One of the many explanations rolled out when explaining the monumental ~54% surge in US stocks from the March panic lows is that rock-bottom yields (and especially deeply negative real rates) help justify equities trading at extreme multiples.
Higher real yields aren’t just kryptonite for gold. They can also play spoiler to stocks, something market participants re-learned in 2018 (figure below).
There’s a sense in which the conditions fostered by the Fed in the wake of the pandemic represent the perfect mix for risk assets: Nominal yields are generally steady at historically low levels, real yields are in sub-zero territory, and breakevens have drifted higher, reaching pre-COVID levels this week.
The trick is to keep this delicate balance intact. The worst-case scenario would be a growth scare that leads to a plunge in breakevens, mechanically pushing up real yields and bolstering the dollar — i.e., a repeat of March. There is no chance of a 2018 repeat where a tightening impulse from the Fed pushes up real rates to the detriment of risk assets.
Another possibility is that nominal yields rise too far, too fast as inflation expectations surge amid rampant worries of currency debasement tied to trillions in stimulus and the longer-run inflationary impact of the pandemic (remember, there are several ways in which COVID-19 could be inflationary down the road, including on-shoring, protectionism, disrupted supply chains, and more “extreme” forms of debt monetization).
SocGen’s Albert Edwards touches on this in his latest missive, out Thursday.
“The S&P has now rallied an extraordinary 55% from the March low to flirt with all-time highs”, he writes, noting that “throughout this period, bond yields have remained near all-time lows [and] many equity strategists see this as one key explanation for the continued appetite for â€˜growthâ€™ and IT sectors, as well as equities overall”.
That’s a recap of the narrative regular readers are all too familiar with by now. The “duration infatuation” in rates and bull-flattening in the curve adds to the bullish case for secular growth shares (like mega-cap tech). The pandemic has simply turbocharged the dynamic.
“On this view anything that triggers a surge in US bond yields also threatens the bullish equity conjuncture”, Edwards goes on to say, before referencing the 2018 experience mentioned above, during which nominal US 10-year yields rose above 3%.
In this context, the July CPI numbers were interesting. As a reminder, core rose the most MoM since 1991.
“As someone who had forecast an intensification of deflationary pressure in the near term, I was most surprised by the 0.6% surge in July’s core CPI”, Edwards goes on to say. He notes that the rebound in items most affected by the pandemic “was not so surprising”, but says he “would have expected clear evidence of sharply falling rents in major cities to have been reflected in the rent component of the CPI”.
This is familiar territory for followers of Edwards’s work, but the overarching message may be on the verge of becoming highly germane.
“In recent months inflation in the CPI shelter has slowed, but it is still recording monthly rises [which] seems very odd as we know rents in major cities are slumping”, Albert remarks.
He cites recent media reports documenting the decline of urban living amid lingering virus containment protocols.
“Landlord revenue from rent collection in urban centers fell 1.4% in June compared with a year earlier”, Bloomberg’s Prashant Gopal wrote late last month, citing data from RealPage and noting that when juxtaposed against a 2.2% rise in the suburbs, the gap is “the widest its ever been in data going back to the mid-2000s”. Gopal adds the following color,
Many urbanites are becoming suburbanites, at least temporarily, moving to larger homes outside the city as long as they can work remotely. At the same time, foreigners who normally keep Manhattan, Miami and San Francisco rental brokers busy have gone silent. The shift comes as much of the appeal of living in dense cities is temporarily on ice, with nightlife shuttered and new anxiety about crowded spaces.
Recent data from Apartment List shows rents dropping quickly in cities “where the local economy is heavily dependent on the tourism and service sectors” and in markets that were expensive prior to the pandemic.
“Today, with a significant share of households now facing financial hardship, landlords have begun to lower rents in order to attract qualified renters to fill their vacancies”, the site said, in a July 28 report.
“For the first time in nearly 10 years, the nationâ€™s effective asking rental rates are dropping”, RealPage’s Kim O’Brien wrote, on July 23.
“On average, the price operators ask new renters to pay came down 1.0% in the second quarter of 2020, leaving rents 0.2% below the year-ago level”, she added, noting that this represents “quite a change from the strong rent growth seen from 2017 to early 2020 when asking rent growth increased at an average annual rate of 2.9%”.
For SocGen’s Edwards, it’s hard to square this circle.
“Why isn’t the very recent slump in US city rents… being properly reflected in the CPI data”, he wonders.
Apparently, the BLS had some answers for Albert, including that i) only a fraction of the rental sample is surveyed each month, ii) the pandemic has made it harder to reach both renters and their landlords, and iii) tenants who can’t afford rent are too ashamed to participate in any surveys.
The read-through, Edwards suggests, is that “core CPI inflation will likely slump in the months ahead as the BLS rent data eventually catches up with reality on the ground”.
I’ll leave it to readers to discern what such a deflationary dynamic would mean for equities (if CPI falls off the map, the Fed would presumably have more plausible deniability to persist in accommodation).