The ‘Just Can’t Win’ Dynamic

I was tempted to say something generic about not wanting to “beat a dead horse,” but I stopped myself.

Usually, when someone starts a discussion with “I don’t want to beat a dead horse,” that’s precisely what they want to do. Almost by definition, that lead-in means the narrator is hell-bent on posthumous equine abuse.

There are countless examples of such conversation starters. “With all due respect” is the classic case of a speaker preemptively absolving himself. If you hear “With all due respect,” whatever comes next is almost guaranteed to be derisive.

So, yes, I did in fact set out to beat the proverbial dead horse, but I’ll make it a swift beating.

One point I’ve emphasized again and again over the past — I don’t know — two or three years, is that the biggest risk from extreme index concentration (figure below) might not necessarily be the concentration itself, but rather the extent to which the secular growth trade (of which mega-tech is representative), is tethered so closely to rates and the curve.

Arguably, one reason US equities held up so well at the benchmark level during the growth scare that unfolded post-June FOMC and in conjunction with the spread of the Delta variant, was the link between falling bond yields, a flatter curve and some equity market heavyweights. Regular readers are familiar with (and quite possibly tired of) this discussion.

It’s always relevant, but it could become even more so over the next few months. As Morgan Stanley wrote Tuesday in the course of cutting US equities to Underweight, “if global growth remains resilient, the US infrastructure bill passes and COVID-19 cases see a near-term peak, US yields need to adjust higher.” That, the bank’s Andrew Sheets noted, “is especially challenging for more expensive ‘growth’ parts of the market, which are trading with a positive correlation to bond prices.”

On the bright side, this means that if growth does decelerate and bond yields remain subdued (or start falling again), tech shares and the names which carry the burden of supporting the rally in cap-weighted indices, will benefit.

The problem with that thesis is twofold. First, bond yields can’t fall much further. Although we’ve been hearing that refrain for years only to see yields keep falling anyway, it’s entirely fair to suggest that the lower yields go, the less scope there is for them to fall further unless you want to posit there’s actually no limit whatsoever to how far they can drop.

BofA’s Michael Hartnett helpfully reminds you that “only twice (in 2013 and 2018) in the past 15 years have bond yield forecasts ended a year higher than where they started.”

Consensus, he noted, “has cut forecasts on average 109bps every year since 2006.”

So, yes, there’s certainly room for yields to fall again, leaving some scope for bonds to cushion any equity selloff. But, as ever, you have to ask what circumstances would prompt another sharp decline in yields. In all likelihood, the answer right now would be a severe winter COVID wave coupled with ongoing evidence of a slowdown in China and a marked deceleration in US growth.

That gets us to the second problem with the thesis that says decelerating growth and subdued yields are a benign development to the extent a growth scare bolsters index heavyweights on US benchmarks. Obviously, reopening names and various reflation expressions would suffer in such a scenario, but it seems likely that most risk assets (equities of any kind) would come under pressure, as the prospect of another downturn outweighed any pseudo-mechanical boost secular growth shares might get from lower yields and a flatter curve.

And this is to say nothing of policy. It seems somewhat dubious to speak of a “waning” fiscal impulse when Democrats are set to reimagine and redefine the state’s socioeconomic role to a degree not seen since The New Deal, but what’s waning are explicit, “right now” measures, such as enhanced unemployment benefits. That, just as the Fed debates the taper.

Never forget that taper risks are two-sided. There’s a tendency to naively assume that the paring of monthly bond-buying must automatically engender higher yields. But if the tightening impulse weighs on the economy, the opposite could occur. Similarly, delaying the taper could eventually prompt bonds to sell off, especially in an environment where inflationary kindling is strewn about the dance floor and everyone is doing a drunken two-step while juggling torches.

When you consider all of the above, note that we can’t just ask what rising/falling yields will mean for the secular growth names that so often play Atlas to the broader market. We also need to ask whether any rates volatility would spill over into the equity space.

“While the uncertainty brought by COVID-19 is likely to fade eventually, there are rising growth concerns as the fiscal impulse decreases and central banks start tapering discussions,” Goldman’s Christian Mueller-Glissmann said Tuesday. “While during the ‘taper tantrum’ equity volatility was relatively low and our rates team expect a much more muted response also in bond markets this time, the larger weight of long-duration secular growth stocks increases the risk of a spill-over of rates volatility into equities,” he added.

In the course of cutting US equities to Underweight Tuesday, Morgan’s Sheets repeatedly emphasized that while the bank is generally constructive from a kind of 30,000-foot view, “the next two months carry an outsized risk to growth, policy and the legislative agenda.”

Again, the risks are two-sided. And while I’ve been keen to elaborate on what I’ve called the “can’t lose” dynamic, there may be a “just can’t win” trade percolating too.