The One Thing Stocks Can’t ‘Live With’

“No matter what, we’ve seen the market predominantly go up, not down,” one PM and equity analyst told Bloomberg Friday, as stocks rose despite (or, in some sense, because of), the lackluster April jobs report. She called it “amazing.”

I suppose that depends on one’s definition of “amazing.” Really, it’s just another manifestation of a dynamic we’ve seen countless times previous, but with a twist.

It harkens back to the “Goldilocks” regime, defined by decent (but not great) growth and subdued inflation. The investment thesis (for risk assets and especially equities) was straightforward: As long as growth was good enough to keep the odds of recession negligible and inflation tepid enough to ensure central banks weren’t inclined to aggressively tighten policy, carry on (and “carry” could be taken both figuratively and literally).

In 2021, the bullish case can tolerate much hotter economic outcomes because, having just come out of the worst downturn in a century, a swift recovery is welcome and the market knows policymakers are still far too shell-shocked to chance any meaningful policy tightening (BOC and BOE nods to tapering notwithstanding).

In many ways, last week was almost too convenient when viewed through this lens. Tech shuddered Tuesday when pre-recorded remarks found Janet Yellen suggesting that rates may have to rise to prevent the economy from overheating. Then, as if on cue, Friday’s jobs report suggested the economy may not be on the brink of overheating after all and tech dutifully bounced back.

When it was all said and done, the S&P was higher for the week.

This can be quite the dizzying dance from a thematic perspective within equities. But it creates an environment that’s conducive to headlines like this one (from the linked Bloomberg piece): “Reflation, Inflation, Deflation — Stocks Can Live With Everything.”

But that’s not entirely true. Stocks can’t live with “everything.” They probably can’t live with Fed hikes or sharply higher real rates, for example. Recall the familiar figure below.

10-year real yields are back to -0.89%, after climbing all the way to -0.62% during Q1’s mini-rates tantrum. The key takeaway from the disappointing jobs report was that it took some pressure off the Fed. For at least another month, any hot data prints will be contextualized by reference to the huge jobs miss. Any urgency to begin the tapering discussion is commensurately reduced.

It’s a balancing act, to be sure. Until very recently, rising breakevens and rebounding commodity prices were a referendum on the Fed’s success at reflating and averting the kind of deflationary spiral that could have accompanied the public health crisis. But you want to engineer reflation without accidentally triggering a full-on inflationary cycle. This job is complicated by pandemic-related supply chain disruptions.

“We have seen real rates and breakevens go in opposite directions before, as in the first days of the 2008 crisis, but never like this,” Deutsche Bank’s Aleksandar Kocic said, in his latest, on the way to noting that,

In 2008, we had a deflationary shock: The collapse of breakevens was so fast and excessive that lowering nominal rates proved to be too slow and inadequate for real rates to adjust, resulting in their temporary rise. Although both episodes are characterized by negative correlations, compared to GFC, the current reaction is, in fact, an anti-2008 mode: Real rates rally in an environment of rising inflation expectations. This mode, we believe, represents a structural shift to the regime with a new Fed reaction function and novel interaction of rates with the policy mix.

The policy mix in the pandemic era (i.e., from March 2020 onwards) is defined by overt fiscal-monetary coordination on a grand scale and in full view of the public (assuming the public cares to notice). This coordination is required due to the unique nature of the crisis and the societal backdrop against which it transpired.

“The underlying dichotomy of the current configuration resides in the fact that this very requirement amplifies the risks of potential side effects of such a policy mix,” Kocic went on to say, adding that “a premature monetary tightening could offset the benefits of fiscal injection and threaten the recovery, while, at the same time, manifest inflationary nature of fiscal stimulus with an overly dovish Fed increases the risk of inflation getting out of control.”

The recent cacophony from pundits succeeded in convincing market participants that the moment of reckoning on the inflation front was close at hand. If they were wrong, it didn’t matter because base effects would make them appear right at least on some days. April’s jobs report took some of the edge off the alarmist commentary.

“We could be only a couple of strong payroll/inflation prints away from [the] moment when decisions about possible revisions of monetary policy will be made, but in their absence, rates could remain in a range or even drift lower,” Kocic remarked, in the same note cited above, on the way to underscoring my contention that stocks can’t actually “live with everything.”

“In the absence of a rates rise… equities could continue to push higher, but would sharply reverse their course if rates break out of the range,” he added. “This mode of contained rates selloff and equity rally has been exploited for some time and the correlations market has almost entirely priced it in.”