First thing on Tuesday morning (and remember, Tuesday is actually Monday for U.S. traders), we suggested that the mood was dour.
I mean look, the mood is guaranteed to be some semblance of dour after a long weekend in the U.S. Americans aren’t a forward-looking bunch. They don’t think about Sunday in terms of “tomorrow is Monday” or, in the case of this week, they don’t think in terms of “Monday is a holiday but Tuesday is not.” Americans think of Sunday like a fun sequel to Saturday – so, more drinking, more laziness, and pretending like work isn’t right around the corner.
So even if futures were green and yields were lower and there wasn’t every reason to believe that we’re going to have to worry about 3% on 10s all week amid the Treasury supply deluge and what should be Fed minutes tipping an inclination to think price pressures are indeed materializing, U.S. traders would be irritated to be back at work. That’s the way it works in America.
But not everyone’s feeling that gloomy vibe. Former trader and current Bloomberg columnist Richard Breslow has the exact opposite read on things. “Today has a distinctly upbeat feel to it [and] that’s rare enough, so I’m going to enjoy it while it lasts,” he writes in his first missive of the week. “Equity markets have been moving around, but the action isn’t couched in dire terms every time there has been a dip [and] the coming bond auction deluge is being discussed in terms of appropriate concessions rather than who’s going to want all of this stuff,” he continues.
The irony there is that what’s actually “rare enough” is Richard Breslow couching things in the most optimistic terms possible, which is what we got this morning.
Anyway, one person who’s not feeling quite so enthusiastic is Morgan Stanley’s Andrew Sheets, who says what we saw in equities earlier this month was an “appetizer, not the main course.”
To be sure, that’s hardly a wildly contrarian take. Sure, most people are still constructive, but as Breslow notes in the same note mentioned above, there’s no shortage of people who can rattle off a list of reasons to be concerned. Essentially, Sheets is warning about the same thing that Deutsche Bank and others have warned on recently – namely that higher real yields could soon present a particular daunting challenge for equities. Recall this from DB’s Dominic Konstam:
However we also know that for SPX in particular it matters where the term premia is falling (or rising). Inflation term premia has turned out to be positive for SPX while real yield term premia is negative. We interpret this in terms of the “numerator” on earnings being levered to inflation so the risk of higher inflation tends to dominate the negative impact on the discount factor for earnings. By contrast there is no earnings leverage to real yields. On the contrary, higher real yield term premia threatens an overshoot of real yields to equilibrium rates which would depress growth. A Fed “behind the curve” maybe about a (bear) steepening in the nominal curve but if it is about a steepening in the real yield curve i.e. the promise of much higher real yields in the future, it is more ominous for equities all else being equal as opposed to a steeper inflation curve. The inflation curve matters not so much because of the threat of higher future inflation per se but because as and when the Fed no longer tolerates higher inflation at any stage, a more aggressive rise in real rates will likely reduce risk neutral rates, which is negative for equities.
In any event, Morgan Stanley’s Sheets offers the following assessment of what he apparently thinks is going to be a “tricky” situation later in the year when inflation pressures continue to build but growth begins to moderate. To wit:
It’s when growth softens while inflation is still rising that returns suffer most. Strong global growth and a good first-quarter reporting season provided an important offset. We remain on watch for ‘tricky hand-off’ in the second quarter, as core inflation rises and activity indicators moderate.
And that gets us back to the above-mentioned Richard Breslow who says “this really does feel like a moment worth savoring, because I don’t have to try very hard to find people only too happy to assure me that the good vibes won’t last” what with “yields too high, equity multiples that won’t keep up, political instability – potential bummers all.”
There you go. Lots of “bummers” on the horizon. So you know “savor” the moment, because if Andrew Sheets is correct, the main course to the “appetizer” we got earlier in February isn’t going to be what one might call “savory.”