It’s always interesting to observe the difference in cadence between the rates crowd and the equities crowd when it comes to the pro-cyclical rotation narrative.
Yes, 10-year yields did manage to claw their way through 1% this month and breakevens hit highs last seen in 2018. But generally speaking, bonds are more reluctant than stocks to price a sustainable shift.
The rates crowd will tell you that, as usual, bonds are “right.” In this case, that generally means that while breakevens may have overshot to reflect reflation optimism, the lack of a truly aggressive selloff and the absence of anything that could even remotely be described as a “tantrum” are a testament not just to the “here and now” reality of the pandemic (which continues to weigh on economic activity) but to the prospect of the dreaded “scarring” effect serving as yet another structural deflationary force down the road.
Equities folks, on the other hand, will suggest stocks got it “right.” That the rally in small-caps and cyclicals was the correct view considering vaccine rollout and the realization of the “blue sweep” following the Georgia runoffs (and everything that’s supposed to mean for stimulus).
The visual (above, from Morgan Stanley) is indicative of the “argument,” although I’d note that it’s somewhat misleading. If you replace nominals with breakevens, you get more “agreement.”
Weighing in, Morgan Stanley’s Mike Wilson reckoned “the reflation rotation may be ready for a much-needed, and deserved, vacation.”
This is a familiar story for regular readers. For a decade (at least), the “slow-flation” macro environment lifted equities expressions tethered to the vaunted “duration infatuation” in rates, leading to epic disconnects between cyclical value on the one hand and, for example, min vol and secular growth favorites on the other.
A pivot away from that to an environment characterized by leadership from cyclical laggards has proven elusive — each rotation a false start, doomed to be described as “nascent” or “burgeoning,” never “sustainable.”
Read more:
To be sure, Wilson isn’t giving up on cyclicals and small-caps, which he said have “correctly traded ahead of the data.” Leadership there is “now well established and quite definitive in its messaging,” he remarked, in the same note, before writing that rates “remain in ‘disbelief’,” a state of affairs he attributed to either the notion that “the economic surge / inflation pressure will be nothing more than a temporary blip and/or the Fed will stay true to its guidance even if growth / inflation end up surprising to the upside.”
The rates crowd would be inclined to say that it isn’t a matter of “disbelief” as much as it is a matter of recognizing the reality of a double-dip downturn in Europe, mass joblessness in the US, the prospect of more bankruptcies, worries about slow vaccine rollout, jitters around inoculation-resistant strains, and lawmakers’ reluctance to countenance Progressive policy proposals with the potential to bring about a sustainable upturn in growth (among other things). On Monday, for example, bonds rallied the most in months on news that Joe Biden’s stimulus plan may not pass until mid-March.
Wilson flagged a divergence between small-caps and small business sentiment, which fell in the wake of Biden’s election. That divergence (which he showed on a YoY basis), “needs to be resolved quickly by improving small business optimism if we are to avoid a material correction,” he added.
The overall message, from Wilson, is that “some consolidation / correction” in cyclicals versus defensives and small versus large “makes sense technically, and even fundamentally.” The figure (below) shows how extended the trade is.
But “consolidation” and even a “correction” doesn’t mean all is lost for the pro-cyclical rotation, nor does a pullback in recent leadership presage a catastrophe for the market as a whole, Wilson said.
“Probabilities suggest [cyclical/defensive and small/large cap ratios] are due for pullbacks that would be perfectly normal in the context of a new bull market that needs to rest,” he remarked, before noting that, in fact, “the overall market also appears due for a rest.”
A Gatorade break (as it were) for the broader market “would also be normal at this stage of the recovery and very much fits our recession playbook,” Morgan added.
A break would be fine, really.
I do wonder about how much a reduction in liquidity would hit the reflation trades, given what a small part of total market cap those represent. When the whole R2K has only about as much market cap as AAPL, it seems like money flow from the latter to the former could easily offset a reduction in overall money flow to stocks.
Slightly related, I was noodling over the implications of looking at EV multiples rather than the media-friendly PE multiple.
Suppose a cyclical stock has 2020 EV $4BN = 2020 equity $1BN + 2020 net debt $3BN. Suppose 2019 EBITDA/share was $2.00, 2020 was -$3.00, 2021 will be $1.00, 2022 $2.00, and 2023 $2.30. Suppose 2020 EV/forward 2021 EBITDA is elevated at 15X, and over the next year valuation declines so that 2021 EV/forward 2022 EBITDA is a more normal 10X. Then from 2020 to 2021, EV would rise by +33% (from 15X $1.00 X shares out to 10X $2.00 X shares out). Suppose 2021 net debt is still $3BN. Then 2021 EV would be $5.3BN ($4BN x 133%) and 2021 equity would be $2.3BN ($5.3BN – $3BN). That’s a +33% increase in EV but a +130% increase in equity value.
This is why when things are rolling over you hide in the names with the lowest debt, but when things are recovering you buy the names with the highest debt. High debt magnifies the moves in equity value. Assuming “high” doesn’t mean “unsurvivable”, and given junk bond yields and Yellen-Powell at the reins, that’s not a difficult assumption.