By now, I doubt anyone needs to be reminded about “what could go wrong,” so to speak, in 2021.
The answer, in a nutshell, is “quite a bit.”
Every year, in November and continuing into December, Wall Street floods clients with year-ahead outlook pieces for every asset class. Usually, there are follow-up notes detailing client “pushback” and/or “risks” to baseline forecasts.
While crystal-ball gazing is always an exercise in futility, the current circumstances make that old adage about it being “tough to make predictions, especially about the future,” seem like an understatement. The “projections” shown below are subject to so much uncertainty that they’re scarcely worth making. Indeed, some have already penciled in a double-dip downturn for the US in the coming quarters as the impact of recent virus lockdown measures begins to manifest in lackluster retail sales and lost labor market momentum.
For what it’s worth, Goldman sees three main downside risks to their S&P outlook, which the bank describes as “optimistic.”
As detailed here on Saturday, the first is just the complexities of the vaccine rollout, both on the supply side and the demand side. Goldman’s outlook for the economy is upbeat versus consensus and that obviously plays into their 4,300 target for the S&P by year-end 2021.
The second downside risk identified by David Kostin is that “fiscal and monetary policy drive a sharper-than-expected rise in inflation and interest rates.”
This is always a bit of a paradox. The Fed’s extraordinarily loose monetary policy is aimed specifically at accommodating fiscal largesse. Officials have made that about as explicit as possible short of cutting out primary dealers and announcing overt debt monetization in a press release. But the very asset purchases and low rates that are aimed at facilitating loose financial conditions and binge-borrowing by the government are only successful to the extent they foster reflationary outcomes in the economy.
Of course, reflationary outcomes generally entail rising breakevens and the revival of pro-cyclical trades that thrive when inflation expectations rise. The trick is to lift breakevens while keeping real rates low, something Jerome Powell has done a good job of since April (figure below).
While the balancing act has gone well, nothing says it can’t go awry. And it’s not just the composition of yields that matters, it’s also the rapidity of any rate rise.
“Some investors have expressed concern that rebounding economic activity, additional fiscal stimulus, and sustained Fed asset purchases could lead to a spike in inflation and a rise in Treasury yields during 2021,” Goldman’s Kostin said. “Although Treasury yields remain low in historical terms, the speed of any increase matters.”
This is well-worn territory, but it’s important. Remember that rapid rate rise contributed both to the February 2018 correction (yields rose prior to the implosion of the VIX ETP complex) and the October 2018 swoon in equities, which kicked off an abysmal quarter that dead-ended in the worst December for US stocks since the Depression.
“Equities have historically been able to digest gradually rising long-term interest rates, particularly when driven by improving growth expectations,” Kostin reminded folks. “However, equity returns have historically declined when rates rise by more than 2 standard deviations in a month.”
That’s your rule of thumb, and it would imply a 37bps rise in yields over four weeks today. So, if 10-year US yields rose to, say, 1.25% by this time next month, stocks could have a problem digesting the move, no matter what the composition looks like.
Lastly (and this could be related, depending on the outcome), Kostin again underscored the importance of the Georgia runoffs for markets.
“Prediction markets currently put the odds of Democratic control of the Senate at 31% [but] the options market currently reflects a clear jump in volatility around the January 5th election,” he wrote, on the way to striking a constructive tone. “We ultimately see upside in equities beyond January, regardless of the election outcome, given our economic forecast and the tradeoff between fiscal and tax considerations,” Kostin said.
I am, of course, in the camp that believes better growth outcomes, demand-side stimulus, and the introduction of policies that promote equality of opportunity, are the only path to sustainable, long-term growth and prosperity. However, my investment horizon is not 250 years (unfortunately). So, I can’t pretend to be completely oblivious to the prospect of a selloff in the near- to medium-term in the event the market isn’t willing or able to reconcile current multiples with higher corporate taxes and higher bond yields, both of which could accompany even the slimmest of Democratic majorities.
What I would say, though, is that I viewed a number of Republican ads for the Georgia runoffs over the weekend in an effort to get a fresh read on just how far the GOP is willing to push the envelope to maintain control of the Senate. The ads are considerably more aggressive now than they were just two weeks back, and that’s really saying something. Frankly, some of the ads seem libelous from my perspective, and sadly, I imagine that kind of willingness to abandon even the pretense of decorum may ultimately swing the vote for David Perdue and Kelly Loeffler, the latter of whom didn’t just take the gloves off, she put on brass knuckles.
For markets, I suppose the “best” outcome (where “best” just means friendly for stocks over a six- to 12-month horizon) is still split government. That said, I have serious reservations about how much longer the country’s socioeconomic fabric can remain intact without transformational change and a ban on the kind of misinformation that’s part and parcel of what counts as political “strategy” in our post-truth world.
I totally agree about the importance of the second derivative.
I was talking to my sister’s husband this weekend. Unfortunately, he is representative of a tranche of white, middle class voters who are mis-informed and mal-educated. Point is, members of the Red Senate, and Red House, are not going to be challenged by a materially important percentage of their respective electorates. We are in a rotten state. Quite literally, we cannot rely on an informed electorate to push back on seditious and ill-conceived strategies to undermine America’s democracy. …all the while, is there anyone who cares about the hungry and homeless.
That we even have to discuss this is a, I don’t know…Google ran out of synonyms by July.
Agree with the 250-year horizon, i.e., we might align with “existential altruism” philosophically, but will only be alive for a three or four dozen more years (the gods willing).
The tears in our socioeconomic are already showing. Rather, I’d submit that the fabric is frayed. At this point, or very soon, say, maybe end of March, maybe summer, maybe 2022, 2023, the only thing missing now that will emerge is a charismatic figure who can unite the downtrodden across race and geography.
Let’s get back to what really matters. I was just reviewing on Bloomberg that $11B of financial firm funds could be available to repurchase stock. Game on in Q1 for XLF.
We don’t have a ton of data points but my reading of History suggests a mass rejection of our model would likely end up being a move to(ward?) fascism. A move towards more justice and altruism seems the least likely outcome.
“Equities have historically been able to digest gradually rising long-term interest rates, particularly when driven by improving growth expectations,” Kostin reminded folks. “However, equity returns have historically declined when rates rise by more than 2 standard deviations in a month.”
I’m not sure a two standard deviation rate rise applies with the current extremely low rates. A 37bp rise does not seem like much to me….
The 10-year is at 92bps. 37bps is more than a third of that. In other words: You could argue it matters more when rates are this low. That’s the whole “fragility event” debate. In the grand scheme of history, 100bps (i.e., one percentage point) would seem like a tiny move. But in this case, it would represent a doubling. If the US 10Y went from 90 to 180 next month, my guess is you’d see a dramatic repricing in stocks
I really appreciate your incisive analysis, Heisenberg, including the acknowledgement that a system predicated on systemic inequities and priviledge will, by default, eventually recoil upon itself.