The Continued Market Rotation From Cyclical to Defensive

One thing I continue to remind myself of is that narratives can be a very powerful driver for the market. During times of market rotation, investors on both sides of the discussion can have clearly articulated near term fundamental reasons for the stock, commodity, etc to go up or down. In the end, taking a broad approach to evaluating the market tends to work out because while history doesn’t repeat, it does tend to rhyme.

In this post I discuss:

  • Changes in currencies and ex-US equities
  • Analyzing commodities and the US rotation
  • Items of considerable interest

Currently the US is showing the greatest economic strength but it is probably only a matter of time before it exhibits characteristics of a slowing economy like the rest of the world. Therefore, the positioning I recommended a few weeks ago remains my current positioning.

Changes in Currencies and ex-US Equities

The Trade Weighted USD has made quite the rebound despite numerous strategists and investors, many of whom I respect, calling for the USD to decline further.

Trade Weighted US Dollar
Source: Bloomberg

Their viewpoint makes sense as the USD has seen its share of foreign exchange reserves and international transactions continue to decline.

Percentage of Foreign Exchange Holdings in USD
Source: Bloomberg

SWIFT Transactions: Percentage in USD (white), Percentage in EUR (yellow)
Source: Bloomberg

However, as trade data in China continues to decline (discussed here: and Loaded and Empty TEUs at the three major ports in the US are slowing, the use of the USD in international trade should increase relative to other currencies, leading to it appreciate.

Total Change of TEUs at Major US Ports (6 month moving average)
Source: Port of Long Beach, Los Angeles, and NY/NJ

Even though the EUR peaked approximately two months ago, investors are still positioned for the EUR to appreciate. Just a reminder, I showed in the China post how the EUR tends to move with the Export Data of China’s major trading partners but with a lag.

EUR/USD Commitment of Traders (COT)
Source: (@movement_cap)

A more consistent correlation for the EUR is actually with a chart I’ve been posting on Twitter showing the change in Demand/Supply for Oil. Since 2005, the EUR has lagged major inflection points of the six-month average of Demand/Supply by four months.

EUR/USD (blue), Oil Demand/Supply lagged four months: monthly data point (red), 6ma (black)
Source: Bloomberg

As the EUR has declined, numerous ETFs associated with Europe have begun to look quite weak. Given the news, it’s no surprise that Italy and Spain are weak relative to the S&P. However, it is surprising that more stable economies, like Germany and Switzerland, look similar.

Italy (EWI) vs S&P 500 (white), ISM Manufacturing (yellow)
Source: Bloomberg

Spain (EWP) vs S&P 500 (white), ISM Manufacturing (yellow)
Source: Bloomberg

Germany (EWG) vs S&P 500 (white), ISM Manufacturing (yellow)
Source: Bloomberg

Switzerland (EWL) vs S&P 500 (white), ISM Manufacturing (yellow)
Source: Bloomberg

Turning to Emerging Market Currencies, a basket compiled by JP Morgan continues to weaken. There wasn’t much of a rebound from the 2016 lows, which initially made me think they had more room to run in the future. Now I’m wondering if it remained low for a reason.

Regardless, as ISM Manufacturing and EM FX declines, the performance of the Emerging Markets Index relative to the S&P 500 should continue to decline.

JPM EM Currency Index (black), Emerging Markets vs S&P 500 (blue), ISM Manufacturing (orange)
Source: Bloomberg

Besides Turkey, Brazil’s currency has been one of the weakest in this basket the past few months and is getting close to the worst level seen in 2015.

Source: Bloomberg

Despite the fact that the Brazil ETF, EWZ, is near all time lows relative to the S&P, I think that this has a long way to go since China’s trade data is still declining and ISM Manufacturing peaked only a few months ago in February. FYI, since 1980 the average peak to trough for ISM is ~18 months.

Brazil (EWZ) vs S&P 500 (white), ISM Manufacturing (yellow)
Source: Bloomberg

Analyzing Commodities and the US Rotation

While ex-US is showing how the market is changing from a cyclical, or weak USD perspective, to a defensive, or strong USD outlook, this is just beginning to show in commodities and in US sector rotation.

With commodities, there are three that I pay the most attention to: Oil, Copper, Lumber.

Starting with Oil, I showed in the previous EUR chart how Demand is weakening relative to Supply. This could change when the May and June data is released (Summer driving season). However, the EUR tends to lead changes in the price of Oil by two months. Therefore, the recent weakness in Oil could go on for some time.

EUR/USD with a 2 month lead (white), Oil (yellow)
Source: Bloomberg

The chart of Copper looks very similar to numerous other charts. More importantly, traders are still positioned for Copper to move higher.

Copper Commitment of Traders (COT)
Source: (@movement_cap)

This is despite the fact that the change in Copper year over year is highly correlated to ISM.

Source: Raoul Pal, Global Macro Investor

At the same point, the price of Lumber has exceeded the previous 30 year high by over 30%. FYI, this is a great example why previous highs should not be viewed as the potential limit, which is a mistake I made when opining on the price of Lumber six months ago.

Source: Bloomberg

Turning to US equities, it looked like there was numerous times when investors were changing their allocation to the Defensive Sectors and Industries. Each time though this failed despite the change in allocation for Currencies and ex-US the past few months. I continue to point to the increase in the Markit PMI data, which is more US focused manufacturing survey compared to the ISM.

However, as UBS showed a few months ago (h/t @TeddyVallee), the US economy is benefiting significantly from the boost in Oil.

As Oil begins to fade, I would expect the other Cyclical Sectors and Industries to begin to underperform the more Defensive Sectors and Industries. As a reminder, market rotation tends to occur around the peaks and troughs of ISM Manufacturing.

ISM Manufacturing (yellow), Semiconductors vs Health Care (white)
Source: Bloomberg

ISM Manufacturing (yellow), Financials vs Consumer Staples (white)
Source: Bloomberg

Items of Considerable Interest

Despite the move off the February lows, the Volatility Spreads (initially discussed here: ) have stayed compressed and never fully recovered. This morning (May 29th), they were under considerable pressure but did recover off the lows by the end of the day.

Generic Volatility Spreads (2ndmonth – 1stmonth) (white), S&P 500 (yellow)
Source: Bloomberg

However, the Volatility Curve is in backwardation for the first time in over a month.

Volatility Curve: May 29th(green), May 25th(orange), May 18th(blue)
Source: Bloomberg

For the rotation from ex-US to US and Cyclical to Defensive to last more than a few months, the Option Adjusted Spreads (OAS) has to increase. As discussed in the China post, there’s little to no financial stress when looking at the spreads. However, it seems like this is beginning to change.

ISM Manufacturing (yellow), Investment Grade OAS (red), High Yield OAS (white), Emerging Markets OAS (green)
Source: Bloomberg

If the Spreads do continue to widen, then the next step is for the lending conditions of US Banks to tighten to businesses of all sizes.

Source: St Louis Federal Reserve

US Banks have already tighten the lending conditions for credit cards and auto loans towards US consumers with lower credit scores.

Source: Barclays

Source: St Louis Federal Reserve

Outside the US, we’ve already seen China’s major trading partners export data decline and the Leading Indicators for Japan decline, which has correlated well with global manufacturing.

Finally, the European Banks tend to be the last ones to tighten their lending conditions.

ECB Survey of Lending Conditions to European Businesses
Source: Bloomberg


Currently the US is showing the greatest economic strength but it is probably only a matter of time before it exhibits characteristics of a slowing economy like the rest of the world. Therefore, the positioning I recommended a few weeks ago remains my current positioning:


  • Overweight (or long) the USD
  • Underweight (or short) Emerging Market currencies


  • Overweight (or long) long dated maturing US debt
  • Underweight (or short) Emerging Market debt


  • Overweight (or long) S&P 500
  • Underweight (or short) Emerging Markets
  • Overweight (or long) US defensive sectors and industries
  • Underweight (or short) US cyclical sectors and industries