Wondering What Marko Kolanovic Thinks About Friday’s Curve Inversion? You’re In Luck…

Last week, JPMorgan’s Marko Kolanovic weighed in on the outlook in light of a YTD surge in risk assets that’s seen the S&P rally to within shouting distance of his 3,000 target which, just two months back, was castigated by some skeptics as being far-fetched.

Long story short, SPX 3,000 doesn’t look so unrealistic anymore and in fact, you could pretty easily argue that it’s a foregone conclusion, although, as ever, nothing is a sure thing in a world where the geopolitical backdrop is hopelessly fraught and “miracles” of modern market structure often act as dry kindling when someone tosses a match.

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Now Vindicated, Marko Kolanovic Explains Dramatic Market U-Turn

It probably won’t surprise you to learn some clients have asked Kolanovic whether the recessionary “signal” from the 3M-10Y inversion changes his outlook on equities. Relatedly, folks are also curious to know whether Marko is in the camp that thinks “this time is different” (so to speak) when it comes to what curve inversion means going forward.

“Over the past 40 years, inversion happened on 5 occasions and the curve was inverted for ~10% of the time”, Marko writes, in a Tuesday note that takes a look at “the path of markets after the first instances of 10Y-3M inversion in 1978, 1989, 1998, and 2006.”

Kolanovic is a quant, so naturally, he wants folks to remember that “strictly speaking it is impossible to derive reliable statistics from this relatively small sample”.

But that (important) caveat aside, he does note that “inversions do show a strong similarity given they are a result of a specific setup of monetary policy and the economic cycle, and hence are likely to produce a similar response by investors and central bankers.”

Marko delivers a series of bullet points on historical inversions, but we’ll just zoom in on three main points, all of which will be familiar to anyone who is steeped in this discussion.

“Given the low 10Y yield, investors reallocate to equities and equity multiples tend to re-rate higher (i.e. ‘Fed model’)”, Kolanovic writes, adding that “following inversion, the Fed tends to stop hiking or commence cutting which can also boost equity valuations.”

The read-through there is straightforward. To wit:

Performance of the stock market after the onset of inversion tends to be extraordinarily strong. For instance ~12 month performance tends to be in 80-90th percentile (Figure 2). The pace of market gains tends to be above average for up to ~30 months after first inversion, after which performance deteriorates significantly.

Here’s an enlarged version of the inset:

(JPMorgan)

Ok, so what’s different this time around and what’s similar to historical inversions?

Taking the latter question first, this episode is of course the result of the Fed hiking and growth slowing. Additionally, the Fed has now adopted a dovish bent.

As far as what’s different, JPMorgan cites lower (and negative) yields around the world and QE, before noting that “China is a key driver of the global economic cycle, and monetary and fiscal policy in China are likely to determine this cycle more so than the Fed.”

When it comes to whether the traditional “lead-time” from inversions to downturns is reliable this time around, Marko adds a bit of color to the debate. With yields still mired in NIRP in some locales, and with “lower for longer” now looking like “lower forever”, it’s possible that higher valuations for equities could be warranted.

Additionally, any inflection (for the better) in China’s economy has the potential to prolong the cycle given that China is the engine of global growth, trade and credit creation. Hopes of “kitchen sink” Chinese stimulus have buoyed the reflation narrative at various intervals in 2019 despite a backdrop that, on most days, suggests the global slowdown narrative is ascendant.

Finally, Marko notes that the conclusion of the Mueller probe removes a handful of “tail risks” and the fact that Trump may seek to boost the economy into the election argues for more fiscal stimulus in 2020, something which also has the potential to extend the cycle.

This comes with the usual caveat that “this time is different” is sometimes a dangerous phrase. That said, Kolanovic is hardly alone in suggesting that this particular inversion isn’t something anyone should panic about – or at least not right now, because even if you do believe the curve is the closest thing we have to a crystal ball, history suggests we’re quarters (at least) away from a downturn, not months.