit and EM) mutual funds have had their biggest 4-week run of inflows since 2013 (Figure 2). Numbers in Europe have been slightly weaker than the US-dominated global totals, but the pattern is similar.”

There is a problem with that: “But while this too might normally be a reason for bullishness, we doubt that the current pace is sustainable.”

Quite apart from the historical inability to maintain this flow rate for long, there is the small problem of the Fed. While at this point a hike on March 15 has been so well telegraphed that it ought not to cause a 2013-style tantrum, we do think much of investors’ willingness to pile into risky assets stems from the lack of return on cash. Each and every additional bp in risk-free yield is likely to make investors think twice about the risk they are running in order to generate return elsewhere.

It is also worth noting that over the past two weeks, BofA has issued a caveat that while retail inflows are seemingly relentless, institutions and hedge funds have recently turned sellers into the rally, and are aggressively offloading to retail, traditionally a market-top indicator. 

2. A rise in real yields should weigh on risk assets

King’s second reason why he thinks the rally has been so strong is that real yields have remained surprisingly low. Even as nominal yields have risen since the US election, almost all of the action has been in inflation (and growth) expectations (Figure 3). Traditionally this is positive for risk assets; in contrast, when real yields rise, it weighs on risk assets – albeit sometimes with a lag (Figure 4).

Citi suspects that what has made this move possible is the market’s willingness to focus on all the potential growth positives and yet shrug off the increasing signs of hawkishness from the Fed. “Such a position seems increasingly untenable on two counts. First, rates markets have now finally adjusted to the new mood music from the Fed, and seem increasingly likely to be confronted with an actual hike; second, the rally in credit was starting to look out of whack even with today’s real yield levels, never mind following any proper adjustment to follow.”

3. Central bank support is set to diminish

While it is no secret that King has long been a closet adherent to Austrian Monetary Theory, in his latest piece King reminds regular readers that one of his favorite model for markets’ behavior in recent years is their correlation with central bank liquidity. While the scale of their purchases over the past half-year or so has been close to record highs, it is already diminishing, and set to diminish further (Figure 5).