The defining feature of 2010 will be… | FT Alphaville

The defining feature of 2010 will be…

Reverse repos.

That’s according to Morgan Stanley’s chief European strategist Teun Draaisma, who reckons the moment the Fed starts to drain excess reserves from the system will be the point at which a 10 per cent equity market correction begins.

Now, the New York Fed conducted its first test of  reverse repurchase agreements — selling assets such as Treasuries to dealers for cash with an agreement to buy them back later at a slightly higher price — last month.

And Draaisma thinks the Fed will go live in March, at which point it will be time to put on the tin hat and rotate into defensive stocks:

There always is some sort of equity market correction around the start of tightening post US recessions. The average such correction has been 13% over 6 months, typically starting around the first Fed rate hike, sometimes earlier (such as in 1976 & 2004). In the aftermath of secular bear markets, the start of tightening leads to an even more severe and longer correction.

This time around, we expect this period of market weakness will start around the time of the start of liquidity withdrawal early in H1 rather than around the first Fed rate hike in H2.

Here is all of that pictorially (click to enlarge):

Equity corrections after Fed rate hikes - small

And this is how Draaisma is positioning himself for this equity market squall.

We are increasing Staples from +2 to +3% OW, Healthcare from +1 to +2% OW; Consumer Discretionary from -2 to -1% UW; reducing Materials from +2% OW to neutral; Financials from -2 to -3% UW by lowering Banks from -1 to – 2% UW (Financials tend to suffer during ‘start of tightening’ phases). After these changes, we are playing our themes of reliable growth / inflation hedges / start of tightening through: OW Energy +3, Consumer Staples +3, Health care +2; Neutral Industrials, Materials, Telcos; UW Tech -1, Consumer Discretionary -1, Financials -3, Utilities -3.

Related links:
[Outlook 2010] The deluge begins – FT Alphaville
The interest rate disconnect – FT Alphaville
Reversing the repo constraint – FT Money Supply