A Trio Of Summer Risks (And Banker Vacation Backlogs)

For most, if not all, of the 12 months since the initial US lockdown, Morgan Stanley’s analysts have steadfastly adhered to some version of the “V-shaped” recovery story.

That goes for both the economy and asset prices. As implausible as it may have sounded early on, it’s turned out to be mostly correct. Obviously, the US labor market is still miles from pre-pandemic levels of employment, and the virus itself is still exacting an enormous daily toll on humanity, with India now on the frontlines of the crisis.

But from a narrow, US-based perspective, the world’s largest economy is poised to boom just a year on from the largest downturn since the Depression and US equities just staged their most spectacular YoY rally in a century (familiar figure below).

In the latest edition of the bank’s “Sunday Start” series, Morgan’s Andrew Sheets began by reminding market participants that “our global economics team has consistently argued that this will be a strong, ‘V-shaped’ recovery, a view that underpinned our strategy preference for early-cycle winners.”

Then, he expressed caution around what he described as a trio of “fundamental challenges.”

These are familiar. The first is essentially the “peak growth” argument. “Better growth is now more widely expected [while] the rate of change for that growth will soon peak, given we’re passing the one-year anniversary of the largest global economic drawdown on record,” Sheets wrote, before suggesting that “inflation [may] switch from being a far-off concept to something appearing regularly in the monthly data.”

If that latter contention (which serves as the second of the three fundamental challenges) is correct, it means it might be time to consider rotating away from early-cycle winners in favor of a quality bent in portfolios.

That’s a theme echoed by at least a few other analysts. Markets pull forward future outcomes, so it’s at least possible that the bulk of the move in the most cyclically-sensitive trades is behind us. To be sure, not everyone agrees with that view. But Goldman now thinks shifting from industrial cyclicals to value is prudent, with the former having already priced in a robust recovery. If economic momentum fades, bond yields fail to rise further and/or the steepener stumbles, Goldman said quality defensives may be on the menu.

The third challenge for Morgan’s Sheets is the virus, but not that any mutation from India might evade the vaccines. Rather, he wondered whether the Fed might run out of plausible deniability sooner rather than later when it comes to persisting in extreme accommodation. He didn’t put it in those terms, but that was the gist of it.

Specifically, Morgan thinks herd immunity in the US is achievable by summer, and while Sheets called that “a public health milestone to be celebrated,” he cautioned that “the implications for markets could be more complicated.” For example, he asked if the Fed can “sustain accommodation if the US hits herd immunity and realized inflation is above 2.0% this summer?”

The answer is “yes.” The Fed can do whatever it wants. But Sheets called it “a trickier message for the Fed to manage.”

Beyond those three “fundamental challenges,” he also flagged what he called “softer, market psychology risks that may be relevant.” One of those risks: Too much accumulated banker vacation time.

There’s an “unprecedented build-up of unused time off and desire to take advantage of it,” he said, before suggesting that “one of the bigger risk-management challenges this summer might be keeping desks properly staffed.”

You may chuckle, but remember: A dearth of liquidity and a lack of market depth can be challenging, especially in August. It’s funny until it’s not. That’s not to say there’s a direct link between humans not being at desks and liquidity disappearing, but the absence of carbon-based lifeforms can be problematic in the event something goes awry and the machines step to the sidelines.

Finally, if you’re inclined to mourn the plight of Wall Street’s analysts and traders, some of whom haven’t been able to vacation as scheduled, don’t. Or maybe save your tears for junior bankers. As Sheets readily admitted, “our industry is well compensated and has been able to work remotely more easily than many others.”