“[It’s] the hope that a COVID ‘new normal’ may not materialize.”
That’s how JonesTrading’s Mike O’Rourke summed up the mood after a rousing start to the new week for US equities, which rallied in delirious fashion on a combination of vaccine news, surging crude and a possible game-changing step towards a fiscal union in virus-ravaged Europe.
Even if Monday’s euphoria quickly evaporates under the heat of some new negative development on the virus front or further signs that relations between the US and China have suffered irreparable damage, the abrupt resurgence of the pro-cyclical trade served as a rather poignant reminder that we’re always just a headline or two away from a narrative shift.
Read more: Caveat Emptor.
Needless to say, many a market participant would be caught woefully flat-footed in the event a pro-cyclical rotation and any attendant bear steepener starts to get traction. After all, the economic backdrop (characterized as it is by the worst data since the Depression and core inflation that just plunged the most in history), doesn’t exactly scream “long cyclicals and high beta”.
But I’d be remiss not to at least acknowledge the possibility that we’re missing the forest for the trees.
I’m highly skeptical of the notion that the inflationary side of COVID-19 (e.g., surging grocery prices and the prospect that on-shoring and supply shortages could drive up prices in both the medium- and long-term) will be sufficient to overwhelm the deflationary supernova that goes along with the worst demand shock seen in a century. Skeptical though I may be, I have argued that side of the coin in the interest of keeping the discussion balanced. Both sides are presented at length in “After The Virus, Hyperinflation Or Deflationary Spiral?”
It’s also possible we’re underestimating how quickly science can move when it’s prodded and funded, and overestimating the assumed psychological damage to consumers.
I won’t weigh in on the vaccine development time line as that’s not my area of expertise, but when it comes to consumer psychology in a post-COVID world, we should acknowledge that Americans aren’t exactly known for being a cautious bunch, always guided by science and reason. For right now, I’m inclined to say that pent up demand for human interaction and nostalgia for “normality” is behind crowded beaches and packed bars in some locales, but it could be that Americans simply shake this off and go back to being the frivolous, free-wheeling, consumption-obsessed bunch they’ve always been.
When you consider the above with the sheer quantum of stimulus already injected into the veins of the still slumbering economy, it is possible that we’ve already overstimulated this sleeping beast, and that once it wakes up, it will rip out the IVs, eat the nearest nurse and run snarling through the hospital lobby and out the front door.
With that in mind, Morgan Stanley writes that while their memory may be a bit fuzzy given the passage of time, their “recollection of investor sentiment during [March of 2009] was very similar to today” where that means “little belief in the ability of the economy to recover sustainably given the damage to the banking system and consumer balance sheet, both of which are in better shape” in 2020.
Morgan ultimately believes that the Fed will succeed in anchoring the short-end, but could lose control of the long-end.
There’s nothing particularly novel about the bank’s approach to this analysis, and sometimes, there’s merit in plainspeak and avoiding the tendency to overthink things.
“With the Fed purchasing so many Treasury securities the general view is that the back end will remain pinned because that’s what the Fed wants to keep nominal rates low and real rates negative”, Morgan’s Mike Wilson writes, on the way to saying that although that could end up being the case, there are “a few possible ways the bond market might be surprised that could drive rates higher than expected over the next few months”.
These are very straightforward and succinct, so I’ll just give you the lightly abridged bullet points from the note. To wit:
- It’s bad for the banking system to have such a flat yield curve and counterproductive to getting M2 growth and therefore inflation which is one major reason why Japan and Europe haven’t recovered since the GFC. If the Fed understands this dynamic, they should/could begin to signal it wants rates to rise at the back end.
- Fiscal stimulus is much greater this cycle than during the GFC and Congress is contemplating more. Could another $1-2T in fiscal stimulus be the straw that breaks the camel’s back bringing out the bond vigilantes? If not, could it at least drive a sharp move higher in breakevens and the term premium?
- The re-opening of America comes faster and goes more smoothly than feared and our V-shaped recovery suddenly looks more likely to the markets. This is our underlying base case.
- Supply chain issues appear as demand returns in certain areas where production has been shut down causing pockets of unexpected inflation
Again, I don’t necessarily agree with most of that, let alone as the rationale for a view that 10-year yields are likely to move markedly and sustainably higher anytime soon, but as Wilson writes, that’s precisely why this is worth keeping in the back of your mind – because nobody expects it.
“We continue to think higher 10-year rates would be perhaps the biggest surprise to markets at the moment and would have significant implications for equity markets and leadership”, the bank remarks.
It would also have “significant” implications at a time when the US is issuing trillions in debt, especially after Steve Mnuchin surprised the market with a bigger duration tilt than some were expecting.
Meanwhile, in the same vein, SocGen’s Sophie Huynh says a V-shaped recovery is not yet priced into stocks for the simple reason that leadership has been concentrated in equities expressions tethered to the vaunted “duration infatuation”. If there’s a pro-cyclical turn, the game changes as the baton is passed and the rest of the market plays catch-up.
“Despite the rally on the S&P 500 since March 23, a V-shaped recovery was not being priced-in”, she writes, in a note dated Monday.
“The rally was dominated by a long duration call (defensives and bond proxies) and COVID-19 sectors benefiting from lower yields and a lockdown situation”, Huynh adds, before suggesting “more upside is possible in a V-shaped scenario, with a rotation into cyclical sectors”.
Going forward, Huynh is looking to the S&P and S&P 400 Midcaps rather than the Nasdaq 100, which has obviously run well out ahead of everything else.
Draw your own conclusions.