Things are going to look a lot different three months from now.
That’s the message from Goldman, whose Kamakshya Trivedi and Zach Pandl suggest the “landscape” for markets could change “substantially” on a trio of fronts by the end of November.
I’ll resist the temptation to bury the lede. The bank thinks options “are underpricing the upside for equity indices from an early vaccine”. And if you posit a scenario where a safe and effective shot comes “early”, you’re almost compelled to suggest that the ever elusive pro-cyclical rotation may finally arrive. Goldman does just that. From the note:
Shifts around vaccine news and the election may also challenge the market’s assumptions about growth and persistently negative real rates, and could prompt renewed rotation towards traditional cyclicals, steeper curves, and outperformance in EM (especially North Asian) FX and equities.
It goes without saying that calls for a sustainable steepener and a lasting rotation into long-suffering cyclicals, have been plagued by false starts for years.
The juxtaposition between blowout mega-cap tech earnings and eye-popping losses for US energy giants last month served as a rather poignant reminder of how rotations tend to be “stillborn”, as it were.
Read more: Rotation Stillborn
Concurrent with the surge in US virus cases and signs of a leveling off in the US recovery, the 5s30s flattened the most since 2017 in July, while 10-year US yields drifted to the bottom-end of the range.
All of that (the blowout results from tech titans against losses for Exxon and Chevron and lackluster machine sales for Caterpillar, alongside the renewed flattener which deep-sixed a consensus steepener call) underscored the pitfalls and myriad perils of forecasting a pro-cyclical rotation that never comes.
And yet, as noted here on Wednesday in “Fingers Crossed“, it does look as though some manner of vaccine is coming sooner than the “typical” timeline for a shot. The existence of a vaccine will change the narrative. Goldman underscores this.
“There is now a good chance that at least one vaccine will be FDA-approved by the end of November and broadly distributed by the middle of 2021”, the bank writes, adding that,
This kind of timeline could see a substantial boost to GDP relative to a “no-vaccine” case, particularly for the US, which is likely to lead the vaccine race and is likely to experience worse outcomes than in Europe without a vaccine. The steep rise in vaccine probabilities is, in our view, one key reason that the equity market has managed to make new highs even without definitive improvement in US health outcomes (the other is the persistent fall in US real yields, which continue to support equity valuations, particularly for long-duration growth or tech stocks).
That latter point is important, as it speaks to the dynamics mentioned above. Lower for longer yields are a boon to secular growth stalwarts and other equities expressions tethered to the “duration infatuation” in rates.
Goldman has incorporated its growth scenarios (which include a baseline, an upside tied to an early vaccine, and a downside linked to a further rollback of the re-opening push in a more severe “second wave” outcome) into US equity forecasts.
“We now see our baseline as consistent with the S&P 500 at around 3390, the upside case with the S&P 500 at around 3700, and the downside case with the S&P 500 at a little below 2200”, the bank writes, in the same note. At current levels, the probabilities assigned to those outcomes are 40% for both the baseline and upside cases and 20% for the downside case. So, there’s a 60% probability that there’s not an early vaccine.
That doesn’t necessarily mean anyone should pile into cash equities trading just ~2% from record highs (on SPX). Rather, Goldman simply suggests the tails are mispriced in options — and “especially” the upside case. As such, OTM calls on the S&P “still look attractively priced” if you’re inclined to believe a vaccine will, in fact, come “early”, they say.
Towards the end of the note, Goldman calls for the rotation that never comes or, as Trivedi and Pandl put it, things may be “setting up for a shift in leadership across markets”. To wit:
We have highlighted that equity upside looks cheap given a fat upside tail from an early vaccine. But we think a vaccine approval could also challenge market assumptions both about cyclicality and about eternally negative real rates, and prompt the kind of rotation that started and petered out in May and early June, supporting traditional cyclicals, steeper curves and banks, and challenging tech leadership.
Note the reference to the late May/early June stillborn rotation. I’ve visualized that in any number of ways over the past two months. You can see it clearly in the following simple figure, for example.
Will this time be any different assuming we do, in fact, start to see a steeper curve and a passing of the leadership baton as vaccine optimism builds?
Expect to see the adjectives “nascent” and “burgeoning” tossed about if/when cyclical value does start to outperform later this year. This is the rotation that never comes. This time may be different. But you’d be forgiven for being skeptical.
Another crucial question is this: Do we really want this rotation? After all, deeply negative real rates have been a pillar of support for equities, and while higher breakevens on renewed faith in a reflationary outcome would mechanically push them lower, that dynamic is not as straightforward further out the curve. Additionally, everyone says the rally needs better breadth — that participation needs to expand beyond the five heavyweights which together comprise 22% of the S&P’s market cap. But it’s by no means clear whether the laggards are truly ready to take the baton or, if they are, whether they’re in good enough shape to run with it.