Delta And The Outlook For ‘Cyclical Risk Relaxation’

One thing, at least, is clear. Market participants have downgraded their view on growth.

That’s evident across both bonds and stocks. Long-end yields are still down some 40bps from YTD peaks in the US, and that’s after the recent move higher. Real yields plumbed new depths as recently as a week ago, and equities expressions tethered to the reflation narrative gave back most (and in some cases all) of their 2021 outperformance.

By now, everyone is familiar with the various explanations on offer. “Peak growth” is popular and likely has some explanatory power. If it’s the rate of change that matters, economic activity has likely crested, as has profit growth. I’m still of the mind that the bond rally (which put 2% on 10s out of reach in the near-term and indeed brought 1% back into the picture) was explainable mostly by way of positioning. But eventually, Delta variant jitters did play a role. Those jitters became the locus of concern in the back-half of July.

“Our view is that the main risk factor driving asset classes over the past few months (and certainly in July) was fear of the Delta variant,” JPMorgan’s Marko Kolanovic said Thursday. “Narratives of peak growth, China slowdown, hawkish Fed, etc., [didn’t] help, but [failed to] resonate with the majority of investors,” he added.

Similarly, Goldman wrote that “the broadest concern about the economic outlook in recent weeks has come from the renewed focus on the Delta variant, and the risks of renewed restrictions or of slower economic re-opening from that source.”

For lack of a better way to put it, summarizing Goldman’s analysis (which involves extracting factor-implied shifts in one-year-ahead growth views since June 1 and then refining them) is impossible. Rather than try, I’ll simply quote the bank’s Dominic Wilson and Vickie Chang, who explain the figure (below) as follows:

One interpretation of the pattern of growth downgrades that we have seen is that the market increased its weight on the possibility of a downside scenario from the virus plus further worry about Chinese growth. This would be consistent with the two clearest market narratives about recent growth weakness. Exhibit 6 shows that the growth downgrades implied by the shifts we have seen in our growth factor match a market that has increased its weight on our Delta downside scenario by around 25pp since early June, alongside some additional downgrade to the China growth outlook.

Note that parsing the situation in China is complicated immeasurably by the difficulty of separating the hit to sentiment from Beijing’s regulatory blitz from pessimism tied to the recent COVID surge.

Wilson and Chang explained that on their interpretation, “the market is applying a roughly 1-in-4 chance” to the bank’s Delta downside scenario. If, however, the Delta story improves, thereby bolstering their baseline view instead (the baseline view calls for only a “modest” economic impact from the variant outside of Asia and across developed economies where vaccination rates are high), the bank sees “room for the market to remove the cyclical discounts that it has applied.”

That’s a (very) roundabout way of saying that the market may have overshot when it comes to pricing in various dour narratives, whether centered around the variant, China concerns, a Fed policy mistake or “peak” growth.

The bank considered four scenarios for what Wilson and Chang described as “cyclical risk relaxation.” They are: DM recovery, US labor market strength, broad Delta relief and US inflation fear. Although they went into detail, I assume I don’t need to explain what each of those scenarios entails. The titles speak for themselves.

Summarizing, Wilson and Chang wrote that “the overall pattern across the first three scenarios is for equities and yields to rise [with] European —and to a lesser degree— US equities offer[ing] the best risk-reward for the DM recovery scenario; US equities and rates the best risk-reward for the US labor market strength scenario; and European equities and parts of X-JPY the best exposure to broad delta relief.” In the inflation fear scenario, stocks drop, front-end rates rise, the dollar appreciates and… well, you can write the rest of that script.

Goldman (God bless them) created a table which shows how various benchmarks, sectors, commodities, rates expressions and FX crosses would fare under the four scenarios. The table is so large that it engulfs the entirety of my 27-inch monitor. I won’t include it. I’m sure it took a lot of effort, but the closing paragraph from Wilson and Chang underscores the futility of forecasting in the pandemic era.

“Both the timing of these shifts and the sequencing is unclear, given the uncertainties over the exact path of Delta infection rates and the data lull until the turn of the month,” they wrote, on the way to (again) suggesting that it may make sense to start adding some exposure to cyclicals. As long as you’re comfortable with “the balancing act between some relief on the growth front on the one hand and worries about inflation risk, Fed tightening and a possible move higher in real yields on the other.”

Now, what did you learn? (That’s a trick question. Don’t answer it.)