Melt-Up Or Euphoria? A Rose By Any Other Name…

“Word is getting around about stocks”, Bloomberg’s Sarah Ponczek wrote Friday, in a sort of tongue-in-cheek nod to the notion that too much attention to the rally could be a bad thing in the event the melt-up morphs into outright euphoria headed into 2020.

By the time the closing bell sounded on Wall Street, US equities had logged another solid session, pushing to even higher highs. The S&P rose a fourth week, the 10th weekly gain in 11.

For its part, the Nasdaq surged more than 2% over the last five days, the best week since late August, when stocks began to recover after a bout of volatility catalyzed by growth concerns and tariff jitters.

The gains off last year’s lows are monumental. Big-cap tech, for example, is up 52% from the December 2018 nadir.

This is on track to be the third best year for the Nasdaq 100 since the tech bubble.

Signs of FOMO aren’t hard to spot. Earlier this week, we briefly documented JPMorgan’s call for a “Great Rotation II” in 2020. In short, the bank is looking for the tide to turn for equity flows after a year in which fixed income funds dominated despite the run-up in stocks.

Read more: Get Ready. ‘Great Rotation II’ Is Coming, JPMorgan Says

Well, in Q4, equity ETFs have taken in more than double the haul of their fixed income counterparts, a dramatic shift from the first three quarters of the year.

That’s the kind of breakdown (i.e., flows into equity funds outstripping those into bond vehicles) that JPMorgan thinks will be the norm in 2020, rather than the exception, as it was this year.

On one hand, it’s easy to suggest this will end poorly. After all, you could argue the geopolitical backdrop is still fraught by the standards of the past two decades.

Then again, central banks have proven remarkably adept at suppressing market-based measures of volatility in the face of intermittent crises and epochal political shifts in western democracies. Although it’s clear Donald Trump’s trade war dented the global economy in 2018, exacerbating the pain from Fed tightening, last year’s losses are a distant memory for almost all asset classes, even as cross-asset vol. hasn’t yet receded to the bubble lows seen during the halcyon days of 2017 (with the exception of FX vol., which is more somnolent than ever).

It’s also possible to argue that intractable political tumult and a manic news cycle are just the new normal – something which can be dismissed as “noise” (figuratively and literally) until it matters. Of course, by the time it matters, it’s usually too late to get out of the way, but that’s another story.

We’ve written previously that’s it’s not difficult to make the case for a return to “Goldilocks” in 2020 – for another year characterized by an “everything rally”, albeit perhaps less impressive than 2019. And in any case, the likely persistence of an accommodative lean from policymakers makes it possible to argue for buoyant risk asset prices on at least a couple of fronts:

1. If, on one hand, growth remains sluggish and inflation fails to respond convincingly, the “everything rally” can persist, as bonds are bid on “slow-flation” dynamics, while “TINA” and the promise of abundant liquidity bolsters equities and credit.
2. If, on the other hand, stimulus does start to manifest itself in better economic outcomes (e.g., an inflection for the better in manufacturing PMIs), you can argue that although bonds may suffer in a pro-cyclical rotation, equities will rise on risk-on sentiment tied to improving macro, and credit can rally as the cycle is prolonged.

That kind of “heads bulls win, tails bears lose” reasoning makes it tempting to stay bullish equities (and credit) as long as there’s not a clear-cut case for aggressive policy tightening or signs of an imminent turn in the US cycle.

“I’m not saying US 10-year yields are going below 1.00%, I’m simply saying that I don’t see scope for a big ‘paradigm-shifting’ fixed income selloff over the course of- or by the end of- 2020”, Nomura’s Charlie McElligott said Friday, elaborating on his macro outlook, which we detailed here at length.

“Bonds will remain supported near current levels based around my view that the Fed’s current ‘QE-Lite’ of T-Bill purchases / Open Market Operations will ultimately turn into something that is closer to ‘OUTRIGHT QE’ over the course of 2020, as they have to begin shifting from purely front-end towards purchases directly into USTs / ‘Duration'”, he said, echoing the sentiments of Zoltan Pozsar, who this month argued that a shift to coupon purchases by the Fed is necessary and inevitable.

That wouldn’t necessarily mean that the Fed was trying to compress risk premia in “classic”, post-crisis, “wealth effect” fashion. Rather, it would be a recognition that bill purchases and repos aren’t addressing the problem – that was one of the main points of Pozsar’s widely-cited December note (see the linked post above for details). As Charlie writes, a shift to QE “proper” would be “in order to add reserves to an extent that can help offset the regulatory capital requirements and ‘broken’ participant incentives which are plaguing funding markets”.

Whatever the rationale, you’d be inclined to think it would mean stability in rates vol., which can anchor the rest of the market, especially if expectations for a V-shaped inflection in growth and inflation expectations don’t materialize, thereby disappointing those expecting a big bond selloff.

As McElligott went on to say Friday, “next year in general can look like an ‘everything rally’, as stable Rates suppress cross-asset volatility and provide a constructive backdrop for both Bonds and Risk-Assets in standard ‘QE / Goldilocks’ fashion”.