Nearly a month on from raising their price target on the S&P, JPMorgan and Marko Kolanovic are still constructive.
There are, of course, risks. But, they’re set against surging corporate profits, robust growth, the easiest monetary policy in history, a gargantuan fiscal tailwind and an acute dearth of alternatives to equities.
In a Thursday note, Kolanovic cited strong earnings, relatively moderate positioning, signs that the Delta variant is “receding” in the US, and a normalization of the bond-equity correlation, in reiterating a generally upbeat view.
He also maintained a bullish disposition for cyclicals and market segments tethered to the reflation macro theme. Indeed, he called a bottom for US yields. “We believe bond yields and cyclicals bottomed last week and are now on an upward trajectory for the rest of the year,” Kolanovic wrote.
Of course, if yields have bottomed, one risk going forward is that the bond market “wakes up” to the reality of Fed-enabled fiscal outlays and ballooning deficits.
On Wednesday afternoon, following an extremely strong 10-year sale, I offered a concise and simultaneously funny summary. “Here again we’re forced to ponder juxtapositions that would seem nothing short of surreal as late as 15 years ago,” I wrote, before asking, “Isn’t ‘reckless’ fiscal policy supposed to be met with a bond market revolt? Where are the storied ‘vigilantes’ of yore?”
Bottom line: On the eve of one of the largest fiscal expansions in US history, and at a time when the disparity between the economy (figure below) and monetary policy has never been more glaring, demand for US debt is stronger than ever, apparently.
Considering Marko’s call that bond yields have bottomed, and the wild juxtaposition between ultra-stimulative monetary/fiscal policy and an economy that’s already poised to overshoot (figure above), Kolanovic noted that the risk of “a potential sharp rise in yields… needs to be carefully considered.” That’s especially true given high inflation.
The good news is, correlations between various sectors and bonds have normalized. “Post earnings season [the] correlation eased, and now all equity sectors have the typical negative correlation to bond prices,” Kolanovic wrote.
One risk is that mega-tech’s correlation with bond yields and the curve (secular growth shares tend to outperform when bonds rally and the curve bull flattens, for example) leaves the “broader” market exposed precisely because the broader market isn’t very broad — the FAAMG cohort comprises an outsized share of the benchmark. So, in a scenario where yields rapidly rise, the names which play Atlas could be vulnerable.
Happily, hedging that risk is consistent with being Overweight cyclicals, which is the trade Kolanovic prefers. He recalled 2018’s VaR shocks, but concluded that the risk of a quick flip in the stock-bond correlation which leads to a broad-based systematic unwind is low. “Looking at the current level of positioning, volatility and other factors, we assess that such an event would require a ~3% selloff in both equities and 10-year bonds in one day,” he said.
While JPMorgan doesn’t think that’s likely, the bank said you can hedge it by reducing equity duration, where that means paring exposure to tech in favor of energy, financials and industrials. Kolanovic warned on ESG again, albeit in tangential fashion. “The bond beta of a tech versus energy ‘market neutral’ position in July was 8, which was equivalent to holding an 80-year bond,” he wrote, calling that kind of risk “frequently overlooked in, for example, ESG portfolios or Long-Short HF pods.”
So, ultimately, Marko thinks bond yields have bottomed, but doesn’t expect a disorderly rise in yields. And remember, it’s the rapidity of rate rise that matters, not so much the level of yields (up to a certain point, at least). What you don’t want is a rapid, disorderly rise in real rates, for example, especially to the extent it turbocharges the dollar. That’s the kind of event that can derail everything from equities to commodities to gold. Outside of that, a benign rise in yields led by breakevens and a move off the lows in reals consistent with a brightening outlook on the economy should be digested well by equities.
On positioning, Kolanovic said Thursday that although the bank’s estimates “have been rising,” they’re currently sitting around average levels historically speaking. Increased exposure from hedge funds and volatility targeting strats “has certainly helped equity markets this year,” he wrote, but noted that corrections typically occur when positioning measures are beyond the ~80th percentile, nowhere near current levels on JPMorgan’s metrics.
Marko also noted that “there were cases when exposure can stay at 100th percentile for a year without a significant correction.”
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